Space 2.0 - A Small Step For Tech Investors

Summary

  • Space 2.0 represents a large new market for technology companies and tech investors – and you don’t have to wait for the SpaceX IPO.
  • If you want to invest now, you can make money from real companies – you don’t have to make all-or-nothing venture capital style bets.
  • Live real-company opportunities right now include Aerojet-Rocketdyne (speculative positioning for a takeout) and Orbital-ATK (merger arbitrage opportunity).

DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.

Introduction

The new space race has begun, and this time its fruits will be enjoyed and its tragedies paid for by corporate enterprises and their investors. The post-WWII space race, beginning with Sputnik I in 1957 and ending with the 2011 final Space Shuttle Atlantis flight, was principally a government enterprise. The original goal was earthbound in nature; namely, success in the Cold War. American capitalism being the eventual victor, it is now the case that Space 2.0 is a commercial endeavor. Mineral rights and extraction, construction, tourism, communications – large swathes of the economy on Earth has ambition to expand into orbit and beyond.

As lifelong technology investors at Cestrian Capital we are naturally drawn to the space market as it represents the largest of all possible new technology markets. We believe space offers the technology investor as much potential as did the Internet in the early 1990s. But as was the case for the pre-Netscape Internet, we are extremely early in the Space 2.0 cycle and it is not yet possible to know the long-term winners. Typically when there is a paradigm shift in an industry, established players lose and new entrants win, even if this takes longer than most commentators predict. For instance, as the consumer Internet grew, telecom carriers lost value as the ISPs and then social networks gained value. In enterprise computing, each time the application delivery model changes (time-shared mainframe >> minicomputer >> client-server >> cloud), a generation of software companies dies and a new establishment arises. So we are fairly certain that we have not yet seen the companies who will come to define Space 2.0, at least not those whose securities can yet be traded. But we want to invest now, at the start of what we believe will be a 30+ year growth market, because we think substantial long term gains can be had.

Investing in Space Tech

Space 2.0 will drive innovation across the tech sector, from silicon to systems to software to services. Such benefit will be felt across the sector in a diffuse manner. However, if one wants to invest specifically in Space 2.0 now, in real companies generating real earnings with tradable securities, one needs to look at those sectors that are actually active right now, as opposed to being under development for the future. This means less focus on Mars tourism and more focus on relatively mundane matters such as the increasing profusion of earth-orbit satellite launches. This is a growing market. From the 1957 deployment of Sputnik I to 2013, there were approximately 6,600 satellites deployed – an average of around 120/yr. Forecasts for the next ten years suggest approx 900 satellites to be launched per year in the coming decade – the increase being a direct consequence of the reduced cost of satellite building and reduced launch costs.

With that in mind we observe there are two areas of real activity and spending growth in the space technology sector which are happening right now. The first is the design, construction and operation of small satellites (“cubesats”) and the second is falling launch costs.

We are presently investigating the satellite value chain with a view to investing. It has its challenges. If we have anything noteworthy to say on the topic we will try to publish something on SA.

Launch on the other hand is most interesting. Launch economics are being revolutionized by new entrants managed as commercial companies – most notably SpaceX and Blue Origin, each of which is run by proven technology CEOs (Musk/Paypal/Tesla and Bezos/Amazon respectively). Privately owned and funded, these companies have introduced technology-sector DNA to a previously government-monopolized sector. This DNA implant is important.

The story of the technology industry since its emergence in the 1960s is one of deflation – specifically it deflates other industries and diverts their earnings into its own. This is why tech has been such an wonderful place to invest for 50 years now – it is a cuckoo in the nest of all other industries. The famous quote by Marc Andreesen (“Software is eating the world”) has been true for a very long time and it has a long way to run yet. It is to our mind no coincidence that the two leading tech CEOs in Space 2.0 have been CEOs of companies which have so significantly disrupted existing industries. Amazon in particular has single-handedly collapsed retail industry margins, beginning with books and now reaching groceries. Amazon’s $450bn market cap represents $450bn-worth of value hoovered out of the industries it has touched. Paypal is now a $75bn market cap business – in touching distance of Mastercard ($147bn) and Visa ($235bn) – a result of disrupting the legacy high-cost banking and credit card industry.

This deflationary zeal is now taking hold of the space industry. As a simple example – a key metric in the industry is “cost per launch”. Prior to the entry of SpaceX, the monopoly provider ULA (a JV between Boeing and Lockheed Martin) billed the US Air Force c.$422m per launch for a satellite deployment – subsequently, comparable contracts were awarded to SpaceX at a charge of sub $100m per launch – in other words a 75% reduction in costs. This level of cost reduction is comparable to the impact of competition in the telecom sector when it was first liberalized in the 1980s. Much like telecom through the 1990s and 2000s, the cost-down impact of new entrants is now being felt by the incumbents. The US Government is steering launch business towards SpaceX and Blue Origin, meaning less opportunities for the old-line companies such as Boeing, Raytheon, Lockheed-Martin, etc, and price pressure on the contracts they do win. If the experience of telecom is anything to go by, one can expect a wave of restructuring and consolidation to go through the old guard. The first fruits of this are just beginning to show – see for instance the $30bn acquisition of Rockwell Collins by United Technologies, announced 4 September this year (United Technologies To Acquire Rockwell Collins For $30 Billion) and the $10bn acquisition of Orbital-ATK by NOrthrop-Grumman, which we discuss below and was announced 18 September this year.

The Defense Issue

If like us you want to make money from space tech, and if like us you aren’t much interested in all-or-nothing startup investing, you are going to have to go hunting in the defense sector, because the tradable securities in space tech are predominantly at present defense companies with a space business unit. This means you have to get comfortable with the fact that if you invest in tradable space sector securities, you are going to be investing in companies that make things like guidance systems for missiles, small arms ammunition, and other products and services delivering potentially unpalatable outcomes. Actually this is also true if you own (eg) Intel or Microsoft, because somewhere in the electronic chain of command that launches an ICBM is an Intel or a Microsoft product handling the instruction set. So it shouldn’t be such a moral leap – you probably already crossed the Rubicon, you just didn’t know it.

The next challenge is that many space business units are very small elements of large, diversified defense businesses. Space may be a high growth opportunity but generalised defense contractors grow at a rate which is pedestrian compared to the tech industry, so with certain exceptions are unlikely to provide the returns that we as tech investors have come to expect. Buying securities in Level 3, Raytheon, Northrop-Grumman, United Technologies or Boeing isn’t likely to appeal.

Space-Focused Public Stocks

In the launch sector that interests us at present, there are two mid-market US companies which offer a relatively concentrated exposure to the space market – meaning, space is a fairly high % of their revenues. They are Aerojet Rocketdyne (NYSE:AJRD) and Orbital-ATK (OA). Each has a legacy that can be traced back to the first space race and each has been through multiple ownership structures. They are both sub $10bn EV companies with fundamentals you can find plenty of detail on elswhere. Both companies produce rocket motors and other propulsion systems for multiple applications, including launch vehicles, satellites and missiles.

Orbital-ATK

  • In the 12 months to end Q2 2017, OA achieved revenue of $4.5bn, EBITDA of $607m (13% margin), unlevered pre-tax free cashflow of $193m. (The cash conversion – ie. UFCF/EBITDA ratio of 32% – is misleadingly low in this period, caused by a large swing in working capital – for the previous quarter the same ratio was 57%).
  • OA is relatively diversified with growth coming from multiple sources, has positive cashflows and a history of paying a dividend each quarter, and is exposed to both new launch opportunities and refurbishing legacy launch vehicles (including missiles). (Anyone who has read our note on Micro Focus International will know we believe in the value of legacy – see Micro Focus International - The Biggest Software Company You've Never Heard Of. Legacy in tech and in aerospace lasts a lot longer than most people expect it to which means one frequently can get into such companies at attractive prices and enjoy the long-lived cashflow that follows).
  • Space represents a very rough 50% of revenues - our estimate - spread across the Space Systems business ($1.2bn revenue producing satellites and satellite subsystems) and the Flight Systems business ($1.6bn revenue producing space propulsion, missile propulsion and some aerospace subsystems).
  • Following the Sep 18 announcement that it was to be acquired by NOC – see more on this below – the business is now priced at an EV of $9.75bn, representing 2.2x TTM revenue, 16.1x TTM EBITDA and 50.5x TTM unlevered free cashflow. Note that the EV includes pension liabilities of some $720m.

Aerojet Rocketdyne

  • In the 12 months to end Q2 2017, AJRD achieved revenue of $1.9bn, EBITDA of $146m (8% margin), and unlevered pre-tax free cashflow of $193m. Space represents significantly more than 50% of revenues, perhaps up to 70% - the remaining revenue is from missiles and real estate.
  • As at 28 September AJRD EV was $3.4bn including $586m of pension liabilities; the EV represents 1.8x TTM revenues, 23x TTM EBITDA and 22x TTM UFCF.
  • AJRD has relatively heavy customer concentration; Lockheed Martin was a 27% customer in FY12/16; ULA 21%, Raytheon 20% and NASA 13%. So fully 81% of revenues in 2016 came from these four customers. Looking through the prime contractor to the end-user, 91% of revenues in 2016 were from the US Government in its many forms.
  • AJRD’s age and legacy of multiple acquisitions of old-line companies can also be seen in its pension liabilities noted above. For the 12 months to end Q2 17, the company spent $30m on pension costs – about the same amount as it spent on capex! These liabilities will continue to rest on the company’s shoulders and represent a drag on the use of cash for operational investment. OA also has a pension burden - however AJRD has a further drag - it owns 11,000 acres of real estate in Sacramento, CA which appears to take up significant amounts of time (much of it is in cleanup and needs re-zoning before it can be developed or sold) but represents little value (c.$70m on the balance sheet at Q2). Perhaps a real estate investor could make money from this - we doubt the company will achieve much by itself and we think the land would be best disposed of to a specialist investor who can take on the cleanup and zoning project.

Comparable Analysis

Having studied the companies earlier this year we believed that OA represented a sound investment, whereas AJRD offered speculative potential. That is not to rate investment over speculation or vice versa, it is simply to put labels to the rationale one might have for acquiring securities in either of these two names. In doing so we lean on the masters, Graham & Dodd, who in their 1934 original version of Security Analysis observed that, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” (See Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions)). We liked the diversified source of revenues, particularly the refurbishment of old missile motors during a time when the US missile inventory is being upgraded and extended, and the discipline that regular dividend payouts bring.

We took a long position in OA earlier this year and have since been rewarded handsomely for that – its pending acquisition by Northrop-Grumman (NOC) was announced 15 September. NOC is proposing to pay $134.50/share; the stock has since traded up to around $133 as noted above in the valuation stats. Closing won’t happen for 8 months however and we believe there may be further upside in OA. Those skilled in merger arbitrage will be able to point you to how to make strong annualised IRRs from the current delta to the proposed acquisition price – see for instance Chris de Muth on SA at Chris DeMuth Jr.'s Blog Posts These methods are not our preserve – we are a long-only investor and we prefer simple securities such as equities and bonds – but we do think that OA remains worth watching. If one invests now, our best assessment is that either the NOC deal closes at the deal price of $134.50 (because we doubt that the deal will be stopped by antitrust issues – there is little product overlap between NOC and OA), or a competing bid comes in which ought to drive some further stock gains. So OA now represents a speculative opportunity. If the merger fails the price will fall materially – which we will see as time to load up on more stock – at only a 22% premium to the undisturbed share price we believe the value of the NOC deal will be recouped by OA within a year anyway.

Turning to AJRD. We believe this may now offer a successful speculative return, even after the run up in the stock price since NOC/OA was announced. The NOC/OA deal looks routine for a tech investor - $9bn acquisitions of one US public company by another, in response to an evolving market that the acquiror is struggling to serve, is bread and butter in tech. It is rare in the Defense sector however and as a result, all midcap and smallcap defense stocks are up in anticipation of further deals. AJRD itself is up from $28 on Sep 15 (the business day prior to the NOC/OA deal announcement) to $35 on Sep 28, a 25% rise (equivalent to the acquisition premium paid by NOC for OA). Boeing fuelled rumours when it announced Sep 19 that it intended to make acquisitions in the sector too – see https://www.cnbc.com/2017/09/20/boeing-says-its-a-buyer-after-northrop-grumman-acquisition-of-orbital-atk.html.

Is there still an opportunity in AJRD?

Although there has been a run-up in price since the NOC/OA deal was announced, the valuation as-is remains below the OA takeout multiples, as follows:

  • Revenue multiple: OA at takeout - 2.2x TTM; AJRD currently 1.8x TTM
  • Unlevered free cashflow multiple: OA at takeout - 50.5x; AJRD currently 22x

EBITDA multiple for AJRD now is a little higher than was OA at takeout - 23x TTM for AJRD vs 16x TTM for OA at takeout. But as SA readers know, EBITDA is a fragile measure of reality and subject to all manner of variances. At Cestrian Capital we prefer to look at revenues (a real thing) and unlevered free cashflow (a real thing) rather than EBITDA (an accounting or presentational thing). So on revenues we have an additional 0.4x TTM upside and on cashflows clearly much bigger upside. Even if AJRD were to be taken out at the same revenue multiple as OA, 0.4x TTM revenues means an additional $760m of value to shareholders (since the net debt component of EV is fixed - so all additional monies go to common shareholders) meaning approximately 29% upside from here or a share price at takeout of c.$45. We could persuade ourselves that the premium should be greater, since acquirors such as BA would be buying what is now essentially the monopoly merchant provider of space vehicle propulsion. That is a prize indeed - it would in essence cement AJRD's buyer in position alongside NOC which is to say in the vanguard of the Space 1.0 players holding back the new entrants of SpaceX and Blue Origin. Incumbency remains a powerful thing in defense contracting and such a merger would make SpaceX and Blue Origin's life significantly more difficult. This we believe is well worth 2.2x TTM revenues.

Conclusion

We believe that AJRD is a strong candidate to be acquired – and that even if no deal materialises, OA losing its independence is likely to mean a boost in orders for AJRD because the prime contractors other than NOC will likely turn to ARJD whenever possible, due to its remaining independence. Assuming NOC/OA closes, AJRD will be the only US domestic (meaning there are no obstacles to supplying the US Government) merchant provider (meaning not owned by a prime contractor such as Northrop-Grumman) of space propulsion systems. With the space segment already growing as a result of unmanned satellite deployment missions – and US manned space flight is expected to resume in 2019 – we see a bright future for AJRD and its stock. We are long AJRD and we expect to do well from it.

This article was written by

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Cestrian Capital Research, Inc

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Disclosure: I am/we are long OA, AJRD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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