Investment Strategy Statement - Cestrian Capital Research

by: Cestrian Capital Research
Summary

Cestrian Capital Research is an equity research firm focused on the space sector, which we believe to be in the early stages of secular growth.

Within the space market, we cover US equities on a long-only basis, looking for long-run investments and short-term trading opportunities.

We use top-down market mapping, fundamentals analysis, and stock price charts to reach our views.

We are an SEC-registered Investment Advisor.

About Cestrian Capital Research

Cestrian Capital Research is an SEC-registered Investment Advisor. Our owners have a combined 40 years’ experience of public and private capital markets. We are a pure equity research business focused on the space sector.

We are ramping up our Seeking Alpha output and are delighted to have the opportunity to lay out our investment strategy in this note, in more detail than is possible in our single-stock or sector notes.

For the avoidance of doubt, “investment strategy” here means the approach we take to our investment analysis. As a pure research firm, we manage no client assets, and the company conducts no proprietary trading or investing.

Investment Strategy

Cestrian’s analysis covers US public companies and, occasionally, international public companies. Our principal focus is the space sector which we believe is in the early stages of a long-run growth period.

Our intended readership is the US investment community, be they qualified individual investors or institutional investors. None of our output is directed at, nor intended to be relied upon, by a UK audience. Our investment analysis is equity-only, long-only. We don’t cover credit instruments or derivatives, and we don’t cover short strategies.

We think about investment opportunities in three categories:

  • Type 1 – Long-Term Hold – a company which we believe is on a long-term revenue and earnings growth trajectory, which has yet to be fully valued in the share price. We rely principally on fundamentals analysis in such opportunities.
  • Type 2 - Range-Bound Trading Opportunity – a company with a short-term volatile stock price where we believe short-term upside is on offer. We rely principally on chart analysis for such opportunities.
  • Type 3 - Unjustified Sell-Off – a company we have long-term faith in where the stock has in our opinion over-reacted to bad news. These opportunities rely on a combination of fundamental analysis and chart analysis.

Securities of Interest

Our focus is the space sector. We believe this sector to be in the early stages of a long-term secular bull market. We believe that it has echoes of the emerging technology sector in the 1960s-1970s and, as technology investors by background, believe a number of parallels apply.

Expanding Customer Base.

The customer base in the space sector is today dominated by state actors – such as national space agencies, weather agencies, intelligence agencies, etc. This is true in the US, Europe, and Asia. But as launch providers and spacecraft/satellite vendors ride the cost curve down, entry tickets are falling, and this is opening up space activities to larger enterprises, private universities, and even high net worth individuals. This bodes very well for significant revenue growth in the sector.

Typically, rapidly declining input costs lead to a rapid expansion of demand and consequent revenues in an industry. For instance, the impact of Moore’s Law on the semiconductor cost curve did something similar in the technology industry, as computers moved from being predominantly the province of government in the 1950s/1960s, into the enterprise with the mainframe through the 1970s, the SMB with the minicomputer in the 1970s/80s, and finally, the individual with the personal computer in the 1980s/1990s.

The cost curve decline in space technology is remarkable. Launch costs have fallen from c.$1bn/launch event in the Space Shuttle era (1981-2011) to c.$100m/event as SpaceX hit its stride in 2016/17, to sub $10m/event now that new entrants such as Rocket Lab are operational. In other words, the cost of sending an object to low-earth orbit has fallen by two orders of magnitude within 10 years. That is a rapid reduction, and we anticipate a proliferation of space applications and customers to spring up in the coming years as costs continue to fall.

Fragmentation-Consolidation-Fragmentation Cycle of Vendors. Commercial for-profit companies have always been the principal suppliers to the mainly government-led space activities of the 20th and early 21st centuries. For instance, the Apollo moon lander was built by Grumman Aircraft, now part of Northrop Grumman (NYSE:NOC), and the Space Shuttle orbiter was designed by Rockwell International, becoming a Boeing (NYSE:BA) product on the acquisition of Rockwell’s aerospace and defense assets by Boeing in 1996.

But until the mid-2000s, there were really only a handful of vendors in the space market, and for the most part, they were buried within large aerospace/defense corporations. This was a function of, inter alia, (a) the principal customers in the space sector were governments, with conservative public procurement rules that naturally favor a small number of large vendors (b) the high upfront capital costs of building space products – for instance, a traditional large satellite for weather or remote sensing might be sold for hundreds of millions of dollars – meaning the satellite builder would have to have a very well capitalized balance sheet to fund the build before the customer took delivery.

A number of factors, mostly cost-reduction related, have come together to deliver a proliferation of smaller vendors. For example, the advent of “smallsats” – meaning small form factor application-specific satellites – has meant that privately-owned vendors such as Planet and Spire are able to build, launch and operate their fleets with much more modestly capitalized balance sheets than, say, Boeing’s satellite division. And data processing costs have fallen such that remote sensing analytics services can be delivered using Amazon Web Services (NASDAQ:AMZN) – you don’t need a supercomputer any longer. (See A Minimalistic Way to Tackle Big Data Produced by Earth Observation Satellites | Amazon Web Services).

When industries become populated by large numbers of small vendors, consolidation usually follows, and this offers opportunity to investors. The technology industry has delivered enormous gains to investors who have been shareholders in up and coming vendors, and we think that the consolidation cycle will come to the space industry within 2-3 years. At the moment, most smaller pureplay space companies are privately-owned, usually VC-backed. Although some of these companies will be acquired directly by strategic buyers, many will IPO in the coming years. These IPOs will, like any IPO, present their own particular risks, but we would expect large-cap aerospace and defense conglomerates to keep acquiring space-focused vendors – the best known example recently was the 2017 $10bn acquisition of OrbitalATK by Northrop Grumman. (See our note).

The wonderful thing about long-run growth industries is that they abhor consolidation as much as the consolidators abhor new entrants. Long-run growth tends to produce multiple generation shifts in the underlying technology. In the tech industry itself, every major shift in technology platform has led to new entrants becoming large companies very quickly. Microsoft (NASDAQ:MSFT) was incorporated in 1981 and went public in 1986, already well on the way to becoming the leading vendor of the PC era – displacing IBM (NYSE:IBM). Microsoft then missed the internet boom, allowing the browser company Netscape to go from startup in 1994 to public company in 1995 to being acquired for $10bn in 1999 ($15bn in 2018 money). Enterprise software was in a consolidation phase from around the mid-1990s to the mid-2000s as IBM, Oracle (NYSE:ORCL), and Microsoft acquired a great many client-server software vendors; but the move to cloud computing wrong-footed these three behemoths and allowed new companies such as Salesforce.com (NYSE:CRM) to go from startup in 1999 to a public company with a market cap of over $110bn at the time of writing. Salesforce itself is now an establishment business, and new entrants in cloud computing go public every month with initial valuations in the low single digit billions of dollars.

Now, we don’t for a moment think that space is as big a market as technology, and so we don’t for a moment expect the same number of vendors to spring up. But we do expect waves of fragmentation, consolidation and fragmentation in the space market. This is fertile ground indeed for the interested investor.

Standardization.

Another key factor required for an industry to accelerate its growth rate is standardization. Be it telecommunications protocols, operating systems or microprocessor architecture, standardization in the technology industry has led to lower costs of entry for new vendors and increasing utility for customers. Standardization in space is just beginning. The development of the International Space Station ("ISS") and the end of the Shuttle program has meant that the ISS has had to be supplied by multiple spacecraft types. So, the Dragon capsule operated by privately-owned SpaceX has to interoperate with systems that can also host the Cygnus capsule operated by Northrop Grumman that can also host the Russian state-operated Soyuz capsule. And experiments delivered to the ISS by multiple providers (universities, private companies etc.) can be run within the standardized NanoRacks platform, which allows for a standard form factor, data interface, and power connector. We anticipate that standards will continue to take hold and that this will further enable the proliferation of vendors in the space market.

Investment Process

As a research firm, rather than a fund manager, by “investment process” what we mean here is – how do we research the companies we cover and how do we arrive at a recommendation. Our approach combines top-down research with bottom-up financial analysis.

Our top-down research is driven by market mapping. You can see a high level version of our space market map here. This gives us the universe of names we need to look into and decide which stocks are sufficiently interesting to provide coverage on. We find companies through desk research, trade shows, conferences, calls with other companies, etc. Our market map will broaden and deepen over time.

Our bottom-up work is numbers-driven. We study company reports and filings, industry reports, other analysts’ notes, and we look closely at fundamental valuations and stock price charts. We situate fundamentals in the context of a company’s peer group and in the context of its revenue and earnings growth. A company trading at a P/E of 10x might be cheap or expensive depending on its growth rate – and a company trading at a p/e of 100x might be cheap or expensive on the same basis. (For a real life example of this, you might see an older note of ours on Veeva Systems here - the section on “Valuation” explains our approach). We also take into account cash flow and balance sheet factors.

Returns

We don’t have a specific investment returns model – again, we are an equity research firm, not a fund manager. We see our job as highlighting upside opportunities on a case-by-case basis, and we will put forward our best opinion on the returns available from any situation we comment on – together with the risks thereof. Space is an early stage market, and that means it is a risky market. For every OrbitalATK ($10bn all-cash acquisition, 22% premium to prevailing share price), there will be at least one Maxar Technologies (a 90% club member! – declining from c.$63/share a year ago to c.$6/share today). What we try to highlight is the multiple ways an investor can try to make money from the companies we cover. Our price target on Maxar (see here) was never achieved, but skilled traders had multiple opportunities to make money during the stock’s decline, even without shorting or playing derivatives.

That said – broadly we are looking for achievable unlevered IRRs in the 10-30% range and beyond. Looking at IRR as a measure is one way we can compare short-term trading opportunities with long-run investments.

Risk Management

In order to assign a positive rating to a stock with the 10-30%+ IRR opportunity we consider, inter alia, the following categories of risk:

  • Are there any catastrophic single points of failure risks? (The sort of risks faced by early stage drug discovery companies). If yes, we are unlikely to rate a stock as a buy. In our experience, one cannot price a single point of failure. Either the company beats the risk, or it doesn’t. And if it doesn’t, investors’ money is more or less gone.
  • Is the balance sheet highly levered? In recent years, rising corporate leverage has been given a free pass, because interest rates have been exceptionally low and the lending environment benign as regards restructuring in the event of difficulties. This period is unlikely to be permanent. Cash flow and debt service and deleverage matter, and if we see companies with cash flow problems, we are unlikely to be enthusiastic about them (bearing in mind we are long-only).
  • Is the regulatory environment supportive? This could be regarding antitrust if the company is highly acquisitive, or regarding tariffs if the company falls foul of the prevailing trade winds.

Generally speaking, we will go into detail on each of our company notes about company-specific risks.

We don’t operate a real-time service, and so we don’t have any hard and fast rules about when to take a loss. In the current volatile environment, each individual investor has to decide how much red ink they wish to bear whilst waiting for a gain. Setting a 5% or 10% stop-loss may be risky in itself amid this volatility, particularly for mid-cap stocks with, say sub $10bn market cap.

What we will do is state our thesis clearly when rating a company positively. If our thesis does not play out, we will highlight this in our subsequent coverage of that stock, and if we ourselves move to the sidelines on a stock (meaning – we are no longer at a buy), we will say so and explain the price at which we go to the sidelines and our reasons why. That could be because our target price has been achieved, it could be because we had an operating thesis that turned out to be wrong, or it could be because our operating thesis was correct, but the market has not assigned any increase in value to that thesis playing out.

Our Seeking Alpha Service

We will usually publish price targets in our single-stock notes and put a time frame around those price targets. Seeking Alpha notes are, as readers know, not updated in real-time, and so we state in our notes that our price target and time frame is our best estimate as at the time of publishing.

We do aim to post updates on companies in our coverage universe as events unfold. If our recommendation changes, we will post this information, but we don’t at this stage operate a real-time service, so there will usually be a lag before we update our targets.

We aren’t in the business of managing client assets or posting blow-by-blow trading instructions, so we won’t be posting notes saying “Buy X at price Y today; sell A at price B today”. We leave it to each individual reader to decide for themselves when to get into or out of any position they wish to hold. All our work is impersonal in nature – that is, it does not constitute personalized investment advice.

We hope you enjoy our work.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.