Summer Series: Electro Optic Systems (ASX: EOS)

Bryce Leske: [00:01:28] Welcome to the Equity Mates Summer Series of 2020, brought to you by superhero who are offering five dollar brokerage and free brokerage on all ETF transactions, head across to superhero.com today to find out more over 12 episodes, we're going to be diving into some of Australia's largest and most well-known companies as selected by you. The Equity Mates community will be unpacking the company, its industry outlook, key financials. And in some instances, we'll also be taking the tough questions straight to the CEO. To do this, as always, I am joined by my Equity Mates Ren. How's it going, Bryce? [00:02:03][35.0]

Alec Renehan: [00:02:03] I'm very good Bryce. Excited to talk about this company. It's a very interesting one in a interesting industry. I've said interesting. A lot of interesting industries. [00:02:12][8.5]

Bryce Leske: [00:02:13] It has its fingers in a few pies, pretty sticky industries to be in as well. So we'll jump into that in a little bit. [00:02:19][6.3]

Alec Renehan: [00:02:20] it's 3M and we're talking about global. [00:02:20][0.6]

Bryce Leske: [00:02:22] Not bad before we kick off massive thanks to Oliver from the Equity Mates community who has helped with the research and analysis of this episode. So, Oliver, thank you very much. Very much. Appreciate your help with this one. Yes. In fact, thank you to all of the Equity Mates community members who have helped with all of the episodes. It's been awesome. [00:02:40][17.4]

Alec Renehan: [00:02:40] So you know what, thanks to all the Equity Mates community members who haven't helped as well. Absolutely. [00:02:45][4.5]

Bryce Leske: [00:02:45] Absolutely. So the company Ren is Electro Optic Systems. ASX ticker is iOS. I was a shareholder until very recently looked at all of his research, regret selling. I really think I should still be in, but I just want to make it very clear that this is not a buy, hold or sell recommendation across this episode. We're just going to be showing you how we think about researching companies. And as always, we're going to be looking at the company summary industry and competitors, the outlook and future plans for AOS, some of the financials, and hopefully we can do a bit of a valuation as well. So ready to kick into it. [00:03:23][37.5]

Alec Renehan: [00:03:24] Let's do it. You seem to know this company better. So tell me about a show. [00:03:27][3.4]

Bryce Leske: [00:03:28] EOS, as I said, is the ticker. Its core business operates in defense contracting markets as well as the space sector and communications. So three sort of distinct business areas has a market cap of just shy of a billion dollars. And it was listed in 2002 on the ASX with a market cap of just shy of 200 million. [00:03:49][20.8]

Alec Renehan: [00:03:49] So not bad, pretty good growth. Another company that was spun out of Australian government like a public company or a public business. Yeah, like I. I don't know. What would you call it? A department? [00:04:00][11.1]

Bryce Leske: [00:04:01] I guess so. [00:04:01][0.4]

Alec Renehan: [00:04:02] Yeah, probably all the sectors. But what I was it was the Australian Commonwealth Space Activities. Yeah. And then it was privatized in nineteen eighty three. Yeah. Pretty, pretty interesting. Similar to CSL. Yeah. Telstra. Yeah. [00:04:15][13.0]

Bryce Leske: [00:04:15] So electro optic systems develop, manufacture and sell telescopes, dome enclosures, laser satellite tracking systems and electro optic fire control systems. They split itself into three arms though, each operating with the same technology in the same business insights but targeting different markets and almost operating in three distinct businesses. So they operate in defense, in space and in communications. And as I said, the management of the business businesses to sort of run independently, but obviously sharing their own trade secrets. I guess given the nuances between the three areas, they kind of need to run that way. And in terms of marketing and sales and whatnot, they sort of split themselves respectively. [00:05:00][44.7]

Alec Renehan: [00:05:01] Yeah. So it operates in Australia where most of its contracts are, but it also operates in a number of countries, the United States, Singapore, Germany, France and some Middle Eastern countries as well. But it's mainly selling to major government players, I guess the Australian Defense Force, Australian Border Force, the US government, and in particular the US military and other NATO allied countries. [00:05:25][24.6]

Bryce Leske: [00:05:26] Yeah, you know, those sorts of contracts, if you're looking at it from my point of view, you know, a pretty reliable contract parties to be involved with. If you're talking big governments in those sorts of things. [00:05:36][9.9]

Alec Renehan: [00:05:36] Yeah, they got money to spend, [00:05:37][1.2]

Bryce Leske: [00:05:38] which you'll get into a little bit. So let's start with the defense side of the business. So as they contract to develop and manufacture advanced surveillance weapons and fire control systems, as we said, they've got projects providing Commonwealth with remote weapons systems, investment and development of counter unmanned aerial surveillance vehicles. So you can imagine the importance of these as drones are ever increasing and becoming a major player in war. They are the only provider of these vehicles with capabilities required to defeat drone attacks, with substantial infrastructure [00:06:17][38.1]

Alec Renehan: [00:06:17] without substantial. [00:06:18][0.4]

Bryce Leske: [00:06:20] sorry without substantial infrastructure. The good thing, though, is that their sales pipeline of defense products valued at 2.8 billion, which is risk adjusted if you remain. The risk of, I guess, the contracts, it's closer to 12 billion. So what that actually means is they are very, very confident that of that 12 million pipeline, 2.8 billion is pretty much locked in the bank and secured. The remaining has some risk or I guess that it hasn't been awarded as yet. So it's an opportunity or a potential? [00:06:49][29.6]

Alec Renehan: [00:06:50] Yeah, I think it might even be worth taking a step back and just explaining this concept of a sales pipeline, which is common for defense contractors here. Raytheon's you know, companies like that Biosystems, stuff like that, or any company with a really long sales cycles. So a lot of these sales take years to make and the contracts to negotiate, the weapons to manufacture, and stuff like that. And so there's a question about when these companies can recognize revenue on their books. And the way that they do it is any revenue they've brought in in the year is recognized as revenue. But there's stuff that's been agreed in future years and that's their sales pipeline. And so they can't recognize that revenue on their books until it actually becomes revenue. But it's going to happen. Well, a percentage of it is guaranteed and then there's a percentage that is less guaranteed, especially with covid and stuff like that, changing government priorities, administrations in the US, stuff like that. But you will say in all of these defense contractors, they have a sales pipeline, and that sales pipeline will stretch years into the future. [00:07:52][62.3]

Bryce Leske: [00:07:53] So that is the defense side of the business. Then we move into I guess, the newer part of the business and where they're hoping for some growth to come in. That is the space systems arm of the business. They design, manufacture, deliver and operate sensors and systems for space domain awareness. Now, I have no idea what this is, but it's used to identify items in orbit in order to reduce the likelihood of collisions. Now, not something that you'd think is, I guess, important, but there are over 500000 bits of orbital debris ranging in various sizes from cricket balls up to, you know, I guess massive rocks and whatnot, flying around it up to, you know, 28000 kilometers an hour. And for people like NASA military who are launching satellites and very expensive pieces of equipment up into space, this sort of a product is very important to them so that they know that they're not going to be firing into a pool of debris, essentially. So that is where they're actually getting a lot of their contract and business from, is partnering with the likes of, you know, NASA and other governments to help them identify this sort of debris in space, I guess, [00:09:03][70.1]

Alec Renehan: [00:09:04] which is only going to become more important as satellites become cheaper and cheaper to launch. Elon Musk wants to blanket the Earth with microsatellites to provide Internet access to all corners of the Earth. There's a whole bunch of companies that are playing in the microsatellite space which are cheaper to launch. But, you know, as the sky gets more filled, being able to launch at the right time in the right trajectories become even more very important. So they also have a sales pipeline for this business on ninety five million dollars on a risk weighted basis or four hundred and twenty five million dollars not adjusted. And so not nearly as big as the defense on, but, you know, meaningful. The third business is the communications system and they develop global satellite communications products, systems and services and a whole bunch of radio and satellite systems for high speed, resilient connectivity from sort of anywhere in the world. They split their communications arm further into two sectors, a ground and then a space based. And that's probably the newest part of their business where there's there's not a lot. So really, there are, I guess, the defense systems contractor. But defense in the broader sense, incorporating communication systems and space as well. They have been impacted by covid. Their supply chain was disrupted during closed shutdowns that they incurred in repairing it. And they've also revised their growth targets down on the back of covid. Previously, they had a 70 percent growth target. They revised that down to 25 percent. Luckily, they were able to do a capital raising to shore up their balance sheet. So they were able to go to the market, go to investors and say we need some money to survive this period. And they raised almost one hundred and forty million dollars to do so. And so now they I guess they have the money, they have the liquidity to navigate however long this Cleverley period lasts. So that's really the company. Three main sectors, defense, space, communications, using the technology they have to sell across those three areas. Anything more on the company now? [00:11:06][122.0]

Bryce Leske: [00:11:06] I think that's a good wrap, Ren. Let's turn attention to the industry now. And of course, in an industry where you are relying somewhat on government spending and service contracts, you're looking for continued growth of that spending to come from the government. So the Australian government spends approximately 200 billion dollars on defense over the next 10 years. That's the plan. The market is valued at around thirty five point eight billion dollars here in Australia, and we spend close to two billion dollars on service contracts in defense a year. So big space for us to be playing sitting pretty well in terms of defense contractors. I think they were 15th largest in the world, which is putting it up there with some of the big players in terms of the space market, Ren a little bit harder to put a finger on because it's, I guess, relatively new in Australia. The space segment, which also includes the communications arm, has had five point six billion in revenue, is expected to grow at sort of seven and a half per cent over the next five years. And the global space industry is worth something around three hundred and sixty billion dollars, with commercial contracts making up roughly 40 percent of that. So they're certainly playing in the right space. We talk about industries that have potential to grow and mean something over the next 20 years. And I can certainly see space being a part of that. [00:12:22][76.1]

Alec Renehan: [00:12:22] If we start with defense, it's a relatively static industry. Governments spend a fair bit on it every year. But, you know, unless we go to war, it's probably not going to grow in a massively meaningful way. You know, Trump was putting pressure on NATO countries to spend more Australia spending a bit more given the regional tensions. But space for me is the one where, like the opportunity for an industry to explode in terms of the amount spent is really there and maybe from governments, but more so from commercial players, more so from the space X's, the blue origins of the world. They're the ones that, you know, if Jeff Bezos becomes the world's first billionaire by successfully mining an asteroid or something like that, space becomes a very interesting place to buy. You know, Trump, when he was in power, wanted NASA to go back to the moon in his second term. So by 2024 and then he wanted to colonize Mars by 2030. It'll be interesting to see how those plans unfold. It will be interesting to see what the European Space Agency, what the Japanese space agency, what China's space agency are all doing in that space. A lot of, I guess, less space savvy countries, you could say, are also developing their own space industry, including Australia. And so that is an industry that is particularly interesting for me. There's obviously a lot of companies trying to play in that space. So it's going to get quite competitive. But, yeah, space, space, space [00:13:44][81.8]

Bryce Leske: [00:13:44] is the place. So let's have a quick look at their competitors. Ren in terms of defense, there is an ASX listed company called Austal. Their ticket is ASPEY. They're a big ship builder and a defense contractor, building ships and high speed support vessels and that sort of stuff. So they do compete in the defense contracting business. Boeing, they're listed on the New York Stock Exchange ticker is Bayet. They compete with defense in space segments that airlines are competing with. And Boeing do have an Australian subsidiary which completes defense contracting work with Australian government. Pretty big companies. We know Boeing with a market cap of about one hundred and sixteen billion. And then there's another American company called Northrop Grumman. And I see they list on the New York Stock Exchange as well, also competing in the defense space. So the other thing to note with this sector is that many competitors of chaos in the defense sphere are sovereignly owned, meaning that the individual governments of that country actually own them. So it is a little bit tough to understand the market share dynamics going on. But in terms of space and communications, and this is one of your favorites, the big player there competing with S.A.S., Sky and Space Global, your favorite company, [00:14:53][68.7]

Alec Renehan: [00:14:55] a company that I did own back in the day, no longer listed in Australia, but luckily sold well before then. There's a bunch of companies making like nanotechnology and microsatellite stuff like that to us, green space, global and Closs Space. But honestly, there's I hate more that we haven't listed here. It's becoming an incredibly competitive part of the market as people find ways to produce satellites cheaper and companies like SpaceX are finding ways to launch satellites cheaper. [00:15:24][29.5]

Bryce Leske: [00:15:25] So, yeah, nice. So before we jump into Outlook and future plans, let's have a quick word from our sponsors. So Ren, we've touched on some of the industry context and competitors of ours, I guess the question is what is to come? Where are we expecting future growth? What does it look like from defense and a space point of view? [00:15:45][19.9]

Alec Renehan: [00:15:45] Yeah, so I think the big thing with an outlook for a defense contractor is so much of it is out of their control. Some of it is. And we'll get to that. But really, the headline is how much are governments and I guess big companies these days in the space sector, but really governments allocating to the industry. And we said that defense spending wasn't growing massively globally. That's not to say it isn't growing. And that's not to say the Australian government isn't spending or the Australian government is looking to increase their spend about 30 per cent holistically, including their spend on space. But it's really going to depend on especially things like the Biden administration, what they do. And, you know, under Obama, this might be a bit of a rabbit hole. But under Obama, overall, defense spending was cut because of budget sequestration, because there was all this tension between Republicans and Democrats, they couldn't agree on a budget. Trump came in increased defense spending. Interesting to see what happens under the Biden administration, the total amount of defense and space spending and where they spend that in particular, things like, you know, Trump created the space force, stripped it out of the Air Force, made it a separate part of the military, increased money to that sector. Will it and keep that structure? What will they spend in space? Those questions are probably like the headline things you want to look at when you're looking at the future prospects under that, whatever the total spend is, then the question is what contracts are coming up, what contracts to have that they're going to have to compete for again, and then what new contracts or contracts with other companies can compete for? Because the opportunity for recurring revenue is there. But it's more you've got to compete for the next contract and like what capability the government want to build and can you compete to build that capability for government? So when you're looking at these defense contractors and when I say that part of it's out of their control, it's that it's not like they can create a weapon system and then go on an advertising campaign and try and sell it to governments. I mean, they can, but a lot of it happens the other way. You know, governments decide that they want a joint strike fighter. They go to market. Lockheed Martin wins that contract. And then Lockheed Martin make the F-35 Joint Strike Fighter for all the NATO countries, Australia, the US, stuff like that, like. So Ágúst needs to be in a position where they're in the cutting edge of technology and can win contracts and build capabilities for governments and militaries to wrap it up. In terms of that, there are some things that we've touched on that they have a I guess, a comparative advantage and compared to their competitors. You touched on the counter unmanned aerial surveillance stuff that they can counter drone attacks. They have technology that allows governments to counter drone attacks more efficiently than some of their competitors. So things like that, they have a special advantage in in the communications sector. AOS have been speaking about trying to disrupt that industry with laser data transfer technology. Don't ask me what laser data transfer technology is, because I couldn't tell you. But there are things like that where they've got particular technologies that they think are better and that they want to sell to governments. And so I think what will be interesting, if you want to be an investor, is how closely does the technology that of us have a comparative advantage in line with what governments and militaries and space organizations are trying to achieve. So, yeah, I think in terms of their outlook and their future plans, as I started this, a lot of it is out of their control, but they have advantages over their competitors that they will try and exploit to win contracts and grow their business. [00:19:22][217.1]

Bryce Leske: [00:19:23] Nice. So let's turn our attention to the financials. Ren topline revenue growth has been chugging along pretty well and pretty. Yes, pretty significant growth 2018. They did about 87 million. [00:19:35][12.6]

Alec Renehan: [00:19:36] Well, hold on, I'll you skip twenty seventeen. They did twenty three million. True. And then that was up almost 300 percent to almost nineteen ninety million. [00:19:44][7.8]

Bryce Leske: [00:19:45] And then again 2019 they've bumped that up to 165 million. So almost 100 percent growth there. So it's a pretty phenomenal top line growth. We know that they have said the impact of covid. They've reduced their growth forecasts by about 75 percent, which we are seeing at the moment. But they're on track for about 183 million this year. So not quite as significant growth as before. But to be expected, given what they have come out and said the last two years, they have turned a profit. Fifteen million in 2013. Eighteen million in 2019, likely to turn a small loss this year because [00:20:20][35.3]

Bryce Leske: [00:20:21] It has hurt them. Obviously, the biggest driver of revenue is coming from their defense systems, making up sort of eighty seven per cent of total revenue space, very small amount, but likely to grow. So keep an eye on that. As well as the communications part, so, yeah, I think it'll be interesting to see how that dynamic changes over the next few years so we can probably do a bit of evaluation Ren. [00:20:42][20.4]

Alec Renehan: [00:20:42] Yeah. So let's start with a relative valuation. So obviously a lot of us weren't profitable in the trailing 12 months because of covid. But if we look at price to sales, they always look quite expensive compared to the industry average. So the industry averages one point six AOS trade at five point three. So really what that tells you is that there's a lot of expectation of future growth built into this company. So give you some specific comparisons. Based Systems, which is based in the UK, trades at a price to sales of zero point nine. Boeing, based in the US, trades at a price to sales of one point eight one point nine, and then Ostro, based in Australia, trades at a price to sales of zero point five. Now the comparisons with those companies aren't perfect like Boeing obviously has a massive consumer aircraft division for want of a better term. Austral, as a ship builder is controversial, shall we say. So, yeah, the comparison isn't perfect. But in terms of the broader industry average, they are expensive. But that is really just because they're less mature than some of the other defense contractors. And there's an expectation that they'll grow faster than some of these other defense contractors. [00:21:56][73.9]

Bryce Leske: [00:21:57] So DCF Ren [00:21:58][1.5]

Alec Renehan: [00:21:59] if we look at a DCF, obviously it's a little bit fraught given they lost money in the trailing 12 months because of covid. But if you look pre-covid, they made about 22 cents per share in earnings per share. If we use our revenue growth rate of sort of six percent, you get a fair value of almost three dollars, which seems low. But if you look at the revenue over the last couple of years, let's say the last five years, their revenue growth rate is twenty nine percent. So you get at almost 14 Dollars share price, which is double what they are. I think it's difficult to value given that they've lost money and they've only been profitable for two years and now they're not profitable again. So I think if we were going to do this properly, we would look at trying to figure out what the future profit looks like without covid and trying to build it from there. But, you know, you could say between 2018 and 2019, they went from 15 million to 18 million in profit. That three million increase is, what, 20 percent. So if you said, like, let's say and this is all very back of the envelope, but let's say they get that 20 percent growth for the next five years, you're looking at almost four dollars a share. [00:23:12][73.6]

Bryce Leske: [00:23:13] So below what it's trading. [00:23:14][1.2]

Alec Renehan: [00:23:15] Yeah, the market has big expectations for electro optic systems. So, yeah, I guess we'll say, yeah. [00:23:22][7.2]

Bryce Leske: [00:23:22] Nice. Well, thank you to all of us for help with the research and analysis of that company. Very much appreciated. And to the rest of the Equity Mates community as well. And thank you to our sponsor for this episode, superhero who are offering five point flat brokerage on ASX transactions and also zero point ETF brokerage fantastic offer. They have a pretty amazing platform as well. So if you're looking to get into the markets or even if you're looking for a cheaper option for your brokerage and to build your ETF core portfolio, head over to superhero.com.au we love what they're doing over there. [00:23:58][35.8]

Alec Renehan: [00:23:58] So, yeah, if you liked electro optic systems, this is the cheapest way to buy them. Yes. [00:24:02][4.1]

Bryce Leske: [00:24:03] Nice Ren. Well, as always, great to chat. Stocks enjoying the summer series of 2020 and we will continue next episode. [00:24:09][5.9]

Alec Renehan: [00:24:10] Sounds good. [00:24:10][0.0]

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