- Sean Rapley
Electro Optic Systems (EOS) -
ABOUT THE COMPANY:
Formed in 1983, the EOS Group of companies became a publicly-traded company on the Australian Stock Exchange in 2002. In 2005 EOS formed a strategic alliance with Northrop Grumman (USA) for the further exploitation of common technologies in the space and military sectors. EOS has invested more than $800 million in Research and Development over the past 20 years, with the majority of this investment yet to be monetised.
The company consists of three distinct businesses as outlined below in Figure 1. presently, the three businesses within EOS are Space Systems, Defence Systems, and Communications Systems:
EOS Space Systems designs, manufactures, delivers, and operates sensors and systems for space domain awareness (SDA) and space control. The Space Systems division is the foundation of the EOS business, and what CEO and founder, Ben Greene refers to as the “mother ship”. The optical technology that is the foundation of the Defence Business and will be the transformation of the Communications Business, was developed in the Space Systems Business.
Space Systems have developed patented technologies that provide EOS with significant competitive advantages, including Advanced Atmospheric Correction Technology, which enables the use of lasers for space communications (with the advantage of 20 times the bandwidth of microwave communications), and results in unrivalled accuracy in tracking objects in space.
The Space System business derives revenue from the following services:
Space Domain Awareness (SDA) Data / Information. EOS is the only qualified provider of this data in the Southern hemisphere, and their systems are the only fully autonomous in the world.
Provide space tracking infrastructure to allies. Any sale or transfer of technology requires the customers to use EOS’s SDA data. EOS provides 60% of all science grade telescopes worldwide.
Space debris management. Current scientific consensus is that there are around 500,000 pieces of space debris larger than 1 cm in Earth orbit, and objects of this size can damage or destroy satellites. This service consists of tracking debris and identifying threats, making it possible for satellites to be manoeuvred to avoid collision. In some cases, this is not possible, and EOS is currently testing a laser than can apply radiation pressure on debris to send them off their collision course. This system is scheduled to be operational by 2022, and will generate a new source of revenue.
Developed high powered laser for Counter UAV application.
EOS’ promotional video on the Space Systems business is here.
In 2019, EOS Space System experienced a disruption of its sales cycle, as the Australian Government cancelled budgeted programs, and now EOS needs to negotiate directly with foreign customers. This change provides the advantage of diversifying EOS Spaces customer base, however, has extended the sales cycle by 18-24 months. EOS reported in their 2019 HY report that they were participating in over $200 million of potential procurements globally, these were the lead element of a larger program, and in each of these opportunities, EOS was either the only source or one of very few qualified bidders.
There is also one significant international contract that was awarded to EOS, that is being challenged by a locally based competitor. EOS expects the customer to successfully overcome this challenge in 2020.
EOS reported at the 2020 AGM, Space Systems is expanding its tracking stations over 2020-21 to meet customer demand.
The Defence System offers a range of stabilised remotely operated weapon systems that can be integrated onto a range of vehicles, which allows weapons to be fired, with lethal accuracy within the protection of the vehicle. The key competitive advantages of their system are:
System weight. Significantly lighter than competitors, allowing the system to be installed on smaller platforms, and allow platforms to be faster.
Accuracy / lethality. The EOS system is significantly more accurate than the competitors in all conditions. This is particularly important in unmanned vehicles, which cannot be reloaded, with the EOS system being able to complete missions with one third the ammunition of the nearest competitor.
The use cases for the remote weapon systems includes:
Remotely Operated Combat Vehicles.
Anti-drone weapon systems.
Ben Greene reported at the time of the 2020 capital raise that EOS has not lost a contract to a competitor in the last 3 years, which demonstrates its market leadership, and EOS is able to charge a premium for the product due to its competitive advantages.
EOS reported a manufacturing backlog of $630 M in early 2020, and expects to win a further $2 Billion in contracts by 2022. EOS report the TAM to be in the order of $24 Billion, and, as at end of 2019, EOS are winning 30% of the market share.
EOS’ promotional video on the Defence Systems business is here.
The Communications System business commenced operation in late 2019, with technological breakthroughs enabling optical space communications, with the potential to increase current microwave based space communications bandwidth by a factor of 20.
The primary mission of the new business is to disrupt the $120 Billion space communications market. Its strategy is to build its own space communications business, based on microwave technology, and then gradually develop and introduce its optical communications system progressively.
It made its first foray into microwave communications with the acquisition of EM Solutions, an Australian producer of satellites communications ground bases, and receivers. It made its second, and most profound acquisition in early 2020, acquiring Audacy, a failed US based Mid-Earth Orbit (MEO)satellite developer, which had the rights to MEO satellite bandwidth, and had plans to launch a constellation of satellites (3 off), with initial commitments of $100 million USD annual revenue from customers. However, to retain the license, Audacy, and now EOS are required to have the constellation operational by 2024.
The constellation, called EOSLinkTM, will provide constant communication link capability to low earth orbit satellites, which Audacy reported to have a TAM of $10 billion USD. Dr Ben Greene reported in the 2020 AGM that the bandwidth EOS has secured via the Audacy acquisition is in the order of 3-4 times larger than the next 3-4 competitors combined, and we understand EOS will have the first satellite constellation to provide this service and as a result, has first mover advantage. this will be enhanced by their optical communications technology that will roll out in around 5-10 years time.
Satellites are capital intensive, and EOSLinkTM, is likely to cost in the order of $900 - $1200 million to build. However, competing satellite communications businesses are highly profitable, with competitor, SES Satellites generating an EBITDA margin of 62% last year, and net profit margin of around 20%.
MANAGEMENT TEAM & OWNERSHIP
The operational team at EOS is stable, with a highly credentialed management team. The company management structure looks something like Figure 2 below.
The EOS board consists of an experienced and capable team, with the Chairman, Fred Bart, appointed to the board in May, 2000. Dr Ben Greene, Ian Dennis, and Lt Gen Peter Leahy have all served on the board for over 10 years. The board holds approximately 10% of EOS shares, with Ben Greene recently becoming a substantial holder in EOS, with a 5% holding, and Fred Bart holding approximately 3.6% of EOS shares.
One institutional investor of note is Washington H. Soul Pattinson and Company, which holds approximately 4% of EOS.
EOS revenue and EBIT results, including guidance for 2020, are outlined in Figure 3 below. EOS operates with a gross margin in the order of 50%, however, by the very nature of the business, experiences very long sales, contract, and payment cycles. This results in large inventories, and ‘work in progress’ items on the balance sheet. COVID-19 has significantly impacted the supply chain of EOS’s customers and suppliers, with the EOS ACT factory floor is currently (as at August 2020) brimming with $150 Million of Defence Systems product that is unable to be shipped, although the defence systems CEO reported in a recent interview they expect this to be cleared by the end of September, possible due to the recently announced contract award with the department of defence (estimated to be up to $150 million).
EOS has experienced significant growth over the past four years, driven by the monetisation of its Defence Systems remote weapon systems (RSW) technology. In order to meet demand, EOS has raised $330 million over the past four years from investors to fund the development and growth of the business. Dr Greene reported at the AGM he expects EOS to have $200 million in cash by the end of 2021, up from $120 million reported on June 30, 2020.
EOS are now in the early phase of monetising their intellectual property, and we believe shareholders faith will be rewarded over the long term. We believe the key drivers for EOS growth are:
Defence: EOS report the demand for its RWS technology to be $1 billion per annum (FY 2019 report), and to have a Total Addressable Market of $24 billion (2020 AGM) over the next 10 years. EOS Reported winning 30% market share in FY 2019 report.
Communications: EOS report commitments of +$100 million USD for EOSLinkTM . Eventually, EOS’s optical communications technology can disrupt the $100 Billion satellite communications business.
Space: With a substantial pipeline ($200 million initially), and an increasing focus on space domain protection. EOS is well placed to address the requirements with the following opportunities from Australian Department of defence alone:
Space situational awareness - $2 billion over ten years (perhaps explains why EOS is developing two new site in Qld and SA to support data sales.
Terrestrial operations in space - $1.4 – $2 Billion from 2027.
Satellite communications assurance - $1.7-$2.6 billion from 2028.
EOS is experiencing significant disruption from COVID-19, however, we expect EOS to deliver $1 billion in annual revenue by 2025, and in the long term, has the potential to earn significantly more annual revenue through its global leadership in all three of its divisions. Its market leadership and competitive advantages allow it to command high margins, and we expect profitability to improve with scale.
RISKS AND WHEN WE’D SELL
We would consider selling if:
Satellite communications business – Interest free loans are expected to assist financing EOSLinkTM. However, if financing cannot be raised, there is a risk of significant dilution of shareholders. Should a significant capital raise be required to fund the project. We expect a capital raise is likely, however, our preference is the project be funded via debt funding.
Satellite constellation failure. There is a risk the project will fail. However, we believe management has redundancy built into the project, with four satellites planned, as opposed to the three originally planned by takeover target Audacy. We will ask a few more questions of management in relation to this to get a better understanding of shareholders exposure to this risk.
Competitive advantages erode. We’ll be watching major tenders for evidence competitors are winning successful projects, or if there is evidence of margin compression due to competition.
Pathway to optical communications technology fails to materials. We want to see a timeline for the implementation of this technology by 2025. If one does not materialise, it may be a sign to sell.
Risk of reputational damage. There is a risk that EOS weaponry is used illegally or used by a questionable regime or power. This is somewhat mitigated by rules concerning who EOS may trade / sell weapons to. Nevertheless, this is a risk, and the consequences may include sanctions from customers and stakeholders, materially impacting the business.
COVID-19 has slowed EOS’s growth trajectory, and severely impacted cashflow, through delayed contract payments, and rising inventories. We believe EOS’s strong balance sheet, and the recently announced department of defence contract award provides an adequate buffer to allow EOS to continue to build it’s capability and opportunities for the post-COVID-19 world.
EOS has developed breakthroughs in technology, allowing its Space Sector to accumulate unmatched leadership in the space situational awareness / assurance, and laser/ optics field; its Defence Systems to develop products that are best in class for accuracy, weight, and lethality; and its Communications Systems business to be the only business of its kind with access, and the opportunity, to implement optical communications technology in satellite communications. These competitive advantages will take competitors substantial time and capital to overcome. Providing EOS with a significant competitive advantage period.
We forecast EOS can deliver profit after tax of $110 million in 2025. Should all three divisions perform, they may beat our estimate handily (albeit with dilution associated with an EOSLinkTM capital raise). At a conservative PER of 20, and discounting the profit to 2020 valuation at 10% pa, we value EOS at $9.00 per share.
Luke’s Fund has held EOS since May 2019.