<THE BORING PORTFOLIO>
The Bore Blasts Off
A closer look at Orbital Sciences
By Alex Schay (TMFNexus6@aol.com)
ALEXANDRIA, VA (Feb. 19, 1999) -- Today, I'll be taking a brief look at a company that has figured prominently in the news of late. As it turns out, 1997 was a transition year for space and information systems company Orbital Sciences (NYSE: ORB), as well as a turning point for the firm's stock. Orbital had faced considerable adversity leading up to that period, losing roughly one rocket a year in launch accidents for the three years prior to 1997. However, the company saw rising earnings and three estimate-beating quarters for the first nine months of the year, and most importantly, Orbital was putting together successful launches.
Then, the "Black Monday" of 1997 occurred, and suddenly, Orbital's reduced operational risk was no longer reflected in its stock valuation -- in fact, in dropping along with the rest of the market, Orbital was awarded virtually the same valuation that it garnered the year before when it faced substantially more uncertainty.
That's a ruthlessly brief summary of the qualitative setting that I encountered when I first began to take a look at Orbital Sciences back at the end of 1997. Based on a comparison between the risk inherent in its valuation, and the strategy that the firm was employing in order to gain competitive advantage in the satellite industry I recommended Orbital Sciences in our 1998 Industry Focus. At the time (Dec. 1, 1997) Orbital was trading at around $24, and where it sits today indicates that the firm has seen less than a market return over that time period. However, since the beginning of 1999, Orbital has declined about $15, or roughly 35%, largely due to some profound accounting changes initiated in the fourth quarter of 1998 (and a re-adjustment of results for prior years).
Last week when I broached the subject of investing in companies "in new fields of activity" where the valuation efforts are based more on strategy (and therefore competitive advantage), rather than an evaluation of current metrics and cost-of-capital-beating efforts, I could very well have been talking about Orbital Sciences. The company's cash flow from investing activities -- primarily in ventures at its affiliates and subsidiaries -- are still dwarfing the cash that the firm is taking in from operations (which is still significantly positive). With the commercial space industry still in its infancy, and Orbital engaged in myriad value creating projects, it can be difficult to put a value on the firm.
Now, at the beginning of 1999, the basic recommendation made back in 1997 has an eery resonance: "Proceeding with the thesis that an environment of steadily reduced risk (as evidenced by total order backlog of $2.9 billion, accelerating earnings and successful launches) will boost the value of the company, 1998 could be a banner year for Orbital." In terms of overarching investment themes, it could well have been written yesterday.
At year-end 1998, Orbital had a total backlog of $4.046 billion, experienced year over year earnings growth of 21% (adjusting for the accounting changes and including the gain on the sale of subsidiary stock in 1997), and successfully completed 56 out of 56 launches over the last 24 months. However, investment "themes" are just the superstructure, built on top of the quantitative edifice. Based on my initial valuation work on Orbital, incorporating the re-stated numbers, I have fair value in the high-$40s on the basis of a discounted cash flow (DCF) analysis, and in the high-$50s based on a sum-of the-parts, slap-on-the-multiple-you-want analysis (they are conservative multiples nevertheless). I'll publish those spreadsheets next week.
Of all the economic drivers that matter, including cash flow and risk (as measured by cost of capital), the most neglected variable has to be the company's competitive advantage period, or CAP. That is, assuming it has one. CAP is defined as the period of time during which a company is expected to generate returns on incremental investment that exceed its cost of capital, thereby creating value.
One of the key determinants of CAP is a company's current return on invested capital (ROIC), where, generally speaking, the higher a company's ROIC (compared with other players in its business) the better it is situated in competitive terms -- because the ratio often reflects some form of competitive advantage, like economies of scale or superior management. Currently Orbital is not generating returns anywhere near its cost of capital, but that will change.
Other factors that affect CAP include the overall rate of change in the company's industry (where high returns in a dynamic business like computer software are not valued as generously as high returns in say, the beverage business) as well as barriers to entry in the business.
Some of the difficulties that arise when applying this scheme to Orbital's present stage of development become apparent when assessing its ORBCOMM satellite communications affiliate. ORBCOMM began full-service in the fourth quarter, providing mobile as well as fixed messaging and data communications to "over 135 companies and government agencies in 25 countries" thanks to its constellation of 28 satellites. At the beginning of February, the firm had orders for 45,000 ORBCOMM terminals, with 37,000 already delivered. In 1999 the company expects to ramp up subscribers to the 250,000 unit level in more than 80 countries (with significant opportunities in trucking, oil & gas, and the electric utility business).
At the current level of revenue per units (RPU) of $40, compared with early company estimates in the low $30 range, these projections can definitely add up in 1999 -- even in light of the new revenue recognition policies at ORBCOMM. Overall, in the "space" that ORBCOMM and ORBIMAGE occupy, the company estimates that it has about a three-year head start on the competition. With the barriers to entry in the space business being what they are, this will prove very significant in the future.
Next week I'll talk about some of the accounting issues at Orbital, as well as open up some of the more quantitative projections for the firm to closer scrutiny. Meanwhile, PeopleSoft is still in the "gather information" stage. Incidentally, it made a strong move today, on no news that I could find. Let's talk about it on the message boards -- or as The Wall Street Journal likes to say, let's "chatter."
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