The company’s long-term contract with Boeing is now being complemented by other large clients within the defence sector.
Defence stocks are back on investors’ radar once again as geopolitical risks and tensions around the world are on the rise.
Governments globally are increasing their defence spend; in March, the US fiscal budget included US$728.5 billion for defence, a 5% increase from 2021.
The defence industry is one of the most resilient sectors, as unlike other industries, the government’s spend on defence does not usually get cut in an economic slowdown.
On the ASX, there aren’t too many defence stocks listed but one that’s gained a lot of investors’ attention is Perth-based Orbital Corporation (ASX:OEC).
The company designs and manufactures integrated engine systems for tactical unmanned aerial vehicles (UAV).
More widely known among the general public as drones, UAVs are aircrafts piloted remotely and are often used by the Army to provide ground troops with intelligence and surveillance data from the air in real time.
Orbital Corp’s capability is in developing world-class spark ignited, heavy fuel propulsion systems for tactical UAVs out of its state-of-the-art facilities in Western Australia and Oregon, USA.
The company’s global reputation has enabled it to sign up some of the world’s leading defence clients – including Insitu Inc. (a Boeing company) and US giant Textron Systems.
Boeing as a client
Orbital has a long-term supply agreement with Boeing Insitu, which involves developing a range of engine models for the company’s flagship UAVs: ScanEagle, ScanEagle2, ScanEagle3 and Integrator.
In February, however, the Boeing subsidiary cancelled the third engine development program under the contract, citing a review of market conditions.
The two companies agreed that volumes for the first two engine models Orbital have in production would not be impacted.
Under the contracted terms, the termination entitled Orbital UAV to a full reimbursement of all the work already undertaken for the third engine – but Insitu is currently contesting Orbital’s claim for $1.8 million.
“We had to cancel any further investment in the third engine production line,” Orbital CEO, Todd Alder, told Stockhead.
“Under the contract, we’re seeking cost reimbursement but we’ve got a dispute with regards to that reimbursement at the moment.”
Alder is confident the dispute won’t lead to any long term damage in the relationship with Insitu, pointing to the fact the first two engine models remain in production.
“We understand Boeing Insitu is a formidable company. They will return, and when they do, we will be there with them.”
But the experience has reaffirmed to Alder what was already known: That there is a long-recognised danger of relying too heavily on one customer.
“This experience has highlighted the importance of customer diversification and that is what we have been progressing over the past two to three years ,” Alder said.
Diversifying into new clients and region
As part of this strategy, the company has recently won contracts with a host of new clients such as US Navy supplier Skyways, Textron Systems, Anduril Industries and a Singapore defence industry customer.
The deal with Textron, one of the largest suppliers of tactical UAVs to the US armed forces, involves integrating Orbital’s UAV engines to Textron Systems’ Aerosonde program.
The company also signed a landmark MoU with a pioneering defence products company, Anduril Industries Asia Pacific, back in May.
Anduril was founded in 2017 by Palmer Luckey, the designer of the Oculus Rift and founder of Oculus VR which was acquired by Facebook.
The Skyways deal, meanwhile, is an exciting one for Orbital because it falls outside the usually strict surveillance and reconnaissance mission scope.
Skyways is an emerging leader in unmanned cargo transport, and has been selected by the US Navy to develop prototypes for long-range naval ship-to-ship and ship-to-shore cargo transport.
“Unmanned cargo transportation is an area that’s receiving significant funding from the US Department of Defence and also in other defence applications as it reduces the personnel risk in transporting parcels” Alder said of the Skyways deal.
And just last week, Orbital also secured a $3.5 million contract with its defence customer in Singapore.
“This contract now takes us into the production of engines for a Singapore domestic application,” explained Alder.
“But what we like about it is it’s a firm step for us outside of the US, and into the Asia Pacific. We expect a pretty big push over the next six to 12 months in this region with further announcements.”
Long revenue stream
Defence stocks do tick a lot of boxes when it comes to a highly investable business model.
Its revenues are based on long term contracts, and the business is almost counter cyclical as government spending cuts in a downturn rarely extend to military spending.
Despite the increasing spending on UAVs, Alder acknowledges that initial contract negotiations can be complex.
“There is a two to three-year lead time just working out and building on those relationships,” Alder said.
“After that comes a two-year development cycle, and only after then that you move into production.”
The good news is that after the development cycle, clients don’t usually change to a new engine contractor, providing companies like Orbital with stable revenues for years.
“Once you’re selected as the propulsion or the engine provider, you’ve got a five to 15-year revenue stream for that particular platform or drone that’s used within that defence portfolio,” said Alder.
FY22 revenue and outlook for FY23
For financial year FY22, Orbital announced unaudited revenue and other income of $18.3 million.
The company said that revenue was impacted by Boeing Insitu’s demand downgrades and order cancellations.
For the full year, Orbital reported an underlying EBITDA loss of $2.9 million and $2.6 million in other income.
The bottom-line net loss after tax came in at $8.9 million (which includes $4.1m of Australian Deferred Tax Asset write off).
At the end of the fiscal year, the company is well funded with a cash balance of $4m in cash and cash equivalents.
Orbital says it’s currently holding excess inventory as a result of Boeing Insitu’s engine demand downgrade and the transition of engine production from the US back to Australia.
However, the company is confident it will run down these excess inventories over the next 18 months.
For its FY23 guidance, Orbital forecasts a revenue of $20m-$25m, and is targeting net profitability.
The company says that production from the two established Boeing Insitu engine model lines will be complemented by a strong pipeline of engineering programs from its other customers in the next 18-24 months.
“Working with this expanded group of customers represents a pathway back to improved FY23 revenue and a sustainable and profitable business,” said Alder.
This article was developed in collaboration with Orbital Corporation, a Stockhead advertiser at the time of publishing.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.