In December 2008, NASA announced that ORB and SpaceX were each awarded CRS contracts (http://www.nasaspaceflight.com/2008/12/spacex-and-orbital-win-huge-crs-contract-from-nasa/):

-          ORB: a minimum of eight missions valued at ≈$1.9bn

-          SpaceX: a minimum of twelve missions valued at ≈1.6bn

Antares:

-          The most important component of ORB’s COTS/CRS program is completing the development of their medium-capacity rocket, Antares (formerly referred to as ‘Taurus II). ORB is in / approaching the final stages of testing Antares.

-          Antares will be used initially on the COTS and CRS programs with NASA to deliver cargo to the International Space Station.

-          Beyond its importance to COTS/CRS, Antares will increase the payload capacity of ORB’s space launch vehicles to approximately 12,000 lbs. for low-Earth orbit (LEO). Accordingly, Antares will meaningfully expand the ORB’s launch vehicles product offering. ORB plans market the Antares rocket to other US Government and commercial customers.

Anteres Timeline:

Presently, the most critical events for ORB relate to the testing of the Anteres rocket. Unfortunately, the timing of the Antares test launches has been delayed repeatedly. The delays related to Antares have come from various sources. Issues surrounding the launch pad and launch complex (completion of construction, testing and certification of infrastructure) have caused the most recent set of delays. But there have been other causes including dealing with subcontractors as well as items internal to ORB. Generally, these are just the sort of projects that typically experience repeated delays.

However, ORB’s credibility with regards to the timing of tests is quite suspect. In fact, I do not have much confidence that the most recent timeline provided by ORB (on the Company’s 2Q12 CC) will in fact be realized. However, I do believe that ORB is certainly in the final months of Antares development / testing.

Following certification of the launch site, between August/September and December 2012, ORB will conduct three major tests (note: all tests technically fall under the COTS, and not the CRS, program). As currently envisioned, the schedule is:

-          Late August / early September – first stage test (hot fire test)

• The first stage test will test the liquid fuel engine for 35-45 seconds

-          Late September / early October – first test launch

• ORB will launch the Anteres rocket with both the first and second stage engines (second state of a solid state fuel engine produced by ATK); the rocket will be launched with a non-full payload

-          December - COTS demonstration mission to the station

• The Antares rocket will be launched with a full payload to be delivered to the ISS

The hot fire test will be critical in evaluating the likelihood that Antares moves ahead as planned – i.e. a success would represent a very significant risk reduction. If the hot fire test is able to run for its full duration and nothing explodes, that is a good sign. Following the hot fire test, it will take about a week for ORB to confirm all technical details.

Will the Anteres rocket be successful?

This is obviously a very near term and significant risk. What we are relying on is the following:

-          ORB’s experience in launching vehicles into LEO is unrivaled, having successfully completed more launches than any entity other than NASA.

-          The CEO has stated that ORB would not put a rocket on the stand unless they were 99% sure it was going to work. [Insurance companies underwrite to an 11% failure rate for LEO rockets.]

-          Based on our discussions with industry participants, no specific concerns have been cited and ORB’s expertise and generally strong tract record are repeated themes. The success of SpaceX is not a direct read through to ORB but does provide clear demonstration of feasibility.

Of course, ORB has suffered rather well publicized failure with their Taurus XL rocket [Antares was to be named Taurus II until the failure of Taurus XL]. On two consecutive launches in 2009 and 2011, Taurus XL failed when the nose cone did not separate to deliver the satellite. ORB is using a different cone for the Antares rocket.

What happens if Antares fails?

The answer to this really depends on the nature of the failure. The Company can’t envision a scenario in which an initial test flight reveals a flaw so fundamental that the entire program would be killed (of course, such scenarios are possible and in which case I’d estimate that the stock probably declines $2-$3):

However, various flaws in design could emerge which would require further work. ORB would not have to use its own money to redevelop the rocket, rather NASA would provide the funding if it wanted a redesigned rocket.

There is no question that further delays would be a negative for the stock. There would be two material impacts as relates to NT results:

1)     Baked in ORB’s 2012 guidance are higher margins for CRS/COTS based on completion of tests in 2012; failure would result in ORB not being able to book higher margins and operating income (relative to guidance) would be negatively impacted by ≈$10mm.

2)     A delay in successful tests would result in a delay in unlocking the receivables related to mission success (see discussion later related to NWC).

Backlog:

ORB’s backlog provides the Company very strong revenue visibility. For 2012-2014, ORB’s backlog covers 95%, 75%, and 50% of projected revenue for each respective year.

Government Funding:

Although the Antares tests post the most significant near term risk, the more generalized risk facing ORB (and all defense names) is sustainability of government spending.

ORB’s primary government exposure is through NASA and the Missile Defense Agency (MDA)

NASA:

In short: the ISS is the most well funded project under NASA purview and within ISS, the ‘ISS Crew and Cargo Transportation’ project is the most well funded item. ISS is clearly a priority of NASA’s. Accordingly, it would seem reasonable to expect that so long as NASA receives funding approximately in line with anticipated  level, the CRS program should be secure from a funding perspective.

[The other area within NASA of importance to ORB is ‘Science’ – in the budget summary (http://www.nasa.gov/pdf/632697main_NASA_FY13_Budget_Summary-508.pdf), the 2013 request of $4.91bn is ≈3% below the allocated amount for 2012. However, the major decline is within ‘Planetary Science’, a segment with which Orbital is not involved. Excluding ‘Planetary Science’, the total ‘Science’ budget shows y/y growth.]

Missile Defense Agency:

It is more difficult to untangle ORB’s exposure to the MDA budget. Overall, the MDA budget will be down in 2013 vs. 2012. ORB’s 2012-2014 guidance assumes continued weakness in the MDA budget.

The MDA 2013 budget proposal can be found here - http://www.mda.mil/global/documents/pdf/budgetfy13.pdf:

Based on our discussions with industry observers and our reading of industry material, although certain priorities within MDA are shifting a wholesale and dramatic reduction in MDA spending is not anticipated.

Financial Targets and Valuation:

[Note – my analysis fully taxes ORB’s cash flows. However, ORB currently has NOLs of ≈$80mm and other tax credits of ≈$30mm. In total, those tax shields are worth ≈$.65/share. ORB currently pays a very low tax rate but expects the tax rate to increase to 35% over the next 2 years.]

Early in the memo I mentioned that ORB’s adjusted EV is lower than its reported EV. The reason for that is ORB’s net working capital currently stands at $121.7mm. That number has grown substantially (4Q09: ($60.7mm); 4Q10: $21.7mm; 4Q11: $58.4mm). From 2003-2011, ORB’s net working capital averaged ≈$4mm. The reason for the working capital builds relate to the COTS/CRS project and the structure of milestone payments. Upon successful testing of Antares, ORB will receive substantial milestone payments and much of ORB’s working capital should be recaptured as cash. If we give ORB full credit work its working capital surplus, EV is reduced to ≈$572mm and ORB’s valuation multiples compress meaningfully.

ORB has historically generated substantial FCF and management is genuinely and highly focused on FCF generation. Moreover, ORB has historically returned substantial FCF to shareholders in the form of share repurchases. Between 2004 and 2009, FCF averaged $74mm/year on average revenues of $912mm. Over that time period, ORB repurchased $200mm+ of shares (≈20% of company).

I believe that ORB is at an inflection point and will begin generating prodigious FCF in 2013. I believe it is guaranteed that ORB will re-initiate their share repurchase program and it is very likely that ORB will initiate a dividend.

I believe that by year end 2013 ORB will have ≈$300mm in net cash (assuming no share repurchases or dividends in the interim) and will be generate ≈$83mm in unlevered FCF in 2013 and ≈$93mm in 2014. Assuming reasonable 9x-11x unlevered FCF multiples on those numbers number plus net cash yields share prices of $17.65-$22.50.

Although the thesis does not at all rely on it, I do believe that ORB may represent an attractive target for either a strategic or financial buyer. Various defense companies are starved for growth, and ORB provides that. Given low cost of financing, an acquisition or ORB at a substantial premium to current price can be justified.

For a financial buyer, using very reasonable assumptions I can arrive at a ≈20% IRR (5 year exit) based on a purchase price 40%+ from current levels.

Risks:

1)     Antares tests fail

2)     All risks associated with Government spending (general decline, NASA sequestration, etc.)

Catalysts:

1)     Successful Antares tests

2)     FCF generation and return of cash to shareholders