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Speedcast hits a speed bump

Charlie Aitken writes that sometimes it’s best to admit you made a mistake and fall on your sword.

Unfortunately, when you are a well-owned growth stock, you can’t downgrade your growth expectations and avoid serious share price consequences. I have to say I was very surprised by the profit miss and guidance downgrade issued by satellite communications company Speedcast (SDA), yet I can’t be surprised at the 40% share price drop to what equated to 20% downgrades to consensus earnings estimates. In what are unforgiving markets, dominated by momentum investors, where P/E is also subtracted alongside earnings downgrades, the punishment for the crime nowadays is large.

Sin bin

The chart below overlays Speedcast consensus earnings estimates for 2018 on its share price. You can see the consensus earnings (red) had been in a steady upgrade cycle and the share price (white) had been following. This has now been reversed.

No doubt Speedcast will be in the “sin bin” for the next six to 12 months. What we need to consider is what drove the earnings disappointment and is it temporary or permanent? The market seems to have taken the view it’s permanent, dropping the P/E to 12.5 times calendar year 2018 earnings and 9.8 times financial year 2019 earnings, or PEG ratios of just 0.5 times and 0.3 times earnings. I suspect that means the market feels another downgrade to expectations will follow in a few months.

Unpleasant results

There was a lot to digest in the first half 2018 Speedcast result and most of it wasn’t pleasant. As UBS pointed out in their recent note, the key negative surprises were: Speedcast downgrading FY18 EBITDA guidance from $155 million to between $135 million to $145 million; First half EBITDA of $60 million, declining sequentially on second half 2017’s $69 million, and missing a consensus of $72 million; and Speedcast announced another large acquisition, Globecomm, for US$135 million, which, while accretive in FY19, lifts pro forma gearing to 3.3 times. Stocks that miss earnings, yet simultaneously acquire another business and lift gearing, do get treated with suspicion by the market.

The below graph shows the 1H 2017 to 1H 2018 underlying EBITDA bridge:

Source: Bloomberg

The combination of events above, including higher interest costs, led to analysts cutting EPS forecasts by just over 20% for FY18 (current year) and nearly 30% for FY19. In simple terms, the stock was trading on 15 times FY19 pre the profit warning and it would be fair to assume the market would reduce the P/E due to uncertainty. This would suggest the stock in the near-term would trade between $4 and $4.50, until there’s more clarity about the earnings outlook.

Lack of certainty  

The certainty of the earnings outlook centres around the problematic energy division. Operationally, the bad news in 1HFY18 was energy returning to a decline, after previously stabilising in 3Q/4Q FY17. Other negatives were un-monetised Carnival Cruise capacity in maritime and Peru contract losses in emerging markets. Also, first half FY18 energy revenues fell to $76 million, compared to first half FY17’s $92 million, with declines being driven by higher rig attrition, contract losses, lower pricing on legacy contracts and customer delays, only partly offset by new activations. Speedcast is guiding for second half FY18 energy revenues to rise to between $85 million to $90 million, but this will require activations to exceed rig attrition.

Encouragingly, a portion of rig growth is underpinned by the Noble contract, and June/July 2018 activations outpaced churn. Looking into FY19, Speedcast reiterated that an energy recovery is likely to benefit land rigs first, then jack ups, and deepwater rigs last. Speedcast is exposed to the last and industry data tabled below from UBS suggests deepwater rig counts remain flat.

Energy surprise

Cleary, the energy disappointment was the unexpected negative surprise in the result and the issue that drove the downgrades. The problem is, as evidenced above, that it is unlikely to reverse in the short term, which means Speedcast stock will remain in the new lower trading range “sin bin”.

While there’s no doubt, on the acquisition maths, that the Globecomm acquisition is cheap and accretive, the bigger problem is that it increases Speedcast gearing at a time of earnings pressure. I don’t think the market disapproved of the Globecomm deal as such, just its timing.

Strategically, Globecomm allows Speedcast greater access into more sensitive sectors of the government vertical. Financially, the Globecomm acquisition price of five times EBITDA post synergies seems inexpensive and analysts believe the synergies of $15 million could prove conservative. On the other side of the equation, Globecomm performance under private equity ownership, post delisting in 2013, has been underwhelming, partly impacted by legacy Afghanistan revenues.

The rising debt situation is what arguably exacerbated the share price sell off. Debt is approaching $500 million and market cap is $1 billion. That is not a wonderful metric and does generate understandable concern.

Time to sell

The question becomes what do we do with Speedcast after a 40% drop in response to a clear earnings disappointment, guidance downgrade and increase in debt levels?

Sell it: there’s too much risk and too much uncertainty.

I broadly believe we are in a monster small cap industrial bubble in Australian equities and therefore I can’t tolerate holding any Australian small cap with rising debt and earnings risk. This is despite the fall in Speedcast shares.

The reality is that Speedcast shares have only fallen back to where they were late last year and remain double the share price they were in early 2015.

I believe in situations like this it is prudent to fall on your sword, admit you made a mistake and sell the stock. That’s exactly what I’ve done while also selling just about all small cap industrial holdings I have in Australia, as I think the risk/reward equation is now swinging towards risk. Risk of capital losses, if any, disappoint in any way due to the very high P/E s, crowded positioning and high expectations.

I say again, I think Australian small cap industrials are a bubble, a classic bubble. It’s time to be prudent and learn the lessons from the Speedcast example.

Perhaps the right switch is from Australian small caps to Australian large caps. That’s a theme I will start to explore.