When financial pundits make decisions, they’re always reminded by the audience when things don’t come to fruition. People will crawl over a football pitch of broken glass just to let someone know they were wrong, but it’s nothing but crickets when you’re right. What’s missing in either case is usually duration. Only when a company goes bankrupt or is acquired can you truly gauge success or failure of any given sentiment. So, last year when we said we liked MDA (MDA TO) more than Rocket Lab (RKLB), it pissed off a lot of RKLB zealots. Here’s how these two companies have performed since our last piece:
- RKLB: -19%
- MDA: +80%
- Nasdaq: +23%
And that’s after RKLB has seen a fair bit of ape hype.
If after another year MDA is performing better than Rocket Lab, we’ll be sure to remind everybody. If not, we’ll sweep it under the rug. Regular readers know we’re only joking because we invest in companies, not stocks. Whether MDA has outperformed RKLB over one year or five years doesn’t make any difference. In the end, it comes down to what realized returns you made on any given stock which will differ by person. Maybe a better question to ask is simply this. Do we still like MDA as much a year later?
MDA’s Gross Margins
Our recent video on hype in space stocks pointed out a major concern around fixed-price contracts. After incurring large losses, leading defense firms are now moving away from fixed-price contracts which means it’s easy for small space companies to start picking up the scraps. Peter Beck fans were shocked when Rocket Lab’s announcement of a $515 million contract didn’t excite the market. Details of that contract show it’s indeed fixed-cost with deliverables expected in 2027. Monitoring gross margins over time will ensure that costs aren’t spiraling out of control.
Likewise, we’ll want to monitor MDA’s gross margins closely as they appear to be slowly sliding lower every quarter.
One argument is that they can make this up on volume. In other words, if they continue growing revenues at a strong clip (30% expected this year at midpoint of guidance vs 26% realized last year) then gross margins can slip a bit and profits will still grow. While the company has been profitable over the past several years, you know the old saying – “profits are an opinion, cash is a fact.”
MDA’s Cash Position
One major concern is the small cash stockpile of $46 million on MDA’s books as of last quarter. Space is typically a capital-intensive industry which is why free cash flows are an important metric to watch. That’s because this metric reflects the cash needed for capital expenditures along with operating expenses. While MDA showed positive operating cash flows over the past three years, a look at free cash flows shows they’re burning through quite a bit.
This becomes a non-issue if they can achieve positive free cash flows this year (which is expected for the first time) and maintain that going forward. If the company is generating cash instead of consuming it, then they won’t have to raise capital by selling shares (this will dilute existing shareholders) or taking on more debt (doesn’t seem like a viable option). Here’s why.
MDA’s Debt
Downwards pressure on gross margins puts downwards pressure on operating margins which means a company becomes less profitable over time. Lenders pay attention to profitability because it demonstrates the likelihood that a loan’s interest payments can be made. That’s why one of MDA’s lenders has several covenants in place as follows:
Our house rule is that if you throw around financial ratios like these you ought to be able to calculate them. In their latest investor deck, we can see how they’re monitoring the net debt to EBITDA ratio over time and that it’s a) quite sensitive to changes in EBITDA and b) has been decreasing as the company decreases total debt outstanding.
A couple things to note here. First, they should be calculating total debt to EBITDA because this is what the covenant states. Second, when calculating the interest coverage ratio, it seems likely they’ll use last twelve months (LTM) for both values as they did in the EBITDA example. We see that your eyes are glazing over so we’ll move on now, but it’s important that investors understand the mechanics behind how debt covenants work because things can go south fast.
Look no further than what’s happening over at Spire (SPIR) to understand how quickly loan covenants can pose a problem for companies that agree to such terms. The reasons these types of loans exist is because the lender has concerns about being repaid when lending into a very risk domain such as the space industry.
MDA’s Backlog
Space companies love to talk about “backlog” and/or “bookings,” both of which should be taken with a grain of salt. Firstly, companies often define these terms differently and we have no color into the certainty of these future revenues. MDA defines bookings as “firm customer contracts” but provides no color on timing.
Actual revenues have a cost of goods sold (COGS) associated with them so we can be sure that the work is being performed at a positive gross margin that affords enough room for profitability. Bookings lack that visibility, and there’s always a chance the work might be under “fixed cost” and that cost overruns can quickly get out of hand. MDA may have over $4 billion in backlog but we’re more focused on what they’re actually able to accomplish in the form of revenues and COGS. Because their covenants are so sensitive to changes in EBITDA, we can only assume this backlog of contracts represents a high degree of certainty when it comes to profitability.
MDA’s Valuation
Not all revenues are created equal, but our simple valuation ratio (SVR) provides a quick way to compare relative valuations. For example, here’s a look at SVR calculated for a handful of popular space stocks (financial data in millions).
ASTS has a ludicrous SVR because they don’t have meaningful revenues which means we wouldn’t touch it with a ten-foot pole. Rocket Lab is enjoying some of the latest space hype which means they’re just above our catalog average of around six. As for the geospatial intelligence providers – Planet and Spire – they both enjoy gross margins above 50%, but are in the dog house right now as reflected by their low valuations. The former has a management team that’s rapidly approaching incompetence while the latter has the aforementioned problems with covenants.
The takeaway here is that MDA doesn’t look overvalued right now, but they’re also operating in one of the riskiest domains we cover, space, which means you should expect lots of volatility. That’s especially true when you have cheerleaders – most of whom know next to nothing about investing – blindly pumping their sacred cows every chance they get. Ignore this noise and focus on what matters – revenue growth, consistent gross margins, and runway.
Conclusion
We always focus on revenue growth because we assume gross margins are healthy and stabilized or trending upwards. When a company has strong revenue growth accompanied by shrinking gross margins, it’s a concern. MDA sits in a precarious situation with their small cash stockpile and debt covenants that could see them run into problems like Spire has. With positive operating cash flows expected this year then perhaps that will give them a bigger buffer to avoid problems. If gross margins continue to shrink, this company will become a whole lot less desirable.
