Electro Optic Systems — Growth from defence

EOS specialises in electro-optics and control platforms, which it commercialises primarily within specialist military applications. The Defence Systems division develops technology for weapon systems optimisation and integration. The key product area is RWS for accurate, rapid firing of kinetic munitions. The latest product incorporates additional Counter Unmanned Aerial Systems (CUAS) or drone defence capabilities. The Space Systems division supplies rugged, high up-time satellite communication (SATCOM) systems for navies and the maritime sector as well as specialist space domain data from its own infrastructure and in-house developed optical capabilities. Our earlier research provides a further overview of the company.

We see three key drivers supporting EOS’s growth prospects.

According to the Stockholm International Peace Research Institute, global defence expenditure rose 9.0% (6.8% at constant prices) in 2023 to US$2.4tn. This was driven by a range of factors, including rising global conflicts, primarily in Ukraine and the Middle East, rising geopolitical tensions in areas such as the China Sea and increasing political pressure, particularly within NATO. Exhibits 1 and 2 highlight the increased US expenditure to support the two key areas of conflict.

Drones provide a threat in both the military and civil arena. Through its RWS capabilities EOS is focused on the military market. The use of drones has accelerated in recent conflicts and this is expected to continue, as highlighted by NATO’s Joint Air Competence Centre, which estimates that the CUAS systems market will grow from US$1.29bn in 2024 to US$7.51bn by 2032, a CAGR of 25%.

Drone warfare has changed battlefield tactics. Drones are relatively cheap depending on the intended use, as low as US$100 for small reconnaissance drones. Along with the unmanned element (ie no loss of personnel), this has made drones a new dispensable tool for the battlefield. This has led to new challenges for defence systems, which have traditionally been designed for single larger missile attacks. Firstly, drones are significantly cheaper than traditional anti-missile systems at up to US$1m per launch, providing an economic dimension, and secondly, the emergence of drone swarm tactics that ‘out-capacity’ traditional defence systems, ensuring penetration of a proportion of drones to their intended target. Exhibit 3 highlights the general classification of drones.

Defence systems come in two categories:

Drone developments include technology to circumvent soft-kill systems and jammers, such as using pre-programmed AI-based systems to eliminate the need for direct ground communication and control. Hence the military’s preference for hard-kill systems.

EOS anti-drone systems are an extension of its capabilities within its RWS portfolio. The Slinger counter-drone system is based on the proven R400 RWS platform increased to 4-axis multidirectional capability, incorporating radar diagnostics and dedicated software along with specialist ammunition to provide a range of up to 1km. It is priced at less than A$1.5m per system, with a per engagement cost of A$100 to A$1,000 depending on the type of ammunition used. The Dazzler uses a non-lethal, zero-collateral laser to degrade, deny and destroy the electro-optical sensors on typical unmanned aerial systems. The system is compatible with EOS current RWS software. Such cost-effective systems are becoming key defence hardware.

The military world is continually advancing in technology to gain a tactical advantage. Two key areas where EOS hopes to participate are HELWs and space warfare.

EOS intends to focus its HELW systems on the 50–150kW domain, the most relevant power range for C-UASs. Larger primes such as Northrup dominate the higher energy levels (up to 350kW), which are being developed for the hypersonic missile market, in particular long-range missiles. This will combine EOS expertise from its RWS business along with its capabilities in laser technology. Developing such a system will be costly, with the timeframe to commercialisation unclear. Hence, EOS intends to seek third-party funding and partnerships.

The sector is developing rapidly. We note that Tactical Advanced Laser Optical Systems (Talos), a consortium led by France-based laser and optics company Cilas, recently won €25m funding for Talos-Two as one of 54 programmes supported by the European Defence Fund. The three-year programme aims to develop two prototype 100kW-class laser weapons with a fully field-ready product targeted for 2030.

The war in Ukraine has highlighted the importance of communications in the battlefield, and hence the importance of satellites and space. Regulations are currently limited, with Russia vetoing the US proposal to ban nuclear weapons in space and the US vetoing Russia’s proposal for a ban on counterspace weapons. Also, the US recently accused Russia of launching ‘a satellite into low Earth orbit that we assess is likely a counterspace weapon’. A further indication of the increased importance comes from the US Department of Defense (DoD) 2025 budget request, which included US$33.7bn for space programmes, including US$4.2bn for more resilient and protected satellite communications, US$4.7bn to develop new missile warning and tracking architectures and US$12.3bn for a range of other capabilities aimed at increasing the resiliency of the DoD’s existing space architectures.

EOS clearly has capabilities from its space surveillance and intelligence services data along with its subsidiary KiwiStar’s optical systems expertise. The level of investment, as highlighted by the DoD budget, and timeframes have led management to look for external funding to develop this business.

The order intake in the first half of the year was a little behind plan, but the timing of contracts, particularly in the defence sector given the additional regulatory hurdles, tends to be somewhat variable. The pipeline remains strong at over A$1bn of opportunities at various stages of negotiation, as highlighted in Exhibit 6. Of particular note are:

H124 sales growth was strong at 92%, with significant gross margin improvement to 43.6% from 34.9% in H123. This fed through to a turnaround at the operating level with a profit of A$3.0m, from the previous year’s loss of A$22.2m. After financing charges, PBT was negative A$3.6m, a 90% reduction from the previous year. EPS showed similar improvement, albeit registering a small loss of 1.8c a share. The balance sheet improvement continued with period-end gross cash of A$52m and a net cash position of A$5.9m.

Defence division: Activity continued to be driven by the delivery of a contract for a large customer in the Middle East. Activity included supply of RWS units to a Western European government on the €15m extension contract announced in December 2023. Counter-drone demand continues to increase, with deliveries commencing on the €9m Slinger counter-drone systems to Diehl Defence in Germany. Demonstration testing continues for two contracts for Ukraine, working towards placing and timing of committed orders.

Space: EM continued to deliver against a c A$202m long-term contract to supply terminals to the Royal Australian Navy, with two key design milestones now completed, and deliver Cobra Maritime SATCOM terminals to the Royal Australian Navy’s existing fleet and customers in Europe. Space Technologies continued to commercialise its technology delivering satellite laser ranging services to longstanding customers, along with a number of smaller contracts with international customers.

Order intake in the period was more limited than hoped, particularly in the Defence division, with Space more positive. The overall order book declined in the period, although, as discussed earlier, the pipeline remains strong. Key contract wins announced in the year to date are:

H124 witnessed a net cash outflow from operating activities of A$30.6m, primarily driven by additional payments to suppliers for long lead time items and an increase in the Middle East contract asset, part of a long-term contract, which is expected to be realised in H224 along with an increase in cash interest paid. During the period, the company raised net proceeds of A$35.4m from a share issue to assist with the purchase of long lead time items, namely kinetics for the defence business.

The company repaid A$20.5m of debt in April to the agreed schedule. EOS has now made two repayments on schedule, with the final A$35m (A$52.1m including capitalised interest) due in October 2025. The group finished the period with gross cash of A$52.2m (net cash A$5.9m).

The Q3 update provided limited additional information (no P&L is required), with the highlight being the lack of significant one-off items and no change to full-year guidance. Net cash from operating activities was A$10.5m and cash used in investing activities was A$7.6m, leading to a A$2.8m increase in the cash balance of $55.0m, excluding A$64.2m of cash deposits held with banks to support bank guarantees. EOS had a gross contract asset totalling c A$79.1m (a A$10.6m reduction from 30 June 2024), almost entirely due to a large customer contract in the Middle East. Management expects this to be largely received in 2024 and into 2025.