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6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 1/18Investigation Companies Manufacturing InvestingShort sellers bring space defence company back toearthAlmost all local hedge funds are short the $700 million ASX-listed Electro Optic Systems, whichis attempting to sell weapons in the Middle East and track rubbish in orbit around Earth withlasers.EOS invests in laser technology to track rubbish in outer space. EOSWMiiiiichaelllll Roddan and Jonattttthan ShapiiiiirrrrroJun 22, 2021 – 5.00amhen IFM Investors global co-head of listed equities Neil Carterrrrrresssssiiiiigned f ffffrrrrrom hiiiiisssss posssssiiiiitttttiiiiion i iiiin J JJJJune 2020 after more than eightyears with one of Australia’s largest institutional investors, the well-knownSydney stockpicker said he would “take a short break then it will be timefor something new”.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 2/18Carter, a former director at Macquarie Group, was right in one respect: itwas a short break.But his quick appointment just a few weeks later in July – as the chiefstrategy officer at ASX-listed Electro Optic Systems – wasn’t exactlysomething new.During his tenure at IFM, the jointly owned investment vehicle for theindustry superannuation fund sector, Carter had spearheaded the group’shot-blooded embrace of Electro Optic Systems (EOS), a fast-growingCanberra-based company that ships military weapons overseas, invests inlaser technology to track rubbish in outer space, and is building aninformation superhighway for the space economy.EOS has courted controversy due to its ties to the murky world of MiddleEastern arms traders, but it has won millions in government researchgrants and gained endorsement from the Australian Department ofDefence.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 3/18Neil Carter was a true believer in EOS even before he joined the company. James AlcockWhen former – and now new – deputy prime minister Barnaby Joycequestioned the company in Parliament in February, the Nationals MP wasso impressed by the local space industry firm he bought a parcel of sharesin the company for his son Sebastian’s trust fund two weeks later.But short-sellers are increasingly questioning the company’s unusualaccounting methods, its lack of cash generation and its governancearrangements. Short interest in EOS recently ticked as high as 9.42 percent, up from 1 per cent a year ago, making it one of the most heavilyshorted stocks in the ASX 300.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 4/18While the stock rose about 200 per cent over the past five years, it lost 50per cent of its value when COVID-19 hit.All but a few local hedge funds are betting the stock has further to tumble.For IFM Investors, falling EOS stock won’t be a problem. While Carter builtup IFM’s investment to a substantial 8.3 per cent of EOS by January 2019,the equities manager was soon forced to sell down the stock.In March 2019, IFM was blind-sided when international corporate activistgroup SumOfUs urged IFM to dump the investment after publicity aboutweapons sales to the United Arab Emirates, a member of the Saudi-ledcoalition that had been accused of committing war crimes in Yemen.The company now has a joint venture program with the UAE’s TawazunStrategic Development Fund to develop high-tech machine guns.By June 2019, IFM had ceased being a substantial holder in EOS. It is clearfrom the performance of the stock in the six months after this that Carterwould not have been happy to sell down the stake.Indeed, EOS briefly became a $1 billion company as the Morrisongovernment expressed interest in acquiring its Remote Weapons Stations.Although he left IFM, Carter is still a central player in securing the futurefor EOS, now responsible for developing the company’s strategic plan,optimising its capital structure, dealing with investors and risk mitigation.Cash drought6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 5/18A major risk facing the company, investors say, is a lack of cash generation.EOS makes its money selling its remotely operated vehicle-mountedweapons platforms to interested nation states.The company’s stellar growth plans were harmed by the COVID-19 crisis,and inventory built up to a total of $138 million at the end of March 2020 assupply chains around the world were disrupted.In 2019, EOS revealed its plans to grow annual revenue from $24 million to$240 million by 2020. In May this year, it went back on the guidancebecause of the pandemic disruption, telling investors to wait another yearfor the result.Of the $43 million of cash inflows between the start of April and mid-Maythis year, $30 million was not cash payments from its main UAE customer,but money “drawn under an international letter of credit which fullycovers this entire contract, through a major Australian bank”, according toa subsequent ASX statement. If the UAE doesn’t end up paying, First AbuDhabi Bank – the largest bank in the UAE – will be chased for payment bythe big four Australian bank.But EOS is not like most manufacturers. While many companies do notbook revenue until their product is delivered to the end customer, EOSaccounts for revenue as it manufactures the weapons.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 6/18EOS chief Ben Greene is an expert on space junk. Janie BarrettRevenue differencesAccording to footnotes in its accounts, it can do this because weapons“manufactured under this contract do not have an alternative use” and thecompany “has an enforceable right to payment for performance completedto date under the contract”.EOS also factors in no chance the customer payment – which has so farfailed to materialise – will not arrive, due to the UAE’s prior “known”6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 7/18payment history and given it is a “government customer secured by a letterof credit”.Due to EOS’ habit of accounting for revenue on manufacture, cash receiptshave lagged booked revenue by $153 million since the start of 2018.As actual money has not yet arrived, EOS has had to tap the marketfrequently to top up its working capital to fund its manufacturingoperations.Although EOS hosed down a September 2019 report by The AustralianFinancial Review that the company was about to raise capital, saying “Thisspeculation is unfounded and incorrect”, the company raised $220 millionin three instances over the next six months.The multiple raisings have piqued the interest of stockbrokers and theiranalysts.Earlier this month, Citi head of small-cap research Sam Teeger upgradedhis rating on the stock to “Buy”. Teeger is bullish on the stock as EOS startsto invoice its customers and diversify its revenue base “beyond a singlemajor customer”.Much of the capital raisings have supported the inventory blowout due to“international air freight bottlenecks”, the need to upgrade equipment, andtroubles with the UAE’s import documentation.By the end of December 2020, EOS had only obtained “written customeracceptance” for just 25 per cent of the inventory, also referred to as “formalcertificates of acceptance”.Delivery delaysIn May this year, EOS, which has more than $120 million worth of productwaiting to be accepted in the UAE, said the weapons were “positioned nearspecified customer delivery sites”. In other words, not yet delivered.The company’s auditor has raised concerns about the ongoing viability ofthe company, given EOS made a loss of almost $30 million over the 2020calendar year, with net cash outflows from operations totalling $110million.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 8/18According to EOS’ auditor, Deloitte’s David Salmon, there is a “materialuncertainty ... on the consolidated entity’s ability to continue as a goingconcern”.Indeed, Deloitte notes the UAE accounts for 60 per cent of total revenue,which is recognised even when it is “not billed to the customer” yet.Still, the government has backed EOS with Department of Defencecontracts worth more than $17 million over the past decade.The government last year threw the company a lifeline, buying 251 remoteweapons stations that were sitting idle in a shed in Canberra, to protectlocal manufacturing jobs.EOS received $5.77 million in JobKeeper payments last year, about half itstotal employee salary and benefits bill over the year of $10.4 million, andanother $1 million in “other COVID-19 government wage subsidies”.While the weapons side of the business faces challenges, the space-facingoperations are more opaque for investors.The company operates the 1.8 metre telescope at Mount Stromlo in theACT, where it is hoping to commercialise a giant laser that finds, tracksand helps remove space debris – a major threat to the $US700 billionworth of satellites and other infrastructure floating in orbit around theEarth. It has been working on the technology for seven years.RELATEDTheeeee s sssspaaaaaccccceeeee bubbllllleeeee t tttthaaaaattttt c ccccoullllld c ccccomeeeee c ccccrrrrraaaaassssshiiiiinggggg baaaaaccccck t ttttoEaaaaarrrrrttttthEOS Space Systems has a close-knit relationship with the AustralianNational University, and has urged the government to continue to supportthe fledgling local space industry due to the threat global supply chainscould fail, in the event allies desert Australia, and to prepare for a situationwhere the country needs a high-tech manufacturing industry to protect itfrom attack.Carter has told investors in EOS that there is “no bigger TAM than space”,referring to total addressable market, a measurement of the absolutepotential revenue available from a market if there was no competition.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 9/18Space has been somewhat lucrative so far. EOS Space Systems has won $34million of government contracts from Geosciences Australia (the agency ofwhich EOS was borne) and the Defence Department.SpaceLink, EOS’ satellite relay operator, is aimed at creating the NBN ofsatellite communication. The company is looking to increase bandwidth incommunication by a factor of hundreds – an upgrade from dial-up tooptics.Despite the government contract wins, the company’s history of patents isslim, and Professor Craig Smith, the chief executive of EOS’ Space Systemsdivision, recently told Parliament: “We typically don’t patent stuff becausein patent things you have to disclose enough information about how it’sdone that people who don’t have respect for intellectual property pick itup. Mostly we maintain trade secrets and know-how.”National security is clearly a priority for EOS, and the company’s board isstacked with an impressive list of names, particularly drawn from theAustralian Army, such as Lieutenant-General Peter Leahy AC and AirMarshal Geoffrey Brown AO. Former minister for sport and multiculturalaffairs Kate Lundy also has a seat.While the board’s history of service to Australia cannot be doubted, fundmanagers have questioned the level of business acumen among the groupof directors.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 10/18EOS chairman Fred Bart has been preparing to release Audio Pixel Holdings new speakertechnology for a number of years. Kirk GilmourWhile EOS chief executive Ben Greene has held the position sincefounding the company in 1983, the company’s long-time chairman iscolourful former rag trader Fred Bart, a well-known poker player who hasbeen connected to six corporate collapses.Bart’s other major chairmanship is of ASX-listed sister company AudioPixel Holdings which, despite having big plans to produce “revolutionary”wafer-thin speakers for more than a decade, has not sold a single chip.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 11/18EOS paid Audio Pixel Holdings around $30,000 a year to share its Sydneyoffice before a relocation to Canberra less than a month ago. EOS came tolife as a listed company via a back-door listing through Growth PropertyInvestments (GPI), a company controlled by Bart. Bart’s wife, Cheryl, waspreviously a board director of EOS.Board movesWhile former Deloitte partner David Black joined the EOS board inJanuary, Ian Dennis, a chartered accountant and serial company secretary,recently resigned from the board after 21 years.Dennis was also on the board of Audio Pixel Holdings, and Black was thesigning audit partner for both EOS and Audio Pixel Holdings for a numberof years until 2016.One fund manager, who is short EOS, said: “Even if the company wasn’thaving these issues with its weapons shipments, we would still see it, asbest, a company with a bad business model.”But Andrew Mitchell, co-founder of small-cap specialist Ophir AssetManagement, said EOS’ bidding for $1 billion of defence contracts could“materialise into significant revenue growth in coming years”.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 12/18“Its SpaceLink venture could also be a game-changer in the global satellitemarket, but will require a material capital injection before the project getsoff the ground,” Mitchell said.Washington H. Soul Patts is one of EOS’ largest shareholders and said theinvestment house was “supportive of the company and managementteam”.“We are excited by EOS’ prospects as it continues to innovate and developnew products and verticals. WHSP believes the company’s technology andIP are world-class and puts EOS at the forefront of its fields globally.”Carter admits that he still has work to do to convince investors of themerits of EOS, but he’s a firm believer in its potential – particularlySpaceLink, to which the market is ascribing a negative valuation.“Our satellite communications business SpaceLink is the picks and shovelsof the new space economy,” he said.Carter says the market views EOS as an industrial company when it has thecharacteristics of a technology company with large total addressablemarkets in the areas that it operates.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 13/18The short interest, he says, is largely driven by quantitative investors whoexpect a third earnings downgrade. Others are betting there will be aninevitable return to the share market for more capital.Carter, however, says EOS will likely be overcapitalised in the comingmonths.He also believes environmental, social and governance concerns are adistraction. The sector is tightly regulated and EOS is subject to rigorousexport controls, while those that work in the sector have a strong sense ofpurpose that they are serving the nation.Businesses in the defence industry that deliver will be supported byshareholders, he said. Defence and metal detection firm Codan, forinstance, is a $3.5 billion company that has gained six times in three years.During his tenure at IFM Investors, Carter helped turn the equities houseinto one of Australia’s punchiest investors.RELATEDSmaaaaalllllllll buttttt a aaaaccccctttttiiiiivvvvveeeee deeeeefffffeeeeenccccceeeee s sssseeeeeccccctttttorrrrr on t ttttheeeee ASXRELATEDCiiiiitttttiiiii l lllliiiiineeeeesssss up buyyyyyeeeeerrrrrsssss f fffforrrrr Ellllleeeeeccccctttttrrrrro Optttttiiiiiccccc SyyyyysssssttttteeeeemsssssBut Carter also backed a few high-profile losers, such as GetSwift, whichwas suspended from the market and accused by the Australian Securitiesand Investments Commission of prematurely announcing deals withcustomers to buoy its share price.IFM also piled into former market darling 1-Page, which at one point had amarket capitalisation of $800 million before it was sold for $1 following amarket suspension. It then became a medical marijuana company.On the other end of the scale, Carter wasssss an earrrrrllllly baccccckerrrrr offfff s sssseverrrrralllllwiiiiinnerrrrrsssss i iiiincccccllllludiiiiing Afffffttttterrrrrpay,,,,, the blistering success of which is widelyknown.6/22/2021 Short sellers bring space defence company back to earthhttps://www.copyright link/companies/manufacturing/short-sellers-bring-space-defence-company-back-to-earth-20210614-p580y4 14/18It’s clear that in the high-risk, high-reward game, some of the companiesbacked by Carter have turned into champions. It remains to be seenwhether EOS is one of them.