When it comes to investing in micro-cap stocks, most investors have one thing to say: “No thanks,” often for good reason. Many, many micro-cap stocks are merely the withered remains of once high-flying companies with little hope of rising again. Others are enterprises that have never been and will never be profitable and will continue to burn investor capital until they are delisted. Others are outright scams or subject to rumor-spreading and manipulation. Might as well shovel cash into the fireplace, right? The truth is that profitable micro-caps with great growth potential do exist, but it takes some research to find them.
Luckily, I took care of that and found AeroCentury Corp. (ACY). I believe this stock has great potential for great capital gains in 2009 and beyond. At a market cap of only $16 million, AeroCentury has room to grow for decades to come before the law of large numbers begin to slow it down. Let me elaborate a little.
AeroCentury operates as a buyer and re-leaser of commercial aircrafts to airlines world-wide. The company operates from California and was founded in 1989. AeroCentury has no employees and outsources all management activities to Jetfleet Management Company. AeroCentury focuses on leasing to regional airlines and earns most of its revenue from Europe and Asia. The rise of oil prices over the last decade has provided an economic tailwind, increasing demand for the smaller aircraft owned by AeroCentury. The company has been voracious in acquiring assets, increasing income-earning assets from $17 million in January 1998 to $119 million now. Currently, AeroCentury owns 41 aircraft.
AeroCentury is in the middle of serious growth in sales and income. Revenue was $24 million in 2007 and the company has already booked $23.7 million through three quarters of fiscal 2008. Revenue will likely come in at about $32 million for fiscal 2008 when the final quarter is reported, growing 33.3% from 2007 and over 250% from 2003 levels.
AeroCentury’s balance sheet does show a high debt-to-equity figure, coming in at 2.15. However, this is in line with industry standards. Leverage is required in order to produce attractive returns on equity when leasing aircraft. Secondly, aircraft are very high-quality tangible assets that retain value, making banks very willing to lend against them. AeroCentury stock is trading at only 46% of the book value of these quality assets, giving investors a wide margin of safety in case of default. The company’s debt is mostly floating-rate and is hedged 80% against fluctuations through a swap agreement.
AeroCentury’s stock price has fallen from a 52-week high of $20.80 to $10.93. Beyond the general bear market, a few factors have turned against AeroCentury. First, the dramatic fall in oil prices has reduced demand for AeroCentury’s aircraft from the extremely high levels of mid-2008. Secondly, the company’s dependence on debt financing in a time of shell-shocked credit markets has made investors wary of any company carrying significant debt. If credit markets eventually normalize and oil prices stay steady or increase, AeroCentury has a bright future and promises even better returns.
But story is just words. I ran a simplified valuation model to determine the present value of AeroCentury stock by the numbers. First, my assumptions:
Although revenue growth rate has been substantial in the past two years, I wanted to use conservative projections. A regression of the past eight years of revenue growth gives a value of 14%. I assumed this growth would continue for 5 years, followed by five years of 12% growth, then by five years of 10% growth.
AeroCentury’s net margin has been extremely variable, ranging between 1.41% and 15.84% in the past five years. One encouraging sign is the company’s outsourced management expense, which has been falling rapidly as a percentage of revenue. Although revenue has grown rapidly, Jetfleet’s management fees have been relatively constant. I’ve projected a long term net margin of 10%.
Growth of Equity
I have assumed that 10% of yearly revenue is retained to the equity base, equivalent to net income. AeroCentury does not pay dividends or have a history of stock sales so I believe this assumption is reasonable.
Required Rate of Return (Discount Rate)
This figure was the most difficult to determine. Regressing five years of monthly returns against the S&P 500 yielded a beta of .50. I believe that figure dramatically underestimates the risk of investing in AeroCentury, so I took as alternate approach. Instead, I took the beta of the Russell 2000 Small-Cap Index, which I calculate at 1.25. I used a risk-free rate of 5% and an equity risk premium of 4.5%. Using those figures gave a preliminary required rate of return of 10.6%. To this, I added a 3% premium for AeroCentury’s extremely small size and high leverage and a 1% premium for the minimal liquidity of the stock. My final estimate for required rate of return is 14.6%.
Long-Term Return on Equity
Like the Net Margin, AeroCentury’s ROE has been extremely variable. The trailing figure is 13.98%. Given the rapid increase in revenues and the capability management has shown, I’ve used a long-term ROE of 13%.
Given all those fairly conservative assumptions, I projected a book value of $198 million in 2024. By that time, I believe the size and liquidity of the stock will have grown, leading the required rate of return to fall to around 12%. Given a 13% ROE and a 12% required rate of return, AeroCentury would trade at 1.083 times book value by the residual income model. That implies a market cap of $214 million in 2024. All that remains is to discount back to the present. Doing so at the 14.6% gives an implied value of $27.7 million, or $17.99 per share. Even using my conservative projections, that is a large premium over the current price and market cap.
But…what if the worst occurs and the company goes under? I tried to capture that additional risk in the discount rate I used. However, for an additional measure of security, let’s assume there is a chance that AeroCentury goes bankrupt in three years, and investors receive only 25% of book value in the liquidation. Using the same required rate of return, AeroCentury is worth only $8.07. Capital losses all around.
Finally, if there is an 80% chance of thriving under the first scenario and a 20% chance of bankruptcy under the second scenario, then AeroCentury stock is worth $16.00. That’s 46% upside from here.
And that, in many words, is the investment case for AeroCentury. The stock has been beaten down far below what the fundamentals justify. AeroCentury is a micro-cap, yet its future is much brighter than most well-known stocks you see on CNBC. Just as a word of warning, AeroCentury trades with very low volume and wide bid-ask spreads. Limit orders are your friends!
Stock position: None.