TAT Technologies (NASDAQ: TATTF) is a tiny maker of specialized parts for military and civilian airplanes. The business has been consistently earning good returns on capital, growing and throwing off free cash flow but its value has recently been masked by a flurry of “corporate actions” which produced complex financials and may have scared off investors.
As a result, the business is now selling for what I believe is a bargain price of about 1.1x the last twelve month’s EBIT and 46% of its book value. Over the next year, TAT should be able to produce much simpler financials that will make the value more apparent.
TAT operates three related businesses in the aerospace industry:
- Gedera makes high-end heat transfer components which cool military and civilian aircraft,
- Bental makes electric motors, primarily for weapons systems on the ground and in the air;
- Limco services and repairs civilian and military aircraft.
Although TAT has an Israeli name, it derives most of its revenue (55.6%) in the US, files US GAAP-compliant financials with the SEC, is audited by a US accounting firm and trades on the NASDAQ (dual listed with Tel Aviv). The company’s functional and reporting currencies are the US dollar, not the New Israeli Shekel (NIS).
Customers and Competitive Environment
Considering its tiny size, TAT has assembled an amazing list of customers, including:
- US Air Force and Navy
- Israeli Air Force
- Bell Helicopter
- KLM Royal Dutch Airlines
I don’t know if these customers share any other supplier, but if they do I’m pretty sure that supplier is worth a lot more than the $8.8m it would cost to buy TAT whole.
Furthermore, these customers are waiting in line: TAT has a back-log of $23m worth of orders for Gedera and Bental, about 7 months worth of sales.
The airplane-parts industry is highly competitive, so how can TAT win such a customer roster while maintaining 20%+ operating margins? The company attributes its success to its highly skilled engineering workforce and integrated manufacturing capabilities. It says it has to stay “on the forefront of technological innovation” to remain its competitive position, implying that the product line is in constant flux.
However, the company spends zero dollars on R&D, does not expect to in the future, and has no trademarks or patents. What’s really going on?
I believe TAT benefits from a combination of:
- high barriers to entry for its competitors,
- highly customized offerings,
- long-term contracts with customers and
- a special “insider” relationship with the Israeli air-force which contributes to its reputation and is hard to duplicate.
Let me describe each of these factors:
- Barriers to entry: TAT has approval from Israel’s government to sell to Israel Defense Forces (IDF) and to the US military. To keep these approvals, TAT must retain tight security procedures and meet strict performance / quality standards for its wares. Although TAT’s military sales were less than 10% of total revenue over the past 3 years, I believe having this seal of approval is a strong selling point for civilian customers as well. The number of competitors who have similar approvals is limited due to security considerations, and it would be difficult for a newcomer to get them. TAT lists its major competitors around the world in a (short) paragraph in its annual report. TAT’s Limco division has similar military approvals in the US, as well as certifications from FAA and a half dozen airplane makers (OEMs).
- Customized offering: The types of parts TAT makes are often custom-designed and manufactured to the detailed space and performance specifications of the buyer. The parts are mission-critical (e.g. if the heat transfer component fails, the plane crashes). This is the opposite of a commodity offering, and helps boost customer loyalty and lower price sensitivity.
- Long-term contracts: Due to the complexity and customization of the parts, TAT’s customers often enter into long-term supplier contracts, to ensure the supply is there. Contracts can last as long as 10 years. This makes it harder for customer to switch suppliers.
- “Insider” relationship: TAT has been selling to the Israeli air force since 1969. Its headquarters facility is located on land leased from the Israeli government. The Chairman of the Board of Directors, Giora Inbar, served 25 years in the IDF and reached a very high rank (Brigadier General). These relationships are hard to replicate.
Financials and Valuation
TAT did not have a single unprofitable year between 1999 and 2008. Its net income grew 4%/year on average. PPE/Sales dropped from 22%+ in 1999 to 13-14% in recent years, indicating the business may be enjoying some operational leverage. TAT has been throwing off free cash flow every year except 2007, which was distorted by the Limco deal (see below). Most of this cash is still on the balance sheet. This would be considered pretty solid performance for an average or even above-average business.
Nevertheless, TAT trades for the distressed price of about 1.1x EBIT, as follows:
Total equity on the 2009Q1 balance sheet was just over $100m, so price/book is about 46%.
Why Is TAT So Cheap?
I think there are a couple of reasons. First of all, TAT serves the aerospace industry and “everyone knows” airlines and defense contractors are in trouble. Second, TAT is a micro-cap at $40m and has never had Wall St. analyst coverage. Third, TAT’s ownership structure and financials are WAY too complex for a company that size. The annual report weighs in at 125 pages. Fourth, TAT is 70% controlled by a single Israeli businessman, Roni Elroy (more on him below).
This limits the stock’s liquidity (although average volume is still over 15k shares/day). Fifth TAT’s net income has fluctuated wildly over the past 3 years, from $6.1m in 2006 to $32.0m in 2007 to $3.9m in the last twelve months ending 2009Q1. It isn’t clear what’s sustainable. Sixth, TAT’s management team is new, installed in 2008.
To top it all off, over the past 12-20 months, TAT has completed two major acquisitions: Bental and Limco, and it’s unclear whether these acquisitions have been successfully digested.
At the current valuation, even if these concerns were mostly justified, I believe the price more than makes up for it. However, let me try to address a couple:
In late 2008, an Israeli investor named Roni Elroy purchased ~70% of TAT. Elroy claims he is following the Warren Buffett model in his holding company, KMN Holdings, which owns two dozen other businesses and trades on the Tel Aviv exchange. Some of Elroy’s stated investment principles are:
- Purchased operation must be simple, "so you can understand what the company does within 10 minutes,"
- Interested in “old economy” companies. Not interested in risk capital or startups, technology or food (?) companies
- Look for companies in trouble that can be purchased at Bargain prices
- Will pay a premium for companies with a long history of profitable operations
- Look at the balance sheet not the income statement
- No auctions
I haven’t done enough research to tell whether this is just lip service or the real deal, but it sounds good.
One of the parties that sold TAT stock to Elroy, FIMI investments, holds an interesting PUT option: It can put 100k shares to Elroy on December 2009 at a strike price of $19.34/share. If it does not exercise the PUT, Elroy can CALL the shares at the same strike price the following month. This tells me that Elroy thinks the shares are worth upwards of $19, and will be highly motivated to raise their value in the next few months.
Shortly after buying TAT, Elroy replaced TAT’s CEO, CFO and Chairman of the Board with his own people. The previous managers had a 20-year tenure with TAT. Compensation for the new board and executives seems to be under control: 17 board members and senior executives were paid a total of $3m in 2008, about $176k/person.
Recent M&A: Limco and Bental
In July 2007, TAT sold about 40% of Limco, a U.S.-based subsidiary, to the public in an IPO at $11 per share. As a result, TAT recognized a capital gain of ~$26 million in 2007 and outsize net income of $32m. Limco shares proceeded to tank and TAT bought them back in June 2009 in a stock swap deal that valued Limco at about $2.56/share. Nice deal if you can get it.
By the way, TAT’s most recently filed financials are from Q1 2009, so this value is not yet reflected.
On August, 2008 TAT bought 70% of Bental, another specialized airplane-parts maker in Israel. The series of transactions used to buy Bental is complex, so it’s hard to tell exactly how much was paid, but the last 15% of the equity was purchased for $1.9m, implying a total valuation of $12.7m. Bental’s operating income in 2008 (full year) was $6.3m on $32m of sales so TAT paid almost exactly 2x Op Income which does not seem like an excessive price, particularly in the context of public comparables, see below.
I analyzed five of TAT’s competitors, small-cap firms that make airplane components: EDAC, TGI, HEI, OTCPK:KRSL and AIR. These trade at an average of 9.38x earnings, 1.09x book, 0.69x sales and 5.52x EBITDA. If we apply the 9.38 earnings multiple to TAT’s last twelve months of earnings, we get a value of 36m for the equity slightly less than the current market cap of 43m.
However, this earnings-based valuation essentially ignores TAT’s hoard of $43m in cash. Adding the cash back, we get a value of 79.58m which is 84% higher than the current value. By the way, TAT’s average competitor has 22% of it’s market cap in cash, as compared to about 100% for TAT.
If we use the other multiples, i.e. book, sales or EBITDA, we get implied valuations for TAT’s equity that are at least 39% higher than the current market price, and that’s before adding back the cash.
- New management, appointed in 2008, begins to affect the financials
- Taking Limco private (deal closed in July) simplifies the financials
- Full year of Bental sales and income show up in financials. So far only $9m of Bental sales & income from Aug-Dec 2008 showed up in 2008 annual report
- Improved liquidity in the stock (TATTF) due to the merger with LIMC. Before the merger, TATTF used to trade a few thousand shares per day. Now, average daily volume for the past three months exceeds 15k shares.
- Put option held by FIMI at $19/share, incenting Roni Elroy, the new owner, to quickly raise the value of the firm.