Arotech Corporation (NASDAQ:ARTX) is an Ann Arbor, MI-based manufacturer of simulation software and lithium battery products for the security, defense and law enforcement sectors. ARTX recently announced Q3 earnings which blew past guidance. This article will examine those results and the guidance given for Q4.
Q3 Results Impress
Arotech had a terrific third quarter, which follows substantial improvements obtained in Q2 operating results that should culminate in a very strong 2013 fiscal year. Highlights of the Q3 operating results were:
- Revenues for Q3 were $23.2 million, compared to $21.4 million for the corresponding period in 2012, an increase of 8.2%.
- Gross profit for the quarter was $6.4 million, or 27.5% of revenues, compared to $5.0 million, or 23.1% of revenues, for the corresponding period last year, a 4.4 % improvement
- Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (adjusted EBITDA) for the quarter was $2.2 million, compared to $1.4 million for the corresponding period in 2012.
- Operating profit for the third quarter of 2013 was $1.4 million, compared to an operating profit of $737,000 for the corresponding period in 2012, an improvement of 90%.
- Net income from continuing operations for the third quarter was $861,000, or $0.05 per share, compared to net income of $498,000, or $0.03 per share, for the corresponding period last year.
Balance sheet improvement was noted as well:
- Cash increased to $4.863 million from $953 thousand in Q2
- Working capital increased to roughly $20 million from $12 million in the prior quarter.
- During Q3, approximately $5.5 million net was raised in an equity offering, accounting for the majority of the balance sheet improvement
- Shareholders' equity increased to $47 million, and share count increased to roughly 20 million shares, giving a book value per share of approximately $2.40
As mentioned earlier, Arotech operates two primary divisions: simulation and training as well as the battery division. The battery division accounted for approximately $5.5 million of revenue in the quarter but contributed only $100 thousand of EBITDA. In speaking with management on this subject they have developed new, value-added, higher margin applications for their batteries and expect that to be a bigger contributor to the bottom line in subsequent quarters. They recently announced a $700,000 order for special application battery chargers used in Unmanned Aircraft Vehicles (drones).
Arotech continues to win new orders. Backlog at Q3 had risen to $74.4 million from $65.7 million at Q2, despite turning in record sales. Subsequent to Q3, Arotech has announced via press release some $14.3 million in new orders.
Guidance for Q4 is a Worry
In their Q3 press release and on their quarterly conference call, management increased full year 2013 revenue guidance to $89-$90 million, up from previous full year guidance of $87-$89 million. Full year EBITDA guidance increased to $6.1 -$6.3 million from previous full year guidance of $4.5 - $5 million. While the increased guidance is impressive at first glance, it becomes more worrisome when one deducts the nine month results-to-date to arrive at what that implies about Q4 guidance. Since Arotech has already delivered 9 month EBITDA of $6.2 million, that implies ostensibly zero EBITDA for Q4. It further implies sequentially lower revenue in Q4 by about $1 million. This seems odd in light of the increased backlog and the obvious trend for new order wins. When I questioned management on this they responded with their desire to be conservative. This conservative bias resulted in them blowing through their previous guidance with their Q3 results. I have nothing against a conservative bias, especially when it comes to making forecasts. But guidance should be guidance, not mis-guidance. When pressed on the issue of Q4, management thought it would be a good quarter, but probably not quite as good as Q3. They cautioned that Q4 contains year end bonuses which inherently make it difficult for Q4 to match the Q3 pace. Were they sand bagging results in their Q2 guidance, so they could over-deliver to expectations in Q3? Are they sand bagging again with a hope of over-delivering in Q4? That is how it would appear to me. If you take $22 million of guided revenue and multiply it by 27%, the Q3 gross margin, you get a contribution of $5.5 million. Deduct Selling, General and Administrative expenses and R&D expense as incurred in Q3 of $4.6 million and you should generate around $1 million of EBITDA. Does this suggest $1 million of bonuses to be paid out? I hope not, as the CEO, CFO and President together took out $1.6 million in combined compensation in 2012. That seems an awful lot to me for a company with only $90 million in annual revenue and $6 million in EBITDA.
Arotech appears under-valued relative to its peers. I first wrote about Arotech in September of this year when it looked as though the US was prepared go to war with Syria. In that article I discussed the valuation gap that existed between Arotech and its larger competitors. I update that valuation table here, comparing Arotech to other defense contractors Raytheon (NYSE:RTN), Lockheed Martin (NYSE:LMT), Boeing (NYSE:BA), Northrop Grumman (NYSE:NOC) and General Dynamics (NYSE:GD):
Arotech is trading at 0.8 x book value, a substantial discount to its peer group. If we take out the anomalies of BA and LMT, we still find average book value for the peer group to be near 2.7 times, a significant premium to Arotech. The peer group has experienced substantial stock price increases since I last wrote, taking average forward PE up to 16 from 12, while Arotech has remained substantially flat in terms of stock price. Arotech has not yet guided for 2014, but assuming that 2014 is slightly better than 2013 one should expect earnings of $0.20 - $0.25 per share. This would be a rather conservative outlook, given the enormous improvement in all operating metrics at Arotech so far in 2013 versus 2012. But going with that assumption gives Arotech a forward PE of roughly 9, just over half the average forward PE of the peer group. This comparison of book value and PE suggests a potential double in the Arotech stock price in the coming year.
Arotech has many positive attributes in terms of its improved profitability, increasing sales, healthy balance sheet and strong and growing backlog of orders. Though much smaller than its peer group, it is more profitable than they are and is growing considerably faster, yet trades at half their multiples.
On the negative side is their guidance. I have a hard time deciding what to make of their guidance. Is Q4 likely to break the trend and deliver zero EBITDA? Or is this management sandbagging results to manage market expectations? If it turns out to be the former, those are not great results; if it turns out to be the latter, that is not great management. Either way, the guidance issue is a negative in my view, and consequently I would lower my own valuation from what the peer group comparables table gives, and place a one-year target on this stock of $3.25, or a 60% upside from its current price.
Disclosure: I am long ARTX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.