(Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.)
- Orbit International (ORBT) remains trapped in a narrow trading range due to the continuing effects of sequestration including budget cuts and contract delays.
- However, legacy orders appear to be only delayed rather than cancelled while several significant orders received subsequent to the end of the quarter should drive a rebound in the backlog.
- Moreover, a recent facility consolidation is expected to produce cost savings in excess of ttm EBITDA, which cuts the current multiple in half.
- Furthermore, a shareholder oriented management continues to repurchase stock (that trades below tangible book value) and recently reduced net debt by >80% using the growing free cash flow.
ORBT operates through two segments:
The electronics segment is comprised of the Orbit instrument division, TDL and ICS subsidiaries. Orbit and TDL supply customized electronic components and subsystems while ICS performs system integration for gun weapons systems and fire control interface as well as provides logistics support and documentation.
The power units segment, comprised of the Behlman Electronics subsidiary, supplies distortion free commercial power units, power conversion devices and electronic devices for measurement and display.
ORBT is headed into orbit but the market is still stuck on the ground
The market appears to have written off ORBT as another casualty of sequestration after revenue decreased 22.3% in the mrq to $6.1 million as weakness in the electronics segment more than offset strength in the power unit segment due to program contract delays, which are expected to negatively impact 4Q13. While the market is typically forward-looking, in the case of ORBT it appears to be the reverse as the following three significant catalysts are being ignored.
Significant margin expansion and cash flow growth. In October 2013, ORBT announced that it would consolidate the operations of TDL into its Hauppauge, NY facility in response to budget concerns and the expiring lease on the TDL facility. This move, expected to be completed before the end of 2Q14, should provide multiple tangible benefits including increased utilization and higher margins. The ~$2 million of annual cost savings alone are greater than the $1.8 million of ttm EBITDA and follow $1.25 million of annual cost savings in 2013 from cost cutting measures (e.g. workforce reduction).
Moreover, the gross margin only decreased 20 basis points to 38.7% despite the significantly lower top line due to the previously mentioned cost cutting, a more favorable product mix at the instrument division and TDL subsidiary as well as a higher gross margin at the power unit segment.
Furthermore, ORBT generated FCF of $2.3 million on a ttm basis (from being slightly negative in 2012), which produces a yield of 14%. The AMT credit of ~$0.6 million and ~$6 million of federal/state NOLs should provide an additional boost to cash flow, especially as the valuation allowance decreased to $3.8 million in 2012 from $9.6 million in 2010.
Growing backlog. The 26% decrease in the backlog to ~$12.7 million due to the previously mentioned delay in orders is less of a concern than it appears for two reasons. First, these orders should only be delayed rather than cancelled as management said that the legacy business remains intact. For example, several follow-on orders expected to be received in late 2012 or early 2013 were only recently awarded while the shortfall from a reduced FAA keyboard order (as part of air traffic control tower upgrades) is expected to be added to future awards.
Second, ORBT received multiple significant orders subsequent to the end of the quarter. For example, this month its power unit received follow-on orders of >$1 million. In October 2013, its electronics segment received an order to supply mission control data entry devices for the E-2D Advanced Hawkeye aircraft. While the contract is valued at >$480,000, ORBT expects a multi-year award of ~$2 million during 1Q14 as well as additional follow-on orders (e.g. 75 new aircraft are expected to enter duty in the near future after completion of initial prototype testing).
Also in October 2013, the electronics segment received a follow-on award from the U.S. Navy valued at ~$1.2 million for the manufacture of color programmable entry panels. This replacement program is also expected to generate follow-on orders due to the large number of destroyers and cruisers in service.
Shareholder focused management. Management continues to maximize shareholder value by shrinking the share count and significantly reducing the leverage profile. This is probably due to the effective insider ownership of 42% if the holdings of director Wayne Cadwallader (managing partner at Elkhorn Partners which owns 20%) and former director Bruce Reissman (who owns 9.3%) are included.
Since January 2012, ORBT repurchased >311,000 shares (at an average price of $3.57) and in November 2013 the board authorized the purchase of up to $400,000 of shares (the maximum permitted by its credit agreement).
Management is clearly aware of the low valuation and considers the repurchase program "at current market prices...to be an excellent use of our cash". Moreover, the growing cash flow was used to reduce net debt by >80% since 12/31/12 to only ~$0.4 million.
Although the current multiple may seem fair at best considering the challenging environment, this backward-looking measure does not include the previously mentioned $2 million of cost savings. If this is included, the multiple would decrease to ~4.5x.
The chart below from an investor presentation earlier this month further highlights the asymmetric opportunity and presents two key takeaways. First, ORBT regularly traded at or above TBV prior to sequestration (effective March 2013 but the market started to price this in beginning in the fall of 2012). However, following the cuts ORBT regularly trades below TBV. While the environment is admittedly more challenging, this is offset by the three previously mentioned catalysts.
Second, prior meaningful discounts to TBV (e.g. >5%) typically marked the low for the stock. Even if there is a several quarter delay until the discount narrows, at a minimum the downside should be minimized.
Source: February 5, 2014 presentation; stock price virtually unchanged since then.
The following are the primary risks to the investment thesis, in order of importance:
- ORBT is highly dependent on the level of U.S. military spending and would be negatively affected by additional cuts. Moreover, there is low visibility regarding the timing of new contracts or follow-on orders. This risk is mitigated as ORBT is often the sole source supplier on a contract.
- The electronics segment is subject to rapid technological change while the power unit segment faces increasing pricing pressure due to budget cuts.
- The loss of a major customer would negatively affect results given the high customer concentration. For example, for the electronics segment agencies of the U.S. Government, Raytheon and Synexxus accounted for ~28%, 13% and 10%, respectively, of revenue in 2012. In the power unit, Viasat., L-3 Communications and Baker Hughes accounted for ~12%, 12% and 11%, respectively, of revenue.
The target price is based on a 6x multiple using ttm EBITDA plus $1.9 million in net projected cost savings (~$0.1 million of cash expenses associated with the consolidation).
The stop loss should be placed below the strong support at ~3.30 or ~5% below. The time frame is 18-24 months given the current uncertainty regarding contract delays and time to receive additional follow-on orders.