Aerosonic (AIM) operates in one business segment, manufacturing airplane instruments. Approximately 28% of its business comes from government, with the remaining amount from the private sector. Also, approximately 40% of its business is from foreign companies in 2010 (30% in 2009). AIM has been working over the past 5+ years to move into the digital instrument market after manufacturing mostly analog instruments prior to this; this follows industry trends. AIM’s major customers are the largest defense contractors and airplane manufacturers in the world, including Lockheed Martin (LMT), Boeing (BA), and Korean Aerospace Industries. These companies have been loyal customers for many years.
AIM looks cheap, but that is a bit deceiving. Here are the numbers:
- P/E: 4.1
- P/B: 1.2
- P/FCF: N/A (FCF is negative due to working capital increases)
- P/S: 0.4
- P/Owner Earnings: 4.48 (TTM OE-5yr avg CapEx)
Why is this deceiving?
AIM went gangbusters in FY2010, posting a 50% year over year sales increase. They have taken a step back in the two quarters of FY2011 because of reduced demand, but are on pace for a profitable year again. It is also worth noting that AIM had a $550,000 gain on casualty loss in 2010, stemming from a fire at one of its manufacturing facilities (more on that later). In FY2011, SG&A costs did not decrease along with sales, driving the decrease in earnings.
A Rough Couple of Years
In 2008, a fire broke out at AIM’s Clearwater, FL manufacturing facility, knocking out parts of production and sending AIM into a full-on liquidity crisis - they needed $5MM in advances from customers just to survive. Facts surfaced that the building had not had an inspection in 11 years. This came on the heels of accounting fraud (see here):
There's a lot of bad karma Aerosonic must cast away. Some of its past top executives — including founder Herb Frank, David Goldman and Mervyn Nabors — over the years have faced various allegations of fraud, misappropriation, tax evasion, stock misrepresentation or dubious accounting practices.
Goldman was sued by the company. As if that weren’t bad enough, AIM has been dealing for a few years with multiple internal control issues stemming from inadequate staffing in accounting. Oh, and AIM was in violation of some covenants on its credit facility with Wachovia. Wow, sounds like a gem.
So... Is It a Gem?
Not exactly, but it’s not coal either. AIM continues to incur costs related to bringing the Clearwater facility back online but capacity appears to be largely restored (the company noted that internally funded R&D in 2Q11 was spent almost entirely on restoring Clearwater operations). The accounting and internal control issues are in the process of being resolved. The credit facility was refinanced with a different bank, although AIM was operating with a waiver from Wachovia.
During its liquidity meltdown, AIM entered into what I would consider to be an unfavorable loan with three private AIM stockholders. On the positive side, the amount outstanding on this loan is low, even though the interest rate is 14% and AIM had originally issued stock and warrants to these investors in consideration for the loan. I attribute this to the tough credit environment of the time and the desperation of AIM management.
Further signs that things are heading in the right direction include the fact that both Boeing and Lockheed Martin were calling AIM during its production issues, wondering when they would be able to deliver their product. AIM manufactures products that no one else does, and apparently does it quite well. There is of course the risk of further downturn in the commercial air industry but, let’s face it, people are not going to stop flying anytime soon.
Despite its challenges, AIM has continued to invest in R&D and has reorganized and enhanced its engineering team even in a tough economic environment. This should pay dividends and allow the company to continue to develop high quality products. AIM is also consolidating its operations in Clearwater, eliminating operations almost entirely at a facility in Virginia. This allow for increases in efficiency. Once this facility is sold, it will allow AIM to focus entirely on Clearwater.
The balance sheet is improving. Debt is higher and cash lower than I would generally like, however this is largely a product of a few challenging years from which AIM is still recovering. Importantly, Net Current Assets exceed liabilities by more than $2MM. I will be watching this closely and looking to bail if things take a sharp turn for the worse. I have been unable to find backlog figures for the most recent quarter.
Insider ownership is strong, with the CEO Doug Hillman owning slightly over 2% and the Board collectively owning over 8%. Hillman recently purchased 5,000 shares, a decent amount for a stock with average daily volume of only 8,000 shares and has purchased 5,000 shares at semi-regular intervals over the past year.
AIM has had more challenges than most over the last few years and has emerged an improved company. With its problems in the past (or mostly in the past), I believe that AIM is well placed to benefit when the commercial airline sector improves. AIM has maintained a commitment to R&D and hiring and retaining key employees. The major defense contractors have been increasing use of subcontractors over the years and AIM seems well-placed to take advantage of this. The fact that Boeing and Lockheed, among others, have stuck by AIM during its troubles speaks to the quality of its products.
So, What Is It Worth?
Annualizing the 6 months of Owner Earnings in FY2011 ($2.24MM) and 5 year average CapEx ($707,000; expenditures are higher now due to the Clearwater repairs), total year Owner Earnings could approach $1.5MM, which implies a P/OE of 6.67 (in reality they will be lower due to inflated CapEx). This is a relatively low multiple for a depressed amount of OE. A P/OE of 10 (a conservative valuation) would imply a price of $4.00, and a 50% return. I feel that this is the minimum potential valuation.
Looked at another way, P/E multiples also imply a higher valuation. Comparable companies have P/E ratios ranging from about 10 to 30 (removing outliers). AIM recorded EPS of $1.09 per share in FY2010 and 65 cents in FY2006. Applying a multiple of 10 would require 40 cents per share in earnings to reach my $4.00 target.