Allied Defense: Smallcap Between a Rock and a Hard Place

We promised that a thorough analysis of Small Cap Watch List member Allied Defense Group (ADG) would be our top priority. So we reviewed the recently issued annual report and here it is.

Allied Defense Group has reorganized into two segments: Ammunition and Weapons Effects, and Electronic Security. A third segment, Seaspace, is classified as a discontinued operation and a buyer is being sought. The ammunition segment produces large-caliber ammunition and mortars for military applications, as well as battlefield effects simulators. The electronic security segment designs, produces and installs security systems, surveillance and electronic data transmission systems. Sales tend to experience some seasonality around the summer and winter holiday seasons. Variations also occur as contracts near expiration/renewal. Orders often can rise ahead of the Sept. 30 U.S. Government fiscal year-end, and orders may be delayed afterward if the government has not yet approved the budget for the next fiscal year.

Sales grew 15% in 2006 due to an acquisition. Sales at MECAR, the company’s largest unit, increased 5% as reported, but were down 1% on a constant currency basis. ADG says its sales are based “primarily on fixed price contracts.” In combination with a reliance on the percentage of completion method, such contracts bear the risk that cost overruns will require significant restatements to reported revenue. Likewise, efficiencies would improve the company’s margins commensurately. Revenue recognized on contracts in progress were 86,571, $81,301 and $115,462 in 2006, 2005 and 2004, respectively. In 2005 the company adopted a more conservative method for evaluating the percentage of completion.

One “foreign government in the Middle East” accounted for 28%, 44% and 56% of company sales in 2006, 2005 and 2004, respectively. The company “concluded its approximately $130 million Foreign Military Sales [FMS] contract in the first quarter of 2005 and experienced lower sales activity for the remainder of 2005 and all of 2006. MECAR anticipated receiving a significant replenishment contract from its largest customer in 2006 but the contract was not received by year-end.”

Gross margins were 17% in 2006, compared to 16% in 2005 and 72% in 2004. They are down primarily due to lower volume at MECAR, which now has negative gross margins. In Q406 the company reached an agreement with labor unions to allow for 6-18 week layoffs while the factory workload remains weak. The company must continue to pay health and vacation benefits, which amount to 8.5% of total employment costs per worker, along with a 6-Euro daily meal allowance. Workers must work at least one full week for each 18 weeks of layoff. At the end of February 2007 135 out of 273 total affected workers were on layoff and white-collar workers were on 4/5 time and salary. Due to internal control deficiencies the company installed an ERP software system, and $1,359 of related costs were capitalized rather than charged immediately to expense. Net losses were realized in 2006 and 2005 due to the lack of substantial orders from MECAR’s principal customers.

Turning to liquidity and the balance sheet, ADG used $2.4 million in cash through operating activities and raised net capital of $19.5 million during 2006. Capital investments totaled $6.2 million. Year-end cash on hand was $20 million. $30 million in convertible notes may be in default due to late registration of the related shares. Until the shares are registered the company must pay 1% monthly in penalties. At worst the company could be forced into bankruptcy as early as this quarter, and three of the bondholders have requested redemptions. If holders are not paid promptly and the notes are found to be in default the conversion price resets to the lowest closing price since the date of the original redemption notice. Since the current share price is well below the current conversion price of $25.85, shareholders would experience significant dilution were this to occur.

The company also has $31 million of guarantees and performance bonds that bypass the balance sheet.
Reserves appear adequate to conservative, with the reserves for warranty, doubtful accounts and inventory all having provisions in 2006 that were greater than the realized charge-offs. Unfortunately, the company has had to increase its deferred tax valuation allowances, indicating that it believes it will “more likely than not” fail to earn enough in the future to use up the tax deferrals.

Overall, cash flow from operations was a fairly modest (compared to the significant net loss) outflow of $2.4 million in 2006. Cash flow improved despite a deterioration in net income due to non-cash expenses as well as reductions in working capital.

The company’s future hinges around its largest customer. In the annual report, the company says they “anticipate a substantial order” from the customer, who has been a “major customer since the 1980’s,” but admit that they “have anticipated receiving this order for approximately two years.” Meanwhile, the company’s backlog has deteriorated rapidly:

Without the anticipated order to replenish it, a substantial portion of the backlog is expected to be filled in 2007.

Assuming the company can sell SeaSpace, investors could expect a modest performance improvement, as the unit contributed $1,210 to pretax losses in 2006. The book value of the unit is $5 million and the company does not expect a significant gain or loss on the sale. If sold at book value, ADG’s enterprise value would fall to $85 million and EBITDA would improve, so the EV/EBITDA ratio and other cash flow to firm value ratios would improve.

Conditions should also improve relative to 2006 due to the cost reduction policies that have been implemented. If 25% of MECAR’s operating expenses could be avoided, we believe the unit would be marginally profitable. A combination of break-even performance at Ammunition and the sale of SeaSpace could conceivably forestall more serious financial difficulty.

As a best-case scenario, we believe cash from operations can recover to the $11 million (ex SeaSpace) the company generated in 2004, and EBITDA to approximately $20 million. On this basis, the enterprise value would look rather low. However, as we noted we believe this is a best case scenario.

There are no options traded on Allied Defense, which is probably just as well. The stock itself looks like a call option on the company’s survival.