70c valuation/strong buy

As of today, Adacel’s market cap is just $26.7mill and the stock is presently trading at a FY04 price to sales ratio of only 0.5. The low share price (305c) reflects underperformance over the last 3 years and market/analyst expectations that ADA’s FY05 results will be similar to FY04 (following large restructuring costs/write downs/exiting loss-making businesses, the company incurred a $25mill loss in 04). I think the market is wrong in its assumption that 05 will not be substantially better than 04; a turn-around is well underway and the stock should be dramatically re-rated over the next few months.

My research leads to me to believe that ADA will (1) report an operating profit this FY, (2) will be cashflow positive this FY, (3) will likely receive a new $5mill contract from the FAA/USAF for 4 MaxSim units in the short term, (4) will likely receive an additional $100mill MaxSim contract from the US FAA in September/October of this year, and (5), is now on a strong growth trajectory from a reduced cost base.

Explanation of (1)-(5):
I arrived at (1) and (2) by balance sheet analysis and research into existing contracts and new contracts won since Dec 31. In summary, I’m expecting 05 operating revenue of around $50mill and operating expenses of $47mill = FY05 operating profit of $3mill.

Assuming that NPAT closely tracks operating profit, following the full year results I’d expect the stock to trade on a p/s ratio of 1.2 and a p/e ratio of 20. This values the stock at $60mill or 70c per share. (Assuming a beta of 1.75, I get an even higher valuation using DCF methodology).

I arrived at (3) and (4) by research into FAA Air Traffic Control simulator procurement plans. Specifically, the recently published FAA 10 year ATC training plan (can be downloaded from the FAA website) clearly shows that the FAA is following the lead of the USAF and plans to place high-fidelity ATC simulators at numerous major airport towers around the US. And just as the USAF purchased its 94 simulators exclusively from Adacel, the FAA looks like it will also be buying exclusively from Adacel.

Thus, in regard to (3) (the potential for a small order for around 4 MaxSim units in the short term), the 10-year plan states: “the FAA has initiated an effort to expand the use of tower simulators to field facilities. This effort is unprecedented in the FAA but has been proven to reduce training time and increase safety in the Air Force. The FY05 omnibus appropriations bill includes US$4mill [A$5mill] for the procurement of simulators. The FAA is identifying airports and developing an implementation plan in anticipation of this funding.” Furthermore, the FAA FY05 Business Plan (a separate document from the 10 year plan) states that the FAA will “evaluate the use of high fidelity simulators to improve ATC training for local facilities by June 2005.” This statement suggests that the FAA plans to purchase US$4mill worth of high-fidelity simulation units in the next month or so, and then trial these units for a few months before making a decision on a larger order.

In regard to (4) page17 of the FY05 Business plan states that the FAA plans to “make recommendations for use of high fidelity simulation by Sept 05.” What this means is that by Sept of this year, the FAA is planning to issue the contract to place ATC simulators in various “field facilities” around the US. My reading of the various FAA documents is that the FAA is planning to place a high-fidelity simulator in perhaps 80-100 of the FAA’s busiest airport towers (just as the USAF did in its towers) to improve on the job training for air traffic controllers.

So why should Adacel get these contracts? In the wake of (i) Adacel’s USAF success, (ii) its reputation of having the most technologically advanced ATC simulator (i.e. MaxSim) on the market, and (iii) given that the FAA has dealt exclusively with Adacel to date, Adacel is clearly the front runner to get both of these contracts. The big contract should be roughly equal in size to the A$100mill USAF contract of a few years ago, and will likely add around $15mill in annual revenue for FY06-08.

If ADA gets the big FAA contract, FY06 should see revenue in the order of $70mill, and operating profits in the order of $6-8mill. If these figures are in the ball-park, following the release of FY06 full year results, I’d expect Adacel to have a market cap of $87mill market (=$1 per share).

Beyond FY07, in addition to MaxSim contracts, a significant proportion of Adacel’s revenue growth will come from royalties earned from Adacel’s voice control technology being implemented in new military aircraft such as the Join strike Fighter, and being retrofitted onto existing aircraft such as the F-18. Adacel’s voice control technology also has the potential to feature in next generation UAV’s. I’ll post more about this side of Adacel’s business at a later date.