ADA Research and Summary

Since the original thread is quite long I figured I would post a summarised update of my research on ADA. I know some journalists and fund managers that read these comments and all the key value investors on HC contributed to the original thread - @vfrioni @ormond @imran khan @peterdoobes @Fire Bull @Stweeve @Fibonarchery so this post should summarise everything in the previous thread in one post, and give newcomers a good basis of where ADA is going. For those who like short "Buy this because its going to the moon" type posts, I apologise, this is long and fairly in-depth, but its only a very small percentage of my total research on the company and its prospects and should provide a solid base for further research.

Adacel Technologies

Simulation and Training
Leader in the US and one of the leaders globally. Advantage is its largest installed system base (>300, significant potential for upgrades as technology has advanced), leading voice recognition technology integrated into their simulators and top grade clients in the FAA, USAF, RAAF, US Army, Air Services Australia and more. There are a handful of competitors but only a small few compete with Adacel’s level of advanced technology and huge customer base, and these competitors do not have a strong foothold in the US - where ADA is the leader.

Growth opportunities: The FAA has indicated that over the next 10 years they will increase their use of simulators in the training of ATCs (air traffic controllers) (see FAA's 10 year plan for 2015-2024). Shortage of ATCs in the US will result in a 50% increase in total new hires in the US over the next five years vs previous five years (~6000 vs ~4000). Adacel are the primary supplier to the FAA of simulation towers and field support, with that contract alone worth US$46m over the next five years assuming all options are exercised (note that in 2013 the FAA put out a statement basically saying why Adacel were the only choice for the TSS Simulation Program, they are entrenched in the FAA). The FAA isn’t the only key client intending to increase their use of simulators (which are more effective and cost efficient than other means such as live training), but also all branches of the US DoD and virtually all ANSPs globally.

There are new markets globally opening up for the use of simulators that previously weren't available for ADA. The upgrading of the worlds ATM systems results in an associated need to train ATCs for new technology and there will be flow on effects to the Simulation markets. ADA are well positioned for this. There is also significant opportunity to win more work with the FAA, USAF (contract now in sustainment phase, worth US$15-$25m over the next five years) and US Army (sole approved provider of mobile simulators). This is what Adacel are referring to when they say they are focusing on winning more work with existing clients.

Air Traffic Management
Aurora (ADA's ATM solution) is used in airspace controlled by the US, New Zealand, Portugal, Iceland, Norway and French Guiana. Their technology is used in two key US airspace programs  - ATOP and ERAM - the latter of which was recently hailed as a success and a key template for future NextGen programs (NextGen is the upgrading of US airspace). Both programs are in partnership with Lockheed Martin.

Growth opportunities: If you follow aviation news you won’t go a day without seeing news of yet another country making progress in upgrading their ATM and ATC systems. It is a global initiative and billions are being invested, with the common theme of upgrading to satellite based technology to improve safety, flight/fuel efficiency, reduce emissions and cope with increased air traffic. Todays ATM and ATC systems simply aren't equipped to handle future (and in some cases current) air traffic, haven't been for some time and now private and government-owned ANSPs are playing catch up.

ATM software is typically a very long upgrade cycle, some technology across the world has been in place since World War 2. That has resulted in lumpy wins for ADA in their ATM business as upgrades have been made here and there, but now what we are seeing is a mass wave of upgrades and significant opportunities for Adacel across the globe. Winning these contracts would result not only in upfront revenue but significant recurring revenue as the model involves providing ongoing maintenance, upgrades and available on-site fields reps. And these contracts are long term - look at ATOP and ERAM - they will be in place (and generating revenue for ADA) for another 20 or 30 years as a critical part of the management of US airspace.

ADA have partnered with Lockheed Martin for ATOP and ERAM but they have and will partner with various ATM global operators to bid for the wave of upcoming programs. What this means is that while their competition are the likes of Thales, Raytheon and Indra they are also in many cases (or in future will be) their partners in key projects, as Adacel can provide key parts of the software integrated into the ATM solution being provided. This flow of new opportunities will continue until at least 2020. Also, expect new contract wins for the upgrading of the overseas French territories, French Guiana was the latest one (which ADA won) and there are four more to be announced with ADA one of three approved suppliers.

Voice Recognition Technology
Lexix is a new product with the ability to sell into all of ADA’s existing markets, the potential of which is hard to grasp but it could be significant. Further, ADA are one of two suppliers to the F-35 Fighter Jet Program, and recent talk of a bulk buy proposal would be significant for ADA, despite full rate production of these jets not beginning until 2019 (the first operational F-35 is due next year). The last licence deal with Lockheed for the F-35’s was in 2013 for the low rate of production phase, I would not be surprised to see further announcements in this regard in the next 12 months or so given the news related to the F-35's lately.

New F-35 orders
http://www.intelligent-aerospace.com/articles/2015/07/ia-f35-jets.html

Bulk Buy Proposal
http://aviationweek.com/paris-air-show-2015/lockheed-pentagon-revive-f-35-block-buy-proposal

They also provide this voice recognition/activation technology in other aircraft including the Aermacchi M346, a training aircraft for the F-35 so sales for this aircraft should closely track that of the F-35 in future years. The market for voice activated cockpits in aircraft is growing and ADA are well placed with their win for the F-35 program as a solid demonstration of their technology.

Outlook
Guidance was provided for $4.5-$5m PBT in FY15. As I’ve said before there was a $0.8m one off bad debt expense in 1H15. They’ve won a large number of contracts recently (>US$90m just for the simulation business) which have given them confidence to signal growth in FY16, with recent announcements stating things like:

“The Board has the utmost confidence that the management team will continue to execute the Company’s strategic plan, and as a result, the Company will continue to show strong momentum and build profitable growth.”

“the Company’s backlog of orders has provided a strong platform for FY2016 and beyond”

ADA have been fairly prudent in providing guidance in the recent past so this hint of optimism is meaningful.

Summary
The market cap currently is around $46m with net cash of $7m. 1H15 saw the inaugural ordinary dividend of 0.75c, that should grow significantly in FY16. Normalised PBT for FY15 is AUD$5.3m-$5.8m with ~$20m of tax offsets against earnings available. 2H will be stronger than 1H and that momentum should continue into FY16.

Net of cash the stock is trading on a PE of 10x FY15, and <10x FY16. High degree of recurring revenue due to large maintenance contracts with clients that they are deeply entrenched with, cost base under control (FY14 saw consolidation of offices and improved program efficiency), plenty of cash for growth opportunities and dividends and a tight register. Large majority of revenues and costs are in USD so they are highly leveraged to a falling AUD (into the 74's as I write this). The dividend yield in FY16 should at least be 5% (which would represent a pay out ratio of just 50% or thereabouts on my modelling, very comfortable given net cash position), and potentially higher.

I see no reason why ADA can’t trade at least on a market multiple (16x FY15 and 14x FY16). If we just assume a continuation of performance of the second half into FY16 that would give a fair value range of 90c - $1. If we factor some growth on 2H15 into FY16 then there is upside there. While new contract wins and expansion of work with existing clients could provide a catalyst to both earnings and the share price I prefer to look at 90c-$1 as the first target as it doesn’t factor in any new contract wins and I think proves fairly conservative.

There is potential upside to the 90c-$1 valuation through accelerated growth on 2H15 and/or the market rating it on the same multiple as its tech peers (in the 20’s vs ~15 for the market as a whole). To be honest if the market recognises the tailwinds at ADA’s backs and prices that in I think a PE well above 15 would be warranted. You only have to look at the likes of PRO, CMP, ALU and others to see what kind of rating ADA could be given if sentiment towards the company begins to change, a similar rating for ADA would push it well north of $1.20, and while I do suspect it will warrant an above market multiple in time, for conservatism I'm sticking to 90c-$1 for now.