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Caveat emptor - Structural Monitoring Systems
Structural Monitoring Systems (ASX: SMN) core technology is called CVM, which detects cracks in planes.
The company was setup in 1997, floated in June 2004 and has been a hell of a rollercoaster ride for investors.
It has done a deal to sell their technology to Delta Air Lines. Alan Kohler spoke to Mike Reveley, the Executive Director, CFO and COO to find out more about the business.
By
Alan Kohler·22 Dec 2017
- Structural Monitoring Systems (ASX: SMN) core technology is called CVM, which is for detecting cracks in planes
- The company was setup in 1997 and was floated in June 2004
- Structural Monitoring Systems has done a deal to sell their technology to Delta Air Lines
Structural Monitoring Systems is a caveat emptor that has been going for 20 years.
The core technology which is called CVM is for detecting cracks in planes.
It uses vacuums – the V stands for Vacuums Monitoring.
It was invented in Perth way back in 1995.
The company was setup in 1997, it looked fine, the stock went to $2 bucks and then went to 10 cents and below – 2 or 3 cents.
It was effectively bankrupt which is when CEO Toby Chandler and Executive Director, CFO and COO Mike Reveley took it over.
Today I'm speaking with Mike Reveley who's the Executive Director, CFO and COO as CEO, Toby Chandler, is travelling.
This company has been a hell of a rollercoaster ride for investors.
Essentially, it’s been spinning its wheels for 20 years and trying to get this technology accepted by the industry and accepted by the authorities.
Mike says now that it’s on the point of go, it’s all ready to take off like the planes that it monitors.
But look, it’s been saying that for a long time.
This time they’ve done a deal with Delta. It’s an actual deal and they’re going to start selling these things next year, they just need approval from Boeing and/or the Federal Aviation Authority in the US. They will make a lot of money if they do, there’s no doubt about it.
The thing is, it's still capitalised at not very much, about $140 million, and as Mike says in the interview, they’ll skip to $100 million in revenue pretty quickly if things start going next year.
It’s a really interesting business with a chequered history you’d have to say; a rollercoaster ride up and down but really interesting and well worth taking in.
Here's Mike Reveley, the Executive Director, COO and CFO of Structural Monitoring Systems.
Mike, I must confess, this company, Structural Monitoring Systems is a complete mystery to me in the sense that the technology was invented in 1995. The company’s basically 20 years old but it hasn’t made a sale. There was talk early on of contracts with Airbus, contracts with Boeing and all sorts of stuff going on. You joined in 2012, what’s your perspective on why this company has been spinning its wheels for so long?
I think that’s a fair question and I think it really goes back to the nature of the industry itself. Sort of like trying to get a drug approved and passed through the FDA, trying to get through a very conservative, and for good reason, regulatory environment in global aerospace just takes time.
This particular technology is really ground breaking, because it’s a technology that you forego visual inspections for a technology that you place on an area of the aircraft and you take readings from.
In very early meetings that I had with the regulatory bodies with the OEMs and the airlines, it became really clear that the industry had not evolved to the point where it could even establish a protocol where it could evaluate if a technology like this is better than the existing inspections.
Is there a mathematical model that you can detect a probability of detection?
It’s called the probability detection curve.
The industry hadn’t even developed that yet, so it had no way of saying is this equal or better to the existing protocols? If it’s not, we’re not going to prove it.
This was really back in as late as 2013-2014. The industry hadn’t developed to the point where it was willing to accept alternative means of compliance for inspections of this nature.
The technology was there, we knew it worked, but the industry wasn’t to the point where the discussion was mature enough to develop even the mathematical protocols to make this happen.
So with the Sandia Labs, the FAA assurance centre, with the regulatory bodies and with the airlines themselves and the OEMs, the industry came together and developed a protocol to do that and we’re the first technology that sort of jumped through that window.
There are lots of advantages to our particular technology, it’s very, very simple.
There’s no electric current that goes through, there’s just basically Teflon sensors which are placed on an area and you pull a vacuum out of that sensor.
They could be anywhere, they could be in fuel tanks. It’s a technology that doesn’t interrupt in any way, shape or form, what’s happening on the aircraft. You’re not running a current through it, so you can have it in any part of the aircraft. Where there’s fuel vapor barriers that could be breached and if you’re running a current through something, you can have a very bad problem with that. Our technology doesn’t do that.
It was simple, it was safe and we could through our lab testing show that it was actually better than the existing physical inspections that were taking place on the aircraft.
Because, like everything else, there’s human error, you’re getting into parts of the aircraft that are hard to see, that are dirty. So, physical inspections are not always that easy to perform.
Long story short, it’s a very tough regulatory environment. The industry itself had to develop to the point where they could determine that our technology was better than the existing protocols and quite frankly, our technology when we first got our hands on it, wasn’t ready for that.
We had to as a company figure out how we were going to effectively take that last leg of the journey to get us to the point where it can get onto aircrafts. It has to be reliable, failsafe embedded within the sensors themselves.
There was additional work to be done on the sensors and the interface.
It took us time to get to the point where we’re ready for where we are right now, which is passing the bars that we pass with Boeing and with Delta and with the FAA.
I’m sure the technology’s fantastic and looks and sounds great, but just to go back to 2007. In April 2007 the company announced an agreement with Airbus, everything was fantastic, it was an important milestone. At that point the share price was $2 dollars. A year later it was 10 cents.
That’s right…
There’s absolutely no clue, really, as to why that happened. I mean, it was completely amazing. Then it stayed at 10 cents for years.
When you joined the company the thing was 10 cents. What happened in 2007?
Well, I think it’s just that, it was technology that was certainly game changing but it was before its time.
Boeing is the manufacturer.
When we got involved in the company, the company had basically ground through the financial crisis, they were burning hundreds of thousands of dollars a month and in some cases they were trying to develop the technology out of a little garage in Perth, they had none of the approvals and certifications that you need to get onto aircraft and they would have spent millions of dollars to get to that point where they’re even certified to get on an aircraft.
What we saw was a great technology but they hadn’t gotten them on aircraft, certainly commercial aircraft.
What we did was, we effectively came in, stabilised the company, brought some capital in.
But the first thing you saw from us was, how do we decrease our burn in the company?
Because we know it’s going to take a few years to get to the point where this is going to be on commercial aircraft.
What we did is we did a deal with AEM, which we talk about more thoroughly during the course of this interview, but AEM had the certifications that SMS needed to get our sensors onto the aircraft.
Those certifications, as I said, would have taken years if we wanted to develop those internally.
In addition, we gave AEM 10% of our company and they took on all the develop costs to get the sensors ready for installation on a commercial aircraft.
That was, from an engineering and manufacturing standpoint, that was a huge relief to the company that they were able to do that from a cost perspective.
We have embedded engineers and R&D specialists that have worked to get the technology ready for commercial application.
It wasn’t before.
Anything that was happening prior to that point was in some ways, not a waste of time because there were tests being done and they were on aircraft, on military programs and such, but there was really no focus to get them into a commercial program.
The first step was to get the sensors certified through our new manufacturing relationship with AEM and then get them aboard at operator.
The next step was to get them aboard a commercial operator and that’s really where Delta came in.
So in connection with Boeing, which is the work that it had done previously with Boeing, was additive to trying to get the Delta program in place, but it was really Delta and Delta Tech Ops, they’re a very forward looking maintenance organisation within Delta and Dave Piotrowski who’s the Senior Engineer at Delta Tech Ops had worked with the sensors previously at another airline, actually at Northwest, so he was something of our technology, brought it into the Delta management and said, ‘Look, we have a technology here which we think can really be a game changer for the maintenance of our fleet.’
He really pushed that up through the management chain, got Boeing and Delta to commit to the program which we supported and for the first time they were really on a – intended to be approved by the FAA and by the OEM for metal cracking on aircraft.
Before, it was all just test programs and to see if it worked and getting us to the point where, okay, the sensors are stable, they’re reliable, but now we’re now in a commercial program with Delta.
That was really the key for us and that goes back to 2014.
It took us a couple of years to get that program in place and then it took us another 18 months to get through that program.
Then it took us some time in addition to that to get the service bulletins re-written by Boeing, which allowed the technology to be approved for that area.
Then we also brought it to the FAA and they reviewed it.
So these things just take time and I think the previous management didn’t understand the nature of the global aerospace industry. I think they were ahead of the curve with the technology but they didn’t appreciate how much time it would take for the industry to catch up.
In addition to that, I think there was some luck here.
Structural monitoring as a whole in the US and for other bridges and pipelines and whatever else was an industry which was growing.
We knew it from the Stanford Conferences – every two years there’s a conference in Stanford, everyone in the world shows up there and they highlight structural health monitoring solutions for various applications.
We’re there every two years.
Toby, who’s the CEO, and myself had some exposure to that. We knew the industry was maturing, we saw technology that needed work but we had a solution for that with the ability to move the product up to AEM for that final development and then we had some support at the FAA assurance centre who also had done work on the technology with the previous management, so there was a lot of work that was done there.
It became ready for, really commercial use and all of that had to come together.
At the end of 2015, David Piotrowski, who you mentioned from Delta and also I think the guy from the FAA airworthiness centre said that it was all go, right?
Right.
And they were getting approval by the FAA. The stock then ran back up to $2 bucks.
From that point on I just think then it seems to me the company became its own worst enemy in a way because the directors starting selling their stock into the rise and then at some point, I’m not sure of the exact sequence, but at some point the company said, ‘Yeah, yeah, the directors have been selling but it’s been a long trip for them, so bear with us.
That’ll be it, there’ll be no more selling by directors.’ Then the shares went up to $2 bucks and they kept selling.
And so all of a sudden, the market and investors became extremely distrustful of the business, it seems to me, as a result of that and there were governance concerns.
Then, just to finish the question, I just noticed in the last two quarterly updates in July and October, you said in July you got $2.9 million in cash, Toby got $2.5 million cash, ‘That’ll be enough, we’ll get to breakeven with that money, that’s fine.’
And then blow me down, without really foreshadowing it, you raised $13 million in a placement. I don’t know, it just seems to me that the company keeps doing stuff that it says it’s not going to do.
No, I think you have to view this in the context of the corporate as a whole, right?
Toby and I came in, Toby initially founded the company…
By the way, he’s a banker and you’re not an engineer, your background is…?
I’m a banker as well.
Two bankers…
Yeah, we’re two very unlikely characters to run in aerospace, two unlikely people.
Look, my background is private equity.
I had a private equity fund that we invested in businesses in China and so I have a private equity background in addition to a more traditional hedge fund background.
Toby and I worked together on the hedge fund side. Toby spent most of his career as a banker at Morgan Stanley and HFCC, so a very sophisticated financial guy, as we both are.
We’re investment people, so we viewed this as an opportunity.
The stock was trading at sub 10 cents. I think our first capital raise was – I think I put money in at about 10 cents, additional capital all the way down to 2.5 cents very, very early on.
It could have got away, this company basically had no cash in the bank and would have gone away.
We found a way to revive the opportunity for shareholders by [Audio cuts out - 18:01.3] and restructuring the company.
We don’t take big salaries.
We my salary right now is about $100,000, so it’s not a market salary. We’re doing this really for shareholders. We brought our guys into it so we want to see this thing work.
Those governance concerns I raised about the selling of shares and all that stuff this year, they all happened after you and Toby took over?
Of course.
We don’t pay ourselves large salaries, we have positions in the company as we do lots of other companies.
But this particular company, we basically – our gains became how we paid ourselves.
Look, if I own a stock at 2.5 cents and it goes to $3 dollars, every day you have the ability to buy and sell shares as an investor and we’re investors at our core.
I think at the end of the day, investors and shareholders were – there was some criticism in terms of that action, but when the majority of your net worth is now taken up within one particular stock, yeah you’re running it but it’s one particular stock and there’s an investment decision that you can make.
Between Toby and I we probably controlled 10% of the company, about that.
We brought in guys like Drake who controlled 21%.
So yeah, there could be criticism but there’s nothing in the charter that says because you’re running a company, you can’t sell shares at any point in time.
There’s something very – I think it’s definitely highlighted in Australia much more than the US.
In the US I’ve never seen that before, actually. I think it is a heightened thing in Australia but at the end of the day I had a significant stake in the company and so does Toby.
From a governance perspective we’ve done everything that we’ve told investors we’re going to do, from saving the company when it was going to go under, to getting us in the first trial for aircraft, to getting through FAA approval, to signing Delta up, to getting through the Delta program, to now signing a commercial contract which will be acted upon in terms of revenue we think in 2018.
From a management perspective we’ve done everything that we’ve said we’re going to do and we feel comfortable in everything that we’ve done.
So I think you’ve got to look at that in terms of, the company would not have existed in 2011 without Toby and myself, it would have been gone.
I don’t want to sound like I’m criticising what you’ve done, obviously the stock is now kind of well above where, obviously it’s been a bit of a rocky rollercoaster ride, but it’s still doing fine.
I do need to make one other thing clear.
When we said we weren’t going to raise any money after the last raise, that was true.
We would not have entered into this transaction had we not had the opportunity to buy AEM, our contract manufacturer.
That was a decision that we made only after we entered into the contract with Delta. Once we knew revenue was proximate, we felt comfortable enough to enter into the transaction with AEM, and that was important for several different reasons, not just because we wanted to buy a company, that’s not it. What was important was, if AEM was going to be sold, we didn’t know who those hands were going to be in terms of our engineers at AEM, our technology, our manufacturing platform, human knowledge, all that stuff would have gone potentially to someone who would value it or not value it.
In addition to that, there is IP considerations in that second-generation sensors, there’s a shared IP potentially with AEM.
When we looked at the opportunities, we knew revenue was proximate, we had concerns in terms of, can we maintain a relationship with AEM in the same way after Dave and Ray stepped down?
We just didn’t know.
And we were essentially very proximate to when Delta after signing that contract are going to be buying sensors.
It was a really sensitive time for us and actually the timing of that was perfect.
In addition, we lifted the purchase price and said, ‘Gee, this company sort of bangs out $13 million Canadian a year, you’re generating $2 million dollars’ worth of EBITDA, it’s fully funded our development to the tune of $4-500,000 a year in terms of direct costs relating to our business that we haven’t had to fund.’
Looking at that and knowing too that if you look at a manufacturing company in North America, they’re typically being sold from between 8 to 15 times EBITDA and we’re looking at less than 5.
So we thought the price was right and we thought the timing was right for that. Absent all of that, we wouldn’t have purchased AEM.
If it wouldn’t have been up for sale we wouldn’t have considered the purchase and we wouldn’t have raised the $13 million dollars.
But that was for a specific reason and use, and I think for shareholders it’s a tremendous benefit for shareholders to have AEM in our umbrella.
Our intention was not to raise any additional capital but this came along at a time when we thought it was in our best corporate interest to do so.
How far do you think you are from positive cash flow now?
What we’ve said is that we anticipate paying a dividend or buying back shares in end of 2018, early 2019.
There’s steps that we need to go through from here with the Delta contract, there’s a progression.
Delta needs to identify applications on their global fleet for our sensors, which they’ve done.
They’re currently up to about 12 or so applications.
After we identify the applications and Delta determines which of those – they want to take all 12, they want to take 4 or 5, how they want to stage this, we’ll go back if we have to go back into the labs at Sandia Labs, the FAA assurance centre, run some probability of detection curves for each of those applications and then we’ll submit those to the OEMs if it’s a service bulletin. If it’s an airworthiness directive that requires a regulatory body to get an approval.
I think that action probably takes us between from here to about June, before we were in a position for Delta or anyone else to be buying sensors from us for commercial application.
That’s general timeline, it could take longer, things typically do as we all know.
But that’s our general thinking, that sort of timeline makes sense to us.
By the end of 2018, early 2019, we don’t have anything to do with the money.
We’re still running this company on the smell of an oily rag, really.
We’re not going to be buying other companies from here.
For us to make sensors, it’s a $35,000 machine which we have to buy if you crank out 6,000 of these things or so a month.
From a capital usage perspective, there’s just not a whole lot for us to do with the money, which is why we said, ‘Look, the best use of any free cash flow for us is either pay a dividend or buy back shares.’ So we think we’ll be in a position in that sort of timeframe.
How much do you sell the sensors for? Do you just sell them each item just selling or do you have any ongoing revenue?
It’s a good question.
The business model is a point of sale, we sell sensors and equipment.
Delta, as the first mover has the most favoured nation status, whereby Delta buys the sensors at less than anyone else in the world will buy them for and they don’t pay an annual licensing fee.
For other airlines besides Delta, there’s an ongoing revenue every year, let’s say a large airline like United or American, a tier one airline similar to Delta, as we scale these up across their fleet there will be an annual licencing fee that also scales up with that adoption.
At the peak it’s probably going to be between $10-15 million a year depending upon how many planes are impacted, how many sensors and etcetera.
There’s a point of sale model and then there’s a licensing agreement that goes along with that point of sale.
Does the licensing agreement include the sensors or not?
No, it’s separate, a separate payment.
The sensors are anywhere from between $1,200 to $6,000 dollars a sensor, that’s what they go for. Then there’s equipment that we sell along with it. I think in terms of a single aircraft, single application, these are big structures, so there’ll be multi sensors, say 8 to 10 sensors for each application plus the equipment that goes along with that, you’re looking at sort of between $25,000 to $35,000 dollars for that one plane to outfit that one application and there’ll be multiple applications on aircrafts.
Has the deal with Delta been inked? Are they definitely going to buy them?
Yeah, we’re in a commercial contract with Delta.
They’re following through on that right now.
We have to get the way it works, so we have to get these approved by Boeing and/or the regulators and once we get the applications that they want to focus on approved, they’ll be buying sensors.
They’re not doing it because they don’t want the technology, they’re doing it because they want the technology, they know it’s going to have a major impact on not just the cost of doing the inspection, but a real critical aspect of this technology is that it keeps planes up in the air.
In some cases, there are multi-day inspections that you’ve got to go through that are not timed well with other inspections that aircraft has to do for engine or whatever, right?
They’re not scaled to come in for inspection, but you’ve got this visual inspection you have to do let’s say on the aft pressure bulkhead.
To get to that area you’ve got to rip out the galley, to rip out the galley you’ve got to be in a maintenance facility and it could take a week to get to the area to do the inspection.
This technology now gives you a way to do that same test in 15 minutes.
So you’re keeping planes up in the air, you’re impacting the utilisation of an aircraft in a material way and that’s really the strength behind the technology.
Sure, your maintenance costs go down but it’s your utilisation going up that the airlines – they’ve done everything they possibly can to keep their utilisation as high as possible.
You get on a plane, by the time you de-board you’ve got people cleaning that aircraft. That’s because they’re trying to do an extra cycle every day because that’s extra revenue.
If you’re talking about a plane that over its life it’s grounded for 10, 15, 20 days or more, to give you an idea what that looks like, for a 737 aircraft you’ve got about $150,000 dollars a day in margin for that aircraft by keeping it up in the air.
For a wide body it’s close to half a million dollars a day.
You don’t want to ground these planes for anything and so this technology gives the operators a way basically to not have to ground the airplane and inspect.
So just to be clear, Delta’s a firm contract subject to approval from Boeing and the FAA?
That’s right.
Well, not necessarily both, it depends.
If it’s a service bulletin there’s no regulatory requirement, so the FAA doesn’t get involved.
That’s just, let’s say, a Boeing or an Airbus decision.
If it’s an airworthiness directive then the regulatory body will get involved and indeed in the Delta program, part of what we’re trying to do especially for the Airbus aircraft because EASA has not seen the technology – they’re the FAA for Europe.
They’re have not done what Boeing and the FAA have done.
It hasn’t got up to EASA yet, so there’s a push within this program to have an Airbus aircraft with an AD so we can get up to EASA and have them approve the technology.
Just to give a sense of the potential here, I imagine that once Delta does it, other airlines will follow suit.
Are there any competitors that you have?
In terms of doing these checks without grounding the airlines and all that stuff as you pointed out, is your system the only option?
We’re the only option.
We’re the only technology approved for hotspot monitoring.
There are some other sensors that will look at corrosion, things of that nature, but we’re the only approved for… I don’t see that changing and in fact, if you talk to Dennis Roach he’ll tell you we probably have an eight-year advantage to anything that could come up but he doesn’t see that as… I was just at the Stanford Conference and there’s nothing that I can see that’s going to interrupt the adoption or from a competitive standpoint of the technology, just don’t see it.
Obviously, you’re still a small company and I just wondered whether you’re an obvious acquisition candidate to somebody. I mean, who is in the business of selling this sort of stuff in the US? Are we talking Boeing or someone else?
It’s interesting.
An OEM did approach the company well prior to us getting involved, the previous management ended up I think reviewing it but maybe turning it down or something, I don’t know, that was probably not a good decision since they effectively were bankrupt.
But an OEM did approach them. We’ll see. We’re not operating under the assumption that that will happen.
I think more likely somebody like a United Technologies or someone that’s involved in the component space that are putting things on aircrafts.
Boeing Airbus, what they do is they just assemble the aircraft, it’s not their technology per se that’s going on this stuff, it’s other companies providing the subsystems for that aircraft.
They’re effectively an assembly line which other people’s tech go onto the aircraft.
If I were to guess it would be somebody that’s in the industry that is also putting tech on aircraft. It could be a private equity company. I think for us to be attractive, strangely our market cap has to go up.
We get to $3-4-5-600 million, somebody is going to probably want the tech and want to take it.
We have been operating in a blue-sky environment for really since its inception.
We do sell sensors and a few hundred thousand dollars a year in sensor sales up to this point and prior to the Delta contract, but in a blue-sky environment, people want to see that you’re in a commercial contract and it’s being adopted in the industry. Then I think we’ll probably get more eyeballs on it, but we’re not operating in that environment, it’s not something that we’re focusing on.
If it never happens, I don’t think it really matters from our perspective or our shareholders.
If it does, we’ll entertain it, but the valuation is going to have to be pretty high because we feel that from here on out as we get into this business model where we’re connecting with the Deltas, the United’s, the Americans, the Qantas’s, and getting our sensors onto aircrafts, the revenue for this actually escalates very, very quickly.
Not only the sensor sales, but also the licensing agreement.
We get to $100 million dollars without a whole lot of thought, just on the royalty payments, the licensing agreements.
It’s a good question, everyone asks that question.
The margins on the licensing agreement are pretty high I guess?
Yeah, 100%.
100% margin. Just one final question, Mike, how come I’m talking to you rather than the CEO? Is he shy?
[Laughs] No. Is Toby shy? No. Toby’s not particularly shy. I was approached by Simon to do the interview. Toby’s been in Asia, he’s been in Australia, New Zealand, travelling, meeting with funds and investors, so I’m the guy available for the call. Hopefully that was okay!
It was fine.
He’s not particularly shy! [Laughs]
No, no, you’ve been a terrific interview, I appreciate, Mike, thank you.
No problem.
That was Mike Reveley, the COO and CFO of Structural Monitoring Systems.
(20min delay)
