Description

After weathering more than a year of the worst industry environment in their 35-year history, Aldila possesses a strong balance sheet, strengthening competitive position and newly reduced cost structure.  However, the stock currently trades at roughly a 50% discount to reproduction costs (conservatively).  True, the golf equipment industry has been more frightening lately than the early round auditions of American Idol.  However, people will start buying golf clubs again someday, and Aldila will look darn cheap when they do.  In the meantime, Aldila will likely turn modest profits and should fair little worse than cash flow neutral.

Background

Aldila is arguably the premier maker of graphite golf shafts, and they were really on a tear until they were blind-sided by the collapse of the market for golf equipment in mid-2008.  They moved swiftly to reduce their cost structure and have been managing SG&A and working capital judiciously ever since.   Despite very low sales for 2009, Aldila’s net loss was just $240K, and they actually managed to pay down $4.7M of debt and generate FCF of $700K.  All this was done while many of its cost reductions have yet to be realized, which should make 2010 results better than those of 2009 even in the absence of top line growth.

Details of Cost Reduction

In 2009, Aldila reduced marketing and promotional expenses by more than $2M per year, closed their “higher cost” manufacturing operation in Mexico, and just this year, Aldila voluntarily moved their listing from the NASDAQ to the OTCQX Premier and deregistered with the SEC to save another $400-500K on an annual basis.  Aldila also downsized its board, which should save them another ~ $80K per year.  Of all these, only the marketing and promotional savings were realized in 2009.  The remainder should come in 2010.

Business Description

The company is comprised of two business segments:  Composite Products and Composite Materials.

Composite Products:

It sells customized OEM and co-branded shafts directly to OEM customers and sells Aldila branded shafts through OEMs and distributors.  The main customers for its graphite shafts are Ping, Acushnet, and Callaway.  These three typically account for more than 50% of its sales.  However, in 2009 they also got back in with Taylor Made – to whom they haven’t sold for years. 

Composite Materials:

While the golf shaft business represents the bulk of their sales (~86%), they also sell composite materials (their intermediate products) to external customers.  They developed this materials capability in ’94 to support their shaft business, but it wasn’t until ‘98 that they began to sell these materials externally.  In 2005, they greatly expanded this capacity to support higher external sales volumes.  Aldila claims these materials are used in industrial roles, airplane parts, medical applications, and others.

Reproduction Cost Valuation

The following data shows Aldila’s balance sheet for the year ending December 31, 2009 together with my adjustments and estimations of reproduction costs.  A discussion of my rationale follows.

*Assumed just $1M in R&D expense for 2009.

**Assumed just $500K in marketing and promotional expenses for 2009.

So, first of all, I added inventory reserves back in.  Then I added $6M to PPE as a very rough and very conservative approximation of reproduction costs of Aldila’s manufacturing operations.  I arrived at this number because Aldila used approximately $6M in CapEx to over ’06 and ’07 to establish their latest plant in Vietnam.  The cost of opening the Chinese facility in ’98-’99 was also approximately $6M.  Therefore, despite the materials facility being in CA and requiring different equipment, it is approximately the same size as the others, and I assigned $6M as the cost to reproduce it.  That brings total PPE (reproduction value) to about $18M, which I believe is fair and probably ridiculously conservative given the latest book value of $11.6M and accumulated D&A of $24.6M, both of which also obviously exclude effects of inflation.

I also added the previous three years worth of R&D expenses and marketing and promotional expenses.  I did this because Aldila’s competitive position is determined by its success on the professional tours (which is driven by product performance – hence R&D), its brand name recognition with the casual golfer (marketing and promotion), and its history of being a reliable supplier to the OEMs.  Aldila also has some interesting patents pending (e.g., S-core technology) that probably required significant R&D expenditure over a number of years.  In any case, I believe the previous three years’ expenses for R&D and marketing represent a minimum of what a new entrant would need to replicate Aldila’s current market position, and I think this is probably conservative.

End result:  Current market price represents a 46% discount to it reproduction cost.

Competitive Position

So I’ve briefly alluded to Aldila’s strong competitive position, but what do I mean?  Well, to start, Aldila has enjoyed tremendous success on the professional tours over the past two years.  In 2009, they won the wood and hybrid shaft count at every major championship, at every World Golf Championship event, and, for the second year in a row, they were the leading wood and hybrid shaft at every FedEx Cup Playoff Event.  According to the Darrell Survey (company that tracks this data), in 2009, Aldila had more total wood shafts in play on the PGA Tour than any other graphite shaft manufacturer and nearly twice as many hybrid shafts in play than any other competitor.   This gives them tremendous credibility with their OEM customers.  Of course, they must also be able to compete on cost, which they obviously do.  They won more than their fair share of competitions in ’09 leading the CEO to comment on the 3Q09 call that going into the 2010 season, “we feel our market share right now is the best it’s probably ever been at the OEM level.”  Furthermore, until the recession forced them to cut advertising, they were on an “Intel Inside”–like marketing campaign to build the brand with end consumers.  I don’t know how successful this recent campaign has been, but as an avid golfer, I can testify that Aldila has been a well-known and respected brand for over a decade.

I don’t mean to say that Aldila is without competition.  It has plenty from the likes of Fujikura, UST, Grafalloy (true temper), Mitsubishi, and others.  However, Aldila is arguably the most innovative of them, which leads to success on professional tours and eventually results in more OEM business.  Aldila is also vertically integrated with their materials business, which is a significant competitive advantage over many competitors (especially when commodity prices rise).  They have also gained market share before and during the recession, which is only making it more difficult for competitors to make the necessary investments to keep pace in shaft technology.

Ok, Maybe the assets are cheap, but why would I want them?

In 2008, with the rug essentially pulled out from under them, Aldila lost $2.5M.  In 2009, benefitting from lower advertising expenses but hurt by ~$1M in costs associated with closing the facility in Mexico, Aldila generated a net loss of only $240K and positive FCF of $700K despite experiencing its lowest revenues since 2003.  This year, Aldila should realize cost savings of ~$1.5M (over 2009) plus a reduction in shaft manufacturing costs associated with moving all shaft production to Asia.  Therefore, assuming 2010 revenues and GM are unchanged over 2009, Aldila should see positive net income and FCF this year.  If industry observers and OEMs are right to think that 2010 will be the beginning of a recovery in equipment sales, Aldila could easily see net income of several million.

Looking at Aldila’s historical results, we see that they averaged ~$9M in net income for the three years prior to 2008 (I am neglecting contributions from the sale of their carbon fiber business in 2007).   If we include the poor results of the past two years, average annual net income for the trailing five-year period comes to $5.2M.  If we further include the poor results from earlier in the decade when Aldila was weighed down by the excess capacity of carbon fiber on the market and their reliance on internal carbon fiber production, average annual net income for the trailing 10-year period comes to $3.2M.

So, considering historical performance, today’s market price looks reasonable to very cheap.  However, I think the two periods of poor performance over the past decade are really outside the realm of normal operating conditions.  I say this because Aldila sold the carbon fiber business that caused them issues several years ago, and now they have the right (not the obligation) to buy carbon fiber from that supplier.  Furthermore, golf equipment sales are typically recession proof.  Aldila claims equipment sales typically fluctuate 2-3% due to recessions.  In the ’08-’09 recession, equipment sales dropped 20-30% from previous year levels!  So, I think the past couple years are more of a 50-year storm than one that you can reasonably expect to show up every decade.  Therefore, I think a fair and still conservative run-rate for net income is $4-5M per year going forward once conditions “normalize” – and this doesn’t necessarily require sales re-attain ’07 levels. 

I really haven’t mentioned their materials segment, and while I’m not counting on much of a contribution from it, I think it could lead to upside surprises in the future.  Aldila only recently added more capacity and only very recently began to market it to non-recreational product markets.  They were “involved in numerous qualification efforts” in 2009 (most likely requisites for selling into aerospace or medical markets I’m guessing), and composite materials seems to be recovering more quickly than the golf segment.  They have seen year-over-year sales increases of 22% and 76% in the 3^rd and 4^th quarters of 2009, respectively.

Ownership

There is strong insider ownership with the CEO holding ~2%, the VP of composite materials has just under 1%, and management has a good record of managing with shareholder interests in mind.  The prudent cost containment since late 2008 and a one-time $5 dividend in 2008 are some recent examples of this.

Also, Lloyd Miller, independent investor, 13% owner of Aldila’s stock, and former Aldila board member (from 2001-07) has been buying consistently, heavily and very recently, and his record with Aldila stock over the past decade is pretty good.

Risks

Many - I’m sure, but I think the main assumption here is that Aldila maintains its competitive position OR that the golf equipment market recovers sufficiently that Aldila can lose market share and still remain profitable.

Catalyst

• Further realization of cost savings
• Modest uptick in demand for golf equipment in 2010
• Continued success in materials business