Description

Investment Thesis

Astronics is a well managed, growing, high quality company that is significantly cheaper than it first appears based on cursory screens. We feel that investors should account for the well-above-average r&d spend (called engineering& development)  that flows through the income statement and serves to depress GAAP profitability. The company spends about 16% of sales on e&d vs its peer group at about 5%. When adjusting for this phenomenon, which we view similarly to growth capex, the company trades quite inexpensively on both an absolute and relative basis. In addition, there have been some trading dynamics involving the largest holder selling down its position that seem to have weighed heavily on this relatively illiquid stock in the past year.

Company Description

Astronics is a leading supplier of products to the aerospace and defense industries. [Their] products include advanced, high-performance lighting systems, electrical power generation systems, aircraft safety systems, electrical power distribution systems and avionics databus products for the global aerospace industry as well as test, training and simulation systems primarily for the military (from latest 10K).

The company’s end markets are as follows: Commercial 65%, Business jets 11%, Military 15%, Test systems 5%, FAA/Airports 4%

The largest product groups in descending order are: Cabin electronics 52%, Aircraft lighting 29%, Airframe power 8%, Test systems 5%, Airfield lighting 4%, Avionics 2%. A brief description of the products follows.

Cabin electronics: In-seat power outlets used to charge laptops and entertainment devices. Demand should  increase as devices become more complicated and varied and wi-fi and voice become a must have for the travel experience.

Aircraft lighting: Cabin lighting systems including exit signs, seat lights, floor tracks. Cockpit lighting systems, escape slide lighting, exteriors.

Airframe power: Starter generators, circuit brakers, etc. In short, the guts of the aircraft.

Test systems:  Communications and weapons test systems and training and simulation devices for military applications.

FAA/Airports: Guidance signs, markers, lights for runways, tower equipment. As airports become increasingly congested, the need for clear and visable signage is becoming more acute.

Competition

Astronics competes with some industry behemoths and its relatively small size and ability to service the customer from design consultation to installation to post-installation support allows them to garner share on new aircraft. They are currently on the Boeing 787, the F-35 Joint Strike Fighter, and the Lear 85: a testament to their product, but surely also, to their customer service culture.

Historical Financials

Source: 2011 10K

Valuation-as reported

Closing Price: $22.97

Shares Outstanding: 14.3mm

Market cap: 328mm

Net debt: 26mm

EV/EBITDA ’13: 7.2 x

EV/EBITDA ’14: 6.4x

FCF % (ttm): 6%

Peer group valuation

                                EV/EBITDA ’13    P/E ’13      R&D as % of Sales

TGI                      6.4x                       11.1x           6.3%

BEAV                 11x                         17.8x           1.5%

ESL                     7.3x                        11.7x           5.3%

HEI                     10.6x                       25.6x          3.5%

ATRO                  7.2x                        12.7x          15.5%

E&D Spend                       Revenue

2003                3.6mm                         33.2mm

2004                5.8mm                         34.7mm

2005                8.9mm                         74.4mm

2006                10.9mm                       110.8mm

2007                14.8mm                       158.2mm

2008                22.9mm                       173.7mm

2009                27mm                          191.2mm

2010                28.3mm                       195.6mm

2011                36.1mm                       228.2mm

2012E              42mm                          265mm

It’s difficult to parse the financials and calculate anything approaching a precise return on e&d dollars spent but management has said that they target a mid to high teens number. Importantly, and why we view a large portion of the spend as discretionary, is that much of the line item involves work done for specific projects. For example , Lear jet will go to them and ask for a power solution for a new model and Astronics devotes resources to that end.  This is different than a company that spends money in the hopes of an unspecified future revenue opportunity.

Valuation-as adjusted for 1000bps r&d normalization

Closing Price: $22.97

Shares Outstanding: 14.3mm

Market cap: 328mm

Net debt: 26mm

EV/EBITDA ’13: 4.5x

EV/EBITDA ’14: 4.1x

FCF % (ttm): 16%

1Q2010     92.8mm                             1Q2011     99.1mm                             1Q2012    102mm

2Q2010     97.3mm                             2Q2011    102.1mm                           2Q2012    114.2mm

3Q2010    100mm                               3Q2011    110.2mm                           3Q2012    115.6mm

4Q2010     99.8mm                             4Q2011    106.3mm                          

Miscellaneous

• We won’t hazard to guess at the largest holder’s intent but note that the firm sold roughly 2mm shares since the end of the March ’12 quarter; significant selling pressure in a name that averaged under 50k shares of daily volume over that timeframe.
• The Chairman of the company, Kevin Keane, sold 140k shares at the end of the year. He and his son have formally offered to take Mod-Pac private and he needed some liquidity ahead of changes in the tax code. I don’t think there’s anything else to read into this.

Conclusion and Price Target

Astronics is a high return business in an industry that seems to have some tailwinds to it based on replacement cycle for business jets, and growth of emerging economies. We view the robust e&d spend as an indication that management is long term oriented and focused on capitalizing on market opportunities rather than trying to play ‘beat the street’ by posting an eye-opening eps number. Much like growth capex for a company facing a long runway for reinvestment in the business, as long as the ‘growth’ e&d is being spent on positive return projects, we are happy to let management allocate capital in such a fashion. They addressed their spending plans (and affect on margins) on the last call:

But I think there's certainly room for increased revenue and relative efficiency in terms of our cost going forward. But, as always, that cost structure or the E&D expense is at least in part driven by our success in the market. And two years out, it's kind of difficult to predict where we're going to be. Again, we think we have a chance to really establish ourselves in certain markets and as A-list customers bring up their airplane development programs, if we get invited to participate, we're going to go after that pretty aggressively. So, if three or four of those companies this time next year have announced plans that include us, that could really drive our E&D expense in 2014 and 2015 for example. But if we get to this point next year and the business jet market is still depressed, then actually it could go down, and we wouldn't rule that out.

Given the discretionary nature of the majority of their e&d spend we add back much of the overspend (and deduct the corresponding r&d tax credits) to arrive at our normalized EBITDA figure of 80-85mm two years out. With a 7x multiple we arrive at our mid $40 target.

 Risks

• Customer concentration risk with Panasonic
• Fixed price contracts could result in margin risk in an inflationary environment
• Unexpected disruption in the aerospace cycle
• Boeing 787 issues cause undeliverable backlog (they currently have about 200k of content per plane)

Catalyst