Description

Despite rapid growth, incredible returns on capital and an industry leading position, Aeroquest trades for about three times what I figure it will earn next year. After that, the company should continue to grow at around fifty percent annually for a number of years into the future. This is possibly the cheapest growth company I have ever seen. More importantly, it has a very wide technological moat.

It has now been a year since I first wrote this up. Please see the prior write-up for info on the business. In the past year, the shares essentially doubled before giving back those gains and are now back to where they were last year. Meanwhile, the business has greatly increased in size and profitability. More importantly, there is much better forward visibility now than there was when I first wrote it up. The backlog remains steady at three to four months and if the company were willing to book further into the future, the backlog would be even stronger—giving great visibility into 2009 earnings. More importantly, at this point last year, the company was primarily servicing the junior mining world. Hence they were dependent on these speculative companies continuing to receive funding. In the past year, an increasingly large portion of the business has shifted to servicing the majors, which should be repeat business with no funding risk. If the juniors can begin to raise capital again, that should only make the market for geophysical services tighter.

At this time last year, the company was working on the acquisition of UTS, a provider of fixed wing geophysics services. The company changed its fiscal year end, and then had a two month stub period and a few integration expenses which have confused everyone in the analyst community—including myself. Going forwards, the numbers will be much cleaner, which should help in evaluating the business.

Estimates and Valuation

The business is somewhat seasonal, with the summer months (Q3 and Q4) having the best revenues and hence much higher margins. I will base the following numbers off the just released guidance. I think they are being conservative, so figure 33m in revenue in 2H instead of the 30.5m-32.5m they guide to. Then 55% growth in 2009. I base this revenue growth off them increasing the number of systems from 27 currently to around 45 by year end 2009, or 4 a quarter going forward. I also assume that margins increase a little and that they get some economies of scale as they grow the business.

                     FY 2008 (e)                FY 2009 (e)

Revs                 57,491                     89,111

Margin              25,830                    42,773

Gross %             45%                        48%

R&D                    410                         614

G&A                 8,666                     11,584

G&A %              15%                       13.5%

Amort                2,640                       3,960

Total Expense     11,716                   16,159 

EBT                    14,115                   27,215

Tax                        4,283                    9,525 

Net Income           9,832                   17,689

Shares Out          33,700                   32,500

Per Share              0.292                     0.544

The company should do around 29c this year and 54c a share next year. At a 20 multiple (conservative for a company with pre-tax returns on capital of around 50% and growing at least 50% a year) it should trade for a bit more than six times today’s quote. This doesn’t give the company any credit for accretive acquisitions or massively better margins if the capital markets open up again for junior mining companies. Looking out another year, FY 2010, starting October 2009, could have earnings of 85c/shr. At a bit better than a 20 forward multiple, you have a 10-fold move within two years or so.

Why Aeroquest Is So Cheap

Like all small-cap equities, the shares have been pummeled by both a lack of interest and liquidity. This was further influenced by the company’s lack of guidance or interest in shareholder relations. Finally, this was all accentuated by a 6,666,667 share bought deal done with Jennings at 3 a share in February—right before the market for small cap securities collapsed. The offering was done to retire all outstanding debt and also to give the company sufficient working capital to handle the growth going forwards. The company also has cap-ex needs for building new systems and purchasing fixed wing aircraft. The total offering was about twice as large as the company’s immediate needs. It spooked the market and broke pricing the first day, Jennings was stuck with shares that it could not place and Jennings has never really gotten behind the name. A number of firms did favors for Jennings by buying the shares at $3, even though the shares were trading for less than that. These firms then proceeded to simply liquidate their positions in the market. One of those firms completely liquidated its position last week—hence the sizable increase in volume.

The shares are cheap, but so are many small cap companies. What will change this?

Share Repurchases

The company has thus far repurchased 795,900 shares or roughly 2% of the total shares outstanding for 2.18. This is also about 12% of the total shares in the bought deal. The company just increased the size of the buyback by another 300,000 shares. Give them credit, even after investment banking fees, they’re great day-traders. They wanted to do a Dutch tender for a much more sizable buyback, but the expenses involved in buying back 3,000,000 shares ($6,000,000) may have been around $1,000,000 and negated the whole advantage of a buyback.

TSX Listing

On Thursday, the shares were listed on the TSX main board. Previously, they were listed on the Venture exchange. This should give much better visibility, and also credibility—the venture is well known for housing companies of dubious quality. For this reason, many institutional accounts in Canada are only allowed to buy TSX main board companies. This listing change should bring a new class of investors to the company.

Better Shareholder Communications

For the first time ever, last week the company pre-released revenues and put out forward revenue guidance for the next quarter. The company also gave better color on the number of systems going forwards and future business plans.

The company intends to be more active in their interface with the street. For instance, they intend to finally put something besides press releases into their website section called ‘investor relations.’ The company even intends to hire an in house person who will strictly field investor questions.

Margin of Safety

Benjamin Graham would love this one. In very rough numbers, at the end of Q3, the company will have a $55 million market cap and $20 million in cash for a $35 million enterprise value. There is no debt and another $10 million in receivables. Going forward, the company should earn just under $5 million after-tax for the next few quarters and after that, the cash flow should really accelerate. At this rate, within six quarters, the whole market cap should be cash—even with the company reinvesting in the business to grow at better than 50% a year.

What Can Go Wrong

I’m baffled at this one. As long as gold stays over $500/oz, silver over $8/oz, copper over $1.50/lb and people want to wear diamonds or drink water, there will always be a demand for these geophysical services using an aerial platform because it is significantly cheaper than other methods of detecting resources that were used in the past. The company has recently diversified into the oil and gas space. While this is a small part of the business, once they are credited with being responsible for a major discovery, this business should pick up significantly which will add to diversification. Aeroquest has now been cited in being responsible for 41 major discoveries in the mining industry. The company is also looking to get into mine field detection and unexploded ordinance. While I doubt these will be significant contributors going forwards, it will help to add some diversity to the revenue streams, especially in the winter months when the core business is weaker.

Catalyst