Description

In all great gold rushes, it’s not the guys who find the metal who make money—it’s the guys selling the picks and shovels. I don’t think this time should be any different from past gold rushes. Many of the pick and shovel types are already up 5-fold. One is still under the radar for a variety of reasons—yet it is probably the best of them all.

Aeroquest flies geophysics surveys for mining companies using helicopters to tow electromagnetic systems or arrays. These systems allow exploration companies to identify potential resource targets for further exploratory drilling.

The genesis of most properties in the past was that a geologist would find an interesting rock outcropping or pebble in a stream and then try to figure out where the main ore-body was. This involved core drilling which is expensive ($120-150/meter or $2 million for a 15,000 meter program) and time consuming as drill cores needed to be sent to an assay lab and logged before you knew if you found something. Often each round of drilling took 3 to 6 months.

Aeroquest uses geohpysics to search for differences in the properties (magnetic, electro-magnetic, etc) in various rock formations. This can give the geologist a better coordinate to target his drilling. This means he is more likely to hit something on the first try and save millions in cash along with a few years to find out if he has something or not. The technology is so popular that the company has a massive backlog and if they doubled their fleet, they could still lease them all out.

This brings us to the equipment itself. The simple math is that a system costs $500k to build, brings in about $2,200k in revenue with a 45% gross margin or over $900k in EBIT. Since only the struts ever need to be replaced, depreciation significantly overstates maintenance cap-ex of less than $100k every four years. Basically, you have a product with an after-tax return on capital of over 100% that has endless demand. The real constraint is the ability for the company to build new systems. The company estimates they can now build six to ten a year after moving into much larger facilities. For the purposes of this write-up, I will assume they only produce six a year. This will create massive growth year over year as they currently only have twelve systems in service.

Part of what makes an analysis of the run rate earnings difficult is that after an array is built, there are certain costs of getting it out into the field and operational along with a lag in time before it begins producing revenue. Therefore, to look at fiscal 2007, we are looking at a company with considerably fewer systems on a TTM basis than at year end along with some costs that are not recurring per each system which are making earnings look weaker. The company should probably capitalize these costs, but they have trouble breaking them out and are trying to be conservative in the accounting. This is further compounded by the rapid growth of systems in service which is increasing at over 50% year over year. Hence earnings from last year’s crop of arrays are diluted by the costs of bringing this year’s systems into the field. This is all a very roundabout way of saying that it is difficult to give real estimates going forwards, or even looking back. Furthermore, this is all complicated by a sizable acquisition which was just finalized yet no financials have been released. I will start by giving numbers on stand alone Aeroquest, then touch on what the new entity will look like. I have taken out restricted stock and stock option expense. The fiscal year ends April of the following year. So year end 2007, ended April 2007 are the most recent numbers.

(million)                        2006 (actual)            2007  (actual)            2008 (estimate)

Revenue                          9.112                        19.875                        33.075

COGS                             5.764                        10.843                       18.191

Gross Margin                  3.348                         9.033                        14.884

Gross %                           36.7                           45.4                            45%

R&D                                 .793                           .531                          .650 

G&A                                2.788                        3.884                          5.084

Amortization                     .954                         1.036                         1.636 

Other Expense                  .363                           .015                          .250

Operating profit              (1.551)                       3.566                         7.514

Tax                                   (.429)                       1.438                          2.542

Net                                   (1.121)                      2.128                          4.721

Per Share                                                            12.1c                          26.8c

To get to these estimates for 2008, I took 2007 run rate and assumed 6 systems built at 2.2m in revs per unit, with a 45% gross margin. I assumed 100k in amortization per array and that each new array will add 200k in G&A expense. I think these numbers are highly conservative for a number of reasons. Firstly, I think the company produces more than six arrays, secondly, 2007 run rate figures include a number of one time expenses that are not broken out well along with expenses for ramping up and moving to a larger facility. Combined, I think these are in excess of $1 million in additional expense. I also think that the G&A per new rig will be considerably lower than $200k. Finally, I think that gross margin will come in better than 45%. The winter quarters are the two weakest, yet in the most recent April quarter, gross margin was 44.8%. If last summer was any guide, during the October quarter, margins increased to 54.6%. This company has a niche product that is increasingly gaining acceptance from geologists. Anything that helps them find the gold, will become very popular fast. I think this will give them a good deal of pricing power going forward. Go to the website and look at some case studies where their technology was responsible for a major discovery.

The main reason for the future upside in margins is that the cost of helicopter rental is about 30-40% revenue or over 60% of the total cost of servicing a client. The newest generation of AeroTEM array uses a lighter composite structure which should allow the company to use a smaller sized helicopter, which should significantly save in fuel cost. Unfortunately, it’s still too early to quantify the total cost savings. If you plug 9 new arrays at a 48 gross margin into my model, you get 38.9c in after tax earnings for FY 2008 ending in April 2008. Finally, the tax rate may be overstated at 35% because of the ability to accelerate the depreciation of the equipment. I should note that for simplicity, I have assumed that all six new arrays start on day 1. This will not be the case. Revenue may be a bit lighter, but earnings should be similar because the 12 current arrays will all be running full time. I can explain this in the questions section if you want.

If you think all these moving parts are tricky, here’s the real tough part. Aeroquest recently announced that they closed the acquisition of UTS in Australia. They refuse to give any numbers other than to say that it is roughly the same size as Aeroquest. They also refuse to comment on synergies, but from what I can tell, there is very little overlap in the businesses and a lot of synergistic potential outside of direct cost containment.

On the business side, the two have very little geographic overlap. Thus, combining the two will give each better ability to source the highest margin projects around the globe. This should lead to higher revenue without much increase in overhead. There should also be some potential to cut some sales expense. The real upside will come from cross-selling the two products.

UTS is focused on fixed wing applications. These applications allow a geologist to see a large surface area with lower resolution. This allows the geologist to then use another technology to pinpoint where the deposit is. Fixed wing flight is a good deal cheaper than helicopter and this has meant that Aeroquest has missed out on larger contracts where it wasn’t economic to use a helicopter. By having both fixed wing and helicopter, Aeroquest will be able to offer fixed wing to gain the contract and then use the helicopter to re-fly the best intercepts to give a much more precise picture of what the ground looks like.

The real upside to this is that it will allow the company to get much better utilization of their existing equipment. Currently, the company is only able to run their arrays at about 30-40% of capacity because they have to be packaged and shipped to the next contract which involves downtime. By having more contracts, the company can better prioritize the servicing of contracts and have less downtime. This could significantly increase revenue per system and lead to organic growth without any price increases.

Let’s assume that UTS is 80% of the size of Aeroquest and is growing at the same rate as Aeroquest. Aeroquest issued 6.8 million shares and financed the cash and promissory note components with an equity offering of 4.5 million units which have 2.25 million warrants struck at 2.45. Finally 450k brokers warrants struck at 1.95 were issued. In total, this is 14 million additional FD shares on top of the 17.6 million FD shares already outstanding. This brings total FD shares to 31.6 million. This basically gives you the same earnings numbers because the FD shares increased at the same 80% rate as the business size increased. UTS is also growing at roughly the same rate as Aeroquest. I apologize in advance for being so vague, but without better numbers, this is all I can get to. This is also part of the reason for it being undervalued.

I have a hard time figuring out valuations for companies, but I cannot imagine that a rapidly growing company with an incremental return on capital of over 100% should trade at less than ten times this years earnings and five times next year’s. The closest public comp, Fugro, trades at 19 times next year’s earnings and isn’t growing anywhere near as fast. The closest comp is Geotech, but they are privately held. Most other companies in the mining services universe have lower returns on capital yet trade for 15-30 times earnings.

I think my estimates are quite conservative. If the company can put 10 or more arrays a year into the field and get 50% gross margins with 10% better utilization, I think they can earn something around a dollar a share after tax by 2010. Seems real cheap at around two a share now.  Of course, I am a large shareholder, so in the interest of disclosure, I am talking my own book.

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