Description

Investment idea:
I believe the market downturn in the commercial aircraft industry has created a buying opportunity for Astronics (ATRO). This is an opportunity to invest in a consistently profitable company with a strong balance sheet that will weather the storm in commercial and general aviation while delivering on strong military prospects over the long-term.

Company Description:
Astronics Corporation designs and manufactures lighting systems for the military, commercial and general aviation markets. Its lighting systems are segmented into three product categories: external, cockpit and cabin lighting systems. For the year ended 2002, I pieced together an estimated breakdown by customer and product as follows:

(in 000’s) Military Commercial & GA Total
Cockpit 12,800 8,000 20,800
Cabin - 6,000 6,000
External 13,500 - 13,500
Other 1,200 1,500 2,700
Total 27,500 15,500 43,000

In regards to customer segments, military has been and is expected to remain a strong source of revenue, while general aviation and commercial transport are weak. One bright spot within the commercial segment has been the regional airlines, but I don’t expect revenue from regional manufacturers to make up for the weakness in the commercial segment.

Astronics has been enjoying revenue from a big win in the military segment since 1999. It designed and supplied the upgraded cockpit lighting systems for over 1,100 F-16’s in the Air Force fleet. Over a four-year period, nearly every light in the aircraft cockpit was fully retrofitted using the Company's technology. Revenue from this contract is slowing to a trickle and is expected to be negligible in 2003 (compared with F-16 sales of $3.2, $18.3, $20.1 and $10.9 million in 1999, 2000, 2001, and 2002, respectively).

The company announced a major contract win in the military segment in 2002—the Joint Strike Fighter (JSF) program. JSF is the DOD’s program to develop a common platform for a military fighter plane (the F-35) for the Navy, Air Force, Marines and allies. The DOD selected Lockheed Martin as the prime contract in October 2001 and awarded them the System Development and Demonstration (SDD) contract to produce and test 22 aircraft. The JSF program is slated to produce 3,000 aircraft in total, and ATRO will be supplying the external lighting systems to Lockheed. Revenue from JSF could total $100 million (beginning in 2006) for ATRO over the life of the program if the 3,000 aircraft target is achieved.

In March 2003, Astronics spun off MOD-PAC (a VIC write-up), its printing business segment that was unrelated to the core avionics business of Astronics.

Investment Merits:
ATRO’s most recent conference call (10/23/03) to discuss Q3 results summed up the company’s story best: long term prospects are attractive due to large contract wins (JSF is the largest, A380 most recent), but the short-term results look dismal due to a depressed commercial market and increased design and development costs to support the future contracts. These two combined short-term factors have resulted in significant margin deterioration for the first three quarters of 2003.

The good news is that the company has a strong balance sheet with enough cash to invest in these product development costs, capex requirements are extremely low ($286k YTD, with no significant increase expected), and management has a good long-term track record.

Upon first look at ATRO’s valuation, it does not appear to be a compelling value play—trailing EV/EBIT of 28, trailing P/E of 45. The attractive valuation is hidden in the fact that the company expenses all development costs for future contracts in the current period. ATRO is investing heavily in development for JSF via engineering talent (which flows to COGS). If we use normalized EBIT margins of 15%, we would get more reasonable multiples of EV/EBIT of 8 and P/E of 12.

When valuing ATRO, I look at the company in two parts: 1) a stable revenue base across all products and customers (excluding any big one-time contracts), and 2) large single military contracts (F-16, JSF).

Stable revenue base: Revenues net of F-16 sales were $21.6, $24.3, $32.5, and $32.0 million from 1999 through 2002, respectively. Management gave guidance of $33 million for Non-F-16 sales in 2003, which they should hit. I would argue that despite the zero growth rate over the last two years, management has done a commendable job of keeping revenue at this level given the downturn in the commercial aircraft segment. As a point of reference, Boeing is one of ATRO’s larger customers and BA’s aircraft delivery has dropped substantially over the last couple years: 527, 381, 280 aircraft deliveries for 2001, 2002, 2003. Boeing does not expect to see shipments increase until 2005, at which point I would look for ATRO’s core revenues to start increasing as well. Lets assume revenue stagnates at $33M. Further assume a 15% EBIT margin (the current year’s EBIT margin has been distorted based on design and development costs for JSF that are expensed in the current period. 15% is ATRO’s historical average). This results in approx $5M annual EBIT. To get to the current EV of $40M, you would need an 8x EV/EBIT multiple, which is low even given a no-growth scenario.

Potential contracts/growth scenarios:
I would argue that based on the current valuation of ATRO, investors are getting the growth scenarios for free—a compelling bargain given the company’s potential $100 million JSF contract and its recent Airbus A380 win. The majority of risk resides with a DOD decision to scale back on production forecasts on the JSF program. An October WSJ article outlined the F/A-22 program and how it was reduced from 648 to 276 over 9 years—the JSF program could take a similar path of downward revisions, but it is impossible to quantify. In a scenario analysis, we can look at two states: 1,500 planes (50% of plan) and 3,000 planes, both beginning in 2006. I will further assume a 15% EBIT margin, due to completion of development costs for this program by 2006. Over a 15 year period, full production would result in incremental $6.7 million in revenue and $1 million EBIT per year.

The following scenarios show some of the upside with ATRO. All scenarios assume a return to 15% EBIT margins (annual EBIT margins range from 14.6% to 17.7% from ’98 to ’02).

Scenario 1) Stable revenue base of $33M: $33 million x 15% = 4,950 EBIT x 7 =34,650 EV – 1,660 net debt = 33,000 market cap or 4.27/share.
Scenario 2) Recovery in commercial & general aviation: this segment returns to peak sales of $20 million (in 2001), resulting in $8 million in incremental revenue to base case = total revenue of $41,000.
Scenario 3) JSF production starts (assuming only 50% case to be conservative), leading to an extra $3.3 million in sales/year, or total revenue of $36,300.
Scenario 4) Combination of JSF (100%) production + recovery in commercial segment: sales of $47,700.

Price targets 1 2 3 4
8x EV/EBIT 4.90 6.15 5.42 7.19
9x EV/EBIT 5.54 6.94 6.12 8.11
10x EV/EBIT 6.18 7.74 6.82 9.04
11x EV/EBIT 6.82 8.53 7.53 9.96

In addition to these scenarios, it is important to recognize that each contract brings additional reputation benefits within the aerospace and defense community. ATRO’s execution on the F-16 contract led to the JSF award, and its recent Airbus A380 award will lead to new opportunities to work directly with Airbus. Management, which I believe to be a conservative group, is optimistic about the company’s long-term prospects and specific proposals in the pipeline.

The company has a strong balance sheet with $1.44 per share in cash, current assets to total liabilities of 0.97, current ratio of 4.5, and tangible net book value of $2.56. Together with the company’s consistent profitability and long-term prospects, I don’t see much downside risk with the current price of $5.00.

Additional investment merits:

Flexible cost structure: ATRO is not a capital-intensive company, rather it invests in engineering talent to design and develop new products. These costs flow directly into COGS and have single-handedly caused the GM% deterioration in the last 3 quarters. ATRO expenses all design and development costs related to new programs under contract (such as JSF, which is in full-fledged development) in the period incurred rather than capitalizing them (as some companies do; e.g. Boeing). Because military contracts have long lead times, this causes ATRO to realize poor margins during project development and high margins during post-development periods of product shipment. As ATRO transitions from F-16 winding down to JSF development, the GM% decline is warranted.

The key question here is whether management is making a prudent capital allocation decision by maintaining the current level of R&D. I believe the upcoming JSF contract warrants this continued investment in R&D. Management has repeatedly stated that if there were no compelling growth opportunities (contracts) on the horizon, they would cut engineering headcount and return to profitability.

Profitability / Management team: ATRO has been a consistently profitable company that has recorded one year of losses in the last 15 (2003 should be close to breakeven). From 1998 through 2002, annual net margins have ranged from 8.2% to 11.1%, ROE from 9.5% to 15.6%, and ROA from 8.1% to 12.6%. The key for the future of this company is management’s ability to balance investment in future prospects (via R&D) with cost management. Management’s experience with the F-16 program, its focus on long-term prospects (JSF), and its track record of consistent profitability provide me with some confidence about their ability to weather the weak segments in the current market and to deliver on the JSF contract. While it is impossible to fully judge management, I have seen signs that would point to their conservative nature. For example, they fully reserve all A/R balances over 120 days and elect not to capitalize development costs on long-term contracts. As an ex-auditor, I believe you can learn a lot about the character of management by its accounting policies. Also, they pay themselves reasonable salaries (CEO $321k, Chairman $548k). Without having done background checks on these guys, my initial take is that the fraud risk is low.


Negatives:
· I generally like to see some meaningful insider buying by management, but there has been practically no activity in the last year. Kevin Keane, chairman, does own 14% of the company, but I would feel better with some large insider purchases.
· Class B shares: the company issued class B shares (each with 10 votes) through dividends in prior years to presumably guard against a takeover. While I don’t have any complaints about the way they manage the company, I don’t view this as a move with shareholders’ interest in mind.
· Making a bad acquisition: The company has indicated they are considering an acquisition with some of the excess cash they have on hand. They announced their potential interest in buying a company about a year ago, but have been prudent about finding the right deal at the right price. They have made several small acquisitions in the past—their largest was Loctite Luminescent Systems in 1995 for $6.3 million in cash. I tend to trust that management will not squander cash on an ill-advised acquisition, but the risk is always there.
· It is not the most liquid of stocks.

Catalyst

· Rebound in commercial segment
· Continued contract wins
· More certainty about JSF program
· Revenue from JSF contract (late 2005 will be earliest)