Description
I expect CVU to at least double sometime between Monday and the next two years. The real reason to buy the stock is towards the end of the writeup. Humour me and read all the way through before skipping to the bottom. Here's an outline so you'll know what you have to wade through:
1: Background
2: Financial highlights
3: No-Growth Valuation
4: Growth Story Valuation
5: Why It's A Buy
6: Why The Opportunity Exists
1: BACKGROUND
CVU is in the defense aircraft maintenance business. They make structural aircraft parts for a variety of different systems, like the C-5A (huge cargo plane), the A-10 ("Warthog", a ground attack plane) and T-38 (a trainer. George Bush spent some time in this plane.) "Structural aircraft parts" boils down to "shell". Exhaust shrouds, wings, doors, _parts_ of wings, _parts_ of doors, etc. They don't do electronics or much with engines. Body work, basically.
The company isn't really a manufacturer; it's more in the project management business. They sub-contract the actual fabrication to others, and then do some final assembly and inspection. One analog to this asset-light business model is Expeditor's International. CVU stands to the actual manufacturer as EXPD does to, say, USAK.
The company was written up here by otto695 in 2002 at $6.30. If I may summarize, the appeal was, "too cheap at < 7x earnings"; the risk was the need to roll over some maturing bank debt.
2: FINANCIAL HIGHLIGHTS
Here are some financial highlights using fully diluted shares as of the November 10Q:
Balance Sheet:
Shares outstanding,diluted: 6.1MM
Stock Price: $10.45
Market cap: $63.7MM
Book: $23MM
P/B: 2.76
Working Capital: $22.6MM
Debt: 0.1
Current Ratio: 6.6
Income Statement, using management's "at least" estimates for '04:
Net Income: $3.7MM
Revenue: $30MM
PE Ratio: 17.2
P/S Ratio: 2.1
Trailing 3 Year Growth Rates, again using '04 estimates:
Trailing 3 Year Revenue CAGR: 12%
Trailing 3 Year Net Income CAGR: -6.4%
Trailing 3 Year EPS CAGR: -20.5%
Yucch! Those EPS growth rates are not pretty. This looks like yet another over-priced value destroyer, although the balance sheet is interesting. We'll get further into the growth rates below.
3: NO-GROWTH VALUATION
We don't need exact figures here; the goal is simply to establish that we're within spitting distance of a price that would make sense to a private buyer who wanted to run the company for current income, with no expectations of or desire for growth.
Management is calling for "at least" $30MM in revenues and $3.7MM in net income for '04. I think $3.7MM is very conservative on $30MM revenues because it implies that Q4 margins drop from 13.8% YTD to 8.7%. Assuming 12% margins in Q4, '04 net income comes in at about $4MM. I believe that if one were to take the company private, you could add on an additional $500k by saving on public-company expenses, and managing for current income rather than growth.
The $23MM of book consists mostly of $22MM in "Costs and estimated earnings in excess of billings on uncompleted contracts" (henceforth, CAEEIEOBOUC). This is the percentage-of-completion accounting equivalent of "work-in-progress".
(Let met digress for a moment. Yes, the company does use POC accounting, which is often a red flag. But I don't think it's a danger here, because the company has many, many small contracts. POC accounting involves booking revenues and profits based on costs incurred during the life of the contract. You know up front how much you're going to get paid for a project. You then just guess how much the project is going to cost, and recognize revenues as actual expenditures approach your estimated cost at completion. This is obviously a recipe for disaster in large and complex endavors, like enterprise resource planning implentations or trans-Atlantic tunnel digging. The risks here are minimal, though, because the estimates are spread out over hundreds of different projects, none of which are of any immense technical complexity.)
CAEEIEOBOUC isn't receivables, let alone cash. But I regard the asset as being solid due to the company's track record, the diversity of its contracts, the minimal chance of cancellation because of the need for their products, and the lack of credit risk.
I'd be willing to take the whole company private for working capital + 6x earnings, or for 0.75x working capital + 8x earnings -- that's $50MM to $53MM, or $8.13 to $8.68 per diluted share. To briefly justify the higher number: I think picking up a pretty solid asset at a 25% discount is attractive, and that a 12% unleveraged return on the goodwill is also a good deal, especially given that '04 is likely to be the bottom of the cycle, and the option to pursue a growth strategy if one chose.
4: GROWTH STORY VALUATION
Since the stock's trading 20% above my high end take-out number, there's got to be more to the story than that. And there is. CVU has substantial growth opportunities, which we'll discuss under the headings Secular, Cyclical, Company Specific and Large Contracts. Here the goal is to establish that the company is reasonably priced as a growth stock.
-- Secular
Helping maintain planes for the Air Force is a great place to be now and for the next, I don't know, at least 6 to 10 years. The Air Force fleet is as old as it's ever been, and it's not getting any younger any time soon. Rumsfeld is against buying new toys, and there isn't room in the budget for new toys anyway. Even if buying new planes would be more cost effective than maintaining the old, the higher upfront costs create short term incentives to stick with the older systems. At some point attitudes will shift, but it will still take years after that for the composition of the fleet to change. Finally, aircraft maintenance is about the last thing in the defense budget to be cut, because it looks really bad when your planes fall out of the sky.
-- Cyclical
This is a bit of an interrupted growth story, because the war in Iraq has acted as drag on maintenance expenditures. From CVU's Q3 earnings release:
"As we have been reporting, the government has been slow to issue major contract releases, in part because of aircraft deployments into areas of conflict. As a result, the military aircraft that we support are not in the depots where they can undergo maintenance and modification."
Rooting around in the records provides evidence for this slow down and lengthening of the awards cycle. Prior to the Iraq war, CVU generally was awarded small contracts within 2 weeks of submitting a bid, but now I'm seeing some awards that weren't granted until 6 months afterwards. The company says that a lot of their bids are just sitting in limbo, waiting for a response from the govenrment.
CVU should still be able to pull off 10% revenue growth for '04 despite the slowdown. Looking forward, the Iraq war is of course a positive for the company. The need for maintenance doesn't go away, it's just postponed. In fact, the need is actually _intensified_, because the planes are flying around in the desert getting dinged up.
-- Company Specific
Three year 12% revenue growth going into a slowdown is pretty good, and the trend should improve as planes either come home or are pushed to the breaking point. The company has competitive advantages that should allow it to continue to grow:
- With only 63 employees, CVU qualifies as a small business. From the 10K: "The military's fiscal year 2003 program goals for small business prime contracting were 23%, with 40% for subcontracting. During 2003, approximately 20% of the value of our current contracts were awarded to us under this program."
- The company calls itself a "mini-prime" contractor. They seem to have a good niche in areas that are too small for the big boys, but too complex for the local machine shop: "Our competitive advantage lies in our ability to offer large contractor capabilities with the flexibility and responsiveness of a small company, while staying competitive in cost and delivering superior quality products. While the larger prime contractors compete for significant modification awards and subcontract components to other suppliers, they generally do not compete for awards for smaller modifications or spare and repair parts, even for planes for which they are the original manufacturer."
- CVU has started to get sub-contracting work from larger prime contractors such as Vought, Northrop Grumman and Lockheed Martin. This is very significant, both as validation of the company's capabilities and as another source of growth. The NOC contract, for instance, could lead to an additional $22MM in revenues between now and '07.
- Management seems competent and honest. Arthur August, the founder, Edward Fred, the current CEO, are ex-Grumman guys. The board has a strong non-executive chairman in Eric Rosenfeld of Crescendo Partners, who is a guest lecturer at Columbia Business School. Rosenfeld owns 17.6% of the company, and was chairman of Spar Aerospace from 1999 until its sale to L-3 (Yes, that's a hint at a possible buy-out down the road).
-- Large Contracts
EPS is down over the last few years because the company's NOLs were used up, but mostly because the company did a follow on offering that increased basic shares outstanding by 85%. (This is when Rosenfeld came in.) The goal was to remove all debt from the balance sheet in order to position the company to bid on larger contracts. They priced the offering at $4/share, or less than 4x operating income -- that should tell you how big management thought the opportunity was. (It should also tell you why small & middle market companies are willing to take on mezzanine debt at 15%.) Since then, CVU has bid on a variety of larger contracts, some of which could double the company's revenues. The impact of such an award would be significant; using YTD margins (i.e., assuming no operating leverage), the company's baseline EPS should be about $1.36/share. Increasing revenues to $60MM from $8MM in 2000 would presumably get the stock a growth multiple, but a market multiple of 15x-20x EPS produces nice gains from the current price.
CVU is so small that their opportunity is essentially infinite; the '04 maintenance budget for a single system, for instance, is more than 12x the company's total revenues.
I'm not an expert on growth stock valuation (or much of anything else). But here's a company with a clean balance sheet, operating in a niche that should see strong demand for years to come, with an asset-light business model (cap-ex = 1.1% of revenues), that should be seeing a cyclical upswing starting soon and has tons of option value because of the possibility of signing a transformative contract that could double revenues overnight -- I'm no expert, but at 15x TTM earnings, CVU doesn't sound expensive to me.
5: WHY IT'S A BUY (finally!)
So maybe CVU's an OK GARP play. Why am I bringing it up here?
Well, remember the "transformative contract that could double revenues overnight"? They freaking signed it already! Last May, in fact:
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CPI Aerostructures Announces Potential Largest Contract in Its History; Seven-Year C-5 Award Valued at up to $215 Million
EDGEWOOD, N.Y.--(BUSINESS WIRE)--May 5, 2004--CPI Aerostructures, Inc. ("CPI") (AMEX: CVU) today announced that the United States Air Force has awarded the Company a C-5 TOP (Wing Tips, Others and Panels) contract, potentially valued at $215 million over a seven-year period. This proposal was "set aside" for small businesses, under which CPI qualifies. The immediate order amount is for $5.2 million, and includes the delivery of wing tips, spoilers and panel assemblies.
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$210MM / 7 = $30MM -- '04 revenues of $30MM -- yep, that's a double.
It's important to note that this is a "requirements" contract, not a guaranteed contract. "Under the terms of this award, the U.S. Government may order parts at any time", including presumably not ordering any at all. But that's OK because:
A: If the contract were guaranteed, we wouldn't be able to buy the stock anywhere near the current price, and
B: I expect that the Air Force will wind up ordering all $215MM. The C-5A was introduced in 1970, and current plans are to keep it in service until 2040. It's an important system that was never that reliable to begin with, and needs all the help it can get.
I'd like to characterize this contract a bit more carefully: It is not guaranteed. But it's way, way more than a "free option". This isn't like "If they win the lawsuit", or, "If they get European approval". This is also better than "a strong expression of interest". The closest I can come is, "these revenues should be realized in the ordinary course of business", but it's actually stronger than that, because I don't think the government can easily pick a different supplier. Unless the DoD changes its mind about the C-5A altogether, CVU should get these orders at some point, and a complete switcheroo by the DoD seems unlikely because:
I: The plane has its supporters.
II: The closest competitor, the C-17, is a lot smaller, and the upfront costs of building enough to replace the C-5A are high.
III: An independent commission studied the issue, and surprised a lot of people by recommending modernization of the system.
The Air Force has told CVU that it will detail it's '05 requirements for this contract sometime in the first quarter. This is the basis for my expectation that the stock will "at least double sometime between Monday and the next two years". The Air Force might order $30MM on Monday, or they might say they're taking nothing this year, or they might not say anything in the first quarter at all. Any of these alternatives is fine with me.
I'm not counting on it, but things could work out better than a double. Obviously it's possible for the company to win other large contracts -- they've got a number of them out for bid right now -- I see no reason why they can't continue taking share, and I expect a general upturn in business regardless of the duration of the Iraq war. I think the company could triple revenues over the next few years (that is, double them even without benefit of the TOP contract), and that there's room for multiple expansion -- see DHB for a (I hope!) comparable.
6: WHY THE OPPORTUNITY EXISTS
Well, there's always the disturbing possibility that I'm missing something. Other than that, here are some things that occur to me:
A: Small & illiquid, with no coverage. I'd like to attribute the illiquidity to extreme undervaluation, but ....
B: The company doesn't screen well. Current ratio is the only financial metric it scores high on. Margins & ROE are good but not outstanding.
EPS has been declining due to the expiry of the NOLs (for what it's worth, the company dug up some addition NOLs which may be applied over the next few reporting periods), the huge increase in the sharecount and some special items in prior periods, like a $2.4MM gain extinguishment of debt in '03. P/B is high. Because of the war, '04 revenue growth is tepid. Cash from operations has been negative, thanks mostly to CAEEIEOBOUC increasing from $10MM to $22MM over the last two years.
(To address cashflow for a moment -- Some of the weakness here is due to increasing revenues requiring increasing amounts of working capital. The rest I attribute to the company being managed for growth in net income, not cashflow. If I understand POC accounting correctly, the company gets to book revenues when it pays its suppliers, so the incentive is to pay bills the second they're presented. Given the low interest rates on cash balances over the last few years, and the good-will that's built up by paying people in hurry, I don't have a problem with this, although I might change my mind if they have to tap their credit line. By way of illustration, accounts payable in '01 was 28% of revenue in '01 vs. 11% today, and they're in a _much_ stronger financial position now. This is the basis for my belief that they can make their suppliers share some pain if they need to.
So I think the low Piotroski cashflow score is misleading. The company doesn't need cash now, and has an untapped $5MM credit line. Maybe they'll require additional funding down the road. I think they could easily squeeze their suppliers or increase the LOC, but I wouldn't mind additional equity either (if issued at higher prices), since it would help liquidity and be likely to attract sell-side coverage. I take Rosenfeld's involvement as adequate insurance against worst-case interpretations of the cashflow statement.)
C: The C-5A TOP contract hasn't hit revenues yet, and may actually increase investor's perceptions of risk, because what if they get nothing in '05? But I think this is silly. Given my perception of the industry background, and the company's financial and competitive strengths, I'd welcome the announcement of a goose-egg from the TOP contract in '05, in the hope that stock would tank so I could pick up more below my take-out price.
D: Arthur August, the founder, is retiring and was selling his stock under a 10b5-1 plan. Apparently his broker dumped 25k shares on the market one day, to the great distress of the retail holders. August has terminated his 10b5-1 sales, and has sold no stock since August 9th.
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Well, I could go on, but I'm sure this writeup is long enough already. To sum up:
-- The stock price is within 20% of where I might want to take the whole company private based on '04 numbers, so there's reasonable downside protection.
-- It's a pretty good growth story without the TOP contract.
-- The TOP contract should double revenues for the next 7 years. News about '05 disbursements should be forthcoming over the next two months.
I own a good chunk of this, have bought at prices slightly higher than the last close, would be willing to add more at the current price as funds become available, and look forward to _making_ funds become available if the price drops.
Other Stuff:
Their web site is good. The last CC is still available, and is worth listening to.
A recent mention in Newsday, the regional newspaper. The closing quote from Mr. Fred is interesting:
http://www.newsday.com/business/ny-bzsmall274126884jan27,0,7404314.story?coll=ny-business-headlines
"Air Force Fleet Viability Board releases C-5A assessment"
http://www.af.mil/news/story.asp?storyID=123008163
"Checking Up on Old Aircraft"
http://www.afa.org/magazine/dec2004/1204aircraft.html
Some comments from L-3's Q4 earnings announcment:
"We expect that for 2005 U.S. defense spending will remain strong as the DoD continues to focus on transforming the military and upgrading its assets. [...] DoD priorities include information distribution, network fusion, SIGINT, rapid strike, ISR, communications, precision weaponry, improved training, aircraft modernization and support [...] With the military engaged in Iraq and Afghanistan, there is a need to ensure that existing aircraft, ships and land vehicles are upgraded and maintained. [...] We believe that the DoD will continue to either delay or cut new platforms [...] but at the same time allocate increased funding for transformation."
I'm being deliberately vague here, because I don't want people to invest on the basis of one month's incomplete information, but the data available to me indicate that smaller orders for January '05 were very strong, possibly indicating that the Air Force is starting to address its maintenance backlog.
Yours,
Bowd
Catalyst
It spoils the write-up to give the catalyst here.