Description

Long FEIM

FEIM operates a few different businesses but they primarily operate as a niche provider of mission critical timing and frequency devices in the satellite industry.  The stock has no analyst coverage and is down 30% from its high reached in April. I think it will be trading at least 50% higher by year-end, could be a double if you take a longer-view (over 1 yr. out) and I think it could be acquired within the next year or two.

 

I see three primary drivers to close the gap between today’s price and an appropriate valuation and these are rapid EBITDA growth, the potential divestiture of a division, and management’s commentary on the last call that they are open to selling the company.

 

1. EBITDA should grow >70% this year and more than double over the next couple of years yet this is trading for a MSD multiple of EBITDA at about 6-6.5x.

2. Management elaborated on their desire to potentially sell a division of the company by year-end after saying the following in their F3Q’15 press release, “we are ready to handle larger new satellite payload contracts.  Looking ahead, our focus will remain on potential corporate transaction opportunities and on rationalizing our segment assets and operations in order to enhance shareholder value.” More on this later in the write-up.

3. On the same call, management indicated they are open to selling the company and recent transactions support a much higher valuation (FlyOnTheWall reported there was rumored interest from Mercury Systems in May of this year).  The founder and CEO owns almost 10% of the company and he is 78 years old, the Chairman of the Board is 80, another President is 75, and of the remaining two directors on the board, one is 86 and the other is 78.  The company recently transformed earnings power by adding manufacturing capacity to support a new product slate and with the business on the tipping point, I suspect a couple contract wins will light the way to an exit from the public market.

 

I think the growth path commands a 10x multiple on EBITDA and on ~$14mm in EBITDA this year that implies a ~$17 stock price. Microsemi’s acquisition of Symmetriciom at over 14x EBITDA also supports this multiple yet a $17 target equates to only about ~8x a conservative estimate of what FEIM could earn in EBITDA next year. The valuation is even more appealing considering the potential for a transaction (divestiture to pad the B/S with additional cash or potential sale of the company).

 

 

Why does the opportunity exist?

I think the opportunity exists because this is an unknown, illiquid micro-cap company without any coverage. Sidoti used to cover it but in their IPO push the analyst was seemingly pressured to abandon it and he dropped coverage last week. The analyst actually really liked the stock, knew the name really well and kept tabs on the industry rags like Space News.  He was forecasting ~$14mm of EBITDA this year (vs. what should be ~$7.8mm this past year), but I think his numbers were very conservative.  His estimate was based on roughly $10mm in incremental revenue yoy but a single contract win could provide run-rate revenue expansion of $20-40mm and the company is targeting 2-4 contracts per year beginning now and three are currently in negotiations. I think it’s likely they blow through his estimates but he didn’t want to look silly with a huge number out there.  Below is a quote from the CEO, Martin Bloch, on the F3Q’15 earnings call….

 

“…we are right now negotiating contracts on three satellites to do the basic development, and we hope to conclude this negotiation before the end of March…the proposal that we have outstanding addresses our existing product line, plus our new products, especially the Ku, Ka band up/down converters and those specialized synthesizers for the Earth-orbiting environment.”

 

The “basic development” amounts to $5-10mm in revenue per satellie, while the up/down converters amount to $20-40mm.  They should win the basic stuff without a problem and if they convert on the rest, well, numbers will be huge.

 

Bullet Point Thesis

• FEIM will earn around $80mm in revenue this year but they are on the brink of earning new contract work that will expand revenue to well over $100mm and lead to a ramp in EBITDA.

• FEIM has evolved from earning about $1mm per satellite to more recently earning about $5-10mm per satellite following an upgrade cycle where they won more content per satellite.  We are now entering a new upgrade cycle.

• Taking more share of the component bill for each satellite is largely the result of the government's shift away from cost-plus contracts and towards more fixed-price work.  When this happens, the Boeing’s of the world subcontract out more work to companies like FEIM who specialize in certain components and can manufacture high quality components for a lower price due to their specialized focus on these products.

• FEIM will begin earning $20-40mm in revenue per satellite by selling a new set of products (up/down converters). Large manufactures have been waiting for FEIM to build the capacity to take on this new business and after over a year of investing in capacity expansion, product testing, product qualifications, etc., FEIM is finally ready to take on contracts and they have entered negotiations with three customers.

• In addition there is a double-digit revenue opportunity for Earth Orbiting military satellites that could add to revenue growth (>$10mm opportunity)

• The only analyst that covered the stock was modelling ~$10mm of top-line growth and on this highly conservative estimate he arrived at EBITDA of ~$14mm this fiscal year.  I suspect they will beat this number but at 10x (and ~8x next year), the stock is worth $17 vs. where it trades today at ~$11.  (Symmetricom deal was at 14x)

• In addition, they have two other wild card opportunities that could be material, they may sell a division to add additional cash to their net cash position, and the 78 year old CEO has stated they are open to selling the company.

• Finally, there are two other wild card opportunities in there other segments but I don’t include these in my analysis and leave them out of my thesis. Success with either one could be a substantial driver of earnings, though.  

 

Background in Detail

Frequency was founded and incorporated in NY in 1961 by Martin Bloch, the current CEO and a Director on the Board.  Bloch worked for seven years during the 1950s for watchmaker Bulova, where as chief electronics engineer he was heavily involved in the development of the world’s first electronic watch. He founded Frequency when he was 25 years old and won a Naval Research Lab contract which buoyed the company until they gathered enough business to become sustainable. Envisioning timing would become a key ingredient of future technology, he focused on timing and atomic clocks.

 

By the 1980’s the military was using Frequency’s products for navigational purposes, guidance systems, encryption needs and radar warning systems on fighter aircraft. Around the same time Frequency established an alliance with TRW, acting as a subcontractor on satellites built for the U.S. government. In ’87 FEI bought a TRW unit, TRW Microwave, paying about $17mm. The acquisition was the start of a shift away from dependence on business from the DOD and an effort to fill the need for private-sector satellite hardware as well as ground-based communications systems.

 

Today the company is the premier manufacturer of precision quartz and atomic clocks to commercial and military satellite programs (over 6,000 assemblies flying).  They operate under three reportable segments based on the geographic locations of the subsidiaries but the primary business is satellite technology.

 

FEI- NY – operates out of New York and its operations consist principally of precision time and frequency control products used in three principal markets- communication satellites (both commercial and U.S. Government- funded); terrestrial cellular telephone or other ground based telecommunication stations, and other components and systems for the U.S. military.

 

• The FEI- NY segment also includes the operations of the Company’s wholly- owned subsidiaries, FEI- Elcom and FEI- Asia. FEI- Asia functions as a manufacturing facility for the FEI- NY segment with minimal sales to outside customers. FEI- Elcom, in addition to its own product line, provides design and technical support for the FEI- NY segment’s satellite business.

• FEIM had a stake in Elcom until they acquired the entire company in February 2012 (bought the 75% they didn’t own for an additional $7mm). Elcom brought Frequency technology in high frequency microwave devices and subsystems. Combined with Frequency, the addressable market for Elcom’s products expanded to include multiple new opportunities in Electronic Warfare, Signal Intelligence and other applications in Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (“C4ISR”).  Elcom’s technology was integrated with FEIs technology to address higher dollar value applications for products.

 

Gillam- FEI - operates out of Belgium and France and primarily sells wireline synchronization and network management systems in non- U.S. markets. All sales from Gillam- FEI to the United States are to other segments of the Company (this is the remote terminal unit, or RTU business they talk about on calls)

 

FEI- Zyfer – operates out of California and its products incorporate Global Positioning System (GPS) technologies into systems and subsystems for secure communications, both government and commercial, and other locator applications. This segment also provides sales and support for the Company’s wireline telecommunications family of products, including US5G, which are sold in the United States market.

 

An overview of segment level earnings, which are lumpy, are below.

 

 

 

 

 

Growth Opportunities

The company cites one longer-term and two near-term opportunities that will drive substantial revenue growth.  On the long-term side they expect slow but steady rollouts of Remote Terminal Units (RTUs); basically smart meters.  On the short-term side they identify primary growth drivers as (i) GPS upgrades, i.e. secure communications and (ii) Satellite Payloads, i.e. more component sales into Satellites (backlog is mostly related to Satellite Payload projects).

 

The satellite piece is broken into two pieces, the first being multi-function communication satellites that cost anywhere between $200mm to $1B and the second being small earth-orbiting satellites.

 

I think the real near-term opportunity going forward is within the space satellite business because (i) the GPS business addresses issues that have been well known to exist for quite some time now and yet they remain unaddressed by both government and DoD, so I’m not sure what will all the sudden drive adoption here...i think this can just keeps getting kicked down the road so i basically ignore this optionality; (ii) the small earth-orbiting satellites don’t require the expensive equipment the multi-function communication satellites do, so there are fewer margin dollars available here (this will drive growth, and on last call Martin indicated this is a double digit revenue opportunity, so over >$10mm at least, but it’s not the primary revenue driver).

 

So in terms of earnings drivers and probability of occurrence, I think we see project wins on the space satellite side drive top-line before we see significant growth in these other areas. The space sat wins will primarily flow through the FEI-NY business, which has been a steady grower in recent years on the heels of Frequency continuing to win a larger share of the components that go into a satellite.

 

 

Space Satellite Business

In 2005, when FEIM was mostly known as a commercial telecommunications company, the satellite business only accounted for about $5.5mm of total revenue whereas today it accounts for north of $40mm and growing.  The growth has not been unexpected.  Since the 2009 shareholder letter, management has laid out a clear path and has consistently forecast their position with decent accuracy.  I bring this up because I think it lends them noteworthy credibility.  (I’ve tried to paste in a slide below but if it doesn’t work, see slide 22 of their January 2015 presentation from the Needham Growth Conference)

 

 

The growth has been driven by a combination of factors, but namely years and years of pressure from the government on manufacturers and suppliers like Boeing and Lockheed to reduce costs while improving component performance. This pressure compels companies like Boeing and Lockheed to be more thoughtful about the pieces of contracts they execute themselves and motivates them to subcontract out areas of work outside their true expertise, which benefits Frequency. So Frequency’s growth has largely been a consequence of the government contracting out more work under fixed price contracts, which in turn pressures suppliers to subcontract more work to specialized component providers like Frequency who can produce for margin within the confines of a fixed price contract award.

 

Therefore the only barrier to growth is Frequency’s ability to manufacture the new component sets customers demand and do it for margin.  Frequency has excelled here with successful R&D programs, a small acquisition, and what Frequency describes as being “hyper-focused” on costs and running a lean structure. Their CFO made the case to me the cost-plus contracts the Boeings and Lockheed’s of the world traditionally received just didn’t motivate the efficiencies Frequency has achieved. I’ve heard various estimates on their pricing relative to peers and I think the variability is due to pricing differing by product category, but on the 4QF’13 call, Martin Bloch said they can do work for about 2/3rds the price their peers can (pg. 12 of the transcript).

 

For a snapshot of their history penetrating a larger and larger percentage of the component bill for a satellite, see slides 14 and 15 of the latest investor deck from the Needham Conference.  They started  out selling just the timing components, then their offering  evolved into a second product module, and now to a third module consisting of new Ku and Ka band receivers and up/down converters.  Some history of this evolution in product offerings follows…

 

 

 

 

History

In their 2009 shareholder letter management began to lay out their longer-term goals with the space business and explained how they would productize the portfolio of technology (no more custom builds), reduce the size and cost of their technology and expand the portfolio of product offerings to try and gain a greater dollar-value per satellite.

 

A year later Frequency saw some project delays but reported their customers were encouraging them to complete their product development and qualification strategy around the new technology they announced they’d be focusing on developing in their 2009 shareholder letter.  Having established a broader portfolio of satellite focused products Frequency announced in their fiscal 2011 shareholder letter they expected annual recurring contract award and product sales to aggregate more than $200mm over the next five years (a target they are set to accomplish). Management said they expected strong revenue growth in the coming year and in fiscal 2012 revenue ended up growing 20%, nearly all of which was in the satellite segment where revenue was up >30% yoy.

 

By fiscal 2012 year end, the satellite business was 49% of revenue, up from a third the prior year, and it was continuing to grow on the heels of increased penetration into the satellite. Frequency was now selling technology surrounding the timing components they built their company on, providing components that used to be manufactured by their customers in-house. Part of their success was due to the February 2012 acquisition of Elcom (offering a microwave source) but much of it was due to in-house R&D at Frequency (Elcom would ultimately drive revenue more in the future).

 

In the Fiscal 2012 shareholder letter management explained they expected to potentially generate revenues of $5mm to $25mm or more from a single satellite payload now, (compared to $1-$5mm per satellite previously) and in F2013 they would expect another increase in revenues from U.S. Government and DOD end-use programs (for the ninth yoy revenue increase in a row). Management explained the government’s mission to achieve better functionality and performance from existing systems and platforms at lower costs was a goal that benefited Frequency greatly because it would help force the hand of the in-house providers like Boeing and Lockheed to subcontract to Frequency. With the expectation the cost saving approach taken by the government would be a boon for business Frequency expressed confidence revenue would be up again the following year in F2013.  Ultimately, for F2013 Frequency reported revenue up 8% yoy with Satellite up 18% yoy.

 

In the F2013 shareholder letter Management explained upgrades were needed for a wide variety of sophisticated electronic platforms and systems and they explained their new products which lighter, required less power, and had a lower cost than competing products, made for a bright outlook in their space business.  (New products included Ku and Ka band receives and up/down frequency converters for satellite payloads).

 

On the 4QF’13 earnings call management laid out the expectation their legacy products would drive continued revenue growth in F2014 and they also updated the street about the next phase of their goal to take more share within the satellite by selling considerably more up/down converters to customers. An excerpt from the call is below.

 

“The new product suit very well the mission in the future, which is the demand for doing a lot more with less. What means is existing satellite platforms, they want to put a lot more channels in order to get more revenue for the commercial side and a lot more bandwidth for the military side. That means you need a smaller size, lighter weight unit. And that was our design objective, our units are considerably smaller than our competition in-house and out of house, and they are considerably lighter in weight. So it's a very exciting product and it's very well received. A lot of this work is done in conjunction with the engineering expertise at Elcom, and we are providing the space guidance and the control so the units can be manufactured immediately for space application on this. So this is not a new product for FEI because we have flown up/down converters on many programs, but they were ones and twosies, now we are attacking the market where there is going to be 40 to 140 per satellite. So the revenue opportunity is considerably higher.”

 

The process of selling a new product into space satellites requires manufacturing the product, testing it, going through a qualifying process, and then establishing capacity credibility and offering the product to new customers. It takes a long time. The opportunity was first announced about 1.5 years prior (which is when the largest shareholder Privet got involved – they own about 10% of the company today) but now they are finally at the inflection point of recording a win and the revenue that should go along with it. In the 1QF’15 call Frequency announced they completed the testing and qualifying process and were beginning to shop the products around.  Martin also gave a brief summary of their position that I think encapsulates the thesis well:

 

I'd like to give you a brief color on where the company is moving and the challenges that we have to face this year. Satellite business is great. We are booking business on our legacy product, and we are going to finish testing this month on our new products and demonstrate them to our customers. Our customers are very interested in the up/down converter receivers because it offers a product that is cost effective and smaller in size and weight, and that's the game plan, to put a lot more capacity on existing satellite platforms.

 

The key to our success in landing a major program on that type is to demonstrate to our customers that we have the capacity to deliver because one satellite of accounts -- of receivers and down converters adds a lot of units to be delivered on this. So our main customers are looking at us very carefully to see what we are doing to increase capacity, how we are doing on the delivery of existing programs that they gave us, and that is the major challenge that we have faced this year.

 

We are -- we have been successful on hiring some skilled people from the outside, but more important is we have started a very significant program of retraining people that are involved in our military and commercial to be able to do space hardware. And that's quite a challenging fact independent on how good these people are. But we have been very successful in getting them up to speed. We are also working very hard and they have good progress at setting up a second shift in order to meet that capacity.

 

Our proposal rate is very excellent, both on existing product, as well as the new products. And we are very encouraged by the opportunities that are in front of us. The secure communication that -- actually, Zyfer is taking the lead on there because it's related to GPS and other synchronization system, which they have experienced, but our technology at New York will come in very heavily into play, both providing the flywheels or the high precision timing that needs to be done in auto to achieve that improvement in security by eliminating the -- or minimizing the ability to jam or to spoof critical communication assets on this.

 

As Alan has mentioned, our margins would have been considerably better at FEI on the satellite business if we didn't make this investment in automated test equipment in order to improve the throughput faster, and at the same time, the training and up-training of people to be able to do that work. Then, a lot of R&D, in addition to what we are spending, fortunately, is also being funded on new programs from the government, which will help us to continue the flow of new products for this year and beyond.

 

Then during the prepared remarks on the next earnings call (2QF’15 call), Martin made the following comment;

 

“We have outstanding proposals for both military and commercial satellite programs. We are ready to accept orders on them now and expect that we will play -- get some orders on the up/down converters before the end of fiscal 2015.”

 

Martin also explained in the Q&A a win could occur as soon as April 2015.

 

Sam Rebotsky, Analyst

Now as far as of the up/down converter, is there -- say, between a 1 and a 10, with 10 being the highest, do we expect to receive, by April, an order? Have the various people that are looking what you're doing prepared, do you think, to give you an order before April 30 of the current fiscal year?

Martin B. Bloch, CEO

I would give it a 7 to an 8.

Sam Rebotsky, Analyst

7 to an 8, okay, okay. So with -- and as far as the next year, do you think we would be at $20 million-plus satellite versus $10 million to $20 million, $5 million to $10 million?

Martin B. Bloch, CEO

As my mother would say, from your mouth and to God's ears. I'll just, if we win, the basic idea at this moment, we are $5 million to $10 million per satellite, and winning a converter job on one of the satellites will easily put us in that range.

Sam Rebotsky, Analyst

Okay. So -- but now, based on what you expect for the rest of the current year, do you expect to do, more or less, in the $20 million-per-quarter range for the January and April quarter? Is that...

Martin B. Bloch, CEO

Sam, on the grounds that I might incriminate, we have never given projections, and I'm too old to start now.

Sam Rebotsky, Analyst

All right. But you said you're going to do what you did in the current quarter for the rest of the year, is that what you just said?

Martin B. Bloch, CEO

No, I didn't say it. Alan indicated that we plan to have increase in revenue and profitability for this year compared to fiscal 2014. And I can definitely tell you that that's the case. The exact number is out of my league.

 

On the next earnings call, the F3Q’15 call, Martin reiterated his confidence regarding the space satellite wins and also commented on the near-earth projects producing north of $10mm in revenue when he said the following in an exchange with a caller…

 

 

Marcel Herbst

Oh, I see. okay. On the last call, you gave it about a 7 or 8 likelihood to get a Ku, Ka band contract before April 30. I was wondering how do you see that now.

 

 

Martin B. Bloch

It's any minute. We're in negotiation right now.

Marcel Herbst

All right. That's good to hear. Regarding your small Earth orbit payload opportunity that you mentioned earlier.

Martin B. Bloch

Yes.

Marcel Herbst

Can you tell us how close are you to adding to the backlog on this? And what kind of annual revenue potential does this product line have?

Martin B. Bloch

Okay. I'll tell you what is right now and a wildcard that nobody can fully define. Right now, we are participating on about a half a dozen military classified Earth-orbiting satellites, plus, of course, we are supplying all the up/down converters and timing for Iridium NEXT, as you probably know. And those Earth-orbiting satellites for DOD and classified mission are becoming more urgent and more numerous in the area. And at that time, they require better performance on timing and frequency and phase noise, at the same time, significant reduction in size and weight because the satellites are smaller and they are more numerous. And we have developed and demonstrated some key building blocks for that arena. So we are starting to get business and probably have -- we probably have a couple of million dollars right now in the backlog for development for this military Earth-orbiting satellites. And some significant contract on -- they are still considered Earth orbiting, but in a slightly different orbit, which are for military and secure end use. The most wildcard is that new Vu Earth opportunity that we're all looking at. If that goes, there's going to be 920 satellites. It's a new Teledesic. And we have submitted proposals.

Alan L. Miller

WorldVu. WorldVu, namely.

Martin B. Bloch

And they are listed as V-U. And it's well-funded. This now -- if it goes, we'll have significant opportunity in satellite. The challenge over there is to build something very reliable and very inexpensive, but the opportunity is there.

Marcel Herbst

You said there is $2 million in for development contract?

Martin B. Bloch

At least $2 million.

Marcel Herbst

How long is the development phase until you go to qualification and production orders?

Martin B. Bloch

That's very -- it's a very fast track and very similar -- you know the new Earth military satellite have the same type of urgency as a geo commercial. They want from cradle-to-grave to get done between a 12- to 18-month cycle.

Marcel Herbst

So it sounds like that this is an opportunity in the 8-figure type of size once this gets going?

Martin B. Bloch

Very true. It's a very exciting market because the quantity is large. And good or bad, the Earth satellite don't last long in orbit.

 

 

Martin expresses confidence they will win up/down converter business, and I think a single win could get them to Sidoti’s numbers (old #s, b/c they no longer cover it), which I think makes the stock very cheap.  But, the company spends a lot of time paying lip service to earnings that are orders of magnitude above Sidoti’s F2015 estimate and this is the real appeal of the stock in my opinion.

 

For reference, Sidoti was forecasting ~$75mm in revenue for F’15 (Q4 announced in mid-July) and $85mm in revenue in F’16 (so this year), which is up only $10mm yoy.  This is despite the fact that they are in negotiations on three contracts which at their legacy value per win would amount to at least $15mm of incremental revenue, and this doesn’t even include the $10mm of near-earth contracts they could win, let alone a $20-40mm contract win for up/down converters.  Importantly, even at a mere $10mm of incremental revenue, Sidoti was forecasting ~$14mm in EBITDA, up ~76% yoy from $7.8mm they should earn this year (again, report mid-July).  I think Sidoti’s margin estimate was reasonable but I think the top-line estimate was very conservative. Even so, the stock is cheap on a $14mm EBITDA assumption (implies it’s trading for ~6x).  

 

Those are the near-term numbers but in terms of looking further out, the company lays out the following expectations (and recall they have an impressively accurate track record when it comes to predicting the course of earnings)…

 

FYI, I’ve tried to paste in the slide but if it doesn’t paste, just pull page 22 of the investor deck.  For a summary, the raw numbers are as follows…

 

New receiver/converter products: $0 revenue today à $60-100mm in 3-5 years

Legacy satellite product line: ~$45mm revenue today à $60mm in 3-5 years

U.S. Govt/DOD Non-space: ~$15mm revenue today à $35mm in 3-5 years

Networks and other products: ~$15mm revenue today à $25mm in 3-5 years

TOTAL: $75mm revenue today (last year) à $180 to $220mm in 3-5 years

 

 

 

Current revenue is running at a ~$85mm run-rate but in 3-5 years they think revenue could be running at $180 to $220mm.  The majority of the growth is expected to come from penetrating the satellite market with their new product portfolio and only assumes they capture three to four satellites per year.

 

On the 4QF’13 earnings call management explained there’s going to be somewhere between 20 and 40 satellites a year that will be procured between commercial and military and they are only looking to capture three or four of these (pg. 12 of transcript).  But even if they only capture a couple, the opportunity is still substantial.

 

The barrier to realizing much higher earnings is a lack of talented and qualified engineers to build the new generation of products, but Frequency has been addressing this issue and they are confident over time they can reach a point where they could win a significant amount of business.  The challenge for them is the amount of time they have to fulfill an order has compressed.  Martin reported in the Needham presentation that the cycle time customers want has gone from over 40 months, to 36-40 months, to now 16-28 months. So not only does Frequency have to build all the additional hardware the customers want, but they have to build it in a much shorter amount of time, and this has put pressure on Frequency’s capacity.

 

Another reason capacity is a challange is because this type of manufacturing requires technicians who are High Reliability certified, what they call High REL on calls sometimes.  In the company’s history they have only had one failure and only a half dozen anomalies; it mission critical design work and some of the folks who build this stuff literally have to go through a NASA training program. Finding NASA certified people who can build these products and ensure they never need maintenance is hard because there just aren’t a lot of High REL certified people out there looking for jobs (and who want to move to Long Island NY, where their facility is). Frequency was able to get some ex-Northrop folks recently and they’ve also been training existing staff, adding some automated tools, and they added a night-shift, but capacity was an issue. Management told me they are at the point where they could fulfill one big order, but two would be pushing it and they probably couldn’t handle three. In terms of how many folks they needed, Martin said on the 1QF’15 call he suspects it’s not a very big number.

 

Tristan Thomas, Analyst (Sidoti)

Okay, a couple of follow-on questions. Any idea of how many new employees you'd like to add?

 

Martin B. Bloch, CEO

To demonstrate our increased capacity for what we have right now on order and what we anticipate of lending an up/down converter program, we have to -- and it's not that many. We need a few good people, we need like less than 12 skilled people, and between 12 and 20 both a combination of what we'll hire and what we'll up-train the people from internally.

 

Tristan Thomas, Analyst (Sidoti)

Okay. And then just one final follow-on question for that. Just regarding when you mentioned transitioning training some of your current employees to work on satellite business, how long do you think that could take?

 

Martin B. Bloch, CEO

Well, that's -- some people, it takes 4 weeks, some people, never. It's just -- the skill that is required -- remember, you're trying to build something on earth, you send it out for 15 years, and you want to make sure that it works, since you cannot send anybody up to repair it, not yet. So the skills and accuracies are just, it's ingrained. And to give you an example, if we will start with 10 people to get them qualified to do soldering and assembly on this, we'll probably will end up with 6 that can do the job.

 

Solutions to the capacity issue include continuing to slowly add and train more people through natural hiring and training processes, or potentially partnering with someone or acquiring a small company with a team of High REL employees. Martin addressed the idea of partnering or acquiring someone in his Needham presentation and I used the replay recording to transcribe his comments which are below. His comment was in response to a question on how they might add capacity.  The questioner asked directly if they’d partner with someone;

 

“Well we have a product specific problem.  We have to find a partner that can build high REL.  When I go to the big boys like the Boeings they say, ‘we know Frequency can build everything, you have demonstrated it over and over again.  But now we are talking about capacity. And we are very concerned about if we give you a 200 down receivers (order) will you be able to deliver in the cycle time that we need.’ So I’ve spent a lot of personal time in really exploring, with various companies that could give us that edge.  We have some opportunities we are looking at but we haven’t found the magic company that would be the magic bullet that would really give us that, that expertise. But I’m sure there is someone there, it just takes a harder look.  We need someone with high REL experience, is accepted by their customers, and isn’t’ on their shitlist, because they won’t’ tolerate their hardware being made by a company they don’t like.”

 

Martin addressed the capacity issue again on the F3Q’15 earnings call in the Q&A and noted they’ve made progress…

 

Unknown Attendee

This question is for Martin Bloch. You mentioned in the press release to get you towards your capacity objective, what is that objective?

Martin B. Bloch

I don't know what you are referring to.

Alan L. Miller

What is the objective?

Unknown Attendee

To what type of volume?

Alan L. Miller

What type of volumes can we handle?

Martin B. Bloch

Well, we are looking for infinity. But our immediate role is to be able to handle approximately 1.5 to 2x our present satellite volume.

Unknown Attendee

Okay. And how many people do you have in the night shift now?

Martin B. Bloch

We have a dozen-plus, but we actually shifted. We have been reasonably successful in shifting some of the day operators in at night whenever we need them so we can test satellites hardware 24/7, which is very important to reduce the cycle time.

Unknown Attendee

And do you think by the end of the year -- fiscal year -- you'll be ready to meet all your capacity?

Martin B. Bloch

There is no such thing as meeting all the capacity because hopefully it's a continuously increasing cycle. We are trying to demonstrate very successfully to our major customers that we can meet the present demands for capacity and shorter cycle time. It's a two-edged sword. Not only is there more hardware, but the cycle time is significantly reduced, which means in addition to the equipment and training and people, we are also investing in long-lead parts because sometimes $10 parts can be 70 weeks, and it screws up your whole schedule on a $1 million or $2 million box. So all of this is being put in place to meet the response time. Response time is #1, 2 and 3.

 

 

In a nutshell, all his customers are interested in more bandwidth, so the objective is to add more channels per satellite on existing platforms (to develop a new platform is a $10B bill, so it makes more sense to use existing platforms). To add more channels they need to reduce the size, weight and power of the hardware to put more on the same payload (from 20 transponders to 150) but the number of satellites being launched is ramping and the cycle times have contracted.  So even though Frequency has accomplished the technological advances necessary to meet these demands and they can do it for cheaper, the in-house guys have retained the business because Frequency can’t handle big orders...yet.  Frequency has made a lot of progress – they could build 20 in 2008 and now they report they can do 140 – but in order to really ramp they need to get some more people hired so they can reach production capacity of ~500 (Martin’s estimate). But, it’s important to realize this is capacity that is needed to get to their ultimate target of winning 3-4 satellites per year. They can beat Sidoti’s numbers with just a single win and even at current estimates the stock is cheap. The capacity issue is an issue in the way of their 3-5 year plan, not an issue in the near-term.  Even so, they are making progress and could handle a contract or two which would allow them to significantly ramp EBITDA.

 

 

Near-term outlook and Valuation

Frequency typically reports Q4 in mid-July. Key near-term items include any commentary on capacity additions, specifically partnering opportunities or opportunities on the acquisition front (they established a $25mm credit line with JPMorgan Chase in June 2013 and have cash and ST investments of about $20mm).

 

Prior to dropping coverage Sidoti was modelling $10mm of incremental revenue and continued improvement in operating margin, from 9.3% this year to 13.2% next year, and you can probably get your hands on his old research if you call their desk.  Martin and Alan both explain in the transcripts (and explained at the Needham conference) that the costs are in place to support a much higher volume of business, so with top-line growth should come attractive margin expansion. Whether Sidoti’s margin forecast proves conservative or aggressive is tough to say, but I think his expectation for only $10mm in top-line improvement this year was very conservative.  The opportunity set in front of Frequency on satellite alone presents very attractive upside optionality and yet investors still stand to benefit from growth at GPS and in the RTU business; areas I didn’t even really touch on but you can read about if you do work on the name and read the transcripts (i’ve provided a little synopsis on these opportunities at the end of the write-up).

 

Considering the growth prospects, I think 10x is a fair multiple on EBITDA and that gets me to the high teens in terms of a target price. Also, as mentioned in the beginning, there has been some deal activity in this space and the deal multiples support a high-teens stock price as well.

 

Downside

My estimate of $14mm of EBITDA this year and further growth next year will get pushed out if they don’t add capacity in a reasonable amount of time.  If the GPS and RTU businesses don’t buoy growth through this period, investors will be left with the legacy Satellite products as the growth engine and this business will transition to a lower pace of growth.  In this scenario, they’d miss my numbers and perhaps report only slight yoy EBITDA growth worst-case.  I don’t believe this to be a likely scenario considering management has a track record of accurately forecasting the trend in earnings and they are very bullish, but at say 6-7x slight yoy EBITDA growth to maybe $10mm, we’d be looking at a stock worth $8 or $9 roughly. I think the stock would be an incredible investment opportunity at that price, but in thinking about the downside risk, that’s where I am.

 

 

Other Opportunities

My thesis really rests on the space sat opportunity because that’s what I expect will be the likely driver of the stock.  But, in addition to the space sat opportunity, there are two other opportunities and I figured I’d present them just to post a complete write-up as the company does indeed discuss these on calls.

 

The other near-term growth opportunities outside of space satellites are (i) selling products to upgrade GPS and (ii) selling what are essentially smart meters, a.k.a. remote terminal units or RTU’s, (near-term opportunity is in France).

 

• GPS enhancements have seen ongoing implementation delays from the government but Frequency is excited about the prospects and this could be a significant growth driver.

• France is upgrading to smart meters and Frequency has won some share.  The timing is uncertain but as France rolls out the meters, there is speculation Frequency could ultimately see well over a hundred million in revenue, (up to $400mm if they win a third of the contract work in France.)

 

RTU Opportunity

Starting with the RTU, or smart meter opportunity, management made the following comment on the 4QF’13 earnings call…(note this falls into the segment for Gillam, which is how it’s referred to on calls)

 

“I want to also address that RTU opportunity on this. There is about 600,000 slots for this RTU, just in France, and this is to provide smart meter readings for the use and the government is supposedly committed to get that program installed as soon as possible. We made, in my opinion, the right decision to write-off the software and hardware investment since we expected the production to be by the end of this year and it's moving to the right. But the opportunities for us, we have qualified products in the system and they are about $2,000 a pop and there is 600,000 Windows just in France and there's also the same will be applicable to other European countries and North Africa. Obviously, we're going to get competition on that. But being first is a big advantage, and I think that will result in an additional brand new mission for Gillam.”

 

Management followed up on this in the Q&A…

 

Unknown Attendee

And one final question. The RTU in France, you mentioned 600,000 units. Say, in a year, what percent of those units do you think your company can get?

 

Martin B. Bloch, CEO

Well, we'll shoot for the most on this point. As is typical for this type of our business, the electric company in France will want 2 or 3 suppliers as they are modus operandi on this. However, we are on the ground floor and the early part of the implementation, we are going to get a good percentage. As time go on, I'm sure there's going to be additional competition. That depends. Our unit is performing very well, our customer is happy with it, and this is one of the things that I will also ascertain on my trip, both from Gillam and from the customer community.

 

Unknown Attendee

Is any of it being used at this time?

 

Alan L. Miller, CFO

Yes. We have 60 units currently being field tested by the electric company. So that's a process that to go through to demonstrate that everything is working properly. And I should point out that there is also another competitor who also has 60 units in the field. So, as Martin was saying, we are not going to get 100% of that market, but we will get some good percentage at some point in time down the road.

 

Martin B. Bloch, CEO

We had previous experience, which are much simpler RTU, that we built for French telecom. It was $2, but we started with 60 and eventually ended supplying to them a couple of million.

 

Unknown Attendee

Because even if you get 1/3 of the 600,000...

 

Martin B. Bloch, CEO

I know that.

 

Unknown Attendee

You've got a couple of hundred million dollars.

 

Martin B. Bloch, CEO

We did the math, Michael.

 

 

The problem is the timing of the rollout is uncertain…

 

Unknown Analyst

And regarding the RTU opportunity. Once the rollout of these -- you mentioned 600,000 units -- happens, over how many years do you think this will take place?

 

Martin B. Bloch, CEO

Do you know the French? I wish I could give you an honest answer at this point. Their schedule was that they were going to start rolling it out in 2012. So they were going to be in full production by this year. So the reason why we took the conservative write-down is because it's moving to the right. But we know that's there. We know this is a government commitment to get it done, but the timeframe is very unpredictable. I'm going to try to get a better calibration on my European trip. I made arrangement to make a special stop in France to see if I can get a better personal calibration.

 

On the F3Q’15 earnings call Martin explained if they don’t win anything here this year, then this business will be shut or sold.  I have no idea what its worth and I don’t include it in my valuation, but it’s probably worth north of zero.  Martin’s comments from the call are below…

 

Tristan Thomas

Okay. Great. I'll be [indiscernible] that was a hypothetical question. I don't know what happened. I know you mentioned that Zyfer was accretive to earnings during the quarter here, what's it going to take to get Gillam back to a similar level where it's actually profitable?

Martin B. Bloch

Again, Gillam?

Joseph P. Franklin

Gillam. Yes.

Martin B. Bloch

A miracle. On this -- I -- but basically is -- they have a couple of exciting products, and that's what we are watching to see if they take traction. And this is basically they developed some RTUs for the French electricity companies. And that is -- has a large market potential. And this is -- there are like 60,000 to 150,000 slots for it just in France. And they and one other large -- Schneider are the only 2 people that have so far submitted acceptable remote terminal units for that program. And the other is the buildup of the wireless network by French Telecom. That's the 2 big opportunities on this. And if this doesn't happen soon, we'll have to do something more drastic.

 

And then later on the call…

 

Marcel Herbst

Yes. In the PR, you spoke about rationalizing our segment assets and operations. I was wondering what that means? And maybe get a little bit more color on how you are doing that?

Martin B. Bloch

Well, we are examining our subsidiaries, especially Gillam, and see how they fit in into our future and see if we can deploy their assets to better benefits of shareholders' value. And we are examining it very carefully to see -- and see what to do about it.

 

So, this is a big opportunity, but to-date it hasn’t panned out.  I guess something to be aware of, though.

 

 

GPS Opportunity

Regarding the GPS opportunity, according to the GAO and other sources reporting on their work, GPS is now essentially an invisible utility and it is dangerously vulnerable to GPS disruption and “spoofing” or jamming (articles printed and in folder).  Frequency has developed solutions to counter GPS jamming and spoofing and it requires upgrading a $10 clock with a $10,000 ruggedized clock.

 

The management team seemed convinced at the Needham conference that this would be a near-term earnings driver and articulates the revenue potential as a substantial opportunity, but when I pressed them in a 1x1, they didn’t have any information they could share to support their view this was imminent or thoughtfully quantify the upside. All they could add was this was a huge problem and it must be addressed for national security reasons. Since the issues with GPS have been known for a couple years (although, it is true they’ve received more attention recently), I think this is attractive optionality but not optionality worth banking on in forward earnings.

 

I think GPS is ultimately an inevitable stream of business but it makes sense to leave this out of the estimate for forward numbers. The near-term drive will be satellite and if and when they do win a satellite project, I think the win will validate the thesis that the in-house DIYrs like Boeing, Lockheed, Iridium, and Thales Alenia are indeed going to outsource this technology to Frequency and have faith Frequency can fulfill the orders, which at the moment seems to be the greatest obstacle to achieving significant earnings growth.

 

 

 

Catalyst

-       

• Announce project wins in space satellite side

• Announce acquisition or partner relationship to add capacity for building space sat components

• Divest Gillam

• Report RTU uptake data that investors can use to estimate forward numbers

• GPS contract win or quantifying earnings potential from GPS.

• Company could be acquired. There are very high barriers to entry here and CEO is 78 years old.  I think an acquirer would find the following items appealing:

• First, the space business is a unique asset. Martin explains you cannot win a contract to fly hardware unless you’ve performed for 5-7 years in space and it’s a very difficult slow process to build that capability.  Frequency has over 6k assemblies in space and in 50 years they have only had one failure and half of a dozen anomalies.  They’ve never lost a payload and the clock is triple redundant.  If you lose the timing system you lose the whole asset and the assets are $200mm to $2B each, so the timing system is the most critical component and Frequency owns this market as the low-cost, high-quality provider.

• Second, the GPS upgrade opportunity and RTU business could be large enough in a couple years to be stand-alone entities.  Someone could buy this and monetize their investment by spinning/selling these in three or five years.