Description

Fairchild Corporation (FA):

I recommend FA as a short. Although the stock is just over $5, this company will very likely go bankrupt in the next year. For no apparent reason, the stock is up over 100% in the last four weeks.

FA is my perfect short: FA’s valuation is absurd; its debt load is far greater than the entire company is worth; business is declining rapidly this year and will decline further next year; FA is currently not profitable and has not been profitable (excluding non-recurring gains) in at least 5 years; FA has not produced positive cash flow in at least 5 years; liquidity is becoming strained; FA is in a competitive, no growth, capital intensive industry; and tangible book value is negative.

DESCRIPTION:

FA is a leading worldwide aerospace and industrial fastener manufacturer and supply chain services provider and, through Banner Aerospace, an international supplier to airlines and general aviation businesses, distributing a wide range of aircraft parts and related support services. FA is one of the leading suppliers of fasteners to aircraft OEMs, such as Boeing, European Aeronautic Defense and Space Company, General Electric, Lockheed Martin, and Northrop Grumman.

The business consists of three segments: aerospace fasteners, aerospace distribution and real estate operations. The aerospace fasteners segment manufactures and markets high performance fastening systems used in the manufacture and maintenance of commercial and military aircraft. The aerospace distribution segment stocks and distributes a wide variety of aircraft parts to commercial airlines and air cargo carriers, fixed-base operators, corporate aircraft operators and other aerospace companies. The real estate operations segment owns and operates a shopping center located in Farmingdale, New York.

FA’s business, mainly selling fasteners for airplanes, has declined about 16% from its peak in fiscal 1998 at $741mm in sales and has shown zero growth for the last three years. The last three years were very strong for new plane builds overall and the economy was fantastic, so FA’s under-achievement in this period is striking.

THE PROBLEM:

September 11, 2001. FA’s track record and debt load were probably worthy of making it a short candidate before the terrorist attacks. With September 11, FA has no hope.

Due to decreased air-traffic, liquidity problems at many airlines, and the large numbers of excess planes being “parked” or put up for sale, airplane build rates have fallen dramatically. Boeing has announced an expected 29% decline in plane deliveries this year, from 527 planes in 2001 to 375 in 2002. Next year, 2003, Boeing is guiding to a further 25% drop to 285 planes (a 46% drop from 2001 to 2003). Airbus, is guiding to similar drops.

Aerospace fasteners are about 90% of FA’s business. This business is tied to new airplane builds. The more airplanes built, the more fasteners they sell. The less built, the less they use. A 46% drop in new plane builds should have a similar effect on FA’s business. These drops have already started to show up in FA’s March 31 results and will get worse every quarter for at least the next two years.

On a positive note, FA will benefit from increased military aircraft builds. BA says military builds should grow at about 10% this year. FA does not disclose the percentage of commercial vs. military, but I assume it is similar to Boeing. If that’s the case, commercial represents about 75% of sales and military about 25%. The growth in this area does not offset much of the fall from the larger commercial division.

REAL ESTATE:
FA has some Real Estate operation that it has been developing for several years. The real estate segment owns and operates a shopping center located in Farmingdale, New York. As of June 30, 2001, they had leased approximately 74% of the developed shopping center. The real estate operations do not produce much income. And given the current state of the commercial real estate market in New York, business is probably pretty bad.

VALUATION:

Shares: 25.1mm
Net Debt: $478mm
Tangible Book: $(56.2)
Enterprise Value: $612.3mm

EV/2001 EBITDA = 9.4x
Debt/2001 EBITDA = 7.4x

(Fiscal year) 2001 2000 1999 1998 1997
Rev 622.8 635.4 617.3 741.2 680.8
EBITDA $65.0 65.1 (20.3) 66.3 54.3
Cap Ex. 16.4 27.3 30.1 36.0 15.0
Interest Exp. 55.7 44.1 30.3 42.7 47.7

Cash Flow (7.1) (6.3) (80.7) (12.4) (8.4)
Earnings Negative

As you can see, FA managed to show negative revenue growth over the last five years and had negative cash flow in EVERY single year. These were some of the strongest economic years in recent history.

Because FA’s business is capital intensive, CapEx is a real expense. EBITDA is not an accurate measure of cash flow, because money must be spent to keep the equipment in order. EBIT is probably a more accurate measure of earnings, and FA’s valuation would look even worse on that measure. But I will look at EBITDA because it is a standard for valuing these kinds of companies.

FUTURE VALUATION:

This calendar year (different from FA’s fiscal year end of June 30), FA’s revenue and EBITDA should fall similar to the expected drop in airplane builds.

(Calendar year) 2002 2003
Rev $500 400
EBITDA 50 40
Interest Exp 50 55
Cap Ex. 15 15

Cash Flow (15) (30)


EV/2001 EBITDA 12.2x 15.3x
Debt/2001 EBITDA 9.6x 12.0x

I assume FA can maintain similar margins to its current margins on much lower sales volume. This is probably much too generous; most likely, margins will fall by more than half with all the unabsorbed overhead. However, I give them the full benefit of the doubt.

Most small-cap cyclical manufactures trade at 6-9x EBITDA.

Comp valuations include:
Goodrich Corp (GR) = 7.8x EBITDA
Curtiss-Wright (CW) = 7.0x EBITDA
Be Aerospace (BEAV) = 8.6x EBITDA

Despite lower valuations, these other companies:
1) have much better operations than FA and have shown some growth over the last five years;
2) are much better capitalized, have better balance sheets, and a couple are much larger;
3) are not as leveraged to plane builds and are thus not facing a potential 40% drop in business over the next two years; and
4) are not about to go bankrupt.

SUMMARY:
FA’s debt amounts 7.4x last year’s EBITDA (6/01 year end). By any account, that is probably more than FA is worth, especially in light of their terrible track record. It is also more than many comparable companies' entire Enterprise Valuation.

More striking, however, is the future valuation. Debt amounts to 9.6x this calendar year’s estimated EBITDA and 12.0x next year’s estimate.

FA’s public debt, the 10.75% Sr. Sub Notes, trade at 50 cents on the dollar. They have a 27% annual yield to maturity. Obviously, the bond market thinks FA is going bankrupt too. At 50 cents, the bonds are effectively valuing FA’s equity at zero, and the entire company at $365mm (about 7.5x 2002’s EBITDA).

Compare this to the current enterprise value of $612mm that the stock market is ascribing to FA. Something is wrong. They can't both be right.

My opinion is that FA will go bankrupt in the next 12 months. If one was so inclined they could buy the bonds for a 27% annual yield and short the stock. I doubt the stock is going to go up 27% per year. I doubt the stock ever goes up from here.

CATALYST:
1) Poor Results. FA’s results will continue to deteriorate for at least the next two years. There is practically no chance of a recovery in their markets any time soon.

2) Bank Covenants and bankruptcy: FA could be forced to reorganize in the near term. FA must maintain an interest coverage ratio (as described in their bank agreement) of greater than 2.0x. For the most recent 12 months it was 2.3x. As FA moves through the year, the rolling 12 month calculation will get worse and worse. I expect them to trip this covenant in the next two quarters.

My personal belief is that FA will trip the covenant by the September quarter. The banks will not let them pay the October coupon on their Sub notes and force a reorganization.

Risk:
FA is fairly illiquid and has a high short interest. These two things can create volatility in the short term, especially for a stock in the single digits. However, if FA files for Chapter 11, as I expect, it doesn’t matter.

Given the rapidly declining business, their poor operating record, the excessive valuation, the massive amount of debt, and the near term potential liquidity problems, I don’t really see how FA stock can appreciate from here.

I think the worst that happens is that FA does not file Ch 11 and the stock goes nowhere. The best case is a 100% return when they file and the stock goes to zero.

Catalyst

CATALYST:
1) Poor Results. FA’s results will continue to deteriorate for at least the next two years. There is practically no chance of a recovery in their markets any time soon.

2) Bank Covenants and bankruptcy: FA could be forced to reorganize in the near term. FA must maintain an interest coverage ratio (as described in their bank agreement) of greater than 2.0x. For the most recent 12 months it was 2.3x. As FA moves through the year, the rolling 12 month calculation will get worse and worse. I expect them to trip this covenant in the next two quarters.

My personal belief is that FA will trip the covenant by the September quarter. The banks will not let them pay the October coupon on their Sub notes and force a reorganization.