Frequency Electronics is a classic net/net that does not lose
money and is trading at ~2.5x EV to a level of EBIT that we consider
the minimum of what such a good business would earn in a normal
environment (not a boom environment, a normal environment). Following
will be a description of this business, a short explanation of what we
think it should be able to earn in the next 3 years, and a simple
illustration of the fact that you're now paying a 25% discount to an
already severely conservative estimate of NCAV.
FEI specializes in the niche of mission critical frequency
control. In English, that means that it develops, manufactures, and
sells timing and synchronization equipment for complex machines such as
satellites, missiles, and telecom base stations. Basically, anything
that works on the basis of signals needs components that accurately
keeps track of time; otherwise, the device either won't work or won't
work as expected. FEI specializes in the most complex types of timing
and frequency controls. These can be divided into the following
categories (I use FY 2009 numbers here because they will be
significantly lower than 2008):
- Satellite payloads - the accuracy needed for
timing devices in satellites is literally orders of magnitude more than
the typical accuracy of, say, a desktop computer (a satellite master
clock, for example, can be off by about a second for every 30,000 years
while a desktop computer clock, as we all know, can be off by a couple
of seconds per day). The nice thing about this division is that it
really has no competitors except for the in-house tech departments of
the satellite companies themselves. For FY 2009, which ends 4/30/2009,
FEI will probably do ~$20M in revenue in this segment, down from over
$30M in FY 2008 due to commercial satellite orders simply not being
booked in light of this recession.
- US Gov't/DOD
non-satellite programs - these include missiles, unmanned aerial
vehicles (UAVs), and other military necessities. Here too, the accuracy
necessary is significantly more than mass produced computing devices.
Here too, the only competitors are the in house departments of the
defense companies. In fact, the newest technology that Frequency is
testing in this segment (low-g sensitivity) has no competitors at all
(even in-house), which is why FEI has been winning significant
contracts here recently. For FY 2009, FEI will probably do ~$10M in
revenue for this segment, which will actually be flat to up a bit from
FY 2008.
- Telecom infrastructure - whether it's
wireless or wireline, data or voice, telecom infrastructure is run on
signals and signal generation and capture must be synchronized
accurately. Here, FEI has a larger competitor in Symmetricom (SYMM),
but FEI's new technology here should give it a decent advantage in
capturing market share in the near and intermediate term. The bigger
deal here is that on almost all fronts, telecom networks are in massive
need of infrastructure upgrades and in one way or another, FEI will be
a large beneficiary of this upgrade. For FY 2009, this segment should
generate ~$25M in revenue.
Valuation
Of course, the major reason the stock is at $2.60 is
because of the massive liquidations everybody has witnessed in the
small cap space. The emergence of a large number of net/nets and
companies trading at 3x FCF has been widely documented (yet, I guess
nobody is willing to bet in size on these companies). But FEI has made
its share of mistakes, and that's the reason you see TTM EBITDA as
negative.
The biggest issue FEI has had is with
gross margins. Anybody doing a few days' work on FEI realizes that the
major question facing this company in the future is: what will gross
margins be on the satellite payload and gov't/DOD segments? I estimate
that gross margins in the telecom infrastructure space are at about
40%, but GMs for the rest of the company are below 30%. To understand
why, we have to go through the history of the satellite payload and
gov't/DOD businesses.
Historically, FEI's business was solely the
clocks that go on board a satellite (~$500K/satellite). Starting
at the end of FY 2007, FEI started to get into the frequency generators
and synthesizers that also went on board a satellite - this is an
additional $7M in product that goes into each satellite that FEI
figured it had the ability to serve. FEI had always supplied these
products on a one-off basis, but the decision to get into the business
of mass producing these things required a rapid and radical upgrade to
the company's manufacturing infrastructure. Suffice it to say that for
the first year, this restructuring of the company's manufacturing
capabilities did not go so well and gross margins for the company as a
whole tanked. At the same time, SG&A and R&D were increasing in
order to build up the company's capability in these products. On the
bright side, FEI's vision was at least vindicated as sales for the
satellite payload segment grew rapidly in FY 2008.
The original contracts FEI won that caused gross
margins to tank have now been completed, and management expects gross
margins for the company as a whole over the rest of the year to be in
the mid-30's range. That would be equivalent to ~5% operating margins
on a company-wide basis. That's still a fairly weak showing, and it's
probably fair given that a bunch of commercial satellite projects have
been delayed due to the economic backdrop. Management expects that at a
higher level of sales in the satellite payload arena, attainable once
the commercial satellite market reaches some level of normalcy (and I
expect that commercial satellite launches will bounce back once the
fear recedes - we're not talking about products bought by
over-leveraged consumers that are never going to get to use their
houses as ATMs again). At that higher level of sales, we expect gross
margins to reach the 40% level and operating margins to reach the 10%
range. On sales of ~$65M, that would result in ~$6.5M in EBIT. At an EV
of $15M, you're now paying ~2.5x that amount.
NCAV and Liquidation Value
Aside
from paying a solid 2.5x EV/EBIT, an investment in FEIM is quite well
protected on the downside by asset value. The latest balance sheet
shows $13.3M in cash, $17.8M in receivables, $29.5M in inventory, and
$6.2M in other current assets. Give full value to the cash, discount the receivables and inventory by
25% (mostly gov't receivables which the gov't is obviously good for,
and inventory that would have substantial value to FEI's defense and
telecom customers), and give 0 value to other current assets, and you
get$49M. Subtract the $22M in total liabilities, and you get $27M compared to a $20M market cap at present.
Liquidation value should be even higher for
Frequency. It has $8.6M in PP&E, a $7.6M life insurance policy on
one of its officers, and investments and loans receivable on the books
for ~$3M. Even if you discount the PP&E and investments by 50%,
you're looking at a liquidation value of $40M, which is about double
today's stock price.
Risks & Free Options
I
would say the biggest risk to this story is management blowing the
strong balance sheet on a stupid acquisition. It's not likely with the
present frustrated shareholder base, but anything is possible with a
management team that is more engineering than finance. The smaller risk
here is screwing up on the manufacturing side and not getting to solid
level of gross margins. In this latter scenario, I can't see much
downside to the stock given where it's trading, but I would think
there's still a decent number of holders who may just get fed up with
management and liquidate their holdings causing the price to tumble.
On the other hand, Frequency also presents several intriguing free options:
- Increased outsourcing among the satellite manufacturers - this
has been a trend in recent years and FEI management sees it
intensifying. Given the Frequency doesn't really have much competition
in the satellite payload arena, this could mean an extra $7M in revenue
for every satellite manufactured that uses Frequency parts. At present,
the vast majority (over 80%) of satellite frequency generators and
synthesizers are manufactured by the satellite companies in-house.
- Low-g success. At present, Frequency's gov't/DOD segment doesn't
generate much in revenues but does have a technology that offers a
100-fold improvement in accuracy for guidance and targeting systems.
The technology can't be mass produced yet but seems to be enjoying
significant success in early testing by the military. Significantly -
no one out there has anything that comes close to FEI's technology here
and management is extremely confident in the defensibility of the IP.
This technology would go into missiles, aircraft, and - potentially the
most exciting - UAVs, which are a growth business for the armed forces.
- Moving further up the ladder of addressable satellite payloads. There's
about $20-25M in timing and synchronization equipment that goes into a
typical commercial satellite. At present, FEI can address ~$7-8M, but
it's working on frequency converters and receivers that would make up
the rest of the addressable payload. Success in expanding the company's
capabilities in satellite payload (profitably, of course) would be a
massive value driver.
(I'd just like to apologize for the formatting - I tried to do this on the VIC site, but it still wouldn't let me put in the bullet points etc. - I'm sure the reader could figure it out. And I'd like to apologize for the late December midnight filing, so to speak.)
Gross margins and operating profitability generating positive momentum over the next 2 quarters