|Shares Out. (in M):||3||P/E||0||0|
|Market Cap (in $M):||14||P/FCF||0||0|
|Net Debt (in $M):||-6||EBIT||0||0|
LGL Group has issued rights to its shareholders to buy ¾ of a share of LGL common for $5.50 for every share they currently own. The offering is unusual in that the $5.50 price is a premium to trading prices rather than the traditional discount. Most investors will not be interested, and the likely result is that substantially all of the offering will be purchased by 17% holder Mario Gabelli and 14% holder and LGL director Marc Gabelli. The rights are tradable and LGL has applied for them to be listed on NYSE American exchange (LGLRT). There doesn’t seem to be a market-maker, however, so I recommend buying LGL common directly instead. This has been thinly-traded historically ($50K a day recently). The rights outstanding until expiration on Oct 10th should provide good liquidity (via arbitrage by rights holders) if the trading price goes even slightly above $5.50.
LGL Group has had a tough history reflected in a valuation well-below comparables. Their major product line, electronics for internet communications, was wiped out by Asian competition over a five year period. The remaining defense and aerospace electronics business is a defensible niche that has remained healthy, however. This business will benefit from new shrewd management implementing a new strategy as well as significant technological changes. In particular, the advent of smaller, cheaper military drones made in higher numbers than expensive fighter jets, tens of thousands of shoe-box sized satellites instead of a fewer number of larger ones, and the militarization of space will drive volumes of flying and orbiting things higher. While aerospace and defense budgets will likely rise slowly, aerospace and defense electronics spending will rise faster. Small flying things need similar control electronics, radar, GPS positioning, and radio communications as their larger counterparts, but there will be more of them. LGL, a preferred supplier to the major defense companies, is positioned well to benefit from the increasing volume.
LGL has two major product lines. The first is the design and manufacture of frequency and timing products. These are principally crystals of quartz similar to those in a quartz watch. Quartz is piezoelectric producing an oscillating voltage as the crystal vibrates at its natural frequency. Counting the oscillations makes a clock. In digital electronics, the clock coordinates the calculations of all the chips on the circuit board; zeros turn to 1’s and 1’s to zero on every clock cycle. For internet communications between servers or wireless base stations, the clock must be very, very precise; much better than your watch which might gain a minute every month. This requires the quartz crystal to be cut and mounted just so, requiring precise engineering and manufacturing that results in a high-priced timing device. Radar, control of fast flying aircraft, and use of global positioning also requires precise clocks. These applications also require military reliability, tolerance of high G forces, tolerance of high and low temperatures without affecting the vibration frequency, removal of the effects of engine vibration (which shakes the crystal affecting the clock) and various other special issues. Typically, the product must be customized to meet specifications of some low-volume space or military application. LGL’s second product line is spectrum control products. These are precision and often customized filters of radio and microwave frequencies for military radio and space communications. These also must survive and perform in various nasty environments requiring qualification to demanding specifications. A supplier established as LGL is with proven reliable components that perform well is very hard to displace.
A major end market for LGL’s timing circuits historically was internet communications. In the year 2000 LGL’s stock reached $70 as the internet was being built out. In 2010 the stock was at $35 as the company did $47 million in revenue with an operating profit exceeding $3 a share while building out wireless base stations. These are higher volume applications that are not as environmentally demanding as space and the military. Around 2010, new Asian competition began to drive prices of LGL’s internet communication components lower and lower as they became a commodity. The company endured about 5 years of losses as they couldn’t reduce expenses as fast as revenues fell. This year, revenues are running at a $24 million rate. Substantially all of the revenue is in the defense and aerospace end markets, however. The internet communications business is substantially gone.
The remaining aerospace and defense business has apparently grown very slowly the whole time. This year revenues are up 15% over the prior year and the company is turning a profit. The market cap is about $14 million but after subtracting out $6 million in cash the business is only being valued at $8 million, or about 1/3 of their sales. The best comparable is the 2012 buyout of publically traded Valpay-Fischer who made similar frequency and timing circuits. The $18 million price was 1.2 times their $15 million in sales. Publically traded Frequency Electronics (FEIM) also trades at an enterprise value/revenue multiple of 1.2 times. LGL’s Gross margins are similar or higher than these comparables and I see no reason LGL shouldn’t trade at a similar ratio of sales; perhaps even higher in view of the strategy change in the next paragraph. It’s not surprising that the Gabelli’s are willing to pay a premium in the rights offering.
A strategic review in 2013 resulted in the hiring of former Valpay-Fischer CEO Michael Ferrantino as a consultant and 6 months later as CEO. Valpay-Fischer was publically-traded prior to being bought out by CTS corporation and the SEC filings are still available. Ferrantino roughly doubled revenues there from 2002 to 2007 while raising gross margins from negative to an industry-leading 40%. He did this by transitioning to more highly-engineered precision products with high reliability requirements. Since becoming CEO at LGL group he has followed a similar strategy, i.e. emphasizing higher margin precision and high reliability components. He also noted on joining the company that LGL was a preferred supplier to the major defense contractors but were only offering a small percentage of the electronics they needed. Furthermore, the contractors wanted to reduce the number of suppliers they worked with. He set about to increase LGL’s share of the business with these contractors by broadening LGL’s product line. The $2 million in R&D spend was directed towards developing new defense products, several acquisitions of technologies were made, and agreements for LGL to offer other companies technologies were signed. Ferrantino also sought to provide more complex assemblies with subsystems containing multiple components that LGL would engineer and qualify. Important to Ferrantino was to seek business that would be in production for 5 or 10 years or more.
Ferrantino has been at LGL for almost four years now. The effects of the strategy change are only now becoming evident in the financials with the 15% revenue growth this year. The development and qualification cycle for these complex assemblies is often three years. This likely explains why improvements are only now showing on the income statement. The new products that went into production this year will remain in production for 5 or 10 years or more. One would expect that next year another new set of products will go into production while this year’s products continue to produce revenue. The next year another new set will be added. While the 15% revenue growth this year is the first significant growth since 2010, it’s likely that this growth will persist or even accelerate for many years to come.
Aerospace and defense electronics markets are likely to grow at a healthier rate than the aerospace and defense markets in general. Autonomous drones are “the biggest thing in military technology since the nuclear bomb”. A nice 60 minutes piece titled “The Coming Swarm” (https://www.cbsnews.com/news/60-minutes-capturing-the-perdix-drone-swarm/) shows how numerous little drones may become. Those drones will need military grade electronics for precise control, radar, positioning, and radio communications. The recent acquisition of rocket motor company Orbital ATK by defense contractor Northrop Grumman is featured in the Tuesday Sept 18th front page article of the Wall Street Journal. The article describes this acquisition as indicative of the impending militarization of space. This is all good news for LGL in view of their relationships with the major defense contractors and the proven reliability of their components in satellites.
The $11 million from the rights offering will be coupled with their $6 million in cash to make an acquisition. In September of 2016, Ferrantino surrendered the CEO position at their major subsidiary, MtronPTI, to focus on “strategic issues”. Acquisitions always present some risk, but I’m comforted by my favorable opinion of Ferrantino’s record. I also like investing with Mario Gabelli. In particular, I’d note that he’s good at anticipating changing trends in industries and getting out early to take advantage. He oversubscribed heavily in a 2014 rights offering at Sevcon recommended on this site (ticker SEVRR). This was Mario getting in front of the electrification trend, to great profit, as the stock more than tripled in three years. I suspect Mario is again getting in front of a trend, aerospace electronics growth from drones and space militarization, with this LGL Group rights offering.
In Summary, LGL appears to be a growth stock at a deep value price. The benefit of a strategy change by a previously successful CEO is just now becoming evident in the financials. Their niche business appears ready to grow, perhaps dramatically, by technological changes enabling autonomous drones and by the militarization of space. A rights offering will provide plenty of shares available to purchase if the price exceeds the $5.50 rights price. Getting out won’t be so easy, however, so manage your position size appropriate to your needs for liquidity. The Gabelli’s are buy and hold investors. If you are too, you might join them in this investment looking to benefit from the long-term growth in aerospace and defense electronics.
Long-term investment, probably dead money until idle cash is invested via acquisition