Description

Pemco Aviation (formerly Precision Standard) performs maintenance and modification of aircraft for the US Government and commercial customers. Despite recent positive developments and the subsequent runup in the stock, it still has a P/E of only 8 and EV/E of 10, even though it has a Year To Date Return on Assets of 18% and a Return on Equity north of 50%. Even using a 40% normalized tax rate, the ROA and ROE were 13% and 39% respectively. Last year, 75% of Pemco's revenues came from the US Government and ¾ of that came from maintenance services on the KC-135 air tanker.

Besides the Government Group, there is a Commercial Services Group (commercial aircraft maintenance and modification services on a contract basis) and Manufacturing and Overhaul Group (designs and manufactures proprietary aerospace products such as guidance control systems and launch vehicles; aircraft cargo-handling systems; and precision parts and components for aircraft). Of last year's $162 Million in Revenues, the highly profitable Government Group had $103 Million, while the unprofitable Commercial and Manufacturing Groups had $40 Million and $18 Million of Revenue, respectively.

Pemco's KC-135 multi-year contract with Boeing was renewed earlier this month and Pemco has announced that its commercial business is seeing an upturn. The KC-135 Stratotanker was built by Boeing from 1957 to 1965. There's approximately 550 still in service. The KC-135 refuels other aircraft in-flight; thus they are essential for long range support of US military missions in parts of the world far from the US' land bases. Believe it or not, they are projected to remain in service for another 40 years. The need for immediate rapid deployment of military forces has insulated the military maintenance and modification industry from many of the effects of the shrinking defense budgets in prior years. Budget restrictions have limited the U.S. Government's ability to replace substantial portions of its aging transport fleets.

Thus, a company that has developed expertise in the periodic maintenance and refurbishment of the KC-135 has something pretty close to an annuity for many years to come. Pemco had a 7 year PDM (Programmed Depot Maintenance) contract with the US Air Force (USAF), administered by Boeing, that expired earlier this year. On December 12, Pemco announced that they had been awarded the new PDM contract, worth $600 Million over the next 6 years, if fully funded. Nothing is ever guaranteed when dealing with the Government, but the odds are very good that Pemco will continue to get this business for many years to come.

The PDM is the most thorough scheduled maintenance "check-up" for a military aircraft, entailing a bolt-by-bolt, wire-by-wire and section-by-section examination of the entire aircraft. The typical PDM program involves a nose to tail inspection and a repair program on a four or five-year cycle, depending on how heavily the plane has been used. In addition to heavy maintenance, the program can include airframe corrosion prevention and control, rewiring, component overhauls and structural, avionics and various other system modifications. The past few years, Pemco has been doing 35-40 KC-135 PDMs annually. A sustained air war would increase these numbers.

There were severe losses in 1997 due to a strike and restructuring. These losses generated a large Tax Net Operating Loss (NOL) carryforward. Thus, Pemco has paid minimal income tax since 1997 and recorded a tax benefit in each of the years 1998-2000. In the first 3 quarters of 2001, they paid $0 in income tax (from the 10Q's supplemental disclosure of cash flow information), but recognized $3.0 Million in tax on the P&L (a 27.8% rate). They still have a Deferred Tax Asset on the books for $1.8 Million.

In September of 1999, Michael Tennenbaum bought control of Pemco from the former CEO, Matthew Gold who had owned approximately 50% of Pemco's stock. Tennenbaum had been Vice Chairman of Bear Stearns before forming his own investment firm. In Q4 of 1999, headquarters were moved from Denver (where Gold lived) to Birmingham, home of the largest Pemco facility. The new CEO, Ronald Aramini, was brought on board January 2000 and had served as the Senior Vice President-- Operations for America West Airlines, Inc., and before that as President and CEO of Allegheny Airlines from 1993 to 1996. Aramini has brought in a whole new management team. Not so coincidentally, a large number of writeoffs were taken in Q4 of 1999. Gold still controls the second largest block of stock.

During 2000 Pemco decided to concentrate its commercial Maintenance Repair and Overhaul (MRO) activities in one location, exit the business of repairing engine nacelles, which had lost money during four of the past five years, and increase its emphasis on the conversion of aircraft from passenger to cargo configurations. Accordingly, the MRO operations in Victorville, California were phased out and all commercial MRO operations are now concentrated in Dothan, Alabama. The Company ceased sales activities in the area of repairing engine nacelles and after performing its responsibilities on its remaining contracts closed this operation in Clearwater, Florida and transferred some employees and most of the remaining inventory and equipment to the MRO operations in Dothan, Alabama.

Now that the KC-135 contract has been renewed, Pemco’s major opportunity is in the conversion of commercial aircraft from passenger to cargo. The rapid increase in worldwide freight shipments has spawned a demand for dedicated cargo aircraft. The majority (70%) of air cargo planes have been converted from a pure passenger configuration. With passenger traffic down after September 11, this percentage may increase. Pemco believes that it is the only company in the world currently certified by the Federal Aviation Administration (FAA) for passenger to freighter conversions of the 737-300. Earlier this month, Pemco announced that it would expand capacity of Dothan by 30% to accommodate increased commercial demand. Aramini’s experience, of course, is on the commercial side.

The new management team has been investing heavily in the business. Capital expenditures increased to $10.7 Million from $3.0 Million and $0.7 Million in 2000, 1999, and 1998 respectively. 2001 Capital Expenditures should be less than 2000 but more than prior years. Despite this Total Debt + LT obligations have declined to $18.1 Million (Q3) from $20.6 and $22.3 Million at year end 2000 and 1999 respectively.

The labor environment is much better than a few years ago. The new labor contract began August 19, 2000 and extends through August 9, 2005. The new contract's five-year term compares favorably to the three-year term of the previous contract. The new agreement calls for wage increases of 17% over the life of the contract and increases in pension benefits.

Because of the writeoffs and tax benefits, I took the average Pretax Earnings (excluding the Q4 1999 writeoffs) for 1999, 2000, and 2001 (est), and applied a 40% Tax Rate to yield a conservative "normal" Earnings rate. This might be overly conservative since there are still some NOL carryforwards remaining and this was a relatively peaceful period for the USAF. During the past 3 years, I estimate Normalized EPS to be approximately $2.00 per share. See the table below for the details of the calculation (I hope the formatting doesn't get messed up). For obvious reasons the funding environment for military programs such as the KC-135 is likely to be much more generous in over the next few years than in the 1999-2001 period.

What are the negatives? It is closely held. Like many of the stock ideas posted on VIC, volume is only a few thousand shares a day. Since so much of Pemco’s business is with the government, If the government got upset with them, that would be a major problem. However, given the KC-135 contract renewal, the current relationship wit the government looks good. The last major negative I see is the current high capital expenditures, which will probably end next year. It is not yet certain if that investment will yield significantly higher revenues.

Given the pricing for other aerospace companies (some with more variable business streams, the high Return on Equity, the relatively low risk in Pemco’s businesses, and the potential associated with heavier defense funding (even without a possible hot war with Iraq), and current low interest rates, a P/E in the mid-teens is appropriate, yielding a fair value of 25-35.

Other statistics and calculations

Enterprise Value = $65 Million (market cap) + $18.1 Million (Debt + Other LT obligations) – 2.0 Million Cash = $81.1 Million

Normalized Earnings Calculations

2001E 2000 1999 Average
Pretax Earnings as reported 14,000 10,620 7,592 10,737
Addback
Former CEO payoff 0 0 1,600 533
Additional Litigation Reserve 0 0 2,700 900
Headquarters Relocation 0 0 400 133
"Unusual" Bad Debt Reserve 0 0 1,600 533
Scaling back Nacelle Operations 0 0 1,300 433
Reserve for Old Inventory at Birmingham 0 0 1,100 367

Normalized Pretax 14,000 10,620 16,292 13,637
Less 40% Tax -5,600 -4,248 -6,517 -5,455
Normalized Earnings After Tax 8,400 6,372 9,775 8,182
Diluted Shares 4,250 4,241 4,061 4,184
Normalized EPS $1.98 $1.50 $2.41 $1.96
EPS as reported $2.40E $2.23 $1.52 $2.05

Catalyst

KC-135 contract renewed December 12, 2001
New management team and controlling shareholder
Increased conversion of passenger to cargo airplane conversions
Increased defense expenditures (even without additional armed conflicts)