Description

INVESTMENT THESIS:
I am recommending the purchase of United Industrial (UIC). The company is transforming itself into a pure-play defense company, one that has a solid backlog, is well-positioned for continued growth, and is sustainably expanding its margins. At 18.40, the stock is only 9.8X current run-rate EPS, which clearly doesn’t reflect its prospects. The defense business’ strength is evident in its 2003 results, where revenue grew 23%, EPS contribution was up 29%, and after-tax cash flow grew 13%. UIC has no debt, repurchased 4.2% of its shares in the past four months, and is now aggressively buying another $10MM of its stock in the open market. I believe the risks to the story are definable and minimal, while the catalysts are several and probable.

UIC reported Q4’03 diluted EPS from continuing operations of $0.47, or $1.88 annualized, implying a P/E of 9.8X, a significant discount to the 20X P/E of its peer group. UIC also carries a $0.40 dividend, a 2.2% yield, which is a rarity in the small-cap defense sector.

BUSINESS DESCRIPTION:
United Industrial Corporation (UIC) now consists of its defense business (AAI Corp., FY’03 revenue of $282MM) and a small energy unit (Detroit Stoker, FY’03 sales of $29MM). Its transportation business (ETI Inc.) has been discontinued and is being wound down. In September 2003, UIC abandoned a long effort to sell the company (with an $18 bid reportedly on the table) due to asbestos litigation complications and the objection of some board members to selling at such a low valuation. As part of this overall change in direction, the company reshuffled its board and management team, announced plans to run UIC as a pure-play defense company and sell non-core businesses and assets, and committed to find new ways to enhance shareholder value. The transformation is well underway, as management discontinued the transportation business, is actively searching for a buyer of Detroit Stoker, has put excess land up for sale, and is aggressively pursuing a stock buyback program.

DEFENSE (AAI CORP.). Founded in 1950, AAI primarily designs, develops, and produces unmanned aerial vehicles (UAVs) and defense electronics testing and training equipment for US (80%) and foreign (20%) militaries. To a lesser degree, it also provides simulators, boresight equipment, hydraulic test equipment, depot outsourcing, and engineering and logistics services to customers worldwide.

Helpful links:
http://www.aaicorp.com/
http://www.aaicorp.com/aaiprod.htm

Positive near- and long-term trends in defense spending make this sector very attractive for small companies like UIC, who gain more from overall spending and less from spending on a single program as do larger prime contractors. Some of these trends include America’s commitment to the global war on terrorism, the changing nature of warfare which demands the increased use of systems and electronics on the battlefield, the recapitalization of major defense assets following a long period of underinvestment, the increased importance of training for modern conflicts, and a strong move to employ sensing and shooting systems that take soldiers out of harm’s way (e.g. UAVs, satellites, cruise missiles, and missile defense). AAI contributed about 91% of total revenue ($282MM) and 99% of continuing EPS ($1.05) in FY’03. It had a total funded backlog of $318MM at the end of FY’03, up 7.5% from a year ago, and backlog has grown much more in early 2004. Due to the nature of percentage-of-completion accounting for contracts, where profits are conservatively lower in the early years (start-up costs) and greater in later years (at delivery), this backlog provides strong visibility into future revenue and earnings. Additionally, AAI’s high level of firm-fixed-price contracts (about 70%) means that every expense dollar saved on a project goes straight to profit, providing it with significant operating leverage.

AAI’s major growth drivers are its Shadow TUAV, JSECTS, and C-17 Maintenance Trainer programs. In late 2002, the US Army awarded AAI a full-rate production (FRP) contract to produce the RQ-7A Shadow 200 UAV as the Army’s sole tactical UAV platform—the first UAV to receive a FRP contract from any of the services. The Shadow’s primary missions are intelligence gathering, surveillance, targeting, and reconnaissance for brigade-level Army commanders to achieve enhanced situational awareness of the tactical battlefield. The initial $86MM contract is for the delivery of nine systems plus spares and repairs through August 2004. Each Shadow “system” consists of four UAVs, two ground control stations, and associated components and support equipment. With the initial award in the late 1990s, AAI joined an elite group of companies fielding major UAV platforms for the military, including Northrop Grumman with its Global Hawk and General Atomics with its Predator A/B, both for the US Air Force.

The Army’s near-term requirement is 41 additional Shadow systems through 2010, or about seven systems per year at $8MM-$10MM per system. AAI believes, however, that as many as 80 systems may eventually be bought over this timeframe, which could bring the total production contract to nearly $800MM. Indeed, on March 1, UIC announced that the Army placed its FY’04 order for eight Shadow systems, but more importantly exercised an FY’03 option for three additional systems. The total value of the order was $97MM ($70MM FY’04 + $27MM options) for delivery through 2006.

With the success of the Shadow in Afghanistan, Iraq, and South Korea, and the cancellation of the Army’s Comanche scout helicopter, it is likely that UIC will experience additional demand for its UAVs and related services. Army officials are quoted as saying that they plan to add $300MM to spending on UAVs due to the Comanche cancellation, and the Department of Homeland Security wants to spend $10MM to test the use of UAVs for border patrol and intelligence gathering. Additional associated support, logistics, and R&D contracts could add another $500MM onto the overall Shadow production contract.

AAI is also currently selling other versions of Shadow (the 400 and 600 models) and Pioneer UAVs to other branches of the US military and to higher-margin foreign militaries, and is teamed with BAE to compete this year in Australia for a contract similar to the US Army’s TUAV program. UAV backlog at the end of FY’03 was 16 systems valued at $127MM. The recent orders add net $68MM to the UAV backlog bringing it to a record level of approximately $195MM, providing substantial support for the growth thesis.

Helpful links:
http://www.aaicorp.com/defense/uav/index9a.htm
http://www.globalsecurity.org/intell/systems/shadow.htm

The AN/USM-670 Joint Services Electronic Combat Systems Tester (JSECST) program has been designated by the DOD as the standard flight-line electronic warfare (EW) test system across all branches of the military. The JSECST is used to quickly and accurately test EW and avionics systems in a range of aircraft, assuring flight crews that their aircraft are mission ready, with capabilities that include threat representative simulations and technique/signal response analysis.

In March 2003, AAI received its third major JSECST production contract award--$16MM from the Navy for 75 units. This brought total contract awards since 2001 to $87MM, with deliveries scheduled from 2003 to 2005. Ultimately, this total contract could be valued at approximately $250MM. In April 2003, the DOD awarded AAI a 10-year support contract to provide maintenance, logistics, and spares for JSECSTs in the field, with an initial two-year contract valued at $5MM. Demand for JSECSTs is being driven by DOD’s desire to reduce the number of operational testing systems in use (some reports say there are more than 2,000 different systems in use today) and lower overall costs of maintenance, training, and logistics. JSECST backlog at the end of FY’03 was $51MM, with additional orders expected later this year. Foreign militaries that employ US airborne platforms are also buyers of the JSECST, notably Australia, and could become significant growth drivers in out years. Like the UAV contract, the JSECST contract has the potential for a long and growing lifecycle.

Helpful links:
http://www.aaicorp.com/defense/test/jsecst/index.html

AAI is a leading provider of aircraft maintenance simulators to the US Air Force, having produced trainers for the E-3 AWACS and E-8 Joint STARS. Its flagship program, however, is the maintenance trainer for the C-17 Globemaster III cargo aircraft, where it is modifying two trainer suites to maintain concurrency with the C-17 production line, building an additional trainer for the Mississippi Air National Guard for $5MMM, and currently building a fourth suite (three trainers) for McGuire Air Force Base under a $38MM contract awarded in July 2003. Total contract awards since inception for the C-17 MTS is $270MM, the largest contract in its history. Boeing’s C-17 program has a very long life expectancy due to recent successful use in global conflicts, Congress’ decision to up the number of C-17s bought above the President’s budget request, and it’s fit with DOD’s goals of transformation (faster deployment of troops and equipment). Backlog at the end of FY’03 was $66MM for the C-17 MTS. The company also recently won a contract to perform maintenance training studies for the C-130 Hercules Avionics Modernization Program (AMP), and while AAI’s initial contract was small ($3MM), it believes the eventual size of the program could exceed that of the C-17 MTS.

Helpful links:
http://www.aaicorp.com/esi/esifeatureprog.html
http://tspg.wpafb.af.mil/ams/c17mts.htm
http://www.globalsecurity.org/military/systems/aircraft/c-17.htm
http://www.globalsecurity.org/military/systems/aircraft/c-130-mods.htm

ENERGY (DETROIT STOKER). Detroit Stoker, which contributed about 9% of total revenue ($29MM) and EPS of $0.19 in FY’03, was founded in 1898 and supplies stokers and related equipment worldwide for the production of steam used in heating, industrial processing, and electric power generation. In 2002, UIC made the decision to shut down Stoker’s low-margin castings business and buy these from lower-cost producers, resulting in significant restructuring expenses but improved margins from 3% to 12% in early 2003, reaching 24% in Q4’03. Stoker is a mature business generating good margins, has low capex requirements, and produces high levels of cash flow. Pitchbooks for its sale are currently on the street, with the sale being managed by investment bank Imperial Capital. It should fetch $20MM-$30MM in a sale, or 4x-5x EBITDA. Although the sale of Detroit Stoker would likely be slightly dilutive, it would finally leave UIC as a pure-play growing defense company.

Helpful links:
http://www.detroitstoker.com/

TRANSPORTATION (ETI INC.). AAI owns 35% of ETI, a company formed in the early 90’s to assemble, sell, and maintain electric trolley buses (ETBs) for metropolitan transit authorities. This business was a disaster. UIC is reporting its results as discontinued, as it is winding down its last ETB contract with San Francisco MUNI. ETI’s 65% owner, Skoda a.s. of the Czech Republic, declared bankruptcy in 2001, thus UIC has been recognizing 100% of ETI’s losses and cash drain. Just last week UIC negotiated a final settlement with MUNI that caps its maximum liability at $18MM and relieves UIC of any significant operational responsibility. UIC has fully reserved for ETI’s losses and hopes to manage the cash impact to less than $18MM. FY’04 and perhaps Q1’05 should show the last negative impacts of ETI on UIC’s financials. There is potential upside in FY’05 from the recovery of fully-reserved receivables outstanding to UIC as a subcontractor to ETI through a performance bond, which could be as much as $35MM or as little as $0. I’m not factoring any recovery into my assumptions.

REVENUE & EARNINGS ESTIMATES:
FY’03 revenue growth of 20% was driven by a 23% increase in the defense business to $282MM offset by a 3.5% decline in Stoker to $29MM. EPS from continuing operations of $1.11 grew about 380% from $0.23 in FY’02. Transportation results impacted EPS by ($1.58) for FY’03, bringing GAAP EPS to ($0.44). I estimate operating EPS, excluding certain one-time expenses (asbestos and restructuring), was $1.20. Similarly, pro forma EBITDA was $36MM.

For FY’04, I believe UIC can report $2.10 in continuing EPS and $55MM in EBITDA. Although that earnings gain may sound dramatic, I don’t think it is a stretch at all. I project Stoker’s sales will decline 3% to $27.6MM, and its operating margin will remain in the high teens due to aggressive expense control during the auction process. It should contribute $0.24 to FY’04 EPS if not sold during the year. Defense should grow revenue at least 10% to $310MM (supported by the current strong backlog) with the operating margin improving to 12% (defense margin was actually 12.7% in 4Q03). Under these assumptions defense contributes $1.90 to FY’04 EPS. It should be noted that during the Q4’03 earnings conference call management guided to margins in FY’04 that should be at least 12.7% (the Q4’03 level, which was up 690 bp sequentially) with hopes of doing even better. If defense margins came in at 13% (which is just average for the peer group) the segment would contribute $2.05 to EPS. I believe the sharp improvement in defense margin seen in Q4’03 is sustainable due to four primary factors: (1) the entry into higher-margin FRP and the maturity in the production processes of both UAVs and JSECSTs; (2) the delivery of C-17 maintenance trainers (i.e. profit recognition); (3) a slight improvement in pension expense due to better performing equity markets; and (4) the decision to run the business as a going concern resulting in employee productivity gains. There are no analysts covering the company and no consensus forecasts.

CAPITAL STRUCTURE:
UIC has $24MM in cash, no debt, and a $25MM line of credit that is fully available. The company has 13.1MM shares out and 1.1MM options out with an average strike of $12.94, thus it has a fully diluted share count of 13.4MM and market capitalization of $247MM. As a reminder, UIC is aggressively buying back its stock and is currently working on its second $10MM program in six months. That company faces up to an $18MM expense to satisfy the San Francisco MUNI liability, which should easily be met with existing resources.

VALUATION AND TARGET PRICE:
At $18.40, UIC trades at 15.3x trailing continuing EPS and 6.6x trailing pro forma EBITDA. On a forward basis, the stock trades at and 8.6x P/E and 4.0x EV/EBITDA. All of these valuations are significant discounts to its peer group, even though UIC is well positioned in above-average growth niches. The peer group currently trades at a 19.7x P/E and 9.6x EV/EBITDA. Giving UIC a peer-average valuation would price it around $40, though it rightly deserves a discount due to its transitioning business structure and asbestos litigation concerns (see below). I believe a target price in the low-$30s is very reasonable, providing about 75% upside.

DEFENSE ELECTRONICS COMP TABLE ON FY’04 ESTIMATES

Ticker Price P/E EV/EBITDA
APSG $25.53 29.3x 12.2x
CUB $25.32 19.9x 11.3x
DRS $27.74 16.1x 10.0x
EASI $47.89 19.5x 10.4x
EDO $24.00 19.0x 7.6x
HRLY $19.33 17.9x 7.3x
LLL $54.75 16.3x 9.8x
STST $15.15 19.2x 8.5x

GROUP AVERAGE 19.7x 9.6x

UIC (TTM) $18.40 15.3x 6.6x
UIC (FY’04) 8.8x 4.4x


RISKS:
LUMPY DEFENSE BUSINESS. For various reasons, smaller defense contractors’ results can often be very lumpy, with swings from quarter to quarter. This primarily results from award and payment delays by the bureaucratic government contracting offices, the mix of contract types during the quarter (firm-fixed-price versus cost-plus), and the timing of payment milestones unique to each contract. Thus, investors should focus on an annual number or a trailing/forward 12 months figure to more accurately gauge performance. The less program diversification a contractor has, the greater the potential for lumpiness of its results. Although UIC could show some quarter-to-quarter variability, I expect at least a 12% annual margin in the defense business, and so does management.

SCALE. Despite its small size, UIC beat out the likes of larger competitors Alliant Techsystems (ATK) and TRW (now Northrop) to win the Army’s TUAV competition. Nonetheless, UIC’s lack of scale could make it hard to fend off larger prime contractors dropping down to compete on its level, or winning significant platform contracts such as the TUAV going forward. Prime contractors such as Boeing (BA), General Dynamics (GD), Lockheed (LMT), Raytheon (RTN), and Northrop Grumman (NOC) all have significant resources to draw on and could win just about any competition they wanted by undercutting bids on contracts. In this environment, UIC could find it hard to compete.

ASBESTOS LITIGATION. UIC and Detroit Stoker have been named as defendants in asbestos-related personal injury litigation involving 19,117 cases. Based on historical data and the large increase in claimants over and above the projected incidence of disease relative to UIC’s products, management believes the claimants in the vast majority of these cases will not be able to demonstrate that they have been exposed to the company’s asbestos-containing products or suffered any compensable loss as a result of such exposure. The history of UIC’s stokers is well documented, and claimants must show exposure to those specific installations. Based on various consultant reports, UIC recorded a $32MM reserve in Q4’02 for its bodily injury liabilities for asbestos-related matters through 2012, and also recorded an estimated insurance recovery of $20MM. UIC believes that its ultimate net asbestos-related contingent liability cannot be estimated with certainty. Worst case scenarios have the liability at $75MM over 40 years and the insurance recovery of that at 70% for a net liability of $23MM. Based on its solid legal defense and track record to date, this liability may be as little as $5MM. UIC will almost certainly retain the asbestos liability even if Stoker is sold.

LIQUIDITY. UIC can be thinly traded on some days, thus consideration of this factor should be taken when entering or exiting positions in the stock.

INSIDER SALES. Recent insider selling has probably cast a negative light, but is not all that it appears. Former CEO, Dick Erkeneff, was forced out in mid-2003 during the board’s shake-up and subsequent reversal of course in its strategic direction. It is speculated that Erkeneff will eventually leave the board, perhaps this year. Since his dismissal, he has engaged in a systematic reduction in his holdings, some of which has been absorbed by the buyback program. I do not believe his selling portends poor results ahead for UIC.

Catalyst

ACHIEVING $2.00+ EPS. If 2004 EPS is anywhere close to $2.00, which I think is highly likely, then this stock is going a good bit higher. Remember, UIC just reported .47 in the most recent quarter.

COMPLETING THE TRANSFORMATION AND ASSET SALES. While UIC may have to pay as much as $18MM in the settlement of its transportation business, it is likely that the company can generate far more cash than that through asset sales. As already mentioned, Stoker could bring in $20MM-$30MM in cash and there is the possibility of upside from the collection of ETI receivables. Additionally, there is $5MM-$10MM in very saleable land adjacent to the company’s HQ in suburban Baltimore that it is actively seeking buyers for. Thus, there should be ample cash to meet its obligations plus continue its buyback and/or raise the $0.40 dividend.

ACTIVIST SHAREHOLDER. Warren Lichtenstein, the current chairman of the UIC board and a principal of Steel Partners, controls 1.58MM UIC shares (12%). Steel Partners has a long history of buying into poorly-managed defense, industrial, and technology companies, installing one of its associates on the board or in top management, and turning the business around. Lichtenstein has been a driving force behind the asset sales going on today, and likely remains interested in the eventual sale of the entire company. One benefit of UIC becoming a pure-play defense company with an attractive set of products and programs is that the company then becomes an attractive acquisition candidate by a larger prime contractor or a bigger defense electronics firm looking to enter the high-growth UAV business or solidify its position in it, such as Northrop Grumman, L-3 Communications, or DRS Technologies.

ANALYST COVERAGE. As it re-emerges as a growing pure-play defense company and executes on its asset sales, UIC should pique the interests of the broader investment community. It is plausible to assume that at least one sell-side firm could pickup coverage of UIC this year.