Ethical Equities is proud to present this report by the rampaging Fire Bull, who is himself an emerging micro-cap investor displaying good risk-reward ratio. I would happily have this guy manage my cash.

We're lucky to have him present one of his favourite investing ideas right now (though I hasten to add, like me, he can and will change his mind on new information, so please don't rely on anything you read on this website, ever.) It's all about education.

Now, without further ado...

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At the outset, I’d just like to say that I gained much of my understanding of Adacel from reading posts on the HotCopper thread. In particular I owe thanks to ambitious.1, Stweeve, Fibonarchery, vfrioni, Ormond, imran khan, peterdoobes, CapitalH and anyone else that I may have missed. Some of this material is likely to have come from what I have read on the forum, although I have verified all research independently. Adacel Technologies (ASX:ADA) is a market leader in the supply of air traffic control training systems, particularly in the United States. It also sells satellite based air traffic management software and voice activation technology used in planes, drones and simulators.

For a small company, Adacel has a fairly extensive product offering which needs to be understood to appreciate the full potential of the company. Here are the key product categories it sells along with a short description on each.

ATC Simulation & Training

This is the core division of Adacel’s business and products range from small mobile training systems to Adacel’s flagship MaxSim product, a fully immersive training simulator. The products incorporate Adacel’s voice recognition technology which increases realism and helps students learn aviation phraseology.

Air Traffic Management

Adacel’s Aurora, is satellite based air traffic management software that can automatically detect potential air collisions before they happen. This reduces workload for controllers and has environmental benefits as the system can help optimise flight plans to save fuel whilst a plane is airbourne.

Voice Activated Cockpit

Voice Activated Cockpit enables the pilot and the aircraft to effectively talk to each other, freeing the pilot’s hands and eyes to perform other tasks. Adacel offers a similar solution for controlling drones.

Air Traffic Control in a Box

Using Adacel’s speech recognition technology, Air Traffic Control in a Box provides automated air traffic control training for pilots and drone operators, which is preferable to using human controllers.

The financial history of Adacel is weak; the company has generated just $8 million of free cash flows in total over the last ten years. However, it is the future and not the past that matters and such a poor track record is precisely what provides the opportunity to buy the stock at a bargain price today.

The company has struggled in recent times because governments around the world stopped spending money on its products after the GFC. This is now changing, as economic conditions have improved, and outdated systems desperately need replacing. Yes, this is a somewhat cyclical business.

In 2013, Adacel’s revenue was $31.3 million, the lowest it has been in the past ten years. In the previous three years, from 2010 to 2012, no significant contract wins were announced which probably explains why 2013 was the low point. However, the company still managed to deliver a small profit before tax in 2013 of $0.9 million.

This is significant for two reasons. Firstly, since the start of April 2015 Adacel has announced more than $120 million of new contracts, which implies that revenue will be much higher in the next couple of years. Secondly, Adacel is now a much better run operation than was once the case. For example, in 2010 the company made a loss before tax of $3.0 million on revenues of $46.4 million. I think this improvement in profitability is down to management, but more on that later.

Air traffic is forecast to grow over the long term as people from developing countries get richer and start travelling abroad. Also, drones are expected to become widely used, further congesting the skies, albeit at a much lower altitude. Consequently, more air traffic controllers and more advanced systems will be required and Adacel should benefit in the following ways.

    1. There is a shortage of air traffic controllers currently, and this combined with expected future demand means that more simulators will be needed.

    1. Adacel now has a large base of installed simulators that will require constant maintenance and updates as the skies get busier and the training needs of controllers change (for example, training on drones). This base is likely to get bigger, indicating that revenues will be less volatile in future.

    1. Radar systems will be replaced by more accurate satellite based systems, the kind sold by Adacel.

    1. Adacel’s voice technology can be used to replace human air traffic controllers when training pilots and operators of drones. This product is called Air Traffic Control in a Box and at the end of 2012, a collaboration between Adacel and Israeli drone simulator company, Simlat, was announced utilising this technology.

    1. The same speech technology is used in Adacel’s Voice Activated Cockpit product, which allows the user to control planes and drones with their voice. The product has safety benefits because it frees up the user’s hands to carry out other tasks.

Adacel has a strong partnership with Lockheed Martin and its Voice Activated Cockpit technology is being used in the prestigious Joint Strike Fighter program. The technology will continue to get high profile exposure from this contract as more fighter jets are rolled out.

Adacel’s air traffic management software, Aurora, is sold as part of Lockheed’s overall air traffic control solution. This allows Adacel to leverage off Lockheed’s name to win contracts that it would not be able to compete for alone.

Adacel is not the only company with these types of products, but it is definitely one of the leaders based on its dominant position in the US market and impressive partnership with behemoth Lockheed Martin.

Also, it should be noted that Adacel’s customers are large public sector organisations and governments which, thanks to their size, have considerable pricing power over Adacel.

Thorney Investment Group, a highly regarded private investment firm specialising in emerging companies, owns just under half of Adacel. It has built up its holding over more than a decade which demonstrates commitment. The long-term major presence of Thorney on the share register is potentially a positive, because it increases the chance of the company being run in the interests of all shareholders. On the other hand, it could lead to neglect of retail shareholders in favour of Thorney, should interests become opposed.

Peter Landos, chairman of Adacel since 2012, is also the COO of Thorney and it seems unlikely that the improvement in profitability evident since his appointment is just a coincidence. CEO, Seth Brown, was hired at around the same time as Mr Landos and probably shares some responsibility for the turnaround.

The new management team has focussed on project management discipline and cut redundant costs which has led to the improved financial results of recent years. In addition, it bought the intellectual property for Adacel’s air traffic management system, Aurora, which means the company no longer has to pay royalties or risk losing the technology to a rival.

More recently, Adacel bought Computer Sciences Corporation’s air traffic simulator business. Crucially, this means that Adacel now has systems at more than 95% of schools in the FAA’s Collegiate Training Initiative program enhancing its leadership position in the American market.

In terms of value, Adacel looks cheap. It has a market capitalisation of less than $50 million at current prices and recently announced that it expects to deliver profit before tax (PBT) of $4.5 to $5.0 million this year.

However, it also has $7 million in cash, no debt and the above figures include $0.8 million of genuinely one-off costs related to bad debts owed by the Ukraine government. Also, profits in the second half of the year are expected to be $3.1 to $3.6 million and so along with the recent acquisition and contract wins, I conservatively estimate PBT to be over $6.0 million next year.

Over the past ten years, Adacel has spent a total of just $5.7 million on capital expenditure. Also, the company has $64 million of retained losses on its balance sheet so I expect free cash flows will be similar to PBT for some time.

Putting it all together, Adacel is trading on a conservative forward enterprise value to free cash flow multiple of about 7x right now. It is by no means a perfect company because it is exposed to economic cycles, has a poor history and has powerful customers. However, it seems that Adacel has put its past behind it and that looking ahead conditions will be much more favourable.

Disclosure: Fire Bull (the author of this piece) holds Adacel Technologies shares. Claude Walker (introduction only) does not own Adacel shares, but may choose to buy Adacel shares at some point in the future. Nothing on this website is advice ever. It is a place to share stories and discuss investing in ethical companies.

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