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Adacel Technologies Limited (ASX: ADA): FY 2018 Results

Matt Brazier — Sun, 26 Aug 2018 05:18:56 +0000

Provider of systems and services for air traffic control (ATC) training and air traffic management (ATM), Adacel Technologies Limited (ASX:ADA) released its results for FY 2018 on Thursday night.

Revenue rose 25.0% to $53.1 million, net profit after tax (NPAT) fell 9.5% to $8.4 million and earnings-per-share (EPS) was similarly down 9.1% to 10.64 cents. Operating cash flow jumped 75.7% to $8.6 million and free cash flow rose 71.2% to $8.1 million thanks partly to a $3.8 million tax refund.

Cash was down 23.4% to $12.5 million following the payment of $9.5 million of dividends and $2.0 million spent on buying back shares during the year. The company announced a final dividend of 2.5 cents as well as a special dividend of 5.0 cents bringing the total dividends declared in the year to 9.5 cents versus 11.75 cents last year, or a yield of 5.6% at current prices.

While NPAT and EPS both fell compared to 2017, underlying profitability actually improved. This difference is due to tax with a $1.4 million tax benefit recorded in 2017 compared to a $1.8 million tax expense for this year. Profit before tax (PBT) improved 29.8% to $10.2 million although this is still below the 2016 peak of $10.8 million. The company has available tax losses in Australia and tax credits in Canada in addition to $3.9 million of deferred tax assets on its balance sheet. These have an estimated value of $11.8 million and $10.1 million respectively and should reduce tax payments in future years.

Adacel typically generates more than two thirds of its revenue from North America with much of the remainder originating outside Australia. Therefore, the business is exposed to currency fluctuations and in particular the relationship between the Australian and US dollars. The Aussie has weakened around 8% against the US dollar in the past year and a continuation of this trend would be good news for Adacel’s Australian investors.

The company generates lumpy one-off revenue from the sale of its systems as well as recurring service fees once a system is installed. As the base of installed systems has grown over the years, so has the defensive quality of the business.

Note the chart above shows the tight cost control on display with overheads lower today than they were in 2015. This also highlights the scalability of the business.

As can be seen above, the stable services business now comfortably covers overheads and Adacel is far less dependent on the contribution from system sales compared to before 2015. Come the next recession, the company’s profit is not going to fall off a cliff, as was once the case.

It was good to see the services revenue return to half-on-half growth, after a weak first half.

Adacel’s investing cash flow history provides further evidence of fiscal discipline. The company expenses almost all R&D investment and tangible fixed asset requirements are minimal. The ability to generate strong free cash flow enables Adacel to pay attractive dividends and is one of its best qualities from an investor point of view.

Systems

Intensifying competition has eroded the gross margin percentage of Adacel’s Systems division. It was 27.9% in 2018 down from 34.8% last year and is expected to continue falling in 2019.

This may not be as bad as it seems. Increasingly it is the services side of the business that drives performance and so discounting the price of systems to win business may be worth doing in order to realise more lucrative service revenue later on.

The company is looking to mitigate the lumpiness of revenue in its Systems division by broadening its product range including offering small footprint land-based ATM systems as well as the oceanic based systems for which it is known. It is also investing in R&D to expand the product range of its ATC simulator business.

Services

The Services segment represents the recurring revenue side of the business and is higher margin than Systems as can be seen in the charts above.

Last year, Adacel was impacted by the loss of a portion of a contract for support services it provides to the US Federal Aviation Administration (FAA). The company has formally protested this contract award and has halted delivery of software support pending the outcome which has further reduced revenue. This dispute drove a 5% fall in Services revenue in 2018 and in Friday’s investor conference call management revealed that the judge overseeing the case dismissed Adacel’s claim. The company has 30 days to appeal the decision.

The above contract loss was partially offset by growth in the separate and existing FAA Advanced Technologies and Oceanic Procedures (ATOP) contract. This is Adacel’s largest and longest serving contract dating back to 2000 and it generated service revenue of around $12 million in 2017. In September 2017 the company announced that the contract had been expanded with annual revenue increasing by 20%. Only 11% of this contract extension was delivered in 2018 and so it will contribute to growth in 2019.

It is worth noting how dependent Adacel is upon the FAA, although this risk is somewhat offset by the huge investment the civil aviation authority has already made in the company’s systems. If the company can reconcile its differences with the FAA then it is easy to see how Services could realise some growth in 2019, especially considering recent System wins.

Room to Climb Further?

In this piece which I wrote for Ethical Equities back in July 2015, I said:

“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.”

Fast forward to today and Adacel trades on a historical enterprise value to PBT multiple of 11.9. I am not sure if the outlook is as rosy today, as it was back then. In the prior article, I used PBT as a proxy for free cash flow because of the company’s available tax losses and credits. The PBT figure used in the previous calculation was my estimate for 2016 of $6.0 million, which turned out to be wildly conservative given the actual result was $10.8 million! For context, the 2015 PBT result was $5.9 million.

The share price closed at 60 cents on the day that my original article was published and the stock is trading at $1.715 at the time of writing giving a capital return of 185% in just over three years. Roughly half of this performance can be thought of as being driven by multiple expansion with the other half due to PBT growth. In addition, the company has paid 18 cents of unfranked dividends representing an income return of 30% over the period.

For the record, I bought my shares for 59 cents in May 2015 and sold them for $1.60 later that year. This was a pleasing result but it turns out that I sold much too early given the share price peaked at over $3 in 2016.

Adacel directors David Smith and Silvio Salom (also the company’s founder) sold 4.7 million shares between them in the second half of calendar year 2017 for at least $2.60 per share. These trades were well timed given the share price today is around 35% below those levels. It is worth paying attention to insider trading activity.

I do not consider that Adacel’s stock represents anywhere near as attractive a prospect today as it did back then. This is partly because it is now trading on a higher earnings multiple, but more importantly there is less visibility of future growth for the company. In July 2015, Adacel had just announced roughly $120 million of new contracts in the preceding few months. In contrast, I estimate the value of contracts announced in FY 2018 is less than $60 million.

Having said that, Adacel remains a reasonably priced decent quality business and although I am not tempted to buy shares right now, I would be fairly content to hold if I did own some in the absence of a superior opportunity.

Note from Claude: I think this is a very insightful write up, and I value Matt’s work here. I largely agree with his conclusions except for the fact that I’m a little more optimistic given the strong cash flow of the business. The company has been buying back shares and paying out dividends so it does seem to want to share that cashflow with shareholders. That’s not as common as I’d like.

Second, I could certainly envision this company being significantly bigger in a few years. Ultimately, however, I am concerned there has not been enough investment in software development and I do not hold shares myself. I would not rule out purchasing some, especially on share price weakness, but I’m not in a hurry.

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Disclosure: Neither Matt Brazier nor Claude Walker own shares in Adacel at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Adacel Technologies Limited (ASX:ADA) is an emerging microcap offering a good risk-reward ratio

Matt Brazier — Thu, 09 Jul 2015 12:40:18 +0000

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.

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

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.

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

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.

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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