Wednesday, 21 November 2007

Research Capital Puts $3 Target On AeroMechanical Services

“$3 in one-year” is the number that Research Capital analyst Jacques Kavafian is projecting for AeroMechanical’s stock based on a multiple of 30 times estimated Fiscal 2010 EBITDA of $7.8 million.

In an extensive report, the longtime noted airline and aerospace makes a number of points including:

  • We believe that the company will grow its earnings substantially over the next several years because of strong demand in the aerospace sector, particularly from airlines in China.

  • AFIRS provides significant competitive advantages over existing products, which we believe may encourage airlines to adopt it as their main flight system data recording device. Our estimates in this report assume the company will achieve less than 2% fleet penetration by 2010 to 1,000 installed units. We estimate that each additional 1,000 incremental installed units could contribute to $0.15 per share to earnings.

    On the subject of AMA’s relationship with U.K. based Meggitt PLC, a world leader in the aerospace, defense and electronics industries:
  • Working with Meggitt is a huge increase in credibility and allows AeroMechanical to work directly with OEMs (Original Equipment Manufacturers ex: Boeing, Airbus etc.) to have its products installed directly on the airframe and thus reduce installation time.

    On AMA’s current contract status:
  • As at September 2007, AeroMechanical had signed 23 airlines for a total of 665 units, of which 66 units had been installed. Of this total, Aloha Airlines is the largest customer, with 28 units installed. Of the remaining 599 units, 470 are for Chinese airlines and the rest spread amongst 20 customers. Plans are to have 100 installed by year-end and 208 by June 2008 based on customers' plans.

It is widely known that the market is waiting for news that AMA has received purchase orders from China. It is an understatement that this would be a milestone event as it has been anticipated for some time. On this matter Mr. Kavafian writes:

  • Of the 23 customers that have currently signed on, three are Chinese airlines (China Eastern with 204 aircraft and two other yet undisclosed airlines totaling 330 aircraft), and the company is in discussions with other airlines (China Southern with 276 aircraft, Shenzhen Airlines with 47 aircraft, Air China with 202 aircraft, Hainan Airlines with 49, Sichuan with 37, and Shanghai Airlines with 51). As part of the research for this report, we had discussions with a Chinese government official regarding the prospects for AFIRS in that market. The introduction was made by AeroMechanical and the official we spoke with indicated that China intends to have AFIRS installed on all its aircraft, although the government cannot mandate privately-run airlines to buy the services. At July 2007, China had 1,080 commercial aircraft and is expected to grow by 150 aircraft per year until 2011, after which the annual growth should be between 200 and 300 aircraft. Furthermore, this official mentioned to us that China does not intend to certify a competing product for at least eight years.

The analyst comments that AMA’s market potential is immense with almost 40 thousand commercial and business aircraft in operation and 51 thousand when including turboprops. He writes that the company’s market potential is a minimum of 12 thousand commercial aircraft. At this time AMA has received Supplemental Type Certificates (STC) (safety certification) or has in process approvals covering a number of airline types such as 737, 767, A330 etc. totaling over 12,300 aircraft.

  • In addition to commercial aircraft, there are over 16,000 business jets and 11,579 turboprop business aircraft around the world that could potentially use AeroMechanical's AFIRS. While business aircraft represent opportunities, the market potential is mainly with operators of fleets such as NetJets because the individual owners may be uneconomic to service.

Mr. Kavafian estimates AMA’s breakeven is 500 AFIRS installations, which is expected to occur in 2009 and that once breakeven is reached, “we estimate that margins will expand sharply with each additional installation.” He adds ”Given the very high margin of each incremental unit beyond breakeven, we estimate that every 1,000 AFIRS installed beyond the initial 1,000 units increases net earnings by $11 million, or $0.15 per share. This assumes the monthly service fee remains at US$2,000, with a stable dollar exchange rate and 38% tax rate. Any revenue opportunity that may be created by further R&D expenditures is in addition to these estimates.”

The analyst also notes the risks associated with the business such as 1) his estimates and forecasts may be too optimistic 2) foreign exchange fluctuations 3) proprietary product issues such as protecting its patents from infringement 4) evolution of technology and products and 5) legal.

On this latter point he writes the following:

  • While the company has received U.S. Patent No. 7,203,630 for AFIRS, the patent is currently under re-examination by the request of competitor Star Navigation Systems Group Ltd. (SNA-V). If any successful challenge in its validity is found, it will likely result in negative financial and operational consequences. Our understanding of the situation is that the re-examination request was not recognized by the Patent Office because it was improperly filed however a refiling is underway. The company has also filed a Statement of Defense and claim damages of $15 million, and has stated “that the case is without basis and that there is no merit to the infringement allegations.”

In closing, we note the title on the report, which sums up why we originally invested in the company and remain upbeat on AeroMechanical:

Disruptive Technology to Take on the World