Tuesday, 17 November 2009

Hugh Cleland's Comprehensive View of AeroMechanical

Dear Readers:

This is an unusual blog in that all I'm doing is introducing an unedited note that Northern Rivers Funds Executive Vice President and Portfolio Manager, Hugh Cleland, wrote on Nov. 16th.
Mr. Cleland's note followed AeroMechanical's announcement that it had entered into an agreement to raise up to

$ 8 million through a brokered private placement.
Here it is:


I got what I wanted from the NBAA conference, and now the L-3 agreement has transformed the company’s prospects.

In the last letter, I promised a more detailed review of AeroMechanical this month. Before I get into the recent developments, I want to remind investors what AeroMechanical does, and why I have long believed that its business model is among the best out there.

What they do: AeroMechanical provides a communications node on an airplane (a "blue box") which interfaces with the voice and data streams generated on the airplane (by the aircraft’s sensors, crew, etc.,), and transmits this information to the ground in real-time (if desired) where it is distributed to the appropriate end-users in usable form. Their systems allow airlines (and aircraft fleets of any kind) to monitor and manage operations’ cost, performance and safety anywhere, anytime, and in real-time.

Why their business model is fantastic: once one of their "blue boxes" is installed on an aircraft, it generates monthly revenue in the $1,000-$4,000/month range, every month for the life of the aircraft. Generating high-margin, monthly revenue from a low-cost piece of equipment installed on a long-life asset? It doesn’t get much better than that. Barriers to entry are enormous, as anyone who has tried to have flight-systems-interfaced equipment certified for installation on a plane can attest. AeroMechanical is currently the only commercial provider of the bundled equipment and services they supply, and their estimated 5-year-plus head-start on the current competition (which has, at best, partial-solutions in relation to AeroMechanical) has likely become permanent because of their agreement with L-3 (because of L-3’s estimated 75% market share in the flight-data-recorder, or "black box", market).

In order of importance, the recent developments include:

1) L-3 agreement: L-3 has over 3,000 customers for its "black boxes", and has an installed base of about 50,000 planes. AeroMechanical has about 30 customers for its "blue boxes", and an installed base of about 200 planes. These customer and installed base statistics provide a useful context for an excerpt from the November 6, 2009 press release: "AeroMechanical Services Ltd. ("AMA") announced today it has signed an agreement with the Aviation Recorders division of L-3 Communications to sell AMA's real-time data communications and internet data delivery solutions for aircraft. Together with L-3's Flight Recorder and Electronic Flight Bag products, these AMA product and service solutions offer customers the ability to receive, record, store, monitor, transmit and analyze critical aircraft flight data, in real time when necessary, to improve both cost-effective aircraft performance and operational safety.

These AMA solutions are marketed under the brand FLYHT, in conjunction with L-3's industry leading line of Flight Data Recorders (FDRs), commonly referred to as aircraft "black boxes." The agreement provides for a reselling and teaming arrangement under which L-3 will offer aircraft manufacturers and civil aviation end users a bundled total system solution to provide for the economical accessing of analytical data that a FDR records via real-time data streaming, from anywhere and at any time around the world. Additionally, AMA will be the exclusive provider to L-3 of Iridium-based real time data communications and internet data delivery solutions including AMA's fuel and emissions management solutions. The team will offer customers multiple commercial options to facilitate purchasing decisions."

The significance of this agreement becomes readily apparent when one builds a discounted cash flow (DCF) model around simply this one area of AeroMechanical’s business. Even using conservative assumptions (no L-3 partnered sales until the second half of 2010, only 25% of L-3’s black box sales from that point on will be bundled with AeroMechanical’s "blue box", lower equipment sales margins to AeroMechanical), we could see AMA’s installed base on a trajectory (from today’s 200) to over 3,000 planes by the end of 2012, and 2012 cashflow in the neighbourhood of $50million. To state the obvious: December 2012 is only three years and one month away. Cashflow like that from a business model like AeroMechanical’s would warrant a stock price somewhere in the $4-$8/share range within three years.

2) Acquisition of the assets of Wingspeed Corporation: For US$250,000, AeroMechanical acquired the assets of Wingspeed, a bankrupt company which was the closest thing to competition that AeroMechanical had. AeroMechanical is assuming five customer contracts, which include equipment installed on fifty one aircraft, and a backlog of 110 aircraft for which equipment had yet to be shipped. The easiest back-of-the-envelope way to look at this transaction is that AeroMechanical acquired 51 more planes for their installed base for an average acquisition cost of $4,900/plane. When one realizes who Wingspeed’s customers are, 3
and the potential to upsell them to afirs™ and UpTime™, it is difficult not to get even more excited.

3) NBAA Conference: NBAA is the National Business Aviation Association. I had a full day and a dinner at the conference on October 21. The main reason to attend the conference was to have dinner with the director of aircraft maintenance and engineering for NetJets Europe. This was an important contact to make because entry into the business jet market has long been held out as an important leg in AeroMechanical’s future growth, with—for example—NetJets alone having a fleet of over 700 business jets. The dinner was more than worth it, as I discovered that—although there are no firm contracts or timeframes as yet—AeroMechanical plays a pivotal role in NetJets Europe’s business plan over the next ten years, starting next year.

So…with the completion of the financing announced today, and the L-3 agreement and acquisition of Wingspeed cementing AeroMechanical’s position as the dominant force in real-time transmission of mission critical operational/ maintenance/safety information in the aviation industry, and (finally!) clear visibility to strong and accelerating cashflow generation, AeroMechanical’s role in our portfolios as a "core" position is assured for years to come.