If all you knew about Adacel Technologies was its share price history, you might think it was a lucky gold explorer.
For the better part of two decades, the stock limped along at a fraction of its listing price – until it ‘struck gold’ in 2015, leaping tenfold to all-time highs, ahead of delivering the best profits in its history.
Despite appearances, Adacel is not a gold explorer. It’s an air traffic software business and a very good one at that. But even though share prices paint an incomplete picture they leave important clues.
In Adacel's case, its inconsistent history suggests it is an unreliable business, rendering its current 17.5 times forward earnings price tag far too high. Seasoned investors also appreciate that stocks that have had a big price surge typically go on to have a breather, or worse (and with egg on our face from our initial Buy recommendation on GBST Holdings, don't we know it).
Transitioned to a recurring revenue model
A wide moat around the ATC simulator business
SPEC BUY, below $2.50
While we appreciate the wisdom behind this conventional thinking, we also appreciate its shortcomings.
As we are about to explain, Adacel's business has been revamped and this has unlocked its true potential. With a wide moat protecting its economic castle from competitors, and some credible growth opportunities, Adacel is reasonably priced even after its price surge.
For risk-tolerant investors, an opportunity awaits.
Before we get to how Adacel has changed, we must first understand its two businesses. To do so, let’s start with the high-pressure world of air traffic control.
Air traffic controllers are responsible for safely directing the flow of air traffic in and out of airports. It's is a highly stressful occupation that requires quick decision-making under pressure. An environment that makes on-the-job training of new controllers impractical, so simulators are used instead.
Adacel is the leader in the North American air traffic control simulator market, supplying Maxsim, its flagship simulator, to airports and training academies. This business contributes around two-thirds of total revenue.
Maxsim can be installed on regular computers right through to life-size replicas of air traffic control towers. There’s nothing special about the off-the-shelf hardware Maxsim uses. The magic is in its intellectual property.
The making of a moat
After a few decades, and more than $100m of client and company-funded research and development, Adacel has built 3D software models of many commercial and military airports. The level of detail is impressive, spanning runways, supporting infrastructure and neighboring properties right down to the runway paint and navigation lights on the tarmac.
On top of the physical environment, Adacel has simulated weather patterns and adverse events to test air traffic control students under many real-world scenarios. It's like a very expensive video game.
Replicating this would be no easy feat, as a competitor would need deep pockets and special access to many airports. What incentive does an airport have to allow a start-up to map out its airport the second time around?
Adacel built the first simulator prototypes for the Federal Aviation Administration (FAA) decades ago. Since then it has cemented itself as the market leader with a market share of which even the Microsoft of yesteryear would be proud.
Maxsim is used in 83% of the schools that provide the initial training (known as air traffic collegiate training initiative schools (AT-CTI)) and exclusively at the FAA Academy where training is completed. There have been some changes to the educational process mind you, but we’ll get to that later.
The installed base of around 350 simulators has an added benefit. Existing users like the FAA have a large sunk cost, estimated to exceed $100m, which is further encouragement for them to stay put.
Adacel’s other business provides air traffic management software called Aurora, which is used by employed air traffic controllers to direct actual flights in and out of airports. It’s hard to imagine software being more business critical.
Aurora is a satellite-based air traffic management system that is used in nine air traffic regions globally. In smaller regions like Fiji, Norway and the French region of Guiana, Aurora is solely responsible for managing the region’s flights. But in more developed areas, Adacel is too small to be considered as a prime contractor, so it partners with the majors (such as Lockheed Martin, Raytheon and Thales) to fill gaps in their capability.
The benefit of this software is that it is not easily changed, which allows Aurora to entrench itself with long-term contracts. This business contributes the remaining third of revenue.
So now we know that Adacel has a market-leading air traffic control simulator business, and a strong air traffic management business. But what explains the step change in performance?
Adacel made two important changes to its business. The first was repositioning from a service to a software business.
Instead of offering bespoke development for one client, Adacel packaged its IP into software modules (including Aurora and Maxsim) and focused on selling them numerous times.
Because the incremental cost of software is very close to zero, selling the same product repeatedly results in growing margins, which helped boost operating margins (before depreciation and amortisation) from 7.5% in 2013 to 25% in 2016.
The most important change, however, was with the structure of its contracts.
Adacel’s initial model generated upfront revenue (comprised of the sale of hardware and software licences) from each simulator sale. But from around 2011 onwards, Adacel began shifting away from the pure upfront model by adding a recurring maintenance component.
Like many licence-based software businesses, the maintenance component approximated 20% of the upfront cost, recurring annually, for software upgrades, maintenance, and support. But more importantly, because Adacel is the only provider that can provide the maintenance on the installed base, it entrenches a high-margin source of recurring revenue across a big network. In its maintenance contract document, the FAA even stated: “Adacel is the only company that can meet the FAA’s requirement because of the need for access to ASI’s proprietary software”.
The revenue change took a while to kick in. But by 2015 many contracts had been renewed, and the benefits were obvious in the reported financials. Adacel is now a much better business, with two-thirds of revenue now recurring.
Highly entrenched software can be a double-edged sword, as the benefit of high switching costs is often offset by poor growth potential. Adacel, though, has some other strings to its bow.
Most importantly, there's an interesting opportunity with airports. When an air traffic controller graduates from the FAA Academy, they are assigned to an airport for further study. The US has more than 400 airports, but less than 40 of these have simulators.
With such low capacity (and a hiring surge due to a Ronald Reagan induced anomaly), it’s no surprise that the waiting list to use a simulator is rumored to be between 12-18 months. The FAA is reportedly looking to increase its network of simulators, which could benefit Adacel handsomely.
Another opportunity is selling Maxsim to new users. With airports becoming busier, there is a greater need for more widespread offsite training. This could include other workers such as baggage and refueling staff, opening Maxsim up to a completely new market.
On the air traffic management side, a specific opportunity exists with the French Territories. Adacel already supplies Aurora for the French Guiana region, but a further four regions are yet to be awarded (including Martinique, Guadeloupe, New Caledonia and Reunion Island) and Adacel is well placed.
Lastly, after years of establishing its credibility, Adacel is now in a position to bid for contracts with NASA. A large, long-term contract opportunity exists, and Adacel has a chance of winning it because the incumbent has been deemed ineligible.
So what could upset Adacel's applecart? Well, a falling out with the FAA would be the biggest risk. Adacel's moat is wide, but its main US simulator competitor, UFA, Inc. has been getting its act together and it even dislodged Adacel from an AT-CTI school recently.
Changes to the educational process could also pose challenges. For decades, the path to becoming an air traffic controller involved training at an AT-CTI school before the FAA Academy. This all changed recently when the FAA started accepting candidates without AT-CTI study but had passed a biographical test instead, which attempts to assess their compatibility at the FAA Academy. The risk here is that the change de-emphasises the importance of the AT-CTI training altogether.
We understand that this change has proved so problematic that the FAA is moving back to the historical model, buts it's something to keep an eye on.
Dollars and sense
Which brings us to valuation. Adacel guided for $7.0-7.5m of pre-tax profit in the year to June 30, 2017, a 33% downgrade on 2016 due to timing issues with the award of lumpy contracts. However, with this financial year all but done, earnings in the 2018 financial year are likely to be a better valuation indicator. On that basis, Adacel is trading on an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) ratio of 12 and a price-earnings multiple of 18.
For a business of Adacel’s quality, that’s not expensive.
But it's worth remembering that earnings can be volatile because Adacel derives roughly one-third of its revenue from lumpy contracts. This keeps many short-term investors away because an earnings downgrade is always one contract delay away. But that also works in reverse, and for a business with Adacel's dominance, it's a risk we're willing to take.
Bearing in mind the risks, though, the recommendation must be deemed speculative and we recommend keeping your portfolio weighting below 3%. It's also a relatively small and illiquid stock, so we'd recommend patience when building a position. We're starting off with a buy price of $2.50 and we urge you not to go much beyond that. With all that said, we're upgrading Adacel to SPECULATIVE BUY.