Adacel: flying low

Until recently, there was more technology in the pockets of American air travellers than in the systems guiding their planes. Despite advancements in GPS, satellite and internet technology, US airspace was still controlled by 1970s-era technology.

This harrowing thought for the aerophobic provides an insightful view of the industry.

Not only are air traffic management (ATM) systems incredibly difficult to replace – it took the Federal Aviation Authority (FAA) 12 years and many billions to do so – but their value is increasing.

That's because the service they provide becomes more important with more planes in the sky. But instead of laying that onto employees' shoulders, software is doing the heavy lifting. The FAA's new ATM system allows an individual air traffic controller to oversee 73% more flights.

The industry's growth is being eaten by software as Marc Andreessen suggests, providing opportunities for businesses like Adacel Technologies.

Incorporating inertia

Adacel plays a dual role in the industry: its simulation software is used to train air traffic controllers (generating about 58% of revenue in the 2017 financial year) and its ATM software directs real-world flights (generating the other 42% of revenue). Both are hard to replicate and difficult to replace.

Adacel's ATM software manages a growing slice of the world's airspace. Developed countries like the US don't trust an Australian small cap to manage their airspace, favouring multinationals like Lockheed Martin instead. So Adacel subcontracts to the majors to fill their missing pieces of the puzzle. But smaller countries are more trusting, with the likes of Fiji, Portugal and the French colonies giving Adacel responsibility for managing their airspace.

The same inertia that kept the US to its antiquated system applies, as changing systems is as risky as it is costly, giving Adacel's ATM business high barriers to exit and an attractive recurring revenue stream.

The moat around its air traffic control (ATC) simulation business, which contributes the remaining 58% of total revenue, may be even wider – with a 90% market share in the preliminary training centres and total dominance of the FAA's training academy. The FAA said it best: 'Adacel is the only company that can meet the FAA's requirement because of the need for access to [Adacel's] proprietary software.'

The FAA is referring to Adacel's electronic replicas of many US airports, recorded from the tarmac and surrounding infrastructure right down to the paint that lines the runway, with simulated weather and adverse events thrown in for good measure. This intellectual property (IP) allows an air traffic controller to train for the airport of their choosing. The cost to replicate this IP is prohibitive, which entrenches Adacel in pole position.

Seat belts fastened

But despite carving an attractive niche, Adacel has experienced turbulence since we first upgraded it.

The market's confidence was rocked when directors sold shares. A signal that may not be negative but is certainly not positive.

Then its ATC simulation business lost a small FAA contract, which left earnings unharmed but signalled increasing frugality from its main customer. The worry is that this is an early symptom of a bigger illness. As we noted in our first review, ‘falling out with the FAA [is] the biggest risk'.

More recently, Adacel missed out on the juicy NASA Simlabs contract, which would not only have turbocharged its earnings but given it a seat at the big boys' table. The credibility boost of winning Simlabs could have set Adacel on course for managing prime airspace.

But even though the foregone opportunity swiped away its icing, Adacel still has a decent cake.

Onwards, and upwards?

Despite the negative appearance of losing an FAA contract, we have no reason to think we're in for a crash landing. The reality is that it would cost a fortune to replicate Adacel's IP and the benefits of doing so would be questionable.

It was disappointing to miss out on the NASA contract, but a growing industry creates new opportunities over time. It hasn't been all bad news, either.

Adacel has won numerous contracts in both its ATC and ATM businesses, including an expansion of its contract with NAV Portugal announced earlier today. This not only boosts its earnings but also dampens concerns about its low research and development (R&D) expenditure.

It's hard to say exactly how much Adacel spends on R&D so the concern is that it's not enough. We can easily see when Adacel spends its own money but distinguishing client-funded R&D from normal revenue is much harder. So contract wins provide comfort that Adacel is spending enough to ward off competitors.

The lower price means Adacel now trades on 14.7 times pre-tax profit, which is far from expensive for a business of its durability. The company is also unlikely to pay tax this year, and far into the future, due to an accumulation of tax assets from prior losses, which adds to its value. We remain comfortable with our $1.80 Speculative Buy price, but as usual we would wait for the price to settle below this level before upgrading. HOLD

Note: The InvestSMART Australian Small Companies Fund owns shares in Adacel. You can find out about investing directly in Intelligent Investor portfolios by clicking here.

Disclosure: The author holds Adacel via units in the InvestSMART Australian Small Companies Fund.

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