Adacel: Interim result 2018

When Adacel reported its full-year result in August last year, its directors were upbeat about its growth outlook.

That confidence has been backed up with new air traffic control contracts in the US and Sri Lanka and, just last week, two further air traffic management contracts in Fiji and French territories Guadeloupe and Martinique. But the loss of an FAA field support contract in November, and the director share sales that proceeded it, continue to dampen the mood.

Adacel often has lumpy results, and this half was no different, with higher systems sales boosting revenue and pre-tax profit. Of bigger concern, though, instead of any set of half-yearly numbers, is whether the lost contract is an isolated event or the start of a trend. As we noted in Adacel adds up, falling out with the Federal Aviation Authority (FAA) is Adacel's biggest risk.

Let's be clear: even if the FAA wanted to displace Adacel it couldn't do so, as it lacks a viable alternative and the funding to do so. Adacel's moat took decades and many millions to dig so jumping it is far from easy.

But the FAA seems intent on penny-pinching where it can by outsourcing smaller, lower value aspects of simulator support to third parties. Adacel was once awarded this work directly but it's now being procured through competitive tender.

Adacel doesn't have a huge amount of this work to lose (we estimate 10% of total revenue), and we've heard the first outsourcing attempt hasn't gone well either, which explains why Adacel's handover date has been extended. The FAA does have a bad record for rushing decisions and eventually reversing them. But even so, this change could provide a marginal headwind into the future.

It's not all bad news though. Just as headwinds with the FAA are increasing, Adacel's ability to win work from other government departments and countries is improving, as the French, Fijian and Sri Lankan contract wins attest. And some large contracts are still outstanding, such as the $72m NASA Simlabs contracts and the two remaining French territories (New Caledonia and Reunion Island).

Even with a slight setback, we still see a bright future for Adacel, but we think it's prudent to reduce our buy price to $2.00 to build in more margin of safety. 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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