CPI AEROSTRUCTURES INC CVU S
October 21, 2011 - 4:36pm EST by
Woolly18
2011 2012
Price: 10.57 EPS $0.98 $1.08
Shares Out. (in M): 7 P/E 10.8x 9.8x
Market Cap (in $M): 75 P/FCF NM NM
Net Debt (in $M): 9 EBIT 10 12
TEV ($): 84 TEV/EBIT 8.4x 7.2x
Borrow Cost: NA

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Description

Short Thesis on CPI Aerostructures (ticker: CVU)

I recommend a short position in CPI Aerostructures (ticker: CVU): program delays and working capital requirements will necessitate a reduction in guidance/estimates and require the company to issue equity. These mutually exclusive events will drive the stock from $11 to $7 (35% return). While the company appears cheap, the aggressive use of accruals is masking the company's financial health and drastically misrepresents valuation. CVU is only $80mm in market cap, but trades roughly 20k shares daily and is easy-to-borrow. Short interest is only 1% of the float.

Key Investment Points:

  1. CVU's three largest programs (representing 50% of 2011E revenues) are at risk for delay or cancellation in the next 3-6 months. This should cause a 10% reduction to guidance/estimates and can potentially lead to a $30mm inventory write-off.
  2. $15-25mm of additional capital will be required to support growth. Program delays will only exacerbate this. With negative cash flow, the capacity to issue incremental debt will be reduced, and we believe equity will have to be issued. The company filed a shelf registration on July 26.
  3. The aggressive use of accruals distorts financial metrics, overstates profitability, and is masking a liquidity crisis. This is evidenced by 10yr cumulative EBITDA of $41mm vs. CFO of -17mm and CVU's 20% discount to peers on a P/E basis but 45% premium on an EV/Sales basis.

Brief Industry Overview: CPI Aerostructures is a supplier to aerospace and helicopter OEMs. Aero structures is a mediocre business - while secular trends have supported outsourced manufacturing from original equipment manufacturers (OEMs, ie. Boeing), the business requires a significant amount of working capital, especially in the early years of program development, and most companies fail to generate positive cash flow. Other industry participants include SPR, KAMN, AAR, LMIA, and DCO.

Company Overview: For nearly 10 years, CVU was a tiny operator in this fragmented industry, averaging $24mm in revenues from 2000-2008. Management changed its strategy several years ago to focus on subcontractor work. The goal was to transform CVU from a Tier III to a Tier II supplier, and they succeeded. Revenues were up to $44mm in 2009-2010, and are expected to be $74mm in 2011 and $95-98mm in 2012. The primary growth drivers are the A-10, E-2D, and G-650 programs (50% of 2011E revenues). For more details, please see the investor presentation http://www.cpiaero.com/ir.php.

A History of Guidance: Accompanying CVU's re-branding strategy as a growth company was lofty long-term guidance. In 2008 management initiated 3-year guidance calling for 2011 revenues of $78-81mm. Much changed in the last three years but until last quarter, CVU's 2011 guidance had not. Even after suffering a major program cancellation (T-38) in 2010, management was able to maintain long-term guidance. After 10 quarters, the streak was broken. Management finally revised 2011 revenues downward in 2Q11 but at the same time, increased 2012 guidance. However, the primary driver of the shift in revenues was a delay in receiving a Blackhawk contract and had nothing to do with CVU's three main programs.  Guidance is now $74mm for 2011 and $95-98mm for 2012 (from $78-81mm for 2011 and $88-91mm in 2012). Driving the growth is the "expectation that [CVU's] three major long-term production programs (A-10, E-2D, and G650) will be in full scale production" (a comment made in nearly all of the company's previous releases).  

From our standpoint, we only see two ways guidance can be achieved: 1) core programs remain on track, or 2) accruals will be used to mask the shortfall.

Investment Point #1: Program Delays Will Necessitate a Reduction in Guidance/Estimates

CVU's three largest programs, representing 50% of 2011E revenues, are materially at risk due to system wide program delays, which will necessitate a further reduction in guidance/estimates beyond what was done in Q2. With one exception, these are not issues inherent with the company but are due to either manufacturing issues with the OEM or funding issues with the DOD (ie. they are out of the company's control).  I expect the timing of this to occur either on the Q3 or Q4 earnings calls. Here is a brief revenue model to put programs in context:

Program ($mm)

2010 Sales

%

2011E Sales

%

A-10

15.4

35%

17.0

23%

E-2D

11.9

27%

13.0

18%

G650

4.4

10%

5.0

7%

C-5

6.5

15%

6.5

9%

All Other Programs

5.8

13%

32.5

44%

Total Revenue

44.0

100%

74.0

100%

 

A-10 Program

The primary driver of guidance revision should be a delay in the A-10 program. In 2009, CVU won a subcontract from Boeing to provide various wing structures as the planes are refurbished. The program generated $15mm of sales in 2010 (35% of total) and is expected to generate $17mm of sales in 2011 (23% of 2011 sales guidance). While its relative contribution is declining, it is still the company's most important program.

The A-10 issues began to surface on May 6 when Kaman (ticker: KAMN), another A-10 supplier, announced during its earnings call that the entire A-10 program had been shifted to the right. Kaman is a much larger aero structures company that has similar content on the A-10 program. A-10 revenues were expected to be $2.5mm in 2010 and were expected to ramp to $12.5-17.5mm (per the Jefferies KAMN initiation dated 10/19/10). Here are key excerpts:

 

  • May 6 Earnings Call: "We're working with Boeing as they've shifted that to the right and that's having a fairly significant impact, quite frankly." KAMN CEO
  • May 6 Earnings Call: "Our prior outlook would have included sales of around $5 million and profits of...$2 million...shifted to the right." KAMN CFO
  • May 9 Press Release: "While we do not disclose the profit level of individual programs, the A-10 program, being aerostructures build-to-print work, is expected to have an operating profit margin below that of our Aerospace segment average"

CVU's stock actually increased in the 10 days immediately following KAMN's release indicating to us that investors are not properly discounting the risk to this program. Part of this is because CVU has not been notified by Boeing of a delay and is proceeding according to plan.

So is the A-10 delay a KAMN problem or program-wide problem?

My channel checks confirm that this is an entire program delay and not company specific. This was confirmed by Kaman, Boeing, and Korea Air Lines (who is also a supplier to the A-10). There are no press releases from either Boeing or Korea Air Lines since it is a small program for both. The nature of the delay stems from the original manufacturer Fairchild, who was acquired by Northrop 20+ years ago. As is often the case with aircraft programs, engineering changes are made as manufacturers climb the learning curve. Boeing had expected all of the A-10 wings to be structurally equivalent but that turned out to be far from the case. Therefore, it is taking Boeing a longer time to remove the wings and engineer their replacements.

Bloomberg News wrote a September 27 article on the delay. http://www.bloomberg.com/news/2011-09-27/boeing-s-other-delay-new-wings-for-the-warthog.html. Several key highlights include:

  • the program has been delayed for 10 months and Boeing has yet to deliver a completed wing
  • the contract is fixed-price, meaning Boeing (and suppliers) are at risk for the delays and subsequent cost overruns
  • the Senate Armed Services committee has cut the program's FY12 funding from $145mm to $0mm because of the delays

Amazingly, CVU stock is +12% while the Russell is +6% since the article's release. We believe most of the reason the stock has not reacted is because Boeing has still not notified CVU of a production delay.

This begs the question: if it is a program wide delay, why would Boeing notify Kaman and Korea Air Lines to halt production but not CVU? This remains the key controversy and while it is not easy to answer, I see three potential scenarios, none of which bodes well for CVU:

1) Full A-10 Delay. Boeing will announce a similar delay to CVU in the near-term. If we assume KAMN had 33% of their revenues pushed out ($5mm of $15mm expected using Jefferies mid-point), then CVU should expect reductions of $5.6mm to revenue, $1.1mm to EBITDA, and $0.11 to EPS. For simplicity, I am assuming average margins and no operating leverage. The $0.11 represents 6% of the midpoint of 2012 net income guidance. This is different than the $5-7mm reduction we already saw in 2011 revenue guidance, which was driven by the Blackhawk program.

2) Partial A-10 Delay. Boeing will renegotiate CVU's contract and we believe this will maintain the delivery schedule but reduce the profit margin. There are several issues at stake: a) relief an OEM would seek from suppliers during delays, which is an industry norm (especially since Boeing is operating under a fixed-price contract), b) additional relief an OEM may seek if it believes suppliers are over-earning, and c) inventory risk. Boeing has the negotiating leverage on items a & b, especially given the comments KAMN made on its Q2 call (and later redacted in a press release), implying a 40% profit margin. It is unclear which statement is correct, and it's possible that both can be (ie. gross margin vs. operating margin). The interesting part is the amount of time KAMN spent addressing this issue when A-10 only represents 1% of revenues (relative to CVU's 23%). An explanation is that perhaps it represents a disproportionate amount of profit. My sense is that Boeing was planning on approaching CVU to cut production when the margin data was released by KAMN. Assuming that CVU would naturally push-back, Boeing used this as leverage in its negotiations. Trading revenues for profits has a negligible financial impact. However, from an aesthetics standpoint, CVU has been pitching growth and we believe it would sacrifice profits (since they are paper and not cash due to percentage-of-completion accounting) for revenues. Assuming production is cut at 50% the rate of KAMN's and margins are reduced 20%, it would result in a $2.8mm revenue reduction ($17mm x  33% x 50%), $1mm EBITDA reduction (($17mm x 19% EBITDA margin) less ($14.2mm x 15% EBITDA margin)) and $0.10 to EPS. There is also significant risk with CVU's completed but not delivered A-10 inventory (we discuss this in detail later on). From a leverage standpoint, we would almost always side with the OEM in this situation.

3) No Delay. Boeing allows CVU to continue full-rate production. Why would they favor CVU over Kaman or Korea Air Lines? 1) Due to the relative importance of the A-10 program to CVU, and 2) the other suppliers have the balance sheets to afford a delay, whereas CVU does not. The financial impact of this scenario gets complicated and is determined by who is going to absorb the risk. Boeing could theoretically take delivery of CVU's A-10 components and pay them, but recent commentary indicates Boeing is refusing to do this. This would have no earnings or cash flow impact from CVU's current plan but would require working capital from Boeing. While it would be small relative to the overall company, Boeing is highly focused on cash generation given the production cycle on its commercial aircraft programs. Another outcome would be for Boeing to tell CVU to continue production but will delay payment and we have early indications that this is happening. This creates an accrual called unbilled receivables (discussed in detail in the next section), which would enable CVU to maintain its guidance but starve the company of cash and create at-risk inventory.

E-2D Program

The second program that remains at risk is the E-2D program. CVU is a subcontractor to Northrop Grumman and generates $13mm of 2011E revenues (18% of total). On July 27, Northrop reported Q2 earnings and missed revenue estimates. Northrop's Aerospace segment had a 10% sales decline and attributed this to the E-2D program and another program (that CVU is not associated with). While this is mainly a timing issue, it is another incremental data point that this contract is particularly lumpy and CVU's guidance is at risk (if Northrop is unable to predict its contract timing, how can CVU?). Most important, E-2D is one of the few programs producing positive cash flow so it has further implications on the need for capital. Northrop received an E-2D contract on July 22 so we expect that the program remains funded but behind schedule. Since it appears as though Northrop was a quarter late in receiving funding, we expect at a minimum CVU will experience the same delay but given the timing of subcontract awards, this could be a two quarter delay. More importantly, on the Q2 earnings call, CVU's CEO highlighted this program as being at risk from a budgetary standpoint. As one of the DOD's growth programs, E-2D has a target on its back given the budgetary environment.  

"Of all the built ones we have, the only one I see having a potential vulnerability to any great extent is the E-2D. And so if they push it out a little and instead of delivering $12 million, $15 million a year in revenue, we only deliver $4 million or $5 million. Okay, my revenue has gone down $10 million."  CVU CEO Q2 Earnings Call

A $10mm hit to this program would cost nearly $2mm of EBITDA and $0.20 to EPS.

G-650 Program

The third program that remains at risk is the G-650 program. CVU is a subcontractor to Spirit Aerosystems (ticker: SPR) who in turn is a subcontractor to General Dynamics (ticker: GD). While the G650 only generates approximately $5mm in 2011 revenues for CVU (7% of total), it accounts for roughly 20% of 2012 revenue growth. Most importantly, it is expected to be a near-term contributor to positive cash flow. Again, this program needs to proceed according to plan in order to achieve this guidance and we have evidence that is not. First a test aircraft crashed earlier this year, which delayed flight testing and could increase risk to certification. GD said during its September investor day that it still expects to complete certification and delivery by the end of this year, but on the margin this is a risk. Second, SPR is now expecting lower margins on the program than it initially planned. This was disclosed in August on SPR's Q2 earnings call. We expect SPR to recapture some of its lost margin from subcontractors including CVU. Since the program was expected to be a near-term cash contributor, these issues will likely have ramifications for capital requirements.

Why Are Delays Significant?

Delays have two effects on a CVU's valuation and risk profile. First, as programs get pushed out, both guidance/estimates will be reduced as discussed above. Second, the use of accruals for aero structures companies creates sizable risk from an inventory standpoint. The T-38 cancellation in 2010 is a perfect case study. Management chose to announce the cancellation of the program during its 4Q10 earnings call. Revenue guidance for 2010 was $51mm and actual was $43mm, with the miss due to the T-38. The Department of Defense (DoD) was supposed to order 10 lots of production but instead cancelled after 9. The lost lot was worth $5 million of revenue to CVU. However, instead of producing 9 Lots, CVU had already been working on Lot 10 and had already booked it as revenues and profit (creating an unbilled receivable that we detail in the next section). The T-38 program was supposed to end the following year anyway and management maintained 2011 guidance, but despite this, the stock fell from $15 to $12 (-20% on the news). Therefore, if a similar revenue cut is made to the A-10 program (which has years ahead of it), we believe the stock reaction could be even higher.

Buying Time....

Ultimately, we expect the program delays to serve as a minor cut as to what we see as massive internal bleeding. This dates back to 2008 when CVU made the strategic decision that it wanted to be a growth company. Aside from winning new business, the company had to "prove" to Wall Street that the numbers would follow. So, it embarked on an aggressive path of percentage-of-completion accounting. We discuss this in detail in the next section. On the Q2 call, management lowered 2011 guidance and subsequently raised 2012 guidance. The justification was "some anticipated contract awards have been delayed by a customer." Additionally management stated in the release:

"As a final piece of the guidance discussion, we expect third quarter revenue for 2011 to be the lowest revenue quarter of the year, while the fourth quarter will be the highest revenue quarter in CPI Aero's history, and by a significant margin. While we don't typically issue quarterly guidance, we feel it is important to point out the revenue level expectations for these quarters, as the revenue timing is somewhat different than it has been historically. This is simply due to the timing of deliveries, and the requirement to purchase materials to coincide with these delivery schedules."

We believe this is indicative of management's aggressive A-10 production schedule and the lack of progress payments Boeing is making due to the change in program specifications and issues surrounding completed inventory. In essence, since the A-10 program is burning cash for CVU and since Boeing has stopped making progress payments, we believe production had to slow in Q3 to buy the company more time to shore up its financing needs. This is supported by new language in CVU's Q2 10Q: "The effect of these conditions on the Boeing contract has resulted in the $9.3 million increase in costs and estimated earnings in excess of billings and had a material impact on our liquidity."

The last interesting point to note is that despite this, CVU is still booking peak A-10 revenues ($17mm annually) despite the fact that Boeing has yet to deliver a completed shipset and Kaman does not expect full rate production until 4Q12.

"We expect to deliver 10 ship sets in 2011, and full rate production for this program to begin in the fourth quarter of 2012, with an average of approximately 47 ship sets being delivered per year." Kaman Q2-10Q 6/30/11

How can one supplier operate at full-rate production the entire year while another expects it to occur in 4Q12? That leads us to the wonderful world of accruals....

 

Investment Point #2: CVU Will Need to Issue Equity in the Next 6-Months

I expect CVU will need to raise $15-25mm of capital in the next 6-months to support working capital requirements and the outcome of expected program delays will only seek to increase this requirement. Since the company has never produced meaningful positive cash flow, I do not believe the debt markets are a viable option to fund the full requirement. CVU filed a shelf registration in Sep-09 and issued equity in Mar-10 to support its growth initiative. The company filed another shelf registration on July 26...

At first glance, it seems counterintuitive for a company with only $9mm of net debt that is expected to generate $15mm of EBITDA this year to need capital. This underscores the poor cash flow characteristics of the industry and the aggressive use of accruals allowable under percentage-of-completion (POC) accounting. These two attributes enable CVU to have reported cumulative EBITDA of $41mm from 2000-2011 YTD, while generating -17mm of CFO.

A Brief Overview of Industry Cash Flow Dynamics: The cash flow distribution of an aero structures company is highly asymmetrical with positive distributions heavily weighted in the back end (if ever). Most of this is just the nature of the industry as large upfront investments in tooling, machinery, and inventory need to be made in the early years of a program's life cycle, and cash flow is only received when deliveries are made in the later years. Despite this, revenues and earnings are booked in the process based on a company's estimate of the total cost of a program. Any time an adjustment is made to that estimate, a positive or negative cumulative catch up is made. If you are looking for more information, the 10k has a decent amount of disclosure (section title: "We use estimates when accounting for contracts"). Additionally, Bank of America - Merrill Lynch usually puts out an annual primer on Aerospace that includes an accounting section that provides further detail. 

Aggressive Use of Accruals Puts the Company At-Risk and Will Require Additional Equity

We believe management is aggressively using accruals in order to maintain a growth schedule consistent with its guidance. The accrual in question is "unbilled receivables" which are revenues the company has booked but has not yet billed the customer for. To put this in perspective, let me use a corny analogy:  Imagine you own a bakery shop and every morning you bake a dozen cupcakes. As soon as they come out of the oven, you book them as revenue because you already bought the ingredients and you finished making them. So your books would show revenue and profit for a dozen cupcakes, even though the store has yet to open for the day. Eventually customers come in and give you cash for the cupcakes but what happens if at the end of the day, you have three cupcakes left over? You have already booked the revenue but the cupcakes are going to be stale. Hold on to that thought...

While unbilled receivables are a common account in aero structures, the degree to which this account has funded CVU's growth is alarming and raises several red flags.

Red Flag #1: CVU is booking a significant amount of revenue for work it has not yet been contracted to complete nor is it billing the customer for the work. Over the last five years, unbilled receivables have averaged 115% of LTM revenues and 95% of NTM revenues. While the practice is aggressive, it has remained consistent over time.

($mm)

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Jun-11

5yr Avg.

Unbilled Receivables

28.4

28.8

31.2

37.9

43.0

47.2

60.8

 

LTM Revenues

25.5

17.9

28.0

35.6

43.9

44.0

53.9

 

% of LTM Revenues

111%

161%

111%

106%

98%

107%

113%

115%

% of NTM Revenues

159%

103%

88%

86%

98%

N/A

N/A

95%

 

There is such a thing as a "normal" amount of unbilled receivables in this industry. Figuring out what that is remains difficult since there are few companies that are pure plays in aero structures and employ P-O-C accounting (vs. units of delivery). However, an analysis of the account for LMIA, DCO, and KAMN, reveals it remains less than 1% of sales. I have seen companies reach as high as 80% but not for prolonged periods of time.

 

Red Flag #2: EBITDA and CFO have no resemblance mostly due to unbilled receivables. From 2005-2011 YTD, the company generated $21mm of EBITDA but $-16mm of CFO. The $37mm difference is almost entirely attributable to growth in unbilled receivables. Looking at 10 years of data, cumulative EBITDA is $41mm and CFO is $-17mm. This overstates CVU's valuation and is the primary reason the company trades at a 20% discount to peers on a P/E basis but a 45% premium on an EV/Sales basis. 

Cash Flow Analysis

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Jun-11

Cumulative

EBITDA

2.9

-1.7

3.3

4.1

6.5

1.1

4.4

20.5

Cash from Operations

-0.7

-1.0

-1.4

-2.8

0.7

-4.0

-7.2

-16.4

Difference

3.5

-0.7

4.7

6.9

5.8

5.0

11.6

36.9

                 

Growth in Unbilled Rec.

2.4

0.4

2.4

6.7

5.2

4.1

13.7

34.9

 

Red Flag #3: If unbilled receivables are used to support growth, why do they grow if revenues decline? Unbilled receivables have grown every year, even in years when revenues declined. We would expect a normal level of growth in unbilled receivables as revenues grow but we would expect the same as revenues decline. In 2005 and 2006, revenues declined by 16% and 30%, yet unbilled receivables grew in both years.

($mm)

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Jun-11

Change in Unbilled Receivables

2.4

0.4

2.4

6.7

5.2

4.1

13.7

% Change

9%

1%

8%

22%

14%

10%

29%

Change in Revenues

-4.7

-7.6

10.1

7.6

8.3

0.1

10.9

% Change

-16%

-30%

56%

27%

23%

0%

22%

 

Red Flag #4: CVU is exposing itself to a significant amount of at-risk inventory. As CVU produces the unbilled receivables, the goal is to eventually get the order, and deliver the product to the customer. But what happens if the customer changes the scope of the program or even worse, if the program is cancelled (back to the analogy, what happens if the cupcakes go stale)? For example, when the DoD halted production of the T-38 at Lot 9 in 2010, CVU had already been working on Lot 10. CVU therefore had to take a $4.5mm charge.  Despite the fact that this program was supposed to end the following year anyway, and management reiterated 2011 and 2012 guidance, the stock still dropped 20% on the announcement. From my conversations with industry experts, the inventory risk should be borne by the OEM, but that only assumes the subcontractor is producing according to schedule. Based on the use of accruals and the rate of production CVU has maintained (compared to KAMN) it is most certainly has excess inventory. This issue has started coming to fruition with new language in the 2Q 10Q.

 "Although this contract does provide for milestone billings, the Company has been limited in its ability to invoice Boeing because of the lack of performance by certain vendors. This has resulted in us not achieving certain milestone billing events. Additionally, the contract provides that we can't bill Boeing for approved changes to first articles until such time as the government approves the entire A- 10 wing. We have submitted all first articles on this program and are awaiting government approval of Boeing's complete submission. Lastly, a significant amount of production has been completed, however can't be shipped and invoiced, as we are awaiting a minor Boeing configuration change. The effect of these conditions on the Boeing contract has resulted in the $9.3 million increase in costs and estimated earnings in excess of billings and had a material impact on our liquidity."

We estimate CVU has $20-30mm of A-10 inventory that Boeing has stopped making payments for since it does not meet specification. Part of this is because the overall program's specifications have changed but part of it is because CVU's vendors have failed to perform. Since this is a fixed price contract, either Boeing or CVU will have to bear the cost to bring the inventory up to specification. Since Boeing has stopped making progress payments, it indicates to us they do not feel responsible. Therefore, CVU can either bear the cost themselves or try to fight Boeing. We would place our bets with the 800-pound gorilla.

 

Expect $20mm of Capital to Be Raised in the Next 6-Months

We have a hard time finding a scenario where CVU can generate positive cash flow until the end of 2012. Assuming the inherent nature of CVU's business requires them to front the cost for their customers (without billing them), this would indicate a $15-25mm build in working capital in the next three quarters to support management's growth projections. To arrive at this, I examine the relationship of unbilled receivables to LTM and NTM revenues, which have averaged 115% and 95% since 2005. If we use the 115% rate and apply it to the midpoint of 2012 revenue guidance of $97mm, we arrive at a 2012 year end unbilled receivable balance of $111mm, a $50mm build from current levels. Even though the account has showed no signs of improving Y-o-Y, we are still going to give management some credit for improving working capital. Our base case assumes unbilled receivables improve from 113% of LTM revenues on 6/11 to 84% by 12/12. Even though the company has never gotten anywhere near such low levels, this still requires a $21mm build in working capital.

 

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Jun-11

2011E

2012E

 

Unbilled Receivables

28.8

31.1

37.9

43.0

47.2

60.9

68.5

82.0

 

% of LTM Revenues

161%

111%

106%

98%

107%

113%

93%

84%

 

% of NTM Revenues

103%

88%

86%

98%

64%

71%

71%

N/A

 

So where can CVU get the capital from? The company has no cash, $7.8mm drawn on its revolver, and $2.2mm undrawn. Interesting to note, they increased the capacity of their $10mm revolver in September for an additional $3mm, but that only lasts through November 2011. Last March they raised $3mm in a registered direct to support growth. While they had the option of issuing term debt they thought the cost of issuing equity at under $8 was cheaper (stock is now $12). The company filed a shelf registration on July 26 for $20mm of securities. It would be difficult to think that in this environment, CVU could issue a significant amount of debt given its cash flow situation. Our conversations with industry participants believes the company's debt capacity can increase to $20mm. That essentially provides $12.2mm of additional debt capacity and our base case is at least a $21mm build in working capital. We believe the equity markets will have to be tapped for some of it.

Valuation

Valuation is difficult to think about given the inherent flexibility POC accounting affords aero structures companies. On an EBITDA and EPS basis, CVU appears cheap relative to the group -- SPR, AAR, LMIA, DCO and KAMN. I believe this is the case because SPR is aggressively overstating their earnings via accruals. That is why CVU trades at a 20% discount on a P/E basis, 14% discount on an EBITDA basis, but 45% premium on a sales basis (all 2012 consensus numbers).

 

Company

Mkt Cap

EV

P/E

EV/EBITDA

EV/Revenues

Spirit AeroSystems

$2,249

$3,295

7.3x

4.7x

0.6x

Ducommun Inc.

$148

$510

5.4x

5.9x

0.6x

AAR Corp.

$685

$1,103

8.1x

4.7x

0.6x

LMI Aerospace Inc.

$210

$203

9.3x

4.6x

0.7x

Kaman Corporation

$799

$922

12.6x

6.8x

0.6x

           

Average

 

 

8.5x

5.4x

0.6x

CPI Aerostructures Inc.

$75

$84

6.7x

4.6x

0.9x

(discount)/premium

   

-21%

-14%

45%

Based on consensus estimates, every $1mm reduction in EBITDA (from program delays), reduces the stock price by 6% and every ½ point of multiple contraction reduces it by 11%. For the purpose of this analysis, I assume Scenario #1 regarding the A-10 program (full delay), a one-quarter delay for the E-2D program, and no delay for the G-650 program. Based on this analysis, I would expect at least a $1.5mm reduction in EBITDA, and a ½ -pt reduction in the multiple to drive a $2.00/share reduction in the stock (17%). Additionally, I assume CVU issues $20mm of new capital. I assume that $10mm of debt is issued to bring the company's debt capacity up to $20mm and $10mm of equity is issued at $11/share. This dilutes the stock a further 10%.

Valuation Analysis

Current

Short-Thesis

Difference

2012 EBITDA

18.3

16.8

(1.5)

Multiple

4.6x

4.1x

-0.5x

       

Market Cap

75

50

(25.3)

Net Debt

9

19

10.0

Enterprise Value

84

69

(15.3)

       

Share Price

10.57

6.46

(4.1)

Shares

6.9

7.7

0.8

 

My expectation that the stock will drop to below $7 may prove to be conservative. Even at $6.46/share, CVU will trade at 0.72x revenues, a 20% premium to its peers' average of 0.60x. Should CVU trade in line with peers, which it should, the stock price would be $5.00.

Risk #1: Can Additional Awards Make Up the Difference if there are Delays?

This is a legitimate risk but we believe there is ample visibility in new awards. For example, management routinely talks about the bid pipeline (see page 18 of its investor presentation). The most near term contract award would be a $125mm award from Sikorsky (division of United Technologies, ticker: UTX), which management has talked about for months and has assigned a high probability of winning. We believe some of the positive news is captured in the stock price but do admit, the award would likely send the stock higher. However, there would be ample notification. First, DoD would need to award Sikorsky the OEM contract for Blackhawk. You can monitor this daily on http://www.defense.gov/contracts/. Additionally, after Sikorsky is awarded the contract, it would take 6-12 weeks for it to award its suppliers contracts. So an award to Sikorsky itself is not market moving but would give short-sellers a very adequate "heads-up."

I actually believe there is more negative risk in this award than upside to this contract. Management has pushed its timing expectation for the award from Q3 to Q4 and now to Q1 2012. The contract in question is for the Blackhawk Block 8 contract which is funded out of the FY12 defense budget. Since Congress has yet to pass the budget, the funds cannot be spent so we believe this is further risk to management hitting its 2012 guidance.

Risk #2: Industry Consolidation

There has been a decent amount of consolidation in the industry over the last several years. CVU has real estate on some valuable programs (particularly Blackhawk) that an acquirer might want access to. While we believe an acquisition could happen at some point, we do not believe it will happen in the next 12 months. First, we do not believe the company is attractive to a financial buyer. This is because of the negative cash flow the company generates and the $15-25mm of additional capital we believe the company needs to fund working capital. Second, several strategic acquirers have recently made large acquisitions and will not be back in the game for some time. This includes DCO and PCP. The company would certainly be much more attractive if it was cash flow positive. Since we do not believe this will happen until the end of 2012 and the timeline for our short-thesis is 6-months, we believe we are well protected.

 

Catalyst

1. Program delays or cancellations in the A-10, E-2D, or G650 programs.
2. Further growth in unbilled receivables.
3. Equity issuance.
    sort by    

    Description

    Short Thesis on CPI Aerostructures (ticker: CVU)

    I recommend a short position in CPI Aerostructures (ticker: CVU): program delays and working capital requirements will necessitate a reduction in guidance/estimates and require the company to issue equity. These mutually exclusive events will drive the stock from $11 to $7 (35% return). While the company appears cheap, the aggressive use of accruals is masking the company's financial health and drastically misrepresents valuation. CVU is only $80mm in market cap, but trades roughly 20k shares daily and is easy-to-borrow. Short interest is only 1% of the float.

    Key Investment Points:

    1. CVU's three largest programs (representing 50% of 2011E revenues) are at risk for delay or cancellation in the next 3-6 months. This should cause a 10% reduction to guidance/estimates and can potentially lead to a $30mm inventory write-off.
    2. $15-25mm of additional capital will be required to support growth. Program delays will only exacerbate this. With negative cash flow, the capacity to issue incremental debt will be reduced, and we believe equity will have to be issued. The company filed a shelf registration on July 26.
    3. The aggressive use of accruals distorts financial metrics, overstates profitability, and is masking a liquidity crisis. This is evidenced by 10yr cumulative EBITDA of $41mm vs. CFO of -17mm and CVU's 20% discount to peers on a P/E basis but 45% premium on an EV/Sales basis.

    Brief Industry Overview: CPI Aerostructures is a supplier to aerospace and helicopter OEMs. Aero structures is a mediocre business - while secular trends have supported outsourced manufacturing from original equipment manufacturers (OEMs, ie. Boeing), the business requires a significant amount of working capital, especially in the early years of program development, and most companies fail to generate positive cash flow. Other industry participants include SPR, KAMN, AAR, LMIA, and DCO.

    Company Overview: For nearly 10 years, CVU was a tiny operator in this fragmented industry, averaging $24mm in revenues from 2000-2008. Management changed its strategy several years ago to focus on subcontractor work. The goal was to transform CVU from a Tier III to a Tier II supplier, and they succeeded. Revenues were up to $44mm in 2009-2010, and are expected to be $74mm in 2011 and $95-98mm in 2012. The primary growth drivers are the A-10, E-2D, and G-650 programs (50% of 2011E revenues). For more details, please see the investor presentation http://www.cpiaero.com/ir.php.

    A History of Guidance: Accompanying CVU's re-branding strategy as a growth company was lofty long-term guidance. In 2008 management initiated 3-year guidance calling for 2011 revenues of $78-81mm. Much changed in the last three years but until last quarter, CVU's 2011 guidance had not. Even after suffering a major program cancellation (T-38) in 2010, management was able to maintain long-term guidance. After 10 quarters, the streak was broken. Management finally revised 2011 revenues downward in 2Q11 but at the same time, increased 2012 guidance. However, the primary driver of the shift in revenues was a delay in receiving a Blackhawk contract and had nothing to do with CVU's three main programs.  Guidance is now $74mm for 2011 and $95-98mm for 2012 (from $78-81mm for 2011 and $88-91mm in 2012). Driving the growth is the "expectation that [CVU's] three major long-term production programs (A-10, E-2D, and G650) will be in full scale production" (a comment made in nearly all of the company's previous releases).  

    From our standpoint, we only see two ways guidance can be achieved: 1) core programs remain on track, or 2) accruals will be used to mask the shortfall.

    Investment Point #1: Program Delays Will Necessitate a Reduction in Guidance/Estimates

    CVU's three largest programs, representing 50% of 2011E revenues, are materially at risk due to system wide program delays, which will necessitate a further reduction in guidance/estimates beyond what was done in Q2. With one exception, these are not issues inherent with the company but are due to either manufacturing issues with the OEM or funding issues with the DOD (ie. they are out of the company's control).  I expect the timing of this to occur either on the Q3 or Q4 earnings calls. Here is a brief revenue model to put programs in context:

    Program ($mm)

    2010 Sales

    %

    2011E Sales

    %

    A-10

    15.4

    35%

    17.0

    23%

    E-2D

    11.9

    27%

    13.0

    18%

    G650

    4.4

    10%

    5.0

    7%

    C-5

    6.5

    15%

    6.5

    9%

    All Other Programs

    5.8

    13%

    32.5

    44%

    Total Revenue

    44.0

    100%

    74.0

    100%

     

    A-10 Program

    The primary driver of guidance revision should be a delay in the A-10 program. In 2009, CVU won a subcontract from Boeing to provide various wing structures as the planes are refurbished. The program generated $15mm of sales in 2010 (35% of total) and is expected to generate $17mm of sales in 2011 (23% of 2011 sales guidance). While its relative contribution is declining, it is still the company's most important program.

    The A-10 issues began to surface on May 6 when Kaman (ticker: KAMN), another A-10 supplier, announced during its earnings call that the entire A-10 program had been shifted to the right. Kaman is a much larger aero structures company that has similar content on the A-10 program. A-10 revenues were expected to be $2.5mm in 2010 and were expected to ramp to $12.5-17.5mm (per the Jefferies KAMN initiation dated 10/19/10). Here are key excerpts:

     

    CVU's stock actually increased in the 10 days immediately following KAMN's release indicating to us that investors are not properly discounting the risk to this program. Part of this is because CVU has not been notified by Boeing of a delay and is proceeding according to plan.

    So is the A-10 delay a KAMN problem or program-wide problem?

    My channel checks confirm that this is an entire program delay and not company specific. This was confirmed by Kaman, Boeing, and Korea Air Lines (who is also a supplier to the A-10). There are no press releases from either Boeing or Korea Air Lines since it is a small program for both. The nature of the delay stems from the original manufacturer Fairchild, who was acquired by Northrop 20+ years ago. As is often the case with aircraft programs, engineering changes are made as manufacturers climb the learning curve. Boeing had expected all of the A-10 wings to be structurally equivalent but that turned out to be far from the case. Therefore, it is taking Boeing a longer time to remove the wings and engineer their replacements.

    Bloomberg News wrote a September 27 article on the delay. http://www.bloomberg.com/news/2011-09-27/boeing-s-other-delay-new-wings-for-the-warthog.html. Several key highlights include:

    Amazingly, CVU stock is +12% while the Russell is +6% since the article's release. We believe most of the reason the stock has not reacted is because Boeing has still not notified CVU of a production delay.

    This begs the question: if it is a program wide delay, why would Boeing notify Kaman and Korea Air Lines to halt production but not CVU? This remains the key controversy and while it is not easy to answer, I see three potential scenarios, none of which bodes well for CVU:

    1) Full A-10 Delay. Boeing will announce a similar delay to CVU in the near-term. If we assume KAMN had 33% of their revenues pushed out ($5mm of $15mm expected using Jefferies mid-point), then CVU should expect reductions of $5.6mm to revenue, $1.1mm to EBITDA, and $0.11 to EPS. For simplicity, I am assuming average margins and no operating leverage. The $0.11 represents 6% of the midpoint of 2012 net income guidance. This is different than the $5-7mm reduction we already saw in 2011 revenue guidance, which was driven by the Blackhawk program.

    2) Partial A-10 Delay. Boeing will renegotiate CVU's contract and we believe this will maintain the delivery schedule but reduce the profit margin. There are several issues at stake: a) relief an OEM would seek from suppliers during delays, which is an industry norm (especially since Boeing is operating under a fixed-price contract), b) additional relief an OEM may seek if it believes suppliers are over-earning, and c) inventory risk. Boeing has the negotiating leverage on items a & b, especially given the comments KAMN made on its Q2 call (and later redacted in a press release), implying a 40% profit margin. It is unclear which statement is correct, and it's possible that both can be (ie. gross margin vs. operating margin). The interesting part is the amount of time KAMN spent addressing this issue when A-10 only represents 1% of revenues (relative to CVU's 23%). An explanation is that perhaps it represents a disproportionate amount of profit. My sense is that Boeing was planning on approaching CVU to cut production when the margin data was released by KAMN. Assuming that CVU would naturally push-back, Boeing used this as leverage in its negotiations. Trading revenues for profits has a negligible financial impact. However, from an aesthetics standpoint, CVU has been pitching growth and we believe it would sacrifice profits (since they are paper and not cash due to percentage-of-completion accounting) for revenues. Assuming production is cut at 50% the rate of KAMN's and margins are reduced 20%, it would result in a $2.8mm revenue reduction ($17mm x  33% x 50%), $1mm EBITDA reduction (($17mm x 19% EBITDA margin) less ($14.2mm x 15% EBITDA margin)) and $0.10 to EPS. There is also significant risk with CVU's completed but not delivered A-10 inventory (we discuss this in detail later on). From a leverage standpoint, we would almost always side with the OEM in this situation.

    3) No Delay. Boeing allows CVU to continue full-rate production. Why would they favor CVU over Kaman or Korea Air Lines? 1) Due to the relative importance of the A-10 program to CVU, and 2) the other suppliers have the balance sheets to afford a delay, whereas CVU does not. The financial impact of this scenario gets complicated and is determined by who is going to absorb the risk. Boeing could theoretically take delivery of CVU's A-10 components and pay them, but recent commentary indicates Boeing is refusing to do this. This would have no earnings or cash flow impact from CVU's current plan but would require working capital from Boeing. While it would be small relative to the overall company, Boeing is highly focused on cash generation given the production cycle on its commercial aircraft programs. Another outcome would be for Boeing to tell CVU to continue production but will delay payment and we have early indications that this is happening. This creates an accrual called unbilled receivables (discussed in detail in the next section), which would enable CVU to maintain its guidance but starve the company of cash and create at-risk inventory.

    E-2D Program

    The second program that remains at risk is the E-2D program. CVU is a subcontractor to Northrop Grumman and generates $13mm of 2011E revenues (18% of total). On July 27, Northrop reported Q2 earnings and missed revenue estimates. Northrop's Aerospace segment had a 10% sales decline and attributed this to the E-2D program and another program (that CVU is not associated with). While this is mainly a timing issue, it is another incremental data point that this contract is particularly lumpy and CVU's guidance is at risk (if Northrop is unable to predict its contract timing, how can CVU?). Most important, E-2D is one of the few programs producing positive cash flow so it has further implications on the need for capital. Northrop received an E-2D contract on July 22 so we expect that the program remains funded but behind schedule. Since it appears as though Northrop was a quarter late in receiving funding, we expect at a minimum CVU will experience the same delay but given the timing of subcontract awards, this could be a two quarter delay. More importantly, on the Q2 earnings call, CVU's CEO highlighted this program as being at risk from a budgetary standpoint. As one of the DOD's growth programs, E-2D has a target on its back given the budgetary environment.  

    "Of all the built ones we have, the only one I see having a potential vulnerability to any great extent is the E-2D. And so if they push it out a little and instead of delivering $12 million, $15 million a year in revenue, we only deliver $4 million or $5 million. Okay, my revenue has gone down $10 million."  CVU CEO Q2 Earnings Call

    A $10mm hit to this program would cost nearly $2mm of EBITDA and $0.20 to EPS.

    G-650 Program

    The third program that remains at risk is the G-650 program. CVU is a subcontractor to Spirit Aerosystems (ticker: SPR) who in turn is a subcontractor to General Dynamics (ticker: GD). While the G650 only generates approximately $5mm in 2011 revenues for CVU (7% of total), it accounts for roughly 20% of 2012 revenue growth. Most importantly, it is expected to be a near-term contributor to positive cash flow. Again, this program needs to proceed according to plan in order to achieve this guidance and we have evidence that is not. First a test aircraft crashed earlier this year, which delayed flight testing and could increase risk to certification. GD said during its September investor day that it still expects to complete certification and delivery by the end of this year, but on the margin this is a risk. Second, SPR is now expecting lower margins on the program than it initially planned. This was disclosed in August on SPR's Q2 earnings call. We expect SPR to recapture some of its lost margin from subcontractors including CVU. Since the program was expected to be a near-term cash contributor, these issues will likely have ramifications for capital requirements.

    Why Are Delays Significant?

    Delays have two effects on a CVU's valuation and risk profile. First, as programs get pushed out, both guidance/estimates will be reduced as discussed above. Second, the use of accruals for aero structures companies creates sizable risk from an inventory standpoint. The T-38 cancellation in 2010 is a perfect case study. Management chose to announce the cancellation of the program during its 4Q10 earnings call. Revenue guidance for 2010 was $51mm and actual was $43mm, with the miss due to the T-38. The Department of Defense (DoD) was supposed to order 10 lots of production but instead cancelled after 9. The lost lot was worth $5 million of revenue to CVU. However, instead of producing 9 Lots, CVU had already been working on Lot 10 and had already booked it as revenues and profit (creating an unbilled receivable that we detail in the next section). The T-38 program was supposed to end the following year anyway and management maintained 2011 guidance, but despite this, the stock fell from $15 to $12 (-20% on the news). Therefore, if a similar revenue cut is made to the A-10 program (which has years ahead of it), we believe the stock reaction could be even higher.

    Buying Time....

    Ultimately, we expect the program delays to serve as a minor cut as to what we see as massive internal bleeding. This dates back to 2008 when CVU made the strategic decision that it wanted to be a growth company. Aside from winning new business, the company had to "prove" to Wall Street that the numbers would follow. So, it embarked on an aggressive path of percentage-of-completion accounting. We discuss this in detail in the next section. On the Q2 call, management lowered 2011 guidance and subsequently raised 2012 guidance. The justification was "some anticipated contract awards have been delayed by a customer." Additionally management stated in the release:

    "As a final piece of the guidance discussion, we expect third quarter revenue for 2011 to be the lowest revenue quarter of the year, while the fourth quarter will be the highest revenue quarter in CPI Aero's history, and by a significant margin. While we don't typically issue quarterly guidance, we feel it is important to point out the revenue level expectations for these quarters, as the revenue timing is somewhat different than it has been historically. This is simply due to the timing of deliveries, and the requirement to purchase materials to coincide with these delivery schedules."

    We believe this is indicative of management's aggressive A-10 production schedule and the lack of progress payments Boeing is making due to the change in program specifications and issues surrounding completed inventory. In essence, since the A-10 program is burning cash for CVU and since Boeing has stopped making progress payments, we believe production had to slow in Q3 to buy the company more time to shore up its financing needs. This is supported by new language in CVU's Q2 10Q: "The effect of these conditions on the Boeing contract has resulted in the $9.3 million increase in costs and estimated earnings in excess of billings and had a material impact on our liquidity."

    The last interesting point to note is that despite this, CVU is still booking peak A-10 revenues ($17mm annually) despite the fact that Boeing has yet to deliver a completed shipset and Kaman does not expect full rate production until 4Q12.

    "We expect to deliver 10 ship sets in 2011, and full rate production for this program to begin in the fourth quarter of 2012, with an average of approximately 47 ship sets being delivered per year." Kaman Q2-10Q 6/30/11

    How can one supplier operate at full-rate production the entire year while another expects it to occur in 4Q12? That leads us to the wonderful world of accruals....

     

    Investment Point #2: CVU Will Need to Issue Equity in the Next 6-Months

    I expect CVU will need to raise $15-25mm of capital in the next 6-months to support working capital requirements and the outcome of expected program delays will only seek to increase this requirement. Since the company has never produced meaningful positive cash flow, I do not believe the debt markets are a viable option to fund the full requirement. CVU filed a shelf registration in Sep-09 and issued equity in Mar-10 to support its growth initiative. The company filed another shelf registration on July 26...

    At first glance, it seems counterintuitive for a company with only $9mm of net debt that is expected to generate $15mm of EBITDA this year to need capital. This underscores the poor cash flow characteristics of the industry and the aggressive use of accruals allowable under percentage-of-completion (POC) accounting. These two attributes enable CVU to have reported cumulative EBITDA of $41mm from 2000-2011 YTD, while generating -17mm of CFO.

    A Brief Overview of Industry Cash Flow Dynamics: The cash flow distribution of an aero structures company is highly asymmetrical with positive distributions heavily weighted in the back end (if ever). Most of this is just the nature of the industry as large upfront investments in tooling, machinery, and inventory need to be made in the early years of a program's life cycle, and cash flow is only received when deliveries are made in the later years. Despite this, revenues and earnings are booked in the process based on a company's estimate of the total cost of a program. Any time an adjustment is made to that estimate, a positive or negative cumulative catch up is made. If you are looking for more information, the 10k has a decent amount of disclosure (section title: "We use estimates when accounting for contracts"). Additionally, Bank of America - Merrill Lynch usually puts out an annual primer on Aerospace that includes an accounting section that provides further detail. 

    Aggressive Use of Accruals Puts the Company At-Risk and Will Require Additional Equity

    We believe management is aggressively using accruals in order to maintain a growth schedule consistent with its guidance. The accrual in question is "unbilled receivables" which are revenues the company has booked but has not yet billed the customer for. To put this in perspective, let me use a corny analogy:  Imagine you own a bakery shop and every morning you bake a dozen cupcakes. As soon as they come out of the oven, you book them as revenue because you already bought the ingredients and you finished making them. So your books would show revenue and profit for a dozen cupcakes, even though the store has yet to open for the day. Eventually customers come in and give you cash for the cupcakes but what happens if at the end of the day, you have three cupcakes left over? You have already booked the revenue but the cupcakes are going to be stale. Hold on to that thought...

    While unbilled receivables are a common account in aero structures, the degree to which this account has funded CVU's growth is alarming and raises several red flags.

    Red Flag #1: CVU is booking a significant amount of revenue for work it has not yet been contracted to complete nor is it billing the customer for the work. Over the last five years, unbilled receivables have averaged 115% of LTM revenues and 95% of NTM revenues. While the practice is aggressive, it has remained consistent over time.

    ($mm)

    Dec-05

    Dec-06

    Dec-07

    Dec-08

    Dec-09

    Dec-10

    Jun-11

    5yr Avg.

    Unbilled Receivables

    28.4

    28.8

    31.2

    37.9

    43.0

    47.2

    60.8

     

    LTM Revenues

    25.5

    17.9

    28.0

    35.6

    43.9

    44.0

    53.9

     

    % of LTM Revenues

    111%

    161%

    111%

    106%

    98%

    107%

    113%

    115%

    % of NTM Revenues

    159%

    103%

    88%

    86%

    98%

    N/A

    N/A

    95%

     

    There is such a thing as a "normal" amount of unbilled receivables in this industry. Figuring out what that is remains difficult since there are few companies that are pure plays in aero structures and employ P-O-C accounting (vs. units of delivery). However, an analysis of the account for LMIA, DCO, and KAMN, reveals it remains less than 1% of sales. I have seen companies reach as high as 80% but not for prolonged periods of time.

     

    Red Flag #2: EBITDA and CFO have no resemblance mostly due to unbilled receivables. From 2005-2011 YTD, the company generated $21mm of EBITDA but $-16mm of CFO. The $37mm difference is almost entirely attributable to growth in unbilled receivables. Looking at 10 years of data, cumulative EBITDA is $41mm and CFO is $-17mm. This overstates CVU's valuation and is the primary reason the company trades at a 20% discount to peers on a P/E basis but a 45% premium on an EV/Sales basis. 

    Cash Flow Analysis

    Dec-05

    Dec-06

    Dec-07

    Dec-08

    Dec-09

    Dec-10

    Jun-11

    Cumulative

    EBITDA

    2.9

    -1.7

    3.3

    4.1

    6.5

    1.1

    4.4

    20.5

    Cash from Operations

    -0.7

    -1.0

    -1.4

    -2.8

    0.7

    -4.0

    -7.2

    -16.4

    Difference

    3.5

    -0.7

    4.7

    6.9

    5.8

    5.0

    11.6

    36.9

                     

    Growth in Unbilled Rec.

    2.4

    0.4

    2.4

    6.7

    5.2

    4.1

    13.7

    34.9

     

    Red Flag #3: If unbilled receivables are used to support growth, why do they grow if revenues decline? Unbilled receivables have grown every year, even in years when revenues declined. We would expect a normal level of growth in unbilled receivables as revenues grow but we would expect the same as revenues decline. In 2005 and 2006, revenues declined by 16% and 30%, yet unbilled receivables grew in both years.

    ($mm)

    Dec-05

    Dec-06

    Dec-07

    Dec-08

    Dec-09

    Dec-10

    Jun-11

    Change in Unbilled Receivables

    2.4

    0.4

    2.4

    6.7

    5.2

    4.1

    13.7

    % Change

    9%

    1%

    8%

    22%

    14%

    10%

    29%

    Change in Revenues

    -4.7

    -7.6

    10.1

    7.6

    8.3

    0.1

    10.9

    % Change

    -16%

    -30%

    56%

    27%

    23%

    0%

    22%

     

    Red Flag #4: CVU is exposing itself to a significant amount of at-risk inventory. As CVU produces the unbilled receivables, the goal is to eventually get the order, and deliver the product to the customer. But what happens if the customer changes the scope of the program or even worse, if the program is cancelled (back to the analogy, what happens if the cupcakes go stale)? For example, when the DoD halted production of the T-38 at Lot 9 in 2010, CVU had already been working on Lot 10. CVU therefore had to take a $4.5mm charge.  Despite the fact that this program was supposed to end the following year anyway, and management reiterated 2011 and 2012 guidance, the stock still dropped 20% on the announcement. From my conversations with industry experts, the inventory risk should be borne by the OEM, but that only assumes the subcontractor is producing according to schedule. Based on the use of accruals and the rate of production CVU has maintained (compared to KAMN) it is most certainly has excess inventory. This issue has started coming to fruition with new language in the 2Q 10Q.

     "Although this contract does provide for milestone billings, the Company has been limited in its ability to invoice Boeing because of the lack of performance by certain vendors. This has resulted in us not achieving certain milestone billing events. Additionally, the contract provides that we can't bill Boeing for approved changes to first articles until such time as the government approves the entire A- 10 wing. We have submitted all first articles on this program and are awaiting government approval of Boeing's complete submission. Lastly, a significant amount of production has been completed, however can't be shipped and invoiced, as we are awaiting a minor Boeing configuration change. The effect of these conditions on the Boeing contract has resulted in the $9.3 million increase in costs and estimated earnings in excess of billings and had a material impact on our liquidity."

    We estimate CVU has $20-30mm of A-10 inventory that Boeing has stopped making payments for since it does not meet specification. Part of this is because the overall program's specifications have changed but part of it is because CVU's vendors have failed to perform. Since this is a fixed price contract, either Boeing or CVU will have to bear the cost to bring the inventory up to specification. Since Boeing has stopped making progress payments, it indicates to us they do not feel responsible. Therefore, CVU can either bear the cost themselves or try to fight Boeing. We would place our bets with the 800-pound gorilla.

     

    Expect $20mm of Capital to Be Raised in the Next 6-Months

    We have a hard time finding a scenario where CVU can generate positive cash flow until the end of 2012. Assuming the inherent nature of CVU's business requires them to front the cost for their customers (without billing them), this would indicate a $15-25mm build in working capital in the next three quarters to support management's growth projections. To arrive at this, I examine the relationship of unbilled receivables to LTM and NTM revenues, which have averaged 115% and 95% since 2005. If we use the 115% rate and apply it to the midpoint of 2012 revenue guidance of $97mm, we arrive at a 2012 year end unbilled receivable balance of $111mm, a $50mm build from current levels. Even though the account has showed no signs of improving Y-o-Y, we are still going to give management some credit for improving working capital. Our base case assumes unbilled receivables improve from 113% of LTM revenues on 6/11 to 84% by 12/12. Even though the company has never gotten anywhere near such low levels, this still requires a $21mm build in working capital.

     

    Dec-06

    Dec-07

    Dec-08

    Dec-09

    Dec-10

    Jun-11

    2011E

    2012E

     

    Unbilled Receivables

    28.8

    31.1

    37.9

    43.0

    47.2

    60.9

    68.5

    82.0

     

    % of LTM Revenues

    161%

    111%

    106%

    98%

    107%

    113%

    93%

    84%

     

    % of NTM Revenues

    103%

    88%

    86%

    98%

    64%

    71%

    71%

    N/A

     

    So where can CVU get the capital from? The company has no cash, $7.8mm drawn on its revolver, and $2.2mm undrawn. Interesting to note, they increased the capacity of their $10mm revolver in September for an additional $3mm, but that only lasts through November 2011. Last March they raised $3mm in a registered direct to support growth. While they had the option of issuing term debt they thought the cost of issuing equity at under $8 was cheaper (stock is now $12). The company filed a shelf registration on July 26 for $20mm of securities. It would be difficult to think that in this environment, CVU could issue a significant amount of debt given its cash flow situation. Our conversations with industry participants believes the company's debt capacity can increase to $20mm. That essentially provides $12.2mm of additional debt capacity and our base case is at least a $21mm build in working capital. We believe the equity markets will have to be tapped for some of it.

    Valuation

    Valuation is difficult to think about given the inherent flexibility POC accounting affords aero structures companies. On an EBITDA and EPS basis, CVU appears cheap relative to the group -- SPR, AAR, LMIA, DCO and KAMN. I believe this is the case because SPR is aggressively overstating their earnings via accruals. That is why CVU trades at a 20% discount on a P/E basis, 14% discount on an EBITDA basis, but 45% premium on a sales basis (all 2012 consensus numbers).

     

    Company

    Mkt Cap

    EV

    P/E

    EV/EBITDA

    EV/Revenues

    Spirit AeroSystems

    $2,249

    $3,295

    7.3x

    4.7x

    0.6x

    Ducommun Inc.

    $148

    $510

    5.4x

    5.9x

    0.6x

    AAR Corp.

    $685

    $1,103

    8.1x

    4.7x

    0.6x

    LMI Aerospace Inc.

    $210

    $203

    9.3x

    4.6x

    0.7x

    Kaman Corporation

    $799

    $922

    12.6x

    6.8x

    0.6x

               

    Average

     

     

    8.5x

    5.4x

    0.6x

    CPI Aerostructures Inc.

    $75

    $84

    6.7x

    4.6x

    0.9x

    (discount)/premium

       

    -21%

    -14%

    45%

    Based on consensus estimates, every $1mm reduction in EBITDA (from program delays), reduces the stock price by 6% and every ½ point of multiple contraction reduces it by 11%. For the purpose of this analysis, I assume Scenario #1 regarding the A-10 program (full delay), a one-quarter delay for the E-2D program, and no delay for the G-650 program. Based on this analysis, I would expect at least a $1.5mm reduction in EBITDA, and a ½ -pt reduction in the multiple to drive a $2.00/share reduction in the stock (17%). Additionally, I assume CVU issues $20mm of new capital. I assume that $10mm of debt is issued to bring the company's debt capacity up to $20mm and $10mm of equity is issued at $11/share. This dilutes the stock a further 10%.

    Valuation Analysis

    Current

    Short-Thesis

    Difference

    2012 EBITDA

    18.3

    16.8

    (1.5)

    Multiple

    4.6x

    4.1x

    -0.5x

           

    Market Cap

    75

    50

    (25.3)

    Net Debt

    9

    19

    10.0

    Enterprise Value

    84

    69

    (15.3)

           

    Share Price

    10.57

    6.46

    (4.1)

    Shares

    6.9

    7.7

    0.8

     

    My expectation that the stock will drop to below $7 may prove to be conservative. Even at $6.46/share, CVU will trade at 0.72x revenues, a 20% premium to its peers' average of 0.60x. Should CVU trade in line with peers, which it should, the stock price would be $5.00.

    Risk #1: Can Additional Awards Make Up the Difference if there are Delays?

    This is a legitimate risk but we believe there is ample visibility in new awards. For example, management routinely talks about the bid pipeline (see page 18 of its investor presentation). The most near term contract award would be a $125mm award from Sikorsky (division of United Technologies, ticker: UTX), which management has talked about for months and has assigned a high probability of winning. We believe some of the positive news is captured in the stock price but do admit, the award would likely send the stock higher. However, there would be ample notification. First, DoD would need to award Sikorsky the OEM contract for Blackhawk. You can monitor this daily on http://www.defense.gov/contracts/. Additionally, after Sikorsky is awarded the contract, it would take 6-12 weeks for it to award its suppliers contracts. So an award to Sikorsky itself is not market moving but would give short-sellers a very adequate "heads-up."

    I actually believe there is more negative risk in this award than upside to this contract. Management has pushed its timing expectation for the award from Q3 to Q4 and now to Q1 2012. The contract in question is for the Blackhawk Block 8 contract which is funded out of the FY12 defense budget. Since Congress has yet to pass the budget, the funds cannot be spent so we believe this is further risk to management hitting its 2012 guidance.

    Risk #2: Industry Consolidation

    There has been a decent amount of consolidation in the industry over the last several years. CVU has real estate on some valuable programs (particularly Blackhawk) that an acquirer might want access to. While we believe an acquisition could happen at some point, we do not believe it will happen in the next 12 months. First, we do not believe the company is attractive to a financial buyer. This is because of the negative cash flow the company generates and the $15-25mm of additional capital we believe the company needs to fund working capital. Second, several strategic acquirers have recently made large acquisitions and will not be back in the game for some time. This includes DCO and PCP. The company would certainly be much more attractive if it was cash flow positive. Since we do not believe this will happen until the end of 2012 and the timeline for our short-thesis is 6-months, we believe we are well protected.

     

    Catalyst

    1. Program delays or cancellations in the A-10, E-2D, or G650 programs.
    2. Further growth in unbilled receivables.
    3. Equity issuance.

    Messages


    Subjectnice analysis - a few questions
    Entry10/24/2011 12:17 PM
    Membermadler934

    Thanks for the detailed analysis. I have looked at CVU in the past and have always been somewhat shocked at the degree of visibility management claims to have.  I have a couple questions:

    1.       Any idea why the company uses POC accounting vs. units of delivery?

    2.       Is there any chance the A-10 program gets cancelled altogether as the Bloomberg article implies?

    3.       Any sense as to what price an equity deal gets done?

     


    SubjectRE: Sikorsky
    Entry10/24/2011 01:44 PM
    MemberWoolly18

    Lukai,

    You bring up a good point and I tried to adequately address this in the risk section of the report. A BlackHawk contract would definitely be a positive for the stock. However, I do not expect this to happen in the next 6-months. The contract CVU refers to is for the UH-60 Block 8, which is funded out of the FY12 Defense Budget. The reason CVU lowered 2011 guidance is because Congress still has not passed the FY12 Defense Budget, which means funds for the Block 8 have not been released. Congress will likely pass the FY12 Budget before the President submits the FY13 Budget in February. Assuming it is passed in late January, it will still take weeks/months for Sikorsky to get its Block 8 contract, and then 2-3 months for suppliers to get subcontracts. That leaves us in mid-late summer of 2012 and by then, CVU will already require $15-25mm of additional capital. Strange things can happen with defense budgets but I believe this risk falls outside the time horizon of my thesis.


    SubjectCVU Announces Equity Offering
    Entry06/07/2012 06:17 PM
    MemberWoolly18
    My thesis was right but I wish my timing was better.
     
    Here comes the equity....
     

    SubjectBad link -- here's the release
    Entry06/07/2012 06:18 PM
    MemberWoolly18
    CPI Aero Announces Public Offering of Common Stock

    EDGEWOOD, N.Y.--(BUSINESS WIRE)--Jun. 7, 2012--CPI Aerostructures, Inc.(“CPI Aero®”) (NYSE MKT: CVU) today announced that CPI Aero and selling stockholders intend to offer shares of common stock in an underwritten public offering. CPI Aero also expects to grant to the underwriters a 30-day option to purchase additional shares of common stock to cover overallotments, if any. CPI Aero intends to use the net proceeds from this offering to fund working capital, other general corporate purposes and to pay down a portion of its revolving credit facility.

    Roth Capital Partnersis acting as the sole book-running manager of the offering.EarlyBirdCapital, Inc.andNoble Financial Capital Marketsare acting as co-managers.
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