Description

SMU

Introduction

SMU can take advantage of four events that have fortuitously converged: a restructuring that sets the stage for a deleveraging of the company, a new management team focused on increasing profitability, significantly higher defense spending that is focused on the products that SMU provides, and rapid adoption of their automotive products.

Background

SMU specializes the development, manufacture and marketing of advanced occupant safety, seating and restraint systems installed in air, ground and sea vehicles. SMU has three business segments, Aerospace/Defense, Commercial Products and Technology Licensing. Aerospace/Defense segment includes military aircraft seating, armor, and crew safety systems. Commercial Products covers products and safety systems for automobiles and trucks and transparent polymer. The Licensing division focuses on monetizing their large patent and proprietary technology portfolios. Last year they had revenues of $97MM, a net loss of $0.52 per share, and currently have $90MM worth of assets and have borrowed around $70MM.

Past Problems

For the past 5 years they have lost money due to management’s inability to focus and control costs. To illustrate, before the restructuring they had seven divisions working on 200 different projects. Due to ill-advised acquisitions their debt levels climbed to staggering levels and their cost of capital is high. Management had little incentive to maximize shareholder value due to perpetual employment contracts that were terminable only for cause, severance packages were for 5 years worth of compensation and all options that officers held were due full payment in the event of change of control, regardless of vest status or strike. Even the fired CEO took all of his options with him and they don’t expire for another ten years.

Restructuring

Starting in October of ‘00, SMU embarked on an aggressive restructuring that has replaced most of the officers, refocused on profitability and dealt with their debt load. The last of the restructuring charges have been made this past quarter and from Q4 ’01 and on, they will be operating as the restructured organization. They obtained additional financing to eliminate a troublesome lender and extend the maturity of outstanding debt in order to solve a looming repayment issue and now lack any principle obligations through the end of ’03. This is the breathing room they sought to focus on the profitability issue.

Ridding themselves of 4 divisions and deciding on the top ten profitable projects to focus on, has helped them save $1MM per year in employee-related expenses and cut 35% off their bloated R&D budget. The recently announced Q3 earnings showed a pro forma net income of $500M demonstrating that the restructuring has helped and will result in future profits with expected net income of between $3-4MM for Q4. Capex will be minimal since they have previously invested heavily in this area, establishing significant production facilities allowing the top line to grow without a commensurate increase in costs.

The plan is to demonstrate to the financial community that they have become a profitable enterprise and then refinance their $70MM in debt at favorable rates which will further put increased pressure on costs. Repayment of 20% of the newly sold debt is planned next year due to the nominal repayment penalties, with the convertibles being targeted for further debt reduction plans depending on how quickly they can refinance existing debt.

Finally they have recently reformed the unreasonable executive compensation mentioned above, by restricting employee contracts to 3 years with SMU retaining the right to terminate at the end of year two, severance is restricted to the remaining term of the contract and options are payable in full only when a hostile takeover occurs. However this zero strike option will soon become void since they are anticipating enacting a poison pill amendment in the near future. Further, outside directors are paid $20M per year in stock rather than cash to further force an alignment of shareholder and directors interests.

Military Opportunities

SMU’s bread and butter has been the military for the past 30 years, accounting for 60% of sales and an average margin of 15%. So extensive is their experience with the military, many of their recent products have had the R&D financed by the military while allowing SMU to retain exclusive commercialization rights.

Current and future military actions will be heavily reliant on SMU’s products due to extensive use of rapid response, highly mobile troops and the public’s sensitivity to casualties. The focus on “small unit actions” means heavy use of helicopters which will increase not only the number of helicopters needed, but increase maintenance and repair needs. SMU controls 70% of the specialized seats that go into military helicopters and a significant portion of the armor plating that is used on various helicopter models is produced by SMU. Other perishable goods that SMU supplies includes life jackets and patented parachutes that are slimmer than normal and thus better suited to flight crews in cramped cockpits.

Since Vietnam the US has had an aversion to casualties and this has led the US to implement systems that can prevent injury or death to their soldiers. SMU recently announced 2 contracts to supply the Army and Marines with ceramic armor inserts that are worn inside of standard issue fatigues to help prevent gunshot wounds. SMU has been sole supplier of these to the military since 1998. The total possible value of the two contracts is almost $60MM through October of ’03 and represents only a fraction of the entire military’s needs.

These extremely lightweight and effective inserts that are becoming standard issue to all troops and according to the Lt. Colonel in charge of body armor acquisition the next standard in protection will be motor-assisted exoskeletons, something far off in the future making ceramic armor the solution for the foreseeable future. In addition, SMU has developed CABS, Cockpit Air Bag System, which will most likely be placed in all 9,000 helicopters deployed by the US to help protect aircrews in the event of a crash. While the initial development and anticipated contract was only for the “Blackhawk” model, extending this to all helicopters is a natural extension. This is the only product of its kind currently available.

Since September 11th, SMU has bid on $90MM worth of military contracts and has been separately solicited for RFPs totaling another $100MM, representing significant possible increases in revenue. This has happened before starting with the Gulf War and through the Balkan peacekeeping mission, expanded military operations have resulted in non-linear increases of military sales for the 2 year period following military activity. Couple this with the inevitable increases in the military budget through the Bush administration and SMU is assured of dramatically increased sales. All of the above is also applicable to increased sales to members of NATO as SMU has retained outside sales organizations to handle marketing to foreign governments in a bid to increase foreign sales.

Automotive Opportunities

Currently SMU supplies significant quantities of Inflatable Tubular Structures (ITS) to BMW outfit the 3, 5, and 7 series of BMW and two models of Land Rover. ITS are airbags that are positioned to protect the head, neck, legs and chest. While the predominate location is on roof by the door to protect against side-impact collisions, they can be placed under the steering column and on the chest portion of the seatbelt. Margins in the Auto division run around 35%.

They have signed agreements with 5 manufactures to supply 15 different platforms (total of 24 different models) with the systems to comply with the upcoming federal mandate (Federal Motor Vehicle Standard No. 201) that require increased safety for side impact collisions for upcoming model years. Deliveries start in ’02 and are through ’04. Customer requests have barred SMU from disclosing size, quantity and even dollar amount, however by the end of the year SMU will be releasing more data on these contracts. The given reason for the silence is the manufacturers’ marketing plans for the new safety features have not yet been implemented. When the details are finally released, earnings and revenues guidance will also be provided , and the transparency will assist the stock price.

Licensing

SMU has never aggressively licensed the 82 patents, 102 patents pending and numerous unpatented proprietary techniques and products relating to the two divisions above. The only attempt of licensing has been for their transparent polymers. In order to monetize their portfolio, SMU has mobilized both in-house and external sales forces to take advantage of this high margin business.

Previously, the only significant licensing agreement has been with the largest European producer of polymer prescription lenses and the largest European manufacturer of luxury sunglasses. These have resulted in average revenue of $500M per year, per licensee for the past 3 years. They are forecasting extensive licensing agreements in the next year. If they add only 5 new agreements of similar size and scope as they have with the lenses above, could add almost $2MM in net income which based on pro forma numbers that exclude restructuring related expenses would have increased net income 30-40%. Clearly licensing’s combination of high margins and rapid growth will play an important role in SMU’s turnaround.

Future

SMU has shown they have repaired and stabilized their fundamentals. The recent Q3 earnings release has shown that the restructured SMU can produce significant revenue and profit. What has yet to be priced into the stock are the future opportunities that include new contracts for the military that could be announced by the end of the year, automaker contracts that will be announced by the end of the year, and the ramping of revenue from their expanded licensing agreements.

Based on SMU’s ’01 pro forma numbers that exclude restructuring, I had SMU generating $105MM in revenues, and net income of $3.5MM. Their market cap (closing price of $5.60) on November 13, 2001 when they released Q3 numbers was around $69MM, giving me a P/E of around 20. I am using market cap instead of per share numbers since even the CEO can’t give an exact number of diluted outstanding so I am erring on the side of caution.

Conservatively speaking, if in ’02 SMU experiences:

*only a 15% increase in revenues,

*SG&A increases 10% due to dramatically reduced R&D (they will be breaking this out of SG&A some time next year but I will treat it as still a part of SG&A),

*Capex spending at maintenance levels,

*interest expense staying stable or increasing slightly to $9MM

*and even using a 37% tax rate (though the have NOLs that will eliminate this),

they should make about $6MM in net income, times a 20 P/E, results in a market cap of about $120MM or a 74% appreciation from the Nov 13th closing market cap; a share price of around $9.00

Catalyst

*Completion of restructuring

*Significant increases in revenues due to a sudden change in defense spending and pending auto regulations

*Commensurate increase in net income

*Increased visibility by analysts and institutions