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Betting On Continued Growth of The Aerospace Industry

January 21st, 2017

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Image Credit:Everett Historical/Shutterstock.com

On the third Monday of each month, Ill comment on the performance of the premium portfolios and provide some additional analysis related to individual stocks. In this article, I will present and explain my valuation model for a new entrant to MoneyGeeks premium portfolios.

Premium Portfolio News

The performance of MoneyGeek's premium portfolios for the month of December 2016 were as follows:

Dec 2016

Last 12 Months

Since Apr 2013

Moderately Aggressive

+4.8%

+24.7%

+52.4%

Very Aggressive

+5.8%

+26.5%

+25.6%

Extremely Aggressive

+6.8%

+31.7%

-1.5%

Because the premium portfolios consist of U.S. and Canadian stocks, it makes sense to compare the results against the S&P 500 and the TSX Composite, which are the most widely used U.S. and Canadian stock market benchmarks, respectively. In December, a hypothetical portfolio of 50/50 Canadian and U.S. stocks would have returned +2.0%, so the premium portfolios outperformed. Let me comment on some of the stocks that had big moves last month.

BBBY: Bed, Bath and Beyonds stock went down by 9% after reporting disappointing earnings. While revenue came in a bit lower than expected, general and administrative (G&A) costs came in higher than expected.

Management has blamed the U.S. election for some of the disappointment regarding revenue, saying they noticed a decrease in store foot traffic in the days leading up to the election. They said that foot traffic recovered post election, so well see if that turns out to be the case.

As for the increase in costs, management attributes much of it to increased investments in information technology. Though such investments may weigh down earnings in the short term, I believe they are vitally necessary. I have written before that retail is becoming more and more of a technology game. BBBYs survival depends on being able to adapt to this new reality. On the other hand, once their survival is assured, I believe BBBY will benefit from the void left by retailers who couldnt adapt.

ET.TO: Shares of Evertz Technologies went up by about 12% in December. I believe this was largely due to the special dividend of $1.28 that the company paid out. Dividend investors generally love such large dividends, so they may have bid up the stock.

MEG.TO, BXE.TO, BTE.TO: Shares of MEG, Bellatrix and Baytex went up by 36%, 22% and 14% last month respectively. This was the result of oil prices rising after OPECs decision to cut their collective oil production.

Thats all I have for updates. As for my TFSA account, it currently looks as follows. Note that I contributed $5,500 to my account at the beginning of this month, and bought TOU.TO with it. I made no other changes.

BTE.TO: 22%

BXE.TO: 21%

MEG.TO: 24%

IBM: 16%

COH: 9%

TOU.TO: 7%

For the rest of this article, I will present and explain my valuation model for Magellan Aerospace, which is the newest entrant to the Premium portfolios.

Magellans Liquidation Value and Earnings Estimates

Magellan (Ticker: MAL.TO) is a supplier to the aerospace industry. They manufacture aircraft components such as horizontal tails and castings in several plants around the world and sell them to larger companies such as Boeing. The company also offers repair services on aircrafts. The following link contains my valuation model for Magellan.

Valuation Model of Magellan Aerospace

The valuation model should look familiar to long time premium members. As usual, the model consists of (1) Liquidation Value: How much money youd receive if the company sold its assets and distributed its proceeds, plus (2) Earnings Potential: How much the company is expected to earn in the future, minus (3) Time Value of Money: Investment gains we miss out on because we have to wait for the company to pay out dividends.

It would be too cumbersome and time consuming to explain every detail of the model. Therefore, I will only comment on a few specific points that I believe are relevant. (New premium members may not fully understand the structure of the model, so I plan on writing an article soon that will give an overview of the structure. But until then, I would encourage new members to read previous premium articles, or to ask a question on the Q&A forum.)

Compared to the majority of other companies, the valuation model of Magellan is pretty straightforward. The Liquidation Value sheet in the model, for instance, doesnt contain any items that are rarely found in other companies. Still, let me comment on a couple of items on the Liquidation Value sheet that you may want to keep in mind.

For a company its size, Magellan appears to hold a larger than normal amount of inventory (i.e. raw metals, finished aircraft parts, etc). Whereas Magellan generated under $1 billion of revenue in 2015, its inventories amounted to $210 million as of the most recent financial statements. This means that Magellans inventories amounted to more than 20% of its sales. This is significantly higher than the level reported by auto suppliers, which many people may see as being somewhat similar. For example, Magna Internationals inventories are less than 10% of its annual sales.

Normally, having large amounts of inventory is a bad thing, as it suggests inefficient operations and/or the inability to sell products. However, I dont think the inventory level is a cause for concern for Magellan because its the consequence of the industry it operates in. Compared to auto suppliers, Magellan manufactures smaller quantities of highly customized parts. Manufacturing such parts tends to take longer, leading the company to report high inventory levels.

Still, manufacturing highly customized parts carries risks. If the customer whom the parts are originally intended for dont buy them, those parts become worthless. There are contractual provisions that protect Magellan from such outcomes, but its still a risk nonetheless. Thats why I ascribed only 30% of the reported value for the companys inventories.

The other Liquidation Value item that I want to comment on is the Intangible assets. This item refers to the value of assets that dont have any physical form. Common examples of this type of asset include customer relationships and patents. In Magellans case, the majority of intangible assets consist of Development costs. Let me explain what that is.

As an aerospace supplier, Magellan understandably spends a lot of money on developing new technologies. But instead of recording this money spent as an expense, the company sees it as a contribution towards a new technological asset. For example, if it spends $10 million on developing a new technology, the value of the intangible asset would go up by $10 million. Because the decrease in one form of asset (cash) exactly balances out the increase in another form of asset (intangible assets), the company doesnt record the money spent as an expense and so its earnings remain unaffected.

From our viewpoint, the big question is whether Magellan can sell the new technology to others. If it does, we would be justified in ascribing value to Magellans intangible assets. If not, that means its liquidation value is 0, and so we should treat all money spent on the technology as an expense. Unsure of the answer to this question, I took the conservative approach and ascribed no value to Development costs of technology.

After taking all assumptions into account, I estimated that Magellan has roughly $190 million in liquidation value, which translates to $3.33/share.

For the Earnings Potential sheet in the valuation model, let me comment on two items in particular: Gain on bargain purchase and Adjustment to inventories.

The Gain on bargain purchase item arises because Magellan bought a company for less than the value of its assets. For instance, lets say that when Magellan bought a company, it had $50 million in assets, $20 million in liabilities (debt, taxes owed, etc), so it had a net asset value of $30 million. If Magellan bought this company for $25 million cash, it would have gained $30 million in net assets for a net gain of $30 - $25 = $5 million. This $5 million would be recorded as Gain on bargain purchase. Thats basically what happened in 2012.

The Adjustment to inventory item shows up on my valuation model because of the way I define earnings - the increase/decrease in the companys liquidation value. Recall that I consider Magellans inventories to be worth 30% of the reported value in a liquidation. Therefore, I adjust my model such that for each $1 increase in Magellans inventory value, I increase the companys liquidation value by $0.30.

For instance, Magellans inventories went up by roughly $12 million in 2015, which means that my estimate of the companys liquidation value went up by $3.6 million that year. Since the company spent $12 million on inventories, but only retained $3.6 million of the value of those inventories, it means the companys total liquidation value went down by $8.4 million (i.e. $12 - $3.6). My adjustments regarding inventories therefore had the net effect of decreasing the companys earnings estimates by $8.4 million. Note that I applied a similar but somewhat more complex logic to adjust property, plant and equipment.

After taking into account all adjustments and after making reasonable assumptions on future earnings, I forecasted that the company will earn roughly $74 million in 2016 (the company hasnt reported its numbers yet), which translates to $1.30/share.

Estimating Magellans Residual Income

The next step to valuing Magellan involves estimating the residual income per share. Residual income is the forecasted earning for next year, minus the opportunity cost of having liquidation value tied up in the company. Let me explain why we subtract the opportunity cost.

If Magellan liquidates some of its assets and distributes the proceeds to its shareholders via dividends, they would then be able to invest that money elsewhere and generate returns. However, by holding onto the assets, the company deprives shareholders of those potential gains. This gain that shareholders miss out on is called opportunity cost. If we want to measure the total net gain that shareholders receive from the company, we would not just take the companys earnings into account, but the opportunity cost as well.

We calculate the opportunity cost of having liquidation value tied up in Magellan by multiplying the liquidation value by a reasonably expected rate of return. In Magellans model and in others, Ive consistently chosen 5% for this purpose.

In order to calculate the 2017 residual income, we next need to estimate Magellans growth rate of residual income. Its important to get this number right, as even a small change in this number will yield rather different estimates for the companys valuation.

The historical record of Magellans growth is encouraging. Magellans adjusted earnings more than doubled from 2012 to 2015, which means that it grew by more than 20% each year. Some of this is due to the global economic recovery, but some of its due to favourable industry conditions.

Over the past few decades, as more citizens of developing countries have become wealthier, the demand for air travel has increased commensurately. In addition, as fuel prices became more expensive, there came a greater push to replace old aircraft with newer, more fuel efficient varieties. As a result, the demand for new aircraft increased by high single digit percentage each year.

As long as developing economies grow richer and fuel prices stay high, I believe the aerospace manufacturing industry will continue to grow relatively quickly. Still, I wanted to be reasonably conservative with my assumptions, so I forecasted that Magellans residual income would grow by 5% per year.

Taking these assumptions into account, I forecast that Magellans 2017 residual income will be roughly $1.19/share. Then, assuming that this number will grow by 5% each year, and using a discount rate of 10% on future earnings, I arrive at the fair value of $27.23/share for Magellan. This number is significantly higher than the share price as of the time of this writing, which is about $17/share.

At this time, you may wonder why other investors, particular big investors, havent bought Magellan shares to the point that its pushing prices higher. While I dont know what others are thinking, there is one aspect of the stock that may be giving them pause.

Unlike most other stocks, the shares of Magellan are concentrated in the hands of N. Murray Edwards, who is the chairman of the board. As of the latest official report, Edwards owned roughly 74% of Magellan. This has two consequences.

First, it means theres not that much stock available to buy. 26% of Magellan is worth about $250 million. If a big fund wanted to buy, say $25 million worth of stock, it would have trouble doing so without causing prices to rise.

Second, it means that Edwards can do what he wants with the company. Big investors tend to want some influence over a company through voting rights. However, those investors would always be outvoted by Edwards.

Of course, these two considerations dont apply to small investors like us. In fact, Edwards ownership of so much stock can be a good thing, since it means hell care about the long term future of Magellan. This is why Ive decided to include Magellan in the Premium portfolios.

Disclosure: I dont own any Magellan stock, but I plan on purchasing some in the near future.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.