Q4 Results & A Look into FTG's FutureListening to the Q4 conference call recording (available on the FTG website) at approximately the 29-minute mark, there is an important comment regarding Q4 results. Management had apparently decided that fulfilment of customer orders was to be prioritized ahead of fully implementing the efficiencies to be gained from integrating the Teledyne and PhotoEtch acquisitions into FTG operations. The decision to place the customer first was, of course, the right decision. However, as a result of this decision the expected benefits to be gained from the integration have been delayed.
Management conducted a thorough analysis of the situation and has determined that the reduction in costs once the efficiencies of the integration are realized will result in increased profit of $2MM per quarter. On an annualized basis this would amount to an $8MM increase in net income or, in other words, $0.35 per share. Obviously this places a different complexion on Q4 results.
Apparently this would be the case even if top-line revenue were to remain flat. This is evidence that the positive effects of operating leverage have been firmly established. In the past, according to earlier assertions by management, it used to be that FTG needed to achieve $1MM revenue per week to break even ($52MM per annum) prior to the Teledyne and PhotoEtch acquisitions. Breakeven revenue certainly will have increased post-acquisition. Nonetheless, operating leverage has been enhanced given the impressive contribution margins already being achieved as a result of the acquisitions.
Speaking of top-line revenue, it would be timely to review the fundamentals on the demand side of the business environment in which FTG operates and, consequently, the potential top-line revenue that FTG can reasonably expect to earn in the future. The following developments appear to be quite positive with respect to FTG's future revenue generation.
IPC continues to report very strong book-to-bill ratios across the PCB industry. According to IPC, the advent of book-to-bill ratios running above parity for the past 11 months has been "driven mainly by growth in orders" and indicates the "likelihood of sales growth in the industry in early 2018." With respect to FTG, strong order growth has contributed to the fact that FTG currently is experiencing historical order backlogs in both the circuits and aerospace divisions as reported during the Q4 conference call.
Boeing's, TTMI's, and United Technologies' (through its pending purchase of Rockwell Collins) entry into the avionics design, supply, and maintenance space is an exceptionally strong recognition by these players that the avionics market is a future growth area. This sentiment is further backed up by industry analysts' forecast revenue growth for avionics suppliers of 7% CAGR over the next four years. FTG, as the only publicly traded sizable entity specializing in aerospace and defence electronics, is well positioned to benefit from this growth.
Efficiencies in aircraft operational performance for the foreseeable future can only arise from: a) improvements to engine performance, b) improvements in airframe aerodynamics, or c) improvements in flight management. Improvements due to airframe redesign lie somewhere in the future. Engine performance improvements are currently being implemented through the introduction of new engines particularly GTFs. With respect to flight management, however, this aspect of aircraft operational performance is primarily avionics-driven -- exactly the principal area of focus for FTG's operations.
Near term, the effect of changes to flight management, such as the mandated introduction of ADS-B next year, will restrict non-compliant aircraft from operating in controlled airspace. For reasons of flight safety and fairness to other users of controlled airspace, FAA has ruled that there will be no further delays or waivers in implementing this mandate. Other follow-on mandates for NextGen (and for SESAR which already are in effect) will further limit the operations of non-equipped aircraft under the "best equipped, best served" principle.
What this means is that those aircraft that have had their avionics updated will have their flight operations expedited ahead of other aircraft that have not had their avionics updated. This is a strong driver for the upgrading of avionics as well as cockpit panels, keyboards, and bezels (which must be part of any digital avionics equipage) not to mention the LED cockpit lighting that commonly replaces obsolescent incandescent lighting at the time that aircraft avionics are being upgraded. FTG shareholders no doubt will immediately recognize that FTG specializes specifically in all three of these -- complex, multi-layer, aviation-qualified PCBs upon which avionics equipment is built; cockpit panels, bezels, and keyboards which serve as the pilot interface with avionics systems; and LED lighting systems which are one of several subsystems FTG supplies to OEM, retrofit and aircraft simulator markets. Furthermore, the validity of the impact of this observation can be confirmed by the increasing backlog for avionics upgrades at FBOs across the country as operators rush to get their aircraft equipped before the mandates come into effect as well as the ongoing demand for avionics technicians to fill the shortage of personnel qualified to carry out this type of work.
It is instructive to recall, in connection with the effect of mandated regulations, the impact of RVSM introduction on aircraft operations. Those operators that did not upgrade flight management systems to RVSM requirements were restricted to flight operations below FL290. Being restricted to lower altitudes where fuel consumption is relatively greater severely restricted the operating range of such aircraft. Not only did passengers resent the additional refuelling stops required for flights that otherwise were easily within the operational range of the aircraft if it were permitted to fly at higher altitudes but, in addition, the high cost of increased fuel consumption made such flights commercially noneconomic. As a result, these aircraft were taken out of service and, in some cases, affected operators went out of business.
Recent approval of the largely-increased Pentagon budget for the next 2 years and the termination of sequestration will allow military aircraft modernization programs to proceed. Lack of funding in recent years has severely restricted procurement programs aimed at bringing avionics systems up to modern standards as well as refurbishment of existing systems that have deteriorated due to increased operational tempo in recent years. FTG as an approved U.S. military supplier will participate in the resupply of the avionics pipeline. Updated procurements plans already are being announced by the Pentagon on a daily basis.
The recent U.S. tax bill provides 100% immediate write-offs for bonus depreciation expensed within the next five years for the purchase of new or used aircraft and for improvements to aircraft systems including avionics upgrades. Industry analysts report that the impact of these provisions will encourage corporate aviation operators to move ahead with plans to upgrade aircraft avionics. FTG shareholders are likely aware that a significant portion of FTG's revenue is derived from the corporate aviation sector.
Finally, the thousands of new aircraft that currently are on order worldwide at commercial, business, and military aircraft manufacturers and on many of which FTG is already contracted to be either a direct or indirect supplier will ensure a base level of revenue for the next decade. The increase in new aircraft delivered also means that many more new aircraft simulators will be delivered to operators. This too is an area in which FTG is well established as a supplier.
All in all, things are looking quite good. FTG has been flying under the radar (so to speak) in the past but it seems this may be coming to an end. Interesting market activity in the past several months may indicate that some entity is quietly accumulating FTG stock. There was a time in the past when avionics manufacturers vertically integrated their supply lines. There appears to be a growing trend across the aviation industry to integrate various components of the supply chain into large aviation conglomerates. Given the highly positive fundamentals for the aviation sector going forward coupled with the historical amounts of excess corporate funds available to be deployed into the market it is perhaps to be expected that this trend would eventually emerge. It would not be surprising to learn one day that FTG is being acquired by a large player who currently is an FTG customer, perhaps a competitor, or, increasingly a possibility, an investment management entity assembling an integrated aviation supplier initiative. Other FTG investors on this board may have their own ideas as to who these possible acquirers may be.
Although FTG obviously is being currently undervalued in the market, it can be reasonably expected that eventually FTG's enterprise value will be recognized and rewarded accordingly. FTG's potential value as a possible takeover target can only further enhance its attractiveness as an excellent medium- to long-term investment. All of the fundamentals are now pointing in this direction.