Wednesday, July 16, 2008

Aldila Shows Value

I have calculated the fair and present value of Aldila’s earnings power to be worth approximately $4.90 per share. I assumed as part of this calculation that Aldila will continue as a going concern. Determining the earnings power value involved calculating the equity holder free cash flows. To be clear, the earnings power value calculation has nothing to do with balance sheet asset values of the company.

One step I took in calculating the earnings power value was to investigate the average operating margin (operating earnings / sales) for the company during the period between 1997 and 2007. It’s important to take a full business cycle in calculating average operating margins because any given year could produce uncommon financial results. For example, during this 10 year period, the highest operating margins occurred in 2004 and 2005 and the lowest margins occurred in 1999, 2001 and 2002. The highest operating margin years over this period coincided with Aldila’s most successful product launch to date with their “NV” line of golf shafts. While shareholders can be hopeful for a repeat of the “NV” shaft success with the recently launched “VooDoo” shafts, for valuation purposes, you will want to use values that you feel reasonably sure will be sustainable in the future. I don’t feel reasonably sure that Aldila will duplicate the success of 2004 and 2005 on an annual basis, but I feel much more confident that they could reproduce the average results obtained during the entire 10 year period.

Fundamental changes to a business model need to be evaluated for significance. It's best to avoid using historical data that doesn’t take into account the recent fundamental business changes as the results can be misleading. Aldila has made some fairly recent changes over the past few years such as selling their joint venture interest in Carbon Fiber Technology LLC (CBT) as well as exiting the hockey stick manufacturing business. My opinion is that both of these changes will not significantly alter future operating margins from the average operating margins calculated during the 1997 - 2007 period. Firstly, external sales of CBT were insignificant contributions to Aldila’s total revenues. Secondly, Aldila has secured purchase agreements guaranteeing the amounts of carbon fiber available to them over the next 5 years. Thirdly, there has been a carbon fiber industry capacity expansion and if this trend continues, it becomes more likely that future supply will be available. Lastly, the hockey segment was a very small component of Aldila’s overall operations and shouldn’t significantly affect operating margins by much. Hockey shaft sales were under 3% of the Aldila’s total sales.

One other important aspect in my earnings power calculation is that I did not account for any growth in sales. I wanted to use a conservative view of Aldila’s earning power potential and not inflate the valuation with what would likely be inaccurate estimates of sales growth. In addition to being conservative, I also believe that this valuation is grounded in facts since I used the average operating performance that Aldila actually produced over the past 10 years.

One potential problem with my earnings power valuation is that Aldila has 3 major customers that account for nearly 65% of their total sales. This concentration of customer sales affords negotiating power to the customers that might have a negative impact on Aldila’s operating margins going forward. One way to deal with this is to more thoroughly investigate the relationships and contracts that exist between Aldila and the their top customers. Another approach is to play the “what if” game and calculate the valuation impact under a slew of different scenarios. In any event, I valued Aldila’s earning power with the top 3 customer relations intact but assumed no growth of sales.

In summary, Aldila is an interesting value play. The stock is trading at less than both book value and earnings power value, it has a trailing P/E ratio of less than 2.5 and it pays 60 cents per share dividend. If Aldila is able to at least replicate the operating success of the past decade into the future then Mr. Market is currently offering this stock at a discount to its intrinsic value.

DISCLOSURE: The author does not have a position in Aldila

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