We’re preparing to move Stock Gumshoe HQ to some new digs, so I’m going to try to keep this brief today — normally my desk only gets organized once a year, so having to commit to filing and moving everything more often than that is really throwing my schedule off kilter.
The pitch we’re looking at is from Cabot Small-Cap Confidential, and we’ve had quite a few readers send in requests for this solution — though the reason this hit the top of the pile, frankly, was that I was pretty curious as well… and it wasn’t a real “hard sell” of a teaser pitch.
The hints all came in the form of a “free” article from editor Tyler London, who took over the newsletter this year — you can see that full article here if you’re interested. It’s not a hard sell, but that newsletter would run you $1,500/year.
The article is based on the premise that oil will continue its rebound in the wake of OPEC’s decision to cut oil production next year by about 1% — and that if this does stick (which is always an open question with OPEC, even if we assume demand stays the same and they get cooperation from non-OPEC producers like Russia and Mexico, both of which have other priorities as well), then small oil stocks will do well.
Laundon is not all that definitive about whether he thinks this will really drive oil back into the $50s (or higher) to stay, but he leans toward acting soon…
“… for investors with a long-term outlook who have been interested in increasing exposure to oil-related small caps anyway, the deal is one more reason to act sooner rather than later. Yes, it has pushed many oil stocks to overbought levels. But the way to balance that is by adjusting the size of your purchases and averaging in (as always), not buying an entire position all at once. One sensible strategy could be to add a little this week, then wait until after this Saturday’s meeting to decide if it makes sense to add a little more.”
And then he gets into the hints about his stock:
“For those looking to move way down the market cap curve to an under-covered small cap value stock that could do far better in the years ahead, I have one in mind….
““If you appreciate staying comfortable in the extreme temperatures of summer and winter, you’ll like this company. It’s a manufacturer of a space-age insulation that has been used by NASA for years….
“Most of its current revenue comes from the $3 billion energy infrastructure market.”
The product is apparently some kind of insulation blanket system that you can wrap around pipes. And, we’re told, it’s widely used:
“Its insulation is used by 24 of the world’s 25 largest refining companies, and by 20 of the world’s 20 largest petrochemical companies. [It is] used in several Canadian oil sands facilities, in subsea oil and gas projects around the world, in natural gas and LNG facilities and by gas, coal, nuclear, hydro and solar power generating facilities. Well known clients include ExxonMobil, ConocoPhillips, Chevron, Petrobras, Total and Shell.”
That’s probably enough clues for us to uncover the “secret” for you, but we’re also told that it’s currently priced under $5, it recently (last month) decided to slow down expansion plans because of concerns about demand when oil prices were falling. Laundon says they can still grow their revenue by 25% without that new facility they were planning to build… and, to make clear, says that this is a “recovery play.”
I’m always curious about little service providers in big industries, since it sometimes doesn’t take much to turn them into big providers (or get them bought out by Shlumberger or the like) if their products or services are indeed unique… though it’s also always wise to mindful of the critical nature of that “uniqueness” — we’ve seen oil services companies in the past collapse because competition was quick to jump in and erode their margins.
And that requires some humility for the risk-taking investor, because it’s hard to really understand an industry’s competitive dynamics unless we’re really steeped in that industry — I have no idea, personally, whether or not there are a dozen great makers of pipe insulation just chafing to take this company’s business if growth resumes… but I can, at least, get you started: This is Aspen Aerogels (ASPN).
Aspen Aerogels is a maker of “blanket” insulation that they make with a proprietary “aerogel” process, and they claim it is superior to all other commonly available insulation for their markets. Much of what Laundon cites in his description is taken more or less directly from the company’s presentations, you can see the latest version of their investor presentation here.
The company has been on a good trend for revenue even with oil and gas prices weak over the past couple years — revenue has continued to climb by better than 20% a year for the past four or five years, though they’ve still been losing money (that growth might be a little deceiving, since they were starting from a very low point as a startup company). They had an exceptionally well-timed IPO in the Summer of 2014, just before the crash in oil prices, which allowed them to retire their debt… and that made the income statement instantly look a lot better without that interest cost (though the share count, obviously, went up sharply at the IPO), and they got close to break-even in 2015.
The concern, and the reason this is a “recovery play,” is that this year’s numbers are going to be worse than 2015’s. So the revenue growth has ended, for now at least, and 2016 will probably end up just a little short of 2015… partly because they’re spending several million dollars to defend patent rights in the US and Europe, which indicates to me, without having looked at the legal proceedings, that there’s some reason for investors to at least be mindful of the process of those patent lawsuits.
In cases like this where we’re looking for growth, I like to try to model how much growth they need to keep the same level of investment going — assuming, for the moment, that the market will want more of their product in the future, and at similar prices.
For the trailing twelve months (those numbers are just below their peak, which would have come in the Spring quarter of 2016), they’ve got revenue of $127.5 million and cost of goods of $98 million, so there’s roughly $30 million in gross profit. That’s a 23% gross profit margin, which is good — they’ve been getting more efficient, that number would have been about 14% two years ago, so they are getting some benefit either from focusing on costs, getting lower input costs from cheaper raw materials, or achieving some economy of scale. That would seem to be probably pretty maxed out at this point, if you want to think about things conservatively, if they only have 25% revenue growth in them before they need a new manufacturing facility expansion… the company is building to “low 20s” for gross margins, so we’ll assume that they can keep up this level of performance.
That means they need to pay their bills, finance any debt they take on for expansion, pay salespeople, and do their R&D to keep ahead of the competition, in addition to paying their legal expenses, out of that $30 million in gross profit… and if there’s anything left over, then that becomes net profit or “earnings”.
Operating expenses (Selling, General and Administrative plus Research and Development) have been extremely consistent over the past several years — they were $30 million back in 2013 when revenue was only at $86 million, and they were at $30 million last year when revenue hit $122 million. That’s also pretty impressive, it means they’re increasing sales without increasing overhead by very much. In the past they had big non-operating interest expenses that ate up a huge amount of additional cash, but the IPO paid off that debt so those numbers have disappeared from current income statements. Operating income (which is gross profit minus total operating expenses) is now negative $3.8 million over the past four quarters, and a small amount of debt means net income is a negative $4.6 million.
So that’s the bogey they have to clear if they’re going to get to profitability — how do they increase revenue enough to cover all those expenses and make a profit? The math problem, if you assume all else is equal, is that you need their total operating expenses of about $34 million (including the small amount of interest expense) to be smaller than their gross profit, so you need gross profit to grow from $29 million to, say, $35 million. To increase gross profit by $6 million, assuming that your cost of goods stays the same, you need to increase your revenue by about $18 million (remember, 33% of revenue is gross profit, after you’ve paid for the raw materials and manufacturing). That would mean, all else being equal, that revenue would have to rise by 14% for the math to work and bring them a profit.
Which is decent news, if we take Laundon’s assessment that they can increase revenue by 25% without investing in their new manufacturing plant as gospel. That means they can get to profitability, but not much more, without their next investment in expansion — which, if things go reasonably well over the coming months and the oil prices rises, might come as soon as next year with an eye on getting capacity substantially higher by 2018 or 2019.
So that’s how I look at these little guys — they are obviously subject to broader market forces, but in this case the numbers work pretty well… unlike a lot of small manufacturing companies, they have a decent chance of becoming profitable without further investment and without some magical future increase in efficiency.
That doesn’t mean they’ll shoot higher — investors in small companies are looking for growth and companies that can become much larger over time or get acquired, not the potential to break even, so the stock isn’t likely to return to its $11 IPO price unless it looks like they’re going to get back on track with 20% annual revenue growth… and if that growth does return, then people might have a chance to get excited about the decent math that is hiding on their income statement. But “decent” by itself doesn’t get a stock soaring, you need either a great story that gets people excited or top-line growth (and preferably, both).
So the two things I’d look at with Aspen, if you’d like to research it further, would be the state of the competition in that segment (including their patent lawsuits and the possibility of acquisition by a big competitor), and the potential for revenue growth to restart next year after a flat year this year. They clearly have some things going pretty well, including a broad list of clients and customers, but they just as clearly are not in a rapid growth phase right now… and if that growth doesn’t restart, either because of new markets or new refinery projects or competing products or because their advanced products are only desirable in small niches of the sector, or whatever, no one’s going to care very much about a little oil services company that’s close to break-even.
That’s my take after half an hour browsing through their presentations and financials, and I’m sure you can add to it — if you’ve got an opinion on Aspen Aerogels, please share with a comment below. Thanks!