In the process of parlaying a lifelong passion into his Motley Fool Hidden Gems newsletter service, Motley Fool co-founder Tom Gardner has mobilized a growing group of investors on a quest for undiscovered small-cap winners -- the next Microsofts
Call it curious praise for a stock newsletter, but impressed as I have been with Tom's recommendations, in my view, they are not even the main attraction. For me, it's the interactive community that has proven to be the most intriguing aspect of my Hidden Gems experience.
After all, it's there that we congregate -- neophytes, masters, and most of us in between -- to dig into Tom's recommendations and the ideas of our peers. It's also where we gather to sift through the entire universe of small-cap companies in search of the "the next big thing." Sure, we hope to strike gold, but we're better investors and wiser Fools merely for the exercise.
In that spirit, I submit my own Hidden Gems candidate before the Star Chamber: InVision Technologies
Controlling 66% of the domestic market and 91% internationally, InVision is the leading supplier of Federal Aviation Administration (FAA)-certified explosives detection systems (EDS). Executives and other insiders own a 17% stake, while institutions control less than 60%. Couple this with a dominant and profitable niche in an increasingly relevant industry, and InVision looks to me a whole lot like a hidden gem.
The company's equipment scans baggage at airports around the world. Before Sept. 11, the dominant baggage inspector hauled a paltry revenue stream of $60 million to $80 million annually. After Sept. 11, interest in InVision products picked up predictably. For the fiscal year ended Dec. 2003, the company expects to do $410 million in business, mostly through its aviation security group.
As a rule, I do not like companies whose revenue streams are dependent on government regulation and congressional budgeting. In this case, however, I am willing to make an exception. I think it is fair to say that homeland security and particularly aviation security are concerns that unfortunately are not going away anytime soon.
The usual suspects like Lockheed Martin
"Growth?" one might ask. "The company projects a 24% decrease in 2004 revenue to $310 million, and you call that growth?" I admit that at first glance, InVision looks very much a one-trick pony. After all, the problem with selling installed equipment as opposed to disposable goods is that the customers don't come back for years. Where's the repeat business in that?
The answer is service. InVision offers a one-year warranty on all products, after which, over 90% of its customers sign up for a service contract. A service contract is worth about 9% of the average selling price (ASP) annually and sports a 40% gross margin. As the installed base of equipment increases, service contracts will be a larger part of company revenue. In 2004, management expects $100 million in service revenue, almost a third of the company's total guidance for the year. Now, that's what I call sustainable repeat business.
And there is plenty of room for the installed base of equipment to grow. Yes, 2002 and 2003 were unusual, as U.S. airports raced to update antiquated security areas. We can't expect airports to continue placing baggage inspection machines willy-nilly about their lobbies. However, the rest of the world has yet to catch up to the U.S. in the penetration of EDS into airport security, providing InVision with plenty of international opportunities. Secondly, the Transportation Security Administration (TSA) has a longer-term project in the works that will add significantly to InVision's business over the next three to five years: in-line deployment.
Paid for by the U.S. government
The TSA has something called "Letters of Intent" (LOI) that are intended to reimburse airports for the cost of capital improvements required to meet congressional security mandates. In other words, InVision is effectively being paid by the government to help airports meet government security regulations. Great! The company didn't even have to bid for the contract, like Lockheed Martin or Boeing
So far, over $1 billion of LOI money has already been allocated for in-line deployment projects at approximately 25 airports in the U.S. This is money in the bag for InVision, and more is expected over the next few years, creating a $2 billion to $3 billion domestic EDS market opportunity. In-line deployment replaces standalone systems in airport lobbies with automatic, integrated systems out of the way of passenger traffic. It eliminates human operators and error, significantly reduces security costs for airports, and improves the passenger experience by decreasing wait time at security checkpoints.
And airports get all this cheap, courtesy of the U.S. government. Talk about a no-brainer for airports and a financial boon for InVision.
Readers familiar with InVision will note that I have yet to mention the company's other business units: YXLON's non-destructive testing (NDT), InoVec's lumber testing, and Quantum Magnetics' research and development. NDT alone represents a $220 million global market, of which InVision has a 32% share. Meanwhile, Quantum is leveraging government research grants to develop exciting new products in personnel scanning, baggage screening, and mine detection using a cutting-edge technology called quadrupole resonance (a derivative of medical MRI).
I also failed to mention management's long-term vision for the company: to leverage its existing technology and market know-how into closely related areas of aviation and homeland security. The potential market for personnel screening, infrastructure, and cargo security is in the billions. It is management's intent to deliver solutions for all areas of the homeland security universe.
Free is good
I omitted these other business lines and growth catalysts from my consideration to demonstrate what a true bargain this company really is. Assume that the significant in-line growth opportunities, the life cycle upgrades, and the recurring service revenue on an ever-expanding product base for the EDS business alone is sufficient to merely maintain $310 million in revenue indefinitely (a conservative assumption that assumes no growth after 2004).
Management has conservatively projected 20% operating margins (down from 30% in 2002) for the company's long-term business model. Assume that the tax rate is 35% and that capital expenditures are 100% of depreciation and amortization in this steady-state exercise.
On these assumptions, I estimate a run rate of $40.3 million in free cash flow. If an investor is willing to pay 10 times free cash flow (an implied 10% discount rate) for this recurring stream, the EDS business alone is worth $403 million. Add in $282 million of cash and subtract $134 million of debt to get a business worth $551 million. At a market cap of $563 million, you essentially get the expansion potential for free. One could do worse.
Put it together
With InVision, we have a highly stable and profitable growth platform in the EDS business coupled with significant upside potential as the company taps into the enormous unmet demand in the homeland security market. I've been over the numbers again and again. It's an uncertain world, but I think I've found a market-trouncer in InVision Technologies.
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