Note: This report is substantially new material. Subsequent reports will have changes highlighted.
Overview[1]
Herley Industries, Inc. (HRLY or the Company), is a supplier of microwave products and systems to defense and aerospace entities for use in command and control systems, flight instrumentation, weapons’ sensors, and electronic warfare systems worldwide. HRLY designs and manufactures microwave devices for use in high-technology defense electronics applications. The Company's commercial technologies comprise of scientific products and medical products. HRLY's primary customers consist of defense prime contractors (including Raytheon, Northrop Grumman, Lockheed Martin, and Boeing), the United States government (including the Department of Defense, NASA, and other United States government agencies), and international customers (including the Egyptian, German, Japanese, and South Korean militaries and suppliers to international militaries). In September 2004, HRLY acquired Reliable System Services Corporation (RSS). In February 2005, the Company acquired Micro Systems, Inc. in Florida. More information on the Company is available at
Investors in HRLY should make an investment decision based on their assessment of the following:
Investment Merits / Investment Drawbacks- According to bullish analysts, HRLY should benefit as the military moves more towards network-centric and as existing platforms and weapon systems receive electronic upgrades to enhance capabilities.
- Given the positive trends in its U.S. military markets and international opportunities, HRLY should be well-positioned for growth.
- Acquisition of Micro Systems could be highly accretive to revenues.
- HRLY is highly profitable, with EBIT and EBITDA margins stronger than most other aerospace & defense players.
- There are potential margin pressures from planned discretionary investments for transition from a microwave components Company to a microwave systems Company.
- The unusually large numbers of programs transitioning from development to production introduces risk, and the Company’s visibility into the timing of orders and revenue appears limited according to bearish analysts.
- Management continues to underperform according to its plan and Street expectations.
- Integration risk could be an issue depending on the complexities/issues of potential deals.
Among the five analysts providing a rating, one has rated HRLY Positive, three have rated it Neutral, and just one has rated the Company Negative.
NOTE: The Company’s fiscal year ends on July 31; all fiscal references differ from the calendar year end.
Recent Events
On March 23, 2005, HRLY announced that it received a contract award in excess of $1.7 million to supply radio beacon sets for the U.S. Navy's F/A-18 E/F "Super Hornet." Herley and Sierra Nevada Corporation are working together on this next generation landing system.
On March 21, 2005, HRLY announced that EW Simulation Technology Ltd. (EWST), a U.K. subsidiary, had been awarded a contract to supply the RF Environment Simulator (RFEG) for Project Echidna. The contract is with the Commonwealth of Australia and is valued in excess of $2 million. The RFEG is a variant of the EWST RSS8000 system, which is already in service in Australia for two other EW programs.
On March 15, 2005, HRLY announced a significant contract award from EADS Defence Electronics, the electronic warfare (EW) house of EADS. EADS Defence provides electronic self-protection equipment for aircraft, ships, and armored vehicles.
On March 11, 2005, HRLY announced that it was awarded contracts totaling $6.5 million to supply flight termination receivers and hybrids for two U.S. military programs.
On March 8, 2005, HRLY reported net revenues for 2Q05 ended January 30, 2005, which were $33.8 million, a 14.8% increase from the second quarter of fiscal year 2004. 2Q05 operating income was $2.5 million, or 7.3% of net sales, as compared to $5.2 million or 17.6% of net sales for the same quarter in the prior year. Net income for the second quarter was $2.1 million or 6.2% of net revenues. Earnings per diluted share were $0.14, on 15.0 million weighted average diluted shares.
Sales
2Q05 revenues came in at $33.8 million, up 14.9% versus $29.4 million reported in 2Q04. Sales grew 5.6% year-over-year due to the CTI and RSS acquisitions, partially offset by a decrease in revenues due to a push-out of Trident and APN-245 ($2.5 million in revenue).
Organic growth was negative at (2%) for the quarter, below the Company’s full-year target of 10% (announced in the October quarter earnings release). The Company reported that $2.5mn of higher-margin sales were pushed to the right, on both APN-245 Radio Beacon Sets (pushed into the April 2005 quarter) and the Trident missile upgrade program (pushed into FY06).
Given below is a summary of total revenues as given by Zacks Digest:
($ in millions) / 2004A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / 2005E / 2006EZacks Consensus / $40.0 / $43.0 / $150.0 / $175.0
Digest High / $122.2 / $33.6 / $33.8 / $41.3 / $44.7 / $151.5 / $178.0
Digest low / $122.2 / $33.6 / $33.8 / $39.0 / $42.0 / $149.0 / $171.4
Digest Average / $122.2 / $33.6 / $33.8 / $39.8 / $43.3 / $150.4 / $175.9
Management's revenue guidance for FY05 was $150 million+. While they did not specifically back away from a previous revenue range of $150 million-$160 million in FY2005, they did note that achievement of the upper end of the range depended on the timing of the receipt of significant amounts of anticipated production contracts in early 4Q05. Management commented on the acquisition pipeline, noting that the Company is in an “an advanced stage” of negotiations to acquire two companies with a combined $30 million in sales. Although one analyst (Raymond) raised his revenue estimate to the low end of management’s range, he remains doubtful of the Company’s ability to meet revenue targets.
One analyst (Bear Stearns) opines that for FY05, Herley’s organic sales should be up just 2-3%. He suggests that the underperformance partly reflects the Company’s dependence on the Air Force and Navy, two agencies that account for 96% of Herley’s revenues.
Margins
HRLY’s gross margin for 2Q05 was 29.3%, down nearly 300 basis points from 1Q05. SG&A rose to 21.9% of sales from 17.3% in 1Q05. Management cited two reasons for the disappointing gross margin performance: 1) the deferral of some higher margin production sales (Trident and APN- 245) and 2) $1.5 million of loss provisions associated with some engineering development programs. This represents the second consecutive quarter of a substantive shortfall in operating profit performance. Management did say they expect bookings to pick up in the second half of the year, consequently gross margins should steadily improve in FY05. Operating margins fell to 7.3% in 2Q05 due to a confluence of weak gross margins and increased business development costs.
Provided below is a summary of margins as given by Zacks Digest:
2003A / 2004A / 2005E / 2006EGross Margin / 33.6% / 34.9% / 31.1% / 33.6%
Operating Margin / 17.8% / 16.0% / 12.8% / 15.8%
Net Margin / 12.6% / 11.1% / 8.6% / 10.8%
While one analyst (Stephens) expects gross margins to improve over FY05 as new higher-margin production contracts begin and development engineering spending declines, he is taking a more conservative stance on what margin level will be achieved. The Company anticipates margin improvement in the second half due to declining development costs and bookings improvement on the planned receipt of new orders in seven major programs. Management believes a gross margin in the 35% range is achievable in FY06 if it is able to execute well on the ramp-up in production on new contracts expected to come on line during the year.
Earnings per Share
HRLY reported 2Q05 EPS of $0.14, which came in at nearly 50% below the consensus expectation of $0.26 as a result of higher investments in engineering development for future programs and recognition of those expenses in the current quarter. 2Q05 EPS witnessed a 41.7% decline from $0.24 reported in both 2Q04 and 1Q05. This marks the fifth consecutive quarter in which the Company has missed expectations.
Provided below is a summary of EPS as given by Zacks Digest:
FY04A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / FY05E / FY06EZacks Consensus / $0.22 / $0.26 / $0.91 / $1.19
Digest High / $0.92 / $0.24 / $0.14 / $0.25 / $0.31 / $0.93 / $1.40
Digest Low / $0.92 / $0.24 / $0.14 / $0.19 / $0.22 / $0.78 / $1.08
Digest Average / $0.92 / $0.24 / $0.14 / $0.22 / $0.28 / $0.87 / $1.20
Management declined to provide EPS guidance due to uncertainties surrounding the purchase accounting for the Micro Systems acquisition, which closed in early February.
One analyst (Raymond) points out that HRLY is currently involved in 20-25 new programs, which should lead to revenue acceleration in the coming years. He suggests that in the meantime, however, these development costs will act as a significant drag on earnings. Another analyst (Stephens) believes that HRLY is well-positioned for growth, given the positive trends in its U.S. military markets and its international opportunities. Over the next several years, the analyst expects HRLY will be able to grow both the top and bottom lines in excess of 10% (excluding acquisitions) although the time frame in which this acceleration will commence remains a question.
Target Price/Valuation
The average Zacks Digest price target for the analysts providing such a number is $20.50 (20.0% upside from the current price). The price target ranges from $19.00 (11.7% downside from the current) to $22.00 (28.7% upside from the current), with a median price of $20.50.
Based on Digest consensus FY ‘05 EPS, the forward P/E is 19.6x. Taking long-term expected growth in EPS into consideration, the Company’s forward P/E to long-term growth ratio (PEG) is 1.29. A PEG under 1.0 is generally considered favorable. However, the individual must determine his/her conviction in the expected long-term growth rate. HRLY could support a higher PEG ratio due to expectations for longer-term growth closer to 15.3%.
One analyst (Stephens Inc.) believes that HRLY’s relatively low multiple has room to expand, and likely will if management is able to execute its business plan and re-establish investor confidence, while another analyst (Roth Capital) suggests that investors should focus on the long-term trends as the Company's efforts undertaken at present should directly correspond to increased bookings in the future with new, sustainable earnings streams.
Metrics detailing Management Effectiveness are as follows:
Metric (ttm) / ValueReturn on Assets (ROA) / 5.4%
Return on Equity (ROE) / 6.4%
Return on Invested Capital (ROIC) / 6.0%
ROA, ROE, and ROIC lag the averages for the overall market (measured by the S&P 500) of 7.4%, 19.5% and 11.2%, respectively.
Cash Flow and Capital Structure
The Company ended 2Q05 with approximately $67.9 million of available cash and short-term securities ($4.52 per share), and the net cash position for the quarter came in at $62.0 million (net of $5.9 million in total debt) as of 2Q05, versus $61.9 million (net of $6.0 million in total debt) in 1Q05. Free cash flow for 2Q05 totaled only $.8 million, just 40% of net income in 2Q05.
The debt-to-capital ratio stood at 3% at the end of 2Q05 versus 3% as of 1Q05, and 3% as of 2Q04. This is a negligible level of indebtedness in absolute terms as well as compared to HRLY’s peer group; a level below 40.0% - 50.0% is generally seen as favorable while a ratio of 60.0% or greater should be cause for concern. Low levels of debt allow flexibility in the ability to make acquisitions, pay down debt, reinvest in the business, etc. In the case of HRLY, low debt should help management withstand current operational and execution difficulties.
Long-Term Growth
The average long-term growth rate of the analysts providing such a number is 15.3%.
One analyst (Raymond James) suggests that HRLY’s long-term outlook remains encouraging, given its acquisition activities, strong Balance Sheet and cash flow. Another analyst (SG Cowen) suggests that HRLY's M&A targets appear to be "horizontal" plays. He also opines that Herley has $44 million of net cash and is in "advanced stage" talks with two acquisition targets with aggregate annual sales of $30 million. Both are "horizontal" plays similar to Micro Systems, with less visible risk than EWST, which was a step into a new product area. One target (about $25 million in sales) would bolster HRLY's presence with the Army while the other would provide millimeter wave technology for missile applications. He also suggests that HRLY may also be an attractive takeout candidate, especially to acquisitive European firms (e.g. Cobham, EADS, BAE) who seek greater exposure to the US defense budget and have a FX tailwind. Another analyst (Stephens) also suggests that these acquisitions, as well as the recently closed Micro Systems deal, focus on Army customers and should position the Company well to benefit from increased spending trends within the Army budget over the next several years.
Individual Analyst Opinions
The list below provides a highlight of relevant information from the most recent reports on HRLY from the analysts currently covering the Company. Please refer to the accompanying spreadsheet for specifics on individual income statement projections, recent revisions to estimates, and justifications for price targets provided.
POSITIVE RATINGS
Roth Capital-Report Date: March 8, 2005 – Stock is rated Buy with $22.00 price target.
The target price is based on a 20.0x multiple to calendar 2005 adjusted earnings plus cash. The analyst opines that investors should focus on the long-term trends as the Company's efforts taken now should directly correspond to increased bookings in the future with new, sustainable earnings streams. The analyst points out that margin for the current quarter came in lower due to higher investments in engineering development for future programs and the recognition of those costs in the current quarter. He, however, opines that as these programs transition from engineering development and into full production, revenue and profits should later 'catch up'.
NEUTRAL RATINGS
Bear Stearns-Report Date: March 10, 2005 – Stock is rated Peer Perform with no price target.
The analyst maintains Peer Perform rating as he does not have sufficient confidence that a steady and consistent recovery will materialize in the near-term.
Raymond James-Report Date: March 10, 2005 – Stock is rated Market Perform with no price target.
The analyst suggests that the Company has fallen short of expectations for the past five quarters, and lacks a specific near-term catalyst. The analyst also opines that the Company’s balance sheet remains strong, with net cash per share of $4.32 and a book value of $13.46 per share, providing some downside protection.
Stephens Inc.-Report Date: March 18, 2005 – Stock is rated Equal-Weight with $19.00 price target.
The price target is based on an EV/2005 EBITDA multiple of 7.0x and a 12-month forward P/E multiple of 15.0x. The analyst believes that HRLY is well positioned for growth, given the positive trends in its U.S. military markets and its international opportunities. Over the next several years, he expects that HRLY will be able to grow both the top and bottom lines in excess of 10% (excluding acquisitions) although the time frame in which this acceleration will commence remains a question. He also believes that HRLY’s relatively low current P/E multiple has room to expand and likely will if management is able to execute its business plan and reestablish investor confidence. In addition, as the Company effectively deploys its sizable cash position its multiple should expand.
NEGATIVE RATINGS
Thomas Weisel-Report Date: March 9, 2005 – Stock is rated Underperform with no price target.
The analyst’s Underperformance rating reflects the Company’s ongoing execution problems, below-peer EPS growth and cash generation, and risk associated with the Company’s expansion from microwave components to microwave systems.
NOT RATED
SG Cowen-Report Date: March 10, 2005 – Stock has not been rated or given a price target.
The analyst opines that stock seems unlikely to recover until visibility improves, which may not occur until 4Q, and/or it receives an acquisition bid. The analyst suggests that HRLY may be an attractive takeout candidate, especially to acquisitive European firms (e.g. Cobham, EADS, BAE) who seek greater exposure to the US defense budget and have a FX tailwind.
[1] Information obtained from Company 10-K, Zacks.com, accompanying Digest spreadsheet.