CVU - CPI Aerostructures Is Significantly Overvalued

Summary

• CVU is a contract manufacturer for aerospace defense contractors.
• The company operates in several different lines, because its core capabilities are in supply and manufacturing management, not in a particular line.
• CVU's market does not have great competitive characteristics. Further, the company has to make difficult estimations to determine costs and revenues on an accrual basis.
• These estimations led to enormous loss recognitions in the past. Although the risk of earnings surprise is lower today, estimations continue to affect margins.
• Trading at sky-high multiples of operating income, which itself is based on estimations, the company is not an opportunity in my opinion.

CPI Aerostructures ( CVU ) is a manufacturer of structural aircraft parts, primarily for defense contractors.

Recent enthusiasm for defense stocks has pushed the company's stock price to local heights. Unfortunately, I do not see an improvement in fundamentals that justify that stock price increase. Based on the long-term average and recent earnings, I believe the stock is overpriced.

Further, CVU's revenue and cost recognition structure is complicated and has generated backward restatements recognizing massive losses several times. Although the risk today is much lower, it should be considered.

Note: Unless otherwise stated, all information has been obtained from CVU's filings with the SEC .

Business description

Contract manufacturing : CVU fabricates many different kinds of aircraft parts. These include wing structures, engine assembly, oil tanks, and electronic sensors. CVU also assembles piece kits used by its customers in their assembly operations.

The company does not develop or design these components but wins contracts to fabricate them from customer designs. They compete based on assembly/manufacturing costs in a bid fashion. Their competitive advantage lies in supply chain management and manufacturing facility management. That is why the company has so many diverse lines of manufacturing.

This is not a great market for many reasons. First, its clients are the primary defense contractors, enormous companies with bargaining power. Second, the contract negotiation is on a bid basis, designed to benefit the customer. Third, although contracts usually last years, the company must readjust its manufacturing operations to new types of components each time a contract ends and a new one is gained for a different component.

CVU's undesirable competitive position is reflected in the company's low and variable margins.

Not growing : CVU has not increased its operating income since 2000. The growth shown between 2000 and 2014 was eliminated when the company had to recognize that it had generated losses on previously considered profitable contracts (more on this later).

Input cost accounting : When CVU wins a contract, the customer may not commit to specific purchases. However, CVU has to invest in assembly lines, tooling, employee training, and facilities.

CVU capitalizes these costs in inventories and in a particular account called contract assets ( in previous years like 2014 , it was called 'cost and estimated earnings in excess of billings').

Moreover, the company estimates a total cost for the project and starts recognizing revenue based on costs incurred over total expenses. Later, receivables are charged against contract assets, and another portion is charged against CoGS.

This accounting practice is permitted and is the basis behind revenue recognition for both services and long-term engineering projects. However, the problem with long-term projects like CVU's is that the accounting requires significant estimations of total contract size and costs and is prone to aggressive accounting.

Unfortunately, CVU had to recognize tremendous losses on this accounting method several times during its history. The reader can see two examples in the years 1999 and 2014/5 in the gross and operating margin chart above.

In 1999 , the company had to write off $12 million in contract assets from the early termination of the MD-90 program (a commercial airplane). These were charged against CoGS and generated negative gross margins. In 2014 , the company recognized almost $50 million in contract losses, again charged against CoGS, generating negative gross profits of $30 million. (Both cases can be read in the linked 10-Ks for the corresponding fiscal years under the Management's Discussion and Analysis heading).

Problematic accounting : For a company with such a complex (and error-prone) accounting system, CVU has also shown problems handling its accounting and financial reporting. These problems are much more recent.

In 2021 , the company amended its annual financial statements for FY19, FY20, and all of the corresponding quarterly reports, to recognize that it had understated inventory obsolescence and reserves on contract assets. The restated financial statements included $4 million in additional losses ($2 million each fiscal year). The company's 10-K annual report for FY21 (ended December 2021) was filed very late, on August 19th, 2022. The report recognized material weaknesses in financial reporting (leading to the FY20 and FY19 restatements).

Valuation

Rising gross profit margins : Although CVU's revenues have decreased YoY, the company's gross profit margins are up significantly. This has led to a recovery in profitability.

However, the reader should be very cautious before extrapolating these margins into the future, given that they are immensely affected by managers' estimations. It is not a matter of bad intentions from management, but rather that the issue is complex because they have to estimate the revenues and costs expected from contracts that have variable demand and take years to complete.

CVU is consistently reporting changes in those estimates, both positive and negative, under the heading 'Favorable (unfavorable) adjustment to gross profit'. For the 9M22 period ( reported in the 10-Q for 3Q22 ), the company recognized $4.7 million in positive adjustments in some contracts and $2.6 million in negative adjustments for others. The net positive $2 million positive adjustment has influenced the company's historically high gross margins shown in this fiscal year.

Riding the defense stock wave : CVU's stock price has almost quadrupled in the past six months. This development has followed the general trend of defense and aerospace stocks since October 2022, as seen in the two charts below. CVU's stock price recovered much more than the indices, probably motivated by the profitability recovery and the extremely low levels it traded previously ($20 million market cap in October 2022).

The risks of restatement are lower now : Before the restatements in 2014, the company accumulated $120 million in contract assets. Today, the company accumulates only $25 million. This implies that the company has not capitalized too many costs and has not brought so much revenue from the future without a corresponding cash inflow.

The company's CFO and working capital buildup was a great leading indicator of the ensuing debacle. Fortunately, CVU's current CFO does not indicate such a scenario, and as mentioned, the company has not built as many contract assets as before 2014.

Average earnings valuation : For the reasons mentioned, it is unadvised to use recent earnings as a metric for CVU's long-term profitability. A better gauge is average earnings over some period of time.

But which period should it be? Should it include the massive loss recognitions? In my opinion, because the company has not capitalized as many costs as it did before the 2014 debacle, that period should be avoided from the profitability calculation.

The chart above shows that the average operating income for the past six years has been $0.5 million. Compared with a current market cap of $50 million, this number alone already implies an overvalued situation.

Current earnings valuation : Even considering the current operating income of $3.7 million, CVU is not an opportunity. From this $3.7 million, CVU has to pay interest on $27 million in debt from its credit facility. This facility accrues interest at prime + 3.5%, or currently 11.25%, according to the WSJ . This implies $3 million in interest payments. As a result, the company would generate pre-tax losses in FY23 even if it maintains the same business level and historically high gross margins.

Conclusion

CVU's stock price has almost quadrupled in the past six months. In my opinion, this was caused by interest in defense and aerospace stocks, and by company-specific factors like higher gross margins and a previously low market cap.

However, CVU's operations have not improved in the past months or years. Changes in estimates caused the recent profitability improvement, which could be reversed later.

On an average earnings basis, then, I believe the company is significantly overvalued. But also on a current earnings basis, given the company's interest burden on its working capital credit facility.

The company's business characteristics do not command such a premium on average or current earnings. I prefer to avoid CVU's stock.

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