Buy Avation* at 5.75p

Before I go any further, I need to litter warnings left right and centre with this recommendation. Whilst PLUS markets is now, as far as I am concerned, a better regulated trading facility than AIM - today's stock is hideously illiquid. However, I am setting a relatively high limit buying price as this stock is ludicrously undervalued and has a long way to run. I expect to see liquidity improve when the stock moves into double digits (which it will) as those that have bought in at lower prices will take a profit instead of holding of for the real value. I also wish to state that I do not own any shares in this company (although at this price I would love to - I will miss out here I'm afraid). I also wish to point out that the only reason WatsHotters get this instead of UK-Microcap is purely because it is listed on PLUS.

Anyway, back to the tip......PLUS listed Avation* is an absolute cracker. With a market capitalisation of just £1.07 million, this is a real tiddler. That said, it shouldn't be. Having secured a pretty chunky debt facility, the company has bought a couple of small aircraft. Crucially though, the aircraft that have been acquired are being leased for a set period and at a pre-agreed rate, guaranteeing it can repay its debt and deliver shareholders a superb uplift in net asset value.

Without any trouble at all, Avation will be delivering pre-tax profits of £400,000 in the first year of the deal, and £500,000 a year thereafter - furthermore, it will have repaid the $9.22 million debt in 6 years, meaning the group will have net assets worth around $10 million (Avation got a bargain in the first instance) and will still be generating profits of £500,000 a year. Obviously depreciation needs to come into the equation somewhere along the line, but my $10 million is about right on current industry metrics. And so, adopting an earnings multiple of say 8 (not expensive for a company with such superb visibility), we have a starting target price of 20p. At 5.75p, Buy at up to 10p with a 18-month price target of 20p.

Business

Avation is a procurement and leasing company that was formed via a demerger from Advent Air* (AAIR). It currently owns two commercial aircraft which are leased to Skywest (part of Advent), producing significant cash flows for the company. The bulk of Avation's balance sheet is comprised of ownership of the aircraft - two Fokker 100, which were purchased for US $8.9 million. The two aircraft are being leased out for $1.8 million a year in an agreement that is set to run for 6 years.

Meanwhile, the original business, which believe it or not was one based on the sale, supply and financing of broadcast equipment together with the ownership of a patented television advertising system; continues to perform well. In its last full year, it delivered a profit of $19,439 on revenues of $1.626 million. This too is a steady as she goes business.

Financials & Forecasts

Avation got a good deal on the purchase of the two Fokkers. And so, even at the end of the loan term period, I reckon a realistic sale value for the plans would not be far off what they actually paid for them. But of course, the depreciation will come down to what the auditors decide.

Assuming the interest payable on the loan runs at a rate of around 7% per annum, the entire sum will be repaid over the agreed 6 years. As the amount payable reduces, profits rise and so based on the $1.8 million guaranteed revenues per annum, after costs and interest, plus a little depreciation, we should be left with a profit of circa $1,000,000 in the first full year, climbing to around $1.25 million by the end of the loan period.

There will be no free cash for dividends as the profits will simply go back towards paying down the debt, though obviously the assets that investors are getting are worth a multiple of the current share price. Not to mention the fact that at the end of all this we have a debt free business with 2 planes, presumably still generating almost $2 million a year in revenues, plus a growing broadcast equipment financing and sale business. The net effect should be a business delivering profits in excess of the current market capitalisation.

And so, to err on the side of caution, I am forecasting pre-tax profits of £450,000 for the first full year of the planes operation, equating to earnings of 2p per share. I am not going to forecast beyond this point as I want to see how the figures actually unravel, but I think it is safe to say that earnings will never fall below this level due to the fixed nature of the contracts.

Conclusion

Whatever way I look at this business, it is cheap. From conversations both with the company and with those in the industry, I don't see why the planes on the balance sheet could not realise a value not too dissimilar from their purchase price should they be sold in 6 years. That said, I have applied a conservative rate of depreciation. At 5.75p we are buying into a business that will have assets worth at least 20p in 6 years by which point it will be throwing off cash of say £750,000 excluding the broadcasting equipment operation. I don't think we will need to wait that long. One set of full year figures will awaken the market to the potential here and as such, I reckon we'll hit the 20p target price well within 18 months. After all, that is only an earnings multiple of 8, which is far from demanding for a stock with such great visibility and superb forward asset backing. At 5.75p, be prepared to pay over the offer for a decent amount of stock and buy at up to 10p with a 18 month price target of 20p.

*Avation and  Advent Air are corporate clients of RSH the company which is the ultimate owner of WatsHot.com