MTI Instruments (MKTY) is a supplier of precision linear displacement solutions, vibration measurement, system balancing solutions, and wafer inspection tools. These tools and solutions are developed for markets that require the precise measurements and control of product processes for the development and implementation of automated manufacturing, assembly, and consistent operation of complex machinery. 

The company has decades of experience in working with OEMs and their subcontractors in the supply of sensors, instruments, and systems technology to incorporate into OEMs’ equipment and major companies’ manufacturing processes. MKTY targets leading companies in specific market segments, including the industrial and consumer electronics, automotive and other precision automated manufacturing industries, turbo machinery, and the research and development aspects within these markets for both product and process improvements. 

As of May 8, MKTY locked-in their largest contract in the history of the company. Over $3 million in orders from the US Air Force. MKTY will churn through this order by the end of 2020. That one order represents 50% of the company’s market cap.

What They Produce

1.) Automated Monitoring & Precision Automation Manufacturing

This allows companies and engineers to rectify system problems before they become costly repairs and maintenance costs. One such solution: Non-magnetic paper-thin probe that allows users to measure and monitor gaps in high power generators, wind turbines, and other auxiliary equipment. 

The company provides advanced linear displacement solutions for OEMs. These solutions are incorporated into a tool or equipment manufactured by a company to monitor performance and/or achieve control. These products are also placed into a process to control the manufacturing of parts, or to measure critical parameters of parts as they leave the process. 

In other words, they’re a small but critical part of larger assemblies. This creates stickiness with their suppliers. Suppliers know the quality of work and the reliability of MKTY’s products. Thus, It would be hard to switch over, even if a competitor is at a lower cost. 

The company has a long-standing track record of excellence with Automated monitoring. MKTY is the preferred supplier for applications that require complex and extremely precise measurement tools of intricate targets and assemblies.

2.) Axial Turbo Machinery

MKTY is a leader in the development and commercialization of vibration measurement and system balancing for axial engines. You can find axial engines on medium to large aircrafts (military and commercial). These measurement and balancing systems are designed to pinpoint engine vibration issues for improved fuel efficiency, lower maintenance cost, and general safety. 

Once again, small but critical components to larger products. The company sells the axial products to major aircraft engine manufacturers, US and foreign militaries, commercial airlines, and gas turbine manufactures. 

3.) Industrial and Academic R&D

This is an interesting business. The company has a dedicated line of various instruments, testers, and tools that help other private R&D teams conduct research. According to the 10-K, these customers include testing and R&D departments in large industries and academia. They also include process development labs focused on automotive, electronic, semiconductor, solar, and material development. 

On the surface it looks like a cap-ex light, high-margin business. The company produced these tools once, and then “leases” them out to other R&D teams for their individual research objectives. 

Product Manufacturing & Operations

Unlike most companies in the sensor, instrument, and systems markets, MKTY is a 100% US-based manufacturing company. The company believes their US based operations provide them with the following advantages: 

• Reducing risk of inadvertent technology transfer.
• Ability to control manufacturing quality.
• More effective customer management and satisfaction process.

So far it’s paid off. MKTY sports long-term relationships with vendors, and they believe most raw materials used in their products are readily available. 

Customer Concentration

MKTY’s largest customer is the US Air Force. The company also has long-standing relationships with businesses in the electronics, aircraft, aerospace, automotive, semiconductor, and research industries. The Air Force accounted for 20% of total revenues in 2017. 

Going Dark (March 19, 2018)

The company filed a Form 15 on Mach 19, 2018, voluntarily de-registering from the SEC. Here’s MKTY’s reasoning behind deregistering: 

“We expect the deregistration of our common stock to result in significant cost savings to MTI in the near term from the elimination of complying with SEC reporting requirements. Also, the deregistration of the common stock will allow the Company to avoid the substantial additional costs associated with the compliance and auditing requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and to focus its resources on increasing long-term growth.”

Although not required, the company will maintain quarter/annual financial statements on the OTC Markets Group website. 

The Balance Sheet (Hidden Assets)

As of December, 2018, the company has around $52 million in NOL carryforwards. This is a huge asset that’s not acknowledged on the balance sheet. In fact, $52 million in NOLs is 6.5x the current market cap. $737 thousand will expire in 2020. The remainder? They’ll expire in 2037. That’s 17 years of NOL carryforwards. 

MKTY carries a robust balance sheet. As of Q3 of 2019, the company sports $5 million in assets, with $1 million in total liabilities. Asset levels dropped in half due to a one-time special dividend of nearly $4 million in July of 2019. If you add back the dividend, the company maintained more than $8 million current assets. 

Management

The company is run by Frederick Jones. Jones is a younger CEO (49), but incentives appear aligned. 26% of his total compensation in 2017 came from Incentive Plan Compensation (based on performance objectives). 

Directors and officers own 45% of the common stock. Brookstone Partners, LLC owns another 40%. This leaves 15% free for remaining shareholders. Brookstone Partners looks like solid capital. Take a look at their investment strategy (per their website):

“To invest alongside founding families and management teams in companies that offer significant opportunities for value creation through organic growth, strategic acquisitions and improvements in operating performance.”

This feels like permanent capital, not a quick turnaround as with most PE firms. Another thing I like about Brookstone Partners is their skin in the game. All the principals commit their personal money into each investment. Here’s their reasoning:

“Brookstone’s principals have personally committed a significant portion of the firm’s equity capital, making them true owners rather than investors of third party capital. As owners, Brookstone’s principals understand the nuances of building successful businesses and have the flexibility to make long-term decisions that are right for the business. As major investors in every deal, our principals pride themselves in having their interests perfectly aligned with those of management teams.”:

Financials

The company generated $1.54 million in EBIT in 2018. Adding the $392 thousand in NOL tax benefits, the company ended 2018 with nearly $2 million in income. MKTY also generated close to $2 million in free cash flow, giving it a 25% FCF yield. 

MKTY ended the year with $5.7 million in cash on their balance sheet. That’s a lot for an $8 million market cap company. So, in July of 2019, management paid around $3.5 million in special dividends to shareholders. That was a 37% dividend yield at the time of issuance. Not bad!

One thing to note about MKTY is the variability in revenues. The company admits that their revenue streams are lumpy in nature. They depend on various contracts with military and commercial enterprises. These contracts can come in waves. One quarter they earn a ton. The next quarter, not so much. This is important when we look at valuation and realistic expectations of the future. 

Valuation

MKTY is cheap. The company trades for less than 5x earnings (25% yield), and if you add back their one-time dividend issuance, they trade at a 7.5% premium to NCAV. At the July 2019 dividend price, a mere three special dividend issuance would cover the original purchase price. You’d get your initial investment back in dividends and retain the business for free. Moreover, that free business can generate over $2 million in free cash flow per year over the next five years.

If they’re able to maintain consistent cash-flows, you’d end 2023 with close to $12 million in cumulative free cash flow (compared to $7 million market cap) and $24 million in Enterprise Value. Adding back the net cash, we get a market cap of $27 million (vs. $7 million current market cap). That’s $2.82/share in equity value (257% increase). 

As nice as the above picture sounds, it likely won’t look like that. The company’s revenues and earnings are lumpy in nature. It’s important we look at downside cases. Let’s assume the company generates $5 million in revenue in FY 2019. Note that the company’s already generated this $5 million as of their Q3 report. So we’re assuming zero Q4 revenues. On top of that, let’s assume the company loses another $1 million in revenue in FY 2020. Then, generates steady-state $4 million in revenues until 2023. 

In this scenario, we’re anticipating a 50% revenue decline in less than three years, and a 50% decline in operating income. We’re also going to assume a 1 million share dilution over the next five years. The company has a history of issuing shares, so I want to make sure that we account for such possibilities in the future. By the end of 2023, we get $4 million in annual revenue, $750 thousand in pre-tax cash flow, and $950 thousand in free cash (thanks to NOLs). That’s a cumulative $7.34 million in free cash flow over the next five years, which equals the current market cap. 

But remember that share issuance. For this scenario, we’re dividing our $15 million market cap by 10.57 million shares. This gives us an equity per-share value of $1.44 (80% upside). 

We also have balance sheet protection. MKTY has enough cash to cover all liabilities three times over. And if we assume a smaller current asset profile (based off continued dividends), we’re still left with around $0.40/share in NCAV as downside protection. 

Risks

There’s three main risks with MKTY:

1.) Wide Bid/Ask Spreads

Shares are rather illiquid and there’s a large bid/ask spread. For example, as of writing, the Bid is $0.81/share. The ask is $0.99. That’s a wide divergence. This makes establishing positions a bit difficult with limit orders. But, you don’t want to place a market order for fear of getting poor cost-basis. 

2.) Customer Concentration

MKTY generated 28% of its product revenue from the US Air Force. This is part of the company’s $9.5 million contract with the Air Force that’s set to expire halfway through 2021. Besides the Air Force, the company recognizes 11% of its revenue from a semiconductor manufacturer in Asia. A breach in one (or both) of these contracts would mean a significant loss in revenues. 

3.) Share Issuance

The company’s increased share count by 200 thousand over the last four quarters. We looked at what the valuation would look like with 1 million shares issued over the next five years. Regardless, I’d like this trend to reverse.