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  Magellan Aerospace is still on the runway

BENJ GALLANDER and BEN STADELMANN

Friday, December 7, 2007

Portuguese explorer Ferdinand Magellan achieved many milestones during his short 41 years on earth. He led the first expedition to circumnavigate the globe. In addition, he was the first European to reach the Philippines and also the first from Europe to reach the Pacific through the waterway that is now named after him, the Strait of Magellan.

His moniker is also attached to the Magellanic Clouds, the spectacular galaxies visible to the naked eye from the Southern Hemisphere, although he did not sail quite that high.

But the celebrated voyage around the world was a harrowing one. Of Magellan's flotilla of five ships, only the Victoria made it home; the remainder were wrecked by storms, captured by enemies or burned to avoid being used by the enemy. Many men died horribly by scurvy and starvation, Magellan himself was killed in a battle in the Philippines. Of 270 crew, there were only 18 survivors.

Closer to home, Mississauga-based Magellan Aerospace's website bristles with high-tech images, a satellite in space, a sleek fighter aircraft and enormous, blasting jet engines. But at the moment, the folks there might be thinking less about the visionary aspect of their namesake and more about the gruelling trials he faced.

We've been watching this enterprise for a few years, though it only recently qualified for one of our criteria — existence for a minimum of a decade — before an investment might be made. In the past, some aerospace picks have done very well in the Contra the Heard portfolio, including Northstar and Spar Aerospace, which was taken over by L-3 Communications for a lovely gain.

Magellan was born from the ashes of Fleet Industries in 1996, and a string of acquisitions over the next few years fuelled double-digit growth. That record drove the stock higher, peaking in 1997 at $11.20. Revenues rose to $625 million in 2000, as contracts were scored to build parts for Boeing, General Electric, Pratt & Whitney and Rolls Royce.

After the severe downturn in the commercial airline sector that followed 9/11, the company tried to shift production to gain more military work. That met with limited success: revenues languished at $478 million in 2003 and the company racked up big losses.

With a recovery in aircraft sales by Airbus, Boeing and Bombardier after 2003, the case for buying Magellan became more compelling. With an increasing backlog of orders, it seemed just a matter of time until the company returned to health, or as that year's annual report title had it, "Positioned and Ready."

Though the stock price was reasonable, each time we reviewed the company we searched in vain for a clear signal that the corner had been turned. Instead there was a troubling pattern of deterioration. Efforts to prop up the balance sheet were costly. A rights offering in 2004 raised $31.1 million but resulted in substantial dilution. One would have thought that raising so much capital would have at least reduced interest expense, but instead that line item jumped from $12.7 million to $23.6 million and has remained stubbornly high since.

What went wrong? Magellan tried to grow its way back to profitability, but poor execution mired these efforts. The acquisitions of Mayflower Aerospace and Haley Industries did halt the revenue decline, but did nothing for margins and sucked up precious working capital.

Plus, when a corporation is tight on cash, it sometimes behaves like consumers caught a bit short before payday: it sells accounts receivable at a discount. The first year Magellan did this, the discount was a modest 3.2 percent. But it's a nasty habit to get into, as over time the rate keeps going up. Last year the discount was 6.3 percent for a total of $3.7 million. That ain't chump change!

At every opportunity, management lays the cause of its problems on a soaring Canadian dollar and high production costs in North America. No doubt these are serious issues, as they are for all Canadian manufacturers, but the excuse doesn't quite cut it. Other competitors, such as Quebec-based Héroux-Devtek, have also been buffetted by these headwinds, but that company is profitable and its stock price has tripled since the lows of 2003.

One thing we still like about Magellan is the strong support it receives from chairman Murray Edwards. Indeed, a key reason that the corporation still has reasonable access to credit is due to his personal loan guarantee. But the corporation's financial straits must tax even a billionaire's patience; $70 million in convertible debentures are coming due next month.

These are treacherous waters for this ship to navigate, and the current stock price of $1.24 reflects the task. While this company appears on first blush to be a bargain, we'll wait to hop aboard until after we see how far Admiral Edwards is willing to go on this rescue mission, along with some notable improvement on the balance sheet.


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