Magellan still faces tough voyage

Portuguese explorer Ferdinand Magellan achieved many milestones during his short 41 years. He led the expedition that was the first to circumnavigate the globe, he was the first European to reach the Philippines, and he was the first European to reach the Pacific through what is now named the Strait of Magellan.

But his celebrated voyage around the world was harrowing. 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 from scurvy and starvation. Magellan, himself, was killed in a battle in the Philippines. Of 270 crew, only 18 survived.

Closer to home, Mississauga-based Magellan Aerospace's(MAL-TSX) 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 Magellan Aerospace for a few years, although it only recently met our rule that a company has to exist for a minimum of a decade before we will consider buying its shares. In the past, some aerospace picks have done very well in the Contra the Heard portfolio, including Chicago-based Northstar Aerospace (NAS-TSX) and Toronto-based Spar Aerospace Ltd., which was taken over by L-3 Communications for a lovely gain.

Magellan, which develops small satellites for the Canadian Space Agency, was born from the ashes of Fleet Industries in 1996; a string of acquisitions over the next few years fuelled double-digit growth. That record drove the stock price higher, peaking in 1997 at $11.20. Revenue 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 after the Sept. 11, 2001, terrorist attacks in the United States, the company tried to shift production to gain more military work. That met with limited success; revenue 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 shares 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, became "Positioned and Ready."

Although the stock price was reasonable, on each of our company reviews, 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 that capital would have at least reduced interest expenses, but instead that line item jumped to $23.6-million from $12.7-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 company is tight on cash, it sometimes acts like consumers caught a bit short before payday - it sells accounts receivable at a discount. The first year that Magellan did this, the discount was a modest 3.2 per cent. But it's a nasty habit to get into as, over time, the rate keeps going up. Last year, the discount was 6.3 per cent - for a total of $3.7-million. That isn't chump change.

At every opportunity, Magellan management blames its problems on Canada's soaring dollar and high production costs in North America. No doubt it is a serious issue, as it is for all Canadian manufacturers, but the excuse doesn't quite cut it. Other competitors, such as Longueuil, Que.-based Héroux-Devtek,(HRX-TSX) have also been buffeted 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 company continues to have reasonable access to credit is owing 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.

That's a treacherous rock for this ship to navigate around, and the current stock price of $1.19 reflects the task. While on initial blush this company appears 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.

This column first appeared on GlobeinvestorGOLD.com.