Arotech Corporation (Nasdaq:ARTX) simply doesn’t know how to make money. The company has accumulated a frightening $100 million loss. The situation might change, and we naturally wish the company well, but this is definitely a warning that should worry investors.
Arotech has been making a lot of noise, but its road to profitability is still a long one. For now, acquisition follows acquisition, contract follows contract, and the company's orders backlog keeps on growing. That's all very well, and even impressive, but just as it did under its previous incarnation as Electric Fuel, Arotech has more than once promised success was just around the corner. It isn’t there yet.
Everything looks peachy at Arotech for the moment. The company talks about expanding in the new businesses Wall Street likes: security, simulators, and armored vehicles. The slogans say it all. Wall Street is in love with Arotech, and its share has been one of the hits of the past year, rising 200% from $1 to $3. At the same time, Arotech has made all the right moves. It raised a lot of money from institutional investors at a large discount on its market price, and acquired activities that boosted its bottom line.
The institutional investors were happy to participate in Arotech's issues. They get shares at a significant discount on the market price, and are able to immediately protect their investments through short sales of the shares, even though most of them are apparently anticipating a quick increase in value.
In at least some cases, institutional investors received convertible bonds at quite a low price, and the rise in Arotech's share price has made converting the bonds to shares worthwhile. Altogether, Arotech has raised $30 million at $1.85-1.90 a share from institutional investors, and gone on a shopping spree that would not shame companies several times its size. Arotech has meanwhile has exploited its skyrocketing share price to make acquisitions.
Everyone has been happy so far, and the gala is at its height. Institutional investors have made a 50-60% profit on their investments; Arotech's share is now priced at $3, after touching $4 in mid-April; the company is pleased with the expected growth in business; and its owners and executives are proud about the simple but ingenious maneuver that put Arotech back in the headlines.
Six months after the issues and acquisitions, tiny Arotech, with a market cap of $30 million, has become a holding company with a focus on three sectors: batteries for various uses; military simulators; and armored vehicles. Arotech - and this is not an error - now has a market cap of $190 million, thanks to the rise in its share price and the share issues carried out during the campaign. This market cap does not include the new shares received by the acquired companies' shareholders, which add another $4 million to Arotech's market cap. Altogether, this group of companies with an iffy past, unclear present, and obscure future (despite optimistic declarations by its managers) has a value of almost $200 million.
Netanyahu joins the fray
Let us begin at the beginning. Arotech's history is laid out in its financial report for 2003. Published April 3rd, the report describes the company's business during the 1990s, when it developed a unique zinc battery intended to become the standard in various industries, including vehicles. The rationale was the use of what was termed at the time environmentally friendly "electric fuel".
Despite promising tests by Deutsche Post, Arotech's product failed to become the industry standard, and the company's management, headed by Yehuda Harats, looked for something else to arouse investor enthusiasm. Arotech began developing a long-life battery for mobile telephone devices. The product was designed for people on long trips, or who are called up for reserve military duty, and are unable to recharge their telephones for extended periods. Benjamin Netanyahu was hired to open doors during his break from politics, but this was not enough for Wall Street.
Arotech simultaneously tried to acquire respectable Tadiran Batteries from Koor Industries (NYSE: KOR; TASE:KOR). Although the deal was not consummated, Koor was nevertheless obliged to invest in Arotech. That transaction took place in early 2000, but the subsequent stock market collapse sent Arotech into a two-year dormancy. In 2002, Arotech acquired IES Interactive Training, a developer of military and civilian simulators, for $8.4 million. In 2003, IES acquired Bristlecone Training Products for $480,000. In its new format, IES's sales rose from $5 million a year to over $8 million in 2003.
Arotech was also expanding into new fields. In 2002, it acquired MDT Armor Corp., a developer of armor for vehicles, for $1.8 million. MDT did not deliver the goods - its revenue fell from $6.4 million in 2002 to $3.4 million in 2003, due to a drop in orders from Israel's Ministry of Defense.
These activities inflated Arotech's balance sheet, and filled its profit and loss statements, but its net loss rose from $17.3 million in 2001 to $18.5 million in 2002, even as its revenue rose from $2 million to $6.4 million. Although the increase was due to acquisitions, Wall Street likes growth.
Arotech's 2003 consolidated financial report fully reflects the acquisitions made in 2002. The company's revenue rose to $17.3 million in 2003, but its operating loss rose from $4.7 million in 2002 to $5.4 million in 2003. The company's net loss in 2003 was $9 million, half the figure for 2002, a figure that Arotech is proud of, but the net loss in 2002 was mostly due to discontinued activities in the battery business. Operationally, Arotech's situation worsened.
To blur the picture, Arotech is pursuing its aggressive acquisition policy. The company made two simultaneous acquisitions, and it must be admitted that it managers have guts: even when mighty Teva Pharmaceuticals (Nasdaq: TEVA; TASE:TEVA) acquires a company, it first completes the process before making another acquisition. Arotech is simultaneously moving on all fronts. In mid-January, it announced the acquisition of US company FAAC Incorporated, a developer of military simulators, for $14 million, including $12 million in cash and the rest in shares.
FAAC reported a pretax profit of $1.8 million in $15 million revenue for 2002. At the time of the acquisition, Arotech SVP Communications Jonathan Whartman said, "Sales in 2003 were a little low, because major contracts were postponed to 2004." But Arotech's consolidated report shows otherwise. FAAC's revenue rose from $12.2 million in 2001 to $15.2 million in 2003, but plummeted to $9.8 million in 2003. This is not a "little low"; it's a precipitous plunge.
Maybe, we shouldn’t linger on petty details when discussing Arotech. After all, its strategy is growth at any cost. FAAC's revenue for 2004 will boost Arotech's consolidated revenue, and it will report substantially higher revenue than for 2003. Moreover, FAAC, which has been in business for 14 years, builds military simulators, while IES builds police simulators. There is potential for synergy, which will help boost Arotech's share.
FAAC takes up an entire chapter in Arotech's 2003 financial report. It turns out that FAAC builds simulators for airborne weapons, mainly for the US Navy and US Air Force, as well as simulators for truck drivers, mainly for the US Army. FAAC has sold 179 vehicle simulators to date, which have helped train 80,000 drivers.
They don't know how to make a profit
Immediately after the acquisition of FAAC, Arotech announced the acquisition of Epsilor Electronic Industries, a battery manufacturer specializing in lithium batteries. Arotech paid $10 million, $7 million in cash, with the rest to be paid in installments over the coming years, on the basis of Epsilor's performance.
Epsilor reported a pretax profit of $1.85 million on $5 million revenue in 2003, compared with a pretax profit of $1.7 million on $4.8 million revenue in 2002. At the time, Arotech stated that it anticipated a major increase in profits from its batteries business, thanks to growing demand from the US Army. Arotech claims that Epsilor's business is synergetic with its other battery businesses.
In any event, the acquisitions are likely to at least double Arotech's revenue to over $34 million, and its orders backlog appears even more promising. In recent months, it has won a series of contracts. MDT won three orders worth $3 million, $5.5 million, and $3.1 million, boosting its orders backlog, which totaled $900,000 as of December 31, 2003. Arotech's batteries business is also booming, winning a $5.2 million order late last year from the US Army for use in Afghanistan and Iraq. Arotech is also receiving orders for simulators. While promising, Arotech still faces some fundamental problems.
The first problem is that Arotech simply doesn’t know how to make a profit. The company's aggregate loss is over $100 million. The situation might change, and we naturally wish the company well, but this is definitely a warning that should worry investors.
The second problem is price. The more the company allocates shares and options to institutional investors at a discount, the higher its price rises. A $200 million market cap means a sales multiple of five or six for 2004, which is definitely not a low figure, especially since the company does not expect to post a profit. And if that were not enough, Arotech's consolidated financial reports list the large number of options given to its managers.
Over three million options were exercised during 2003, apparently at $1.20 each. Employees and top executives Robert S. Ehrlich, Steven D. Esses and Avihai Shen still hold nine million options at an average price of $1.37. There is a good chance that they will convert these options to shares, affecting Arotech's earnings per share. If all the options are exercised, that will raise Arotech's market cap by $27 million and its shareholders equity by $13 million.
The third problem, and possibly the most important, is Arotech's rate of acquisitions. It's no secret that mergers and acquisitions usually fail. Serial acquisitions increase the risk of failure, and Arotech's risk is high. After all, it is run by men, not supermen, and it's hard to see how it disperses its administrative resources among so many acquired companies. The acquisitions have contributed in the short term, investors are satisfied, and the share is skyrocketing, but in the end, all these businesses must be tied together. That is Arotech's big test.
Accumulated losses
The shareholders equity item in Arotech's balance sheet is its accumulated profits, or rather, its accumulated losses. In effect, this is the sum of the company's bottom lines since it was founded, and reflects is business over time.
Nevertheless, there are advantages in losses. Accumulated losses can offset future profits, reducing tax liability on those profits. This will come into play when the company actually reports a profit, and it is possible, provided Arotech meets certain accountancy criteria, that the tax benefit can be taken in advance. Arotech may recognize its tax assets at the expense of future profits.
Published by Globes [online] - www.globes.co.il - on April 28, 2004