Date: February 10, 2011
Welcome to Aeroquest International. After several difficult years, we finally find ourselves in 2011 in an improving and growing market again in most of our businesses. However, while we see it now as we head into fiscal 2011, fiscal 2010 was different.
I would like to describe fiscal 2010 as an inflection year for Aeroquest International. I call it that because during the year we saw good evidence of a turnaround in our markets, but the effect of the turnaround had not yet been reflected in our financial results by year-end. As a result, Aeroquest’s financial and operating performance was below its expectations and below what we would consider to be acceptable performance for a typical year. The primary reason for the shortfall is the fact that our markets have not rebounded as quickly and as sharply as we had hoped they would.
In the long run, the health of our industry is determined by the level of commodity prices; high commodity prices stimulate exploration – both because firms generate more cash flow, enabling them to spend more, and because higher commodity prices expand the range of economic resources. For example, exploration projects that might be uneconomic and consequently uninteresting when gold is at $400 per oz. may become viable and much more exciting when gold is at $1,400 per oz.
However, in the short run, it is the financing market – the market for risk capital - that drives the demand for our services. If risk capital is not readily available for exploration companies, they are not as comfortable spending on exploration at the levels they would like. Most of Aeroquest’s revenue is derived from spending in the highest risk, longest term category of exploration – grassroots exploration. Since these types of projects do not typically pay off for five to 10 years, they require an atmosphere of reasonable optimism and business confidence. On balance, fiscal 2010 did not provide the required level of optimism and confidence.
We were pleased to see that there were a significant number of exploration companies raising funds in fiscal 2010 even if this did not translate directly to a big increase in spending in our sector of exploration services. We are also encouraged that activity in sectors related to ours – like contract drilling – seems to have begun to recover with many drillers operating at or near capacity as we ended September of 2010.
These things all contribute to a higher sense of optimism on our part for 2011, however, before we talk about the future, let’s review the past year in more detail.
Review of Fiscal 2010
We have three principal lines of business, which we describe as Airborne Geophysics, Aerial Geomatics, and Instruments & Sensors.
Airborne Geophysics
Airborne Geophysics is our largest business segment by almost all measures. In fiscal 2010, we made significant progress in completing the re-branding of our service offering in this segment. We have brought our two principal operating subsidiaries – Aeroquest Surveys and UTS-Aeroquest – together as one organization, called Aeroquest Airborne. This was a part of the One Aeroquest initiative I described in last year’s Letter to Shareholders. This change will make it easier for our customers to interact with us, eliminate any confusion that may have been left over from our acquisition of UTS Geophysics, back in 2007, and allow us to focus on building the value of one brand, rather than having to spread our marketing and advertising energies over two brands.
During fiscal 2010, we also saw a recovery in our fixed wing operations. Fixed wing surveys, generally magnetic or gravity surveys, are normally less expensive on a per line kilometer basis than helicopter surveys. For this reason, the fixed wing side of the business generally out-performs the helicopter side of the business during the market troughs (one can cover more ground for the same price, or the same amount of ground for a lower price). We finished the fiscal year 2010 with a very healthy level of backlog in our fixed wing operations – in excess of 660,000 line kilometers representing approximately 40% of our current annual capacity in fixed wing.
The two weakest points of Airborne Geophysics’ performance this year were: 1) our overall performance in helicopters; and, 2) our gross margins in fixed wing surveys.
Helicopter Performance
There is no dancing around this issue. This segment of our business has been very weak for two years now. Over 50% of the cash burn in our business over the past two years has come from our decision to try to retain a critical mass of people and capacity in this operation. These have been difficult times and there have been some times this past year when we wondered whether or how long we could afford to continue. However, when this segment turns around, it is capable of being the single largest contributor to revenue and EBITDA, and for this reason we have continued to support it. We are looking for a turnaround in our helicopter operations in fiscal 2011; indeed the business overall requires it.
Fixed Wing Margins
Our gross margin in fixed wing surveys was 18% for the year. This is well below the level we would normally expect and is a result of several factors:
- Price continued to be the basis of competition. For example, our average revenue per line kilometer of fixed wing surveys in fiscal 2010 was $13.18 – as compared to, say, fiscal 2008 when it was $15.81 per line kilometer.
- We got off to a very slow start in fiscal 2010. As late in the year as February (the fifth month in our fiscal year) we had no material backlog in this segment (and little revenue). All of the sales performance in the year in fixed wing came in the last seven months of the year; and
- Once we got going, we were slower to ramp up than we had hoped. We went from a position of having two of our 10 fixed wing systems to 11 of 11 fixed wing systems flying within a few months. Complicating the issue was that these 11 systems were flying in six different countries spread over three continents. This logistical complexity stretched the limits of our suddenly understaffed organization and was reflected in higher than expected survey costs in our fourth quarter, in particular.
This may all sound a little bit like I am making excuses, and to some degree I am. None of us in the company was really pleased with how long it took us to get flying and profitable in our fixed wing operations. In spite of all these reasonable justifications, we all felt that we could have done it better and faster.
Overall, Airborne Geophysics contributed $23.5M of revenue during the year and generated an EBITDA Contribution of ($2.1M).
Aerial Geomatics
On September 30, 2009, we closed the acquisition of Optimal Geomatics, a publicly listed Canadian company in the aerial geomatics, or remote sensing, space. Aeroquest Optimal, as it is now known, provides mapping services to its customers in the United States, Canada and South America, focusing in particular on ortho-photography and LiDAR.
In its first year as part of Aeroquest International, the Aerial Geomatics group under-performed slightly relative to expectations. There were a number of contributing factors but the two most significant were a higher than normal requirement to outsource activities, and a noticeable fall off in new business in the second half of the year. With respect to the first of these two issues, Aeroquest Optimal, like many companies of its size is limited by having only one of a particular sensor. Because of conflicting commitments to clients, we sometimes cannot use our own sensor on all the work we have been awarded. When this happens we outsource that work to another firm in the industry. However, we are not generally allowed to keep the margin associated with that work. While we continue to record the revenue, the cost of sales associated with that revenue is generally 95% or more as a result of the outsourcing requirement. This shows up as a negative variance to our profitability without being a negative variance to our revenue. In fiscal 2010, this happened more often than we expected it would and more often than we would have liked; and as a result, hurt our expected profit margin considerably. We are addressing this by expanding the number of sensors we will have available for both ortho-photography and LiDAR in 2011.
The second factor was a rather abrupt decline – industry-wide – in contracts in the second half of fiscal 2010. We managed to recover somewhat by the end of the fiscal year, signing a large contract with the United States Army Corps of Engineers (USACE) , St. Louis office (up to US$10M, over up to five years), but that award came too late in the year to affect revenue in the year. The decline in demand the second half of fiscal 2010 has variously been attributed to government entities having spent all of their stimulus money in the first half of the year, or choosing to direct more of those funds into what are known as “shovel-ready” projects. Shovel-ready projects employ people – construction workers - and are thus priority targets for government stimulus spending. In any event, we have seen a pick-up in activity since late in fiscal 2010 in the government sectors of USACE, State and Local Governments (S&L), and Departments of Transportation (DOT’s). The private market, which we refer to as A&E (Architecture and Engineering) remained quiet throughout the year.
Aerial Geomatics contributed $7.6M in revenue during the year and ($0.2M) in EBITDA Contribution.
Instruments and Sensors
In fiscal 2010, we changed the name of our subsidiary Geophex to Aeroquest Sensor Technologies or Sensortech for short. We made this change both to reflect its status as a member of the Aeroquest Group, and to better designate its future strategy and direction, which increasingly will be focused on developing commercial applications for its various technologies.
Sensortech has a positive year. It successfully demonstrated two devices from its GEMTM brand technologies. One is a hand-held unit that combines the patented GEM EMIS technology with Ground Penetrating Radar (GPR) to produce a unit that uses Electromagnetics to determine metal content and GPR to define the size and shape of the object. During the year, we sold a half a dozen proto-types to the US Military for testing and evaluation purposes.
Sensortech also developed two versions of a vehicle-mounted GEM array – to be attached to the front of a Humvee army vehicle. The array units use multiple coils to more accurately pinpoint the location of buried metallic objects. The data coming from the sensor coils can be relayed to a computer in the cab of the Humvee and processed and interpreted in real time, allowing the Humvee – at speeds of up to five km/hour, to either stop or take evasive action to avoid running over a buried landmine or IED.
Just after fiscal year-end, Sensortech received notice of a $0.7M award from the US Department of Defense’s Commercialization Pilot Program (CPP) to enable it to turn these prototype metal detectors into commercially viable products.
In fiscal 2010, Aeroquest Sensortech was responsible for $2.5M of revenue and $0.7M of EBITDA Contribution.
Performance against 2010 Objectives
We established three objectives for ourselves for the year. Here is how we did against them:
| Objective | Achieved | Outcome |
| Get back to profitability | NO | Our consolidated net loss for the year was ($8.6M), an improvement over 2009, but still unacceptable. |
| Rebuild our capital base | NO | Our Liquidity (Cash, plus Net non-cash working capital, plus Net credit available) was $8.1M at year-end, as compared to $12.6M at the beginning of the year. |
| Become One Aeroquest | YES | During the year, Optimal Geomatics was repositioned as Aeroquest Optimal, Geophex was re-branded Aeroquest |
| Sensortech and, just after year-end, we announced that UTS-Aeroquest and Aeroquest Surveys would be combined into one business unit – Aeroquest Airborne. |
Performance against Strategy
We also had several strategic imperatives that we have been pursuing over the past four years. Here is a summary of our fiscal 2010 performance against those initiatives:
| Strategy | Accomplishments |
| Establish ourselves internationally |
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| Expand our addressable market |
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| Identify complementary technologies |
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In summary, we believe that we made substantial progress against our strategy and in our non-financial performance objectives; however, we under-performed significantly against our financial objectives.
Fiscal 2011 Objectives
In fiscal 2011, as in previous years, we have established certain objectives of ourselves for the upcoming year.
| Principal 2011 Objectives |
| 1. Restore profitability and the fortress balance sheet. Our financial objectives are clear; the company must be profitable and awash in liquidity if we want to be able to fund our growth potential. |
| 2. Re-build the Aeroquest franchise. Following on the successful re-branding of our business units to One Aeroquest, now take it to the next level – create an enduring franchise and re-establish the culture. |
| 3. Re-establish technological leadership in our three core businesses. Leadership in our industry comes through the effective combination of people and technology. In fiscal 2011 we will reposition ourselves at the forefront of technology in each of our three core businesses and focus on further developing our people into the most admired team in our industries. |
In summary, we’ve come through another difficult year. At one level it is not surprising; the world continues to be a very uncertain place and we operate primarily in a highly volatile industry that requires a certain level of business optimism. That volatility works in both directions however; it hurts us badly during downturns, but also gives us the capability, in theory at least, to recover just as quickly during upturns. I know I speak on behalf of all of our employees when I say that we, too, cannot wait for the return to the growth and profitability levels that we expect during the recovery.
Thanks again for your patience.
Roy T. Graydon