No. of Recommendations: 8
BUSINESS
INVN (InVision Technologies, Inc.) is the maker of the big baggage inspection machines you see in all the airports today. INVN has developed much of the technology for non-intrusive baggage inspection for explosives and was the technology and revenue leader for baggage inspection machines. Before 9/11, INVN was still relatively obscure with a low revenue level (about $60-$80M) and small but persistent losses, and was getting ready for another round of layoffs.

Clearly 9/11 changed everything for INVN. FY2002 revenue was $439M, 6 times FY2001's revenue. The aggressive deadlines to install baggage inspection capability in all US airports by the end of 2002 were met, largely with InVision machines ordered by the FAA (now TSA). 4Q02 revenues alone were greater than FY1999, FY2000, and FY2001 combined, a factor of 10 higher than the previous year's 4Q.

INVN has impressed me greatly in their ability to ramp revenue by a factor of 10, and then down again by a factor of 2-3 as the aggressive deadlines passed, while keeping their margins nearly constant. Starting in mid-FY2002, gross margins have been consistently at about 40-43%, and operating margin has been about 30% (from near zero) although the last two quarters have seen a reduction down to 20% due to increases in SG&A mainly for acquisition assessment, and general headcount increases. Going forward, it is probably better to count on a 25% operating margin or slightly less, rather than 30%.

One of the things that I am convinced of in business is that the ability of a management team to deal positively with random events thrown their way has more to do with long-term success than almost anything else. Over time such a team builds a competitive advantage where others may miss chances to do so. (As Charlie Munger likes to say, "You never know what's going to happen, but you need to be prepared for it.") In my mind, INVN's demonstrated results puts in about the highest category I've seen in quite a while.

Future goals for INVN are to improve the throughput of their machines so that 100% of all baggage can be inspected, and to expand internationally. Currently (first 9 months of 2003) 26% of INVN's revenue is international, up from 16% last year. New technologies are being developed as well as aggressively acquired. Additionally, warranty and service revenue will increase substantially as the newly-installed machines come off their 2-year warranty period. TSA has also made it clear they would like a single solution for all baggage inspection, which positions INVN extremely well.

Most of the executive management team has been at INVN for 5 years or more, including the CEO at 11 years.

10K, DEF14A
Both the 10K and DEF14A (Proxy Statement) are clean, well written, and no red flags. The CEO was on the compensation committee until Nov 2002, but the company's compensation structure is quite reasonable. There is a good discussion of risks in the 10K, although the list is rather long.

NUMBERS
As described above, INVN's revenue, operating income, etc., have bounced around a lot. I believe the relevant historical data is from FY2002 and TTM, but with reference to previous years as appropriate.

FY2002 revenue: $439M; TTM revenue guidance: $410M.

Operating margin: FY2002 30.2%, TTM 28.9%

Working capital has bounced around a lot, recently due to very large ARs in FY2002 that got paid in lumps. 4Q02's AR, for example, was $173M. The current snapshot is probably a better indicator; AR is $66M and all net Working Capital is $72M, 18% of the projected FY2003 revenue. In any case, the trend is good: AR as a percentage of revenue has dropped from historical levels from 30% - 40% of revenue (wow, that's bad) to the current 13%. Inventory has shown a similar trend but not of the same magnitude. In other words, asset management has greatly improved. Put another way, AR turns is now at 5.0 (I'd like to see 6.0, in general), and Inventory turns is now at 4.6 (I like to see 4.0).

CapEx has been low and fairly constant at about $1M/year. This year's company projection is $5M.

Current Ratio is very strong at 4.6.

Cash is $282M, roughly $16/share.

Total Long Term Debt is $126M, including a recent $125M convertible senior note offering. This represents a Debt/Equity ratio, not counting Goodwill as an asset, of 51%.

VALUATION
This is the hard part and there are going to be a lot of swags here, but reasonably comfortable from my point of view.

The company is quite forthright in saying that it is difficult to provide guidance; until 2Q03's conference call they provided none at all and then only revenue guidance, not profit. I imagine that this also scares off analysts, and as a result may produce a bargain price for a fundamentally sound company.

Revenue guidance for FY2003 is $410M and FY2004 is down to $310M as INVN expects a lull in orders as airports are redesigned to accommodate high-throughput inline baggage inspection and lobby space is given back to retailers.

Revenue: I will use the $410M INVN is guiding for FY2003. After that, I will start at $350M, 12% higher than INVN's FY2004 guidance, as they have a history of understating guidance. Starting from $350M, I will assume a starting growth rate of 20% revenue growth per year, reducing by 10% per year (i.e. year 2's growth rate is 18%, year 3's is 16.2%, and so on). These are all guesses and yours will be just as good as mine.

Other assumptions that go into the FCF calculation:

* Operating margin: as discussed above, I will choose 25%

* Working capital needs: hard to pin this down as it varies all over the map depending on payment schedules. The current TTM period shows working capital at 16% of revenue. I will choose 20% of revenue. Purchase contracts provide for an initial payment that covers most working capital needs, so INVN does not have to put up the full Working Capital itself, so the 20% number should be quite conservative.

* Tax rate: standard 38%

* Depr/Amort: I will assume 0%

* CapEx: historically this has been quite low, $3-$5M/year, 1% of revenue. I'll say 2%

* Annual share dilution of 5%

FCF = Revenue * ( (OperatingMargin + DeprAmort) * (1 - TaxRate) - CapEx) ) - WorkingCap*IncrementalRevenue

Using these assumptions, FCF projections per share, assuming 5% dilution/year, are as follow, along with the present value of each future FCF discounted at 12%:

Year Rev FCF/sh PV@12%
2003 410 3.64 3.64

2004 350 3.43 3.07
2005 420 2.06 1.64
2006 488 2.44 1.74
2007 559 2.75 1.75
2008 633 3.04 1.73
2009 707 3.32 1.68
2010 782 3.57 1.62
2011 857 3.80 1.54
2012 931 4.00 1.44
2013 1003 4.17 1.34

Note the rapid FCF decrease in years 2004 and 2005; actually this is only in comparison against high FCFs in 2003 and 2004 due to reduction in revenue and therefore lower working capital requirements, which contributes directly to higher FCFs.

The sum of discounted FCFs from 2004 through 2013 (10 years) is $17.54/share. The 2003 FCF results are already mostly built in to the current balance sheet numbers, which I calculate conservatively (non-working capital net current assets) at approximately $12.33/share; by 4Q03 this should be maybe about $14/share.

Terminal value: I will take the last discounted FCF ($1.34) and assume it goes on forever, and discount it at a 12% rate, which is $1.34/0.12 = $11.17/share. To be conservative, I will take only half that value.

Total IV = $14 + $17.54 + 0.5 * $11.17 = $37. INVN closed today at $31.92/share, a 14% discount from this IV calculation.

CONCLUSION
Clearly there is a lot of latitude in valuing a company such as INVN and the scenario above is only one of a wide spectrum of possibilities. However, assuming that increased baggage inspection is a certainty, that international airports will follow suit with mandatory baggage inspection installations, and that INVN will continue to perform well in the face of new random events, I think most valuation calculations will probably show INVN to be undervalued today. In addition, INVN's management team has shown what I think is outstanding capability to manage their business, and their long history with the company bodes well for the future.

Disclosure: I invested a pretty substantial amount in INVN this summer. I performed this analysis as part of a general portfolio review and based on its results, am happy to keep my INVN investment.
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No. of Recommendations: 0
Excellent discussion and valuation.

Thanks
>^..^<
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Hi mklein,

I concur with mskk - excellent piece of work thank-you

Regards
Philip
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<admiraltroll>
I concur with mskk - excellent piece of work thank-you

Regards
Philip


and

<kitkatlub>
Excellent discussion and valuation.

Thanks
>^..^<


[blush] Gee, thanks guys, particularly considering your expertise in these matters. I do hope the investment pays off nicely. So far so good.

-Mike (mklein9)
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Great analysis. I'm taking a look at INVN after reading the article today on the Fool. Do you happen to have a spreadsheet that you used to do your calcs? I'm trying to put together on myself, and can use any help I can get. Thanks!

Gator
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Hi Gator -- I don't have a ready-made spreadsheet of the type you're probably looking for. I use a combination of tools, the primary of which is a large and increasingly complex program I have written in combination with a downloaded subscription database from the AAII.

The only thing I have that might be useful is a spreadsheet that will calculate cash streams and discounted values for 10 years, plus a guess at a terminal value... but it's less generally useful than it might sound because you have to enter the cash flow *starting value* manually, along with initial growth rate and discount rate. Those are the hard parts.

-Mike (mklein9)
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