Force Protection--Explosive Turnaround Story.

Have you ever gazed at a stock that fundamentally looked like all the stars were in alignment for probable share price gains, but something nagged at you not to push the BUY button?

Sales at Force Protection (FRPT.OB-$6.41), a Ladson, S.C.—based maker of ballistic and blast-protected military vehicles, rocketed to $90.8 million for the six-months ended June 30, 2006, up from $1.2 million for the full FY ended December 31, 2001.

The Company, which bled red ink for five years, went from a ‘Going Concern’ being issued by its accountants in April 2006, to finally achieving profitability, recording a net profit of $568,382, or share-net of $0.01, for the 1H:06, the result of a sharp increase in demand for the Company’s armored vehicles in Afghanistan and Iraq.

In February 2005, the Company affected a 12:1 reverse split of its Common Stock. The Company, however, has finally rewarded its long-suffering shareholders, with the stock price climbing 305.7% in the last year.

Roadside bombs, which the military calls improvised explosive devices (IEDs), are the cause of most of the combat deaths and injuries in Iraq.

According to a recent military report, insurgents planted a record number of roadside bombs last month. Approximately 2,625 bombs exploded or were discovered before they could detonate in July, up from 1,454 in January. And as the ‘conflict’ [Ed. note: O.K. CIVIL WAR!] widens in Iraq between Shiite and Sunni insurgents, more U.S. troops will find themselves in harm’s way.

Force Protection produces two series of armored vehicles—the Buffalo and Cougar—to detect IEDs and landmines. These protective vehicles are designed with advanced V-shaped hulls to help deflect the blasts of the bombs away from the passengers within, too, and can travel at speeds up to 70 miles per hour.

The Buffalo is the heavier of the two products—weighing 22 tons—and is designed principally for route clearing activities. It integrates a blast resistant capsule with an American-made truck engine and drive train.

The Cougar—at about 14 tons—is lighter than the Buffalo—but is built to offer a similar level of blast protection. It is designed to withstand a 30-pound blast of TNT to either the front or rear axles as well as a 15-pound blast to the center portion of the vehicle. A 4-by-4 Cougar is equipped with tires that will run even when flat.

The Cougar can be configured to complete a wide variety of mission requirements. The newer, Hardened Engineered Vehicle (HEV) can serve as a mine-proof troop transport vehicle, a law enforcement special response vehicle, a weapons platform, or an escort protection vehicle.

Current backlogs indicate substantial growth in sales over the next several quarters (but are already reflected in recent stock price gains). The Company forecasts 2H:06 delivery of 164 armored vehicles, as compared to actual delivery of 37 vehicles in the 2H:05. Revenue is primarily recognized at the time goods are delivered and accepted by the customer.

The world market for mine-protected vehicles is growing rapidly. Landmines and IEDs are the weapons of choice for terrorists and insurgent groups because they are highly effective yet relatively low cost. With increasing world tensions, we agree with management that there is a need for vehicles that can provide a level of protection against these threats during a variety of missions. Such missions include troop transport in and around unexploded ordnance or mine threat areas as well as route clearance and humanitarian de-mining—which require entrance into known mine fields.

Most of these missions require operating in areas of known terrorist activities and have traditionally been accomplished using light weight wheeled utility vehicles, including, for example, the High Mobility Multi Wheeled Vehicle (better known as the “Humvee”). However, Humvees were never designed to sustain high—powered explosive blasts and these un-armored utility vehicles are vulnerable to enemy fire and offer a prime target for attack.

Additionally, trying to better the armor and blast protection of the Humvee by retrofitting heavy armor into its hull, has not worked and has increased the mechanical wear caused by the added weight, too.

Conventional armored vehicles such as the Bradley and the Abrams tank do offer some protection from ballistic and blast threats. However, even these are too often no equals for the latest batch of powerful IEDs. Further, these vehicles are expensive, and require substantial resources to maintain. They are large and difficult to maneuver in crowded urban environments.

Force Protection is working on a blast-protective vehicle capable of carrying cargo and troops. This prototype, the Mine-protected Utility Vehicle/Rapid Deployable, or MUV-R (dubbed the Mover), is a potential replacement of the Humvees used by the military.

There are an estimated 150,000 Humvees in active service in the U.S. military. The government is expected to put out a request for replacement proposals in November (with production expected to start in 2008). A contract win by Force Protection could be a future footprint of success for the Company and its stock price.

To date, the Company has experienced no fatalities in any of its vehicles.

In our view, as the U.S. military increases its focus on protecting our troops—and expands [NOT contracts] its ‘peace-keeping’ efforts in Iraq, Force Protection should witness an increasing market demand for its products.

During 2005, Force Protection depended on two principal customers, the United States Army and the United States Marine Corps. Albeit there is risk with such a limited customer base, the Company recently announced it has been awarded a contract by the British Ministry of Defense for more than 85 Cougar Explosive Ordnance Disposal (EOD) vehicles.

As evident in the Common Stock price gain this year, investors have jumped onboard Force Protection due to the clear signs of a turnaround in the Company’s fortunes. Given growth shows no sign of slowing—why the apprehension in buying shares for our portfolio?

Financial Considerations

In the 1H:06, gross margins improved 400 basis points to 18.5%, which management attributes to increased vehicle production and increased operating efficiencies.

Many government contracts are fixed-price and maybe subject to termination or renegotiation at the convenience of the government. And, large portions of the Company’s factory expenses are fixed. Ergo, management would be unable to reduce expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. As a result, expected profits could become realized net losses.

For the six month period ended June 30, 2006, after years of bleeding red ink, Force Protection generated positive cash flows from operations (CFFO) of 4.0 million. However, the 10Q Detective notes that if you back out the $7.2 million increase in accounts payable, CFFO flips back into the red--$(3.2) million.

The Company has (historically) depended on the capital markets to stay afloat and fund continuing operations. For example, on July 24, 2006, corporate realized net proceeds of $39.2 million through the sale of 8.25 million shares of its Common Stock (at $5.00 per share) in a private placement to institutional investors, including John Hancock and Cortina Asset Management.

As of August 14, 2006 Force Protection had approximately 51.1 million shares of common stock issued and outstanding, up from 21.7 million at FY ended December 31, 2003.

The accumulated deficit (as of June 30, 2006) was $(48.9) million. The book value was $0.08 per share.

Management is optimistic that infrastructure expenses previously incurred in connection with the production ramp-up will begin to level off or decline and that the Company will continue to experience increased levels of positive cash flows from operations as the Company increases the volume of vehicle production. Management also expects that such positive cash flows will allow the Company to pay down all or a portion of its short term debt and reduce the level of its accounts payable ($21.9 million).

In addition to growth acceleration, there is also the possibility of a growing recurring revenue stream from the sale of spare parts and other support services. During the FY ended December 31, 2005, spare parts contributed 10.9% to total sales of $44.8 million

As of June 30, 2006, the Company had $3.4 million in cash, the Total Debt was about 30.3% of Total Equity, and for the 1H:06, the interest coverage ratio finally swung positive—albeit a less than stellar 1.35 times operating income.

Corporate Governance Issues

Effective April 18, 2005, Gordon McGilton was promoted from Chief Quality Officer to CEO. Along with the usual salary [$420,000] and bonus-option incentives, the Company also agreed to pay Mr. McGilton "in kind" compensation in the amount of $20,000 (in the form of a Vortex jet boat). This "in kind" compensation was for work performed by Mr. McGilton as an independent contractor during 2001 and 2002—three years earlier?

And, it is not like McGilton could not afford to buy a NEW boat, for he received options to purchase 1,000,000 shares of Common Stock at an exercise price of $0.72 per share (which vest on January 1, 2007)—now worth an estimated $6.4 million.

In addition to his duties as CEO, McGilton is a principle of APT Leadership, a consulting firm the Company hired to provide various “business consulting services, training seminars and certain business software.” Through the period ended June 30, 2006, APT Leadership billed Force Protection a total of $563,120 for such services, training and software. In addition, Force Protection entered into an agreement with APT Leadership pursuant to which the Company purchased a non-exclusive right and license to use the “diagrams, methods, concepts and business operating system functionality” contained in APT Leadership software and presented in APT Leadership's training seminars. Force Protection also paid a one-time license fee of $60,000 and agreed to pay an annual license fee thereafter of $50,000 under the terms of the said agreement.

The 10Q Detective would like to know—why the need for this leadership training? According to the APT Leadership website, the consulting firm provides motivational services designed to get employees “working together towards the organization’s goal.” The Company is selling armored vehicles—not burgers. Would not the monies be better spent on defense lobbyists? Or, given the highly politicized nature of weapons procurement programs, perhaps the monies ought be channeled as PAC money to the re-election campaign of embattled Congressman Henry Brown (R-SC), a big advocate for Force Protection on Capitol Hill.

Investment Risks & Considerations

Force Protection markets its products to a limited customer base and if the Company does not find acceptance of its products within that customer base, or if the Department of Defense (because of budget issues) cancels contracts, its business may fail. As previously mentioned, the Company did just receive a contract with the British government for 85 Cougar armored vehicles.

The Company is subject to significant competition from companies that market products that perform similar functions. This competition could harm the Company’s ability to win business and increase the price pressure on its products. The firms that Force Protection competes against include large, multinational vehicle, defense and aerospace firms such as BAE Land Systems, Iveco DVD (Italy), Textron, Stewart & Stevens, Australian Defense Industries, Oto Melara (Finmeccanica-Italy), and General Dynamics.

On June 16, 2006, Force Protection significantly improved its competitive position when it signed an intellectual property agreement to develop and market patented Blast Manipulation Technology (applicable to wheeled and tracked vehicles) with South Africa’s Council for Scientific and Industrial Research (CSIR), a world leader in (blast-resistant) lightweight composite research. Still, it troubles us that corporate—perhaps to raise EPS visibility—is spending less than four cents of every sales dollar on R&D. Ought the Company be spending more on technology and research to exploit their competitive advantage?

With relatively short production runs and high fixed factory costs, contrary to what management would lead us to believe, sustainability of future profitability is difficult to predict. Force Protection is benefiting from the U.S. military’s need to and ramp-up of combat-ready protective vehicles for service in Iraq and Afghanistan. There is no guarantee that the Company will be awarded procurement contracts in the future for the replacement of legacy systems (such as Humvees); and, to date, the Company has had limited success in diversifying into other markets.

Valuation Analysis

After an extended period of downsizing, followed by mergers (to consolidate excess capacity), the Land Combat Systems (LCS) industry appears to be in the midst of a robust growth period—both domestically and globally. For example, given the expanding demand for protected vehicles for military applications in Iraq and Afghanistan, and the move toward transforming legacy systems in both the U.S. Army and the U.S. Marine Corp., industry pundits predict that more than $2.0 billion per annum over the next twenty years could be infused into the domestic LCS industry.

The impact of globalization is also leaving its footprint on the U.S. LCS industry.

In our view, the trend of mergers and acquisitions are likely to continue, and Force Protection could find itself on the front-end of a merger by a foreign concern (probably a U.S.-NATO ally) looking to build a presence, competitive advantage, and an increased access to U.S. markets.

Is the Common Stock of Force Protection worthy of new investments?

Manufacturing needs of the U.S Military will keep sales (and profits) trending higher through at least the 2008 timeframe. However, we believe that the market has already discounted this timeframe (witness the 305.7% price gain in the past 52-week period). After 2008, all bets are off—new faces in the White House, compounded by rising deficits and Social Security payments, could spell cutbacks in Department of Defense spending.

In our opinion, Force Protection’s management does not have the know-how to be profitable as a ‘low-volume’ producer—with only two product lines, the Company is highly dependent on ramping up production for sustainable profitability. And management has yet to demonstrate its ability to leverage its core-competence by exporting its blast-resistant technology.

Is Force Protection attractive as an acquisition candidate? In our view, this is a probable outcome, for the Company would be an attractive purchase for a (NATO-ally) European defense contractor looking to establish a U.S. footprint to improve their likelihood of winning Pentagon contracts. FY 2005 LCS transactions sold at an average EV/sales multiple of 1.65 times.

The current enterprise value of Force Protection is $331.24 million. Assuming the Company sequentially grows sales in the 2H:06, and exists the year (optimistically) with $240 million in full-year 2006 sales, that places an EV/sales multiple of 1.38 times on the price of the Common Stock. EV/sales of 1.65 times puts the Common Stock of Force Protection at $7.75 per share--a 20.9% premium above its current share price.

In June 2005, Britian’s largest defense contractor, BAE Systems, completed the acquisition of Arlington, VA. —based United Defense Systems (UDI), a dominant player in domestic LCS (like the M2 Bradley Infantry Fighting Vehicle) and a global leader in ground combat vehicles and precision munitions. The transaction for UDI was valued at $3.97 billion, or 1.73 times trailing twelve-month sales of $2.29 billion.

In the summer of 2004, BAE Systems outbid General Dynamics (by $100 million) for Alvis Vickers, the UK's principal land systems business. BAE paid almost $651 million, or 1.03 times Alvis’ trailing twelve-month sales.

At a current price of $6.41 per share, the Common Stock of Force Protection is valued at a P/S of 1.36 times FY 2006 exit sales of $240 million.

A turnaround at Force Protection is well underway, but lingering concerns on future contract wins will likely put a ceiling on further multiple expansion. A step-up in new product flow coupled with new contract wins—especially Humvee replacement orders—are the necessary positive catalysts for additional short-term trading gains in the price of the Common Stock.

Sales growth acceleration beyond FY 2008 is cloudier. However, industry consolidation trends bode well for shareholders in Force Protection.

The 10Q Detective, however, prefers to stay on the sidelines—at least for now.