After receiving an award for innovation in the NDT industry in mid-2014, the company has continued to establish itself as an industry leader in the field of structural health monitoring (‘SHM’). The company recently received results of a long-term test of 70 sensors, which has shown promising results. Further news of a MOU between Airbus subsidiary TESTIA and the Company whereby TESTIA will become fully integrated with the Company’s development and production should mean fast-tracked commercialisation. FAA approval for use as an ‘Alternative Method of Compliance’ (‘AMOC’) is anticipated by the Company in the near future; but despite these developments, SMS’s share price has remained steady. This report makes a preliminary assessment of the market potential of SMS’s technology suite by examining the real savings of CVM technology across three core markets. We estimate the value of these savings from the technology to be in the field of AU$1 billion per year.

Important Note: this document has been prepared by the Sales, Trading and Investment Advisory department and not by a Research department. Mac Equity Partners seeks to and does business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this as only a single factor in making their investment decisions. The company featured in this document should be considered speculative in nature and carry a high degree of investment risk. Please consider if investments in these types of companies are appropriate for your personal circumstance.

www.macequity.com.au

STRUCTURAL MONITORING SYSTEMS PLC

UPDATED REPORT APRIL 2015

www.smsystems.com.au

Non-destructive testing and inspection (NDT/NDI) of critical structures and components of infrastructure is an extremely important aspect of asset management, safety and operational efficiency. Analysts at Frost and Sullivan1 put the global market for NDT/NDI at over $2.5 billion. The exorbitant cost and challenges involved in building new infrastructure has resulted in significant ageing of existing infrastructure; in turn, extending the useful life of ageing infrastructure is driving the need for inspection services. To assess the integrity and prevent catastrophic failures, NDT/NDI inspection is of paramount importance. Previously, NDT/NDI has been carried out in a labour-intensive manner that requires professionals to physically assess structural damage and fatigue in a painstaking manner. • This involves either visual identification of structural deficiencies or using equipment

such as ultrasonics or eddy currents to detect minute damage both outside and inside structures. Depending on the structure and the elements inspected this could require structure disassembly.

• The shortcomings of this process include significant labour and overhead costs, indirect operating costs of asset downtime, and the static nature of testing which

An Overview of SHM

Recent testing shows promising signs High barriers to entry due to significant regulation in aviation; CVM technology nearing FAA approval Main target market is highly competitive making large-scale adoption likelySignificant cost savings and asset productivity improvement holds for a diversified range of markets outside of aviation Vertically integrated alignment with significant aviation market players from Anodyne Electronics, Boeing and Delta.Recognised industry leader in SHM market; award-winning NDT technology

Investment Highlights

AIRBUS BOOKS A TICKET ON THE NEXT FLIGHT.

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GICS Sector Tech, Hardware & Equip Shares on Issue (m)* 95.84 Share Price ($) 0.43 30 Day VWAP ($) 0.42 52 Week High/Low 0.65 / 0.18 Market Cap ($m) 41.2 Cash ($m)* 0.3 Debt ($m) - Enterprise Value ($m) 40.9 NTA per share ($) 0.002 Options on Issue (m) 2.41

*Does not include recent $700,000 capital raising

12 MONTH PERFORMANCE

BOARD OF DIRECTORS Toby Chandler Managing Director David Veitch Non-Exec Director Andrew Chilcott Non-Exec Director Michael Reveley Non-Exec Director

MAJOR SHAREHOLDERS Drake Private Investments LLC 20.9% AEH Corp 7.6% Mclarty Family Trust 7.2% Toby Chandler 6.1% Citicorp Nominees 4.6%

Total 46.4%

FINANCIALS FY2014 FY2013 FY2012

EBITDA ($m) -0.75 -0.91 -1.27 EPS (¢) -0.008 -0.013 -0.022 P/B N/A 274.5 38.1

MAC EQUITY PARTNERS Bryant Mclarty, Managing Director

bmclarty@macequity.com.au Patrick Davis, Associate

pdavis@macequity.com.au

The CVM Suite of Products

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Figure 1: The CVM Set-Up

Comparative Vacuum Monitoring (CVM) is a Structural Health Monitoring technique used to detect cracks, corrosion and debonding of metals and composite materials. As such it is an extremely useful maintenance tool used to ensure structural integrity in order to prevent catastrophic events and facilitate the continuous operation of machines. The technology is 100% owned by Structural Monitoring Systems (its holding company), who holds 20 patents for technologies in the USA, Australia and Europe and are in the process of applying for 20 more.

CVM works by measuring airflow between alternating tubes or galleries containing air at atmospheric pressure and partial vacuum pressure (CVM Sensors). If no flaw is present, the vacuum gallery will remain stable – but if a flaw develops air will flow through the passage created from the atmosphere to the vacuum galleries. The rate of airflow gives an indication of the size of the crack. The sensors are made from a light, durable teflon requiring only a vacuum (KVAC5) to operate and a transducer (PM200) to read airflow.

The simplicity of the CVM technology means a significant comparative advantage over other technologies (more detail in a later section). Some of these features include: ◦ Light weight, non-electrical sensors◦ Data acquisition on both a periodic and continuous basis◦ Made from radar transparent material◦ Low power requirements

Each of these features makes CVM applicable across a range of structures, especially in hard-to-reach components where the cost of direct maintenance is high. Non-electric sensors mean more reliable readings, less to go wrong under different conditions (such as changing humidity and moisture) and less risk of electrical failure. Readings also take place from system-internal variables (i.e.

the pressure inside the sensors) and not from outside variables such as readings taken from piezoelectric or acoustic sensors.

One drawback from this feature is the reliance on outside temperature and pressure making continuous assessment of aircraft structures (which travel across different altitudes) less viable with CVM. While the company has developed a prototype to fix this (the IFS-01 Flight System), it is unlikely this will be readily available in the near future.

Despite this, aircraft may still be monitored on the ground in both continuously and periodically. Radar-transparent material is important for military aircraft, and the low power requirements of the system make it suitable for most applications. Lastly, the company has he potential to develop remote monitoring through wireless technology could add even more value by making the technology almost completely autonomous.

cannot monitor damage as it develops. • Furthermore, depending on the technology used, NDT/NDI

may result in sub-optimal detection of structural fatigue and damage due to the element of human error in inspections, a lack of access to key areas and limits of use of dangerous methods such as x-rays and isotope radiography.2

• Despite these drawbacks, NDT/NDI is a necessary process and a regulatory requirement of many industries makingapplications numerous and potentially lucrative.

The basic approach of Structural Health Monitoring (SHM) is to make non-destructive testing and inspection as much a part of structures themselves as possible3. The aim is to detect, where possible, the presence, location, severity and consequences of damage in a structure4. SHM is an improvement on existing NDT/NDI because technologies in this area perform the same objective, but on an autonomous level in a way that gathers superior information about the development of structural damage that can be known in real time or on a periodic basis. Technologies in this market have the potential to add value to businesses using these technologies in three ways: 1. Increasing Asset Productivity:

a. Improving NDT/NDI means repairs are better managed, increasing asset life and reducing future repair costs.

b. Quicker NDT/NDI processes from SHM will reduce asset downtime while NDT/NDI is carried out.

2. Reducing Direct Costs: an automated detection of structuraldamage mean less labour and overhead costs associated with NDT/NDI.

3. Improved Safety:a. Better detection of damage will reduce the likelihood of

catastrophic events; a benefit that may be captured by lowercosts of insurance on assets and operations of companies whouse these technologies.

b. Monitoring areas prone to damage will:◦ reduce the need for over-engineering◦ increase innovation in design◦ reduce manufacturing costs◦ allow more loads on structures

Some concerns over the technology that must be overcome before widespread adoption is seen include:

◦ Cost of sensors and sensor systems◦ Ease of use as well as small coverage area of sensors◦ Validation of performance and certification of use◦ Changes to maintenance programs

3/10

Key Applications

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Earnings Potential: Margins and Market Size

CVM technology is applicable across a wide range of metallic and composite structures, detecting cracks, corrosion and debonding making it suitable for monitoring of areas of existing concern or in “hot-spot” areas prone to such damage. In short, in any situation where metal fatigue or other structural damage can have disastrous effects, there is a market for SMS.

Commercial Aviation: SMS’s cornerstone application, the company has invested most of its resources into seeking FAA and other regulatory approval to become an alternative compliant method of NDT/NDI. For good reason SMS has been actively engaged in testing its technologies over the last decade with the biggest names in commercial aviation. The company has recently completed a test of 70 sensors on-board seven Boeing 737-NG aircraft for certification by the FAA as an AMOC. This, it is hoped, will then accelerate approval on other types of aircraft. 65 of the sensors perfomed as expected with 5 returning false positives likely due to installation error. No false negatives were detected. Final completion of data collection is expected Q3 2015.

Planes undergo significant fatigue over their lives as they pressurise on ascent and descent, putting older planes more at risk of structural fatigue. Without NDT/NDI, the cost of maintaining and operating airplanes would increase dramatically, while the safety of flying would decrease significantly. Presently approximately 70-80% of aircraft NDT/NDI is performed on the airframe, structure, landing gears and remaining 20% or so is carried out on engine & related components: SMS is targeting the larger market5.

As will be discussed below, aircraft are obliged by most regulatory bodies to undertake scheduled maintenance inspections, which range from 10 hours to several weeks. Any alternative method to current painstaking NDT/NDI would be welcome news for airline companies

with razor-thin (1%) profit margins, who spent $59 billion on maintenance in 20136.

Furthermore, increasing use of composite materials on aircraft without suitable NDT/NDI methods give significant opportunity for CVM products which can be used on composites. According to the company’s report, and unidentified aircraft manufacturer has been testing CVM technology aboard “the Client’s fleet of modern single-aisle passenger jets, operated by multiple commercial carriers.”

Military Aviation: maintenance expenditure in the global military aviation market eclipsed that of commercial aviation US$61 billion6. Given the extreme conditions that military aircraft are placed under it can be expected that ensuring their structural integrity is more challenging. While payloads per aircraft are, on average, much smaller in military aircraft (making CVM less efficient), the market is still evidently significant.

Bridges: CVM technology was fitted on a bridge in Illinois to monitor existing areas of concern in 2011. Knowing the integrity of bridge structures can lead either to extended existing bridge lives or lead to more timely repairs which on a government budget is a big win. In addition to SMS’s key markets, it is logical to see applications across a range of metallic structures that the company does not seem to have pursued intently, including: • Oil and Gas Infrastructure; oil pipelines and drilling rigs where

corrosion is unavoidable and tremendously expensive.• Other Infrastructure; power plants and large industrial buildings.• Other Vehicles; heavy industrial automotives, trains and ships.

This section attempts to unlock the underlying potential of the market that CVM is operating in. The extent to which SMS can capture this potential in coming years is discussed in following sections that take into account competition, bargaining power of producers as well as end users, licensing strategies and quality of management.

Airlines We build a model of the savings that CVM would bring to the normal operations of an airline company once it is accepted as an alternative method of NDT/NDI. Consider the following example; for a Boeing 737-800: § The plane has a capacity between of 150 - 215 economy

passengers. § The company operating the plane runs at an average of 85% of

capacity (similar to Delta’s long run average). § The plane operates a three-hour flight, three to four times per

day with average revenues per ticket of $300. This is an average utilisation of between 9-12 hours/day; the industry average is closer to 9 hours.

§ The company’s gross margin is between 30-50%. We disregard the fixed costs of the plane and costs not associated with extra flying time as they are sunk costs.

§ The company has a tax rate of 30% on marginal profits. § Based on these assumptions, the cost of grounding a plane for

on hour in terms of foregone profit is between $500 and $1,400.

Furthermore, the scheduled maintenance for the average 737-800 is as follows:

Table 1: Plane Check Frequency for a 737-8007 Amount of Time A-Check B-Check C-Check D-Check

Between Checks 500 FH = 42 days N/A 4-6,000 FH =

0.9-1.4 years 96-144 Months

Taken Per Check 10 Hours 10-24 Hours 3 days-1 week 1 month

Average Hours/Year 86.90 - 93.91 72

Average Hours of Overlap 5.31 - 9.39 0

Total Hours/Year 81.60 - 84.52 72

Because a B-check covers A checks, C checks cover B and A checks etc., overlaps in maintenance inspections occur that are accounted for. This gives us an average of 240 hours that planes are grounded for maintenance checks per year. The company is confident that CVM would save two days or 48 hours of downtime per plane per  

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year as time taken to open, examine and close sections to check the aircraft structure are saved. Given the cost of grounding a plane for one hour is between $500-$1400 in lost profit, this makes for savings of $24,000-$67,000 per plane per year, in indirect costs alone.

To calculate the savings from direct costs, assume two NDT/NDI technicians work at the same time on one plane at a rate of $50/hour. Furthermore, the cost to rent a hangar is $5000/day or $200/hour8. 48 fewer maintenance hours saves an additional $15,000 per plane per year.

The savings of CVM technology do not stop there; suppose for a cargo plane the addition of CVM sensors meant welds and other structural supports no longer need be over-engineered; and parts could be made from composite rather than metallic materials. This would save weight (either increasing loads or reducing fuel consumption) as well as reducing manufacturing costs of planes themselves. If CVM improves the detection of flaws in aircraft (rather than simply meet pre-requisite benchmarks) and thereby reduces risk of a catastrophic event, this has implications for the cost of insurance of aircraft as well as airline branding with respect to safety. Thus we approximate that potential savings per plane could be upwards of $39,000 to $82,000 per plane per year.

The World Airliner Census 2013 puts the current number of commercial aircraft (both regional and mainline) at around 25,0009

with the top 10 mainline aircraft (CVM’s most relevant market) at 16,824. The number of aircraft has grown at 5%/year for the last 20 years, and is expected to grow at a similar rate for the next two decades11. Given this market size and using our 737 figures as an average, the total potential for CVM technology could be as high as $1.3 billion/year growing to $3.4 billion in 20 years, when accounting only for large planes.

Table 2: Top 10 Mainline Aircraft by Number9

Aircraft 2013 2012 %Change

Airbus A320 5632 5180 8.7%

Boeing 737-6/7/8/900 4693 4265 10.03%

Boeing 777 1188 1095 8.5%

Boeing 737-2/3/4/500 1089 1164 -6.4%

Airbus A330 1020 927 10.0%

Boeing 757 812 846 -4.4%

Boeing 767 795 818 -2.8%

Boeing 717,MD-80,DC-9 744 776 -4.1%

Boeing 747 585 623 -6.1%

Airbus A340 266 298 -10.7%

Furthermore, with the current MRO size of $59 billion and line maintenance costs accounting for 20% of total maintenance, there is potential still. A 2% improvement in overall MRO if CVM was applied to every relevant plane would mean a similar valuation of CVM’s maximum potential at $1.18 billion/year. The global MRO market is expected to grow in line with the aircraft market. Given this potential, the airline industry is expected to be an early adopter of the technology with several key industry features that make this likely: § Highly competitive industry with very low margins making any

cost-saving technology attractive.

§ A technologically progressive industry that supports innovation. § Highly regulated NDT/NDI requirements making burdensome

maintenance more costly. § Despite two main manufacturers (Boeing and Airbus), pressure

to reduce overall costs from their customers is high. § Manufacturers are also likely to benefit any improvements in

innovation in design that CVM affords them. § Many airlines also are opting for older aircraft that incur more

routine structural testing making retrofit applications of CVM attractive.

§ High industry growth; as previously mentioned Boeing expects this to average 5%/year in the long term.

Military Aircraft Approaches to structural health monitoring in the US$61 billion/year military MRO industry have proved fruitful. Instead of focusing on increasing flight hours, these programs tend to save governments by increasing asset life, reducing direct maintenance cost and reducing over-engineering. One program (though not entirely similar to CVM) run by the US Navy claims:

“With the implementation of SAFE, the CH-53E program hopes to achieve cost savings while ensuring safety is not compromised. Other studies have shown that smaller programs have been able to achieve 50% increase in component life using SAFE. Initial analysis has shown that if the CH-53E program achieves 25-50% savings in retirement time or maintenance burden, the program could save in the neighbourhood of $20M per year.” 12

While the potential for CVM applications is strong, demand is likely to be less significant than the commercial market due to: § Size of aircraft being too low to justify alternate means of

NDT/NDI. § Generic SHM approaches to what are very diverse aircraft. § Existence of other SHM programs that do not need the approval

of central regulatory bodies such as the FAA in the commercial aircraft market.

However for more expensive and technologically advanced aircraft (which may cost more than commercial aircraft), safety and proper maintenance are in high demand; this is backed by the Australian Defence Force’s significant interest in CVM technology in the last decade. If CVM can achieve similar savings to the SAFE program, the market potential across all defence forces is large. Given that the US Navy (with 3700 aircraft) believes it can save $20 million/year, or $5500 per aircraft, demand across 30,000 aircraft could be as much as $150 million/year.

Table 3: Total Military Aircraft by Country13

Rank Country Number of Aircraft 1 USA 13,683 2 Russia 3082 3 China 2788 4 India 1785 5 Japan 1595 6 South Korea 1393 7 France 1203 8 Egypt 1100 9 Turkey 989

10 North Korea 943

31 Australia 395

Total 28,956

Competition in Structural Health Monitoring

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Bridges In America alone there are 67,000 structurally unsound with an anticipated cost to repair or replace of US$76 billion. This is a figure of 10% of all bridges but these structurally unsound bridges take up 30% of total bridge length making them significant14. This problem is not just in America; of Canada’s 80,000 bridges 30% are in the same boat with an estimated cost to replace of CAD$5 billon15. This pattern is similar across most developed countries.

The Federal Highway Administration (USA) estimates that to eliminate the nation’s bridge deficient backlog by 2028 requires an investment of US$20.5 billion annually whereas only $12.8 billion is  

being spent currently. With limited funding, the question is where to start yet have the greatest impact. CVM has a strong application in monitoring suspect areas that would allow bridges to take on more loads and continue service, extending asset life and potentially saving governments across the world billions. It is able to do so because by monitoring structurally unsound areas in real time, bridge operators can continue to use the bridge until it is unsafe to do so; whereas currently the risk of failure between inspections leads to premature closure.

The body of research on structural health monitoring has been growing rapidly since the early 1990s with many companies and universities involved in its development. Despite over two decades of development, most SHM products remain either relatively immature relative to the demands of their target markets, or extremely specified to one purpose. This means that there is a strong opportunity for the manufacturer of a simple, one-size-fits-all-structures product that would benefit from the first mover advantage of setting the industry standard. The results of our analysis of SHM competition are summarized in Table 2.

Commercial and Military Aviation Much like there is a variety of existing NDT/NDI methods, Comparative Vacuum Monitoring is only one of several techniques that could be used in SHM; others include using fibre optics, piezo-electric sensors and acoustic emissions. As previously mentioned, 70-80% of NDT/NDI tasks are on things such as airframes and structures, whereas 20-30% is on engines. There is already a very healthy industry of engine health monitoring, led by large industry players such as Rolls Royce, Meggit, GE Aviation etc. as they are more critical structures. SMS’s target market lies with structural maintenance that requires less specialized technology, which has the benefit of greater economies of scale.

In the structural monitoring market, the level of competition is not black and white. There are several technologies already on market such as Lufthansa Technik’s percolation sensors that detect moisture in critical areas and therefore allow inspectors whether or not it is worth opening up areas to inspect for corrosion. These on-market technologies again tend to be specialized in their applications meaning there is still a lot of room for CVM technology. The real threat is likely to come from other broad-based technologies such Accelent Technologies’ piezo-electric sensors which has very similar capability to CVM.

Another key factor in competition is the role of aviation regulators; because law mandates maintenance checks, SHM applications can only be valuable if they are allowed to fully substitute current NDT/NDI methods. While SHM technologies are unlikely to 100% replace existing methods once approved, without regulatory approval for use on aircraft there is no market. This creates a significant opportunity for the owners of patents approved for use as it will restrict entry of new competitors. SMS has taken over 20 years of development and is only now on the brink of FAA

approval. The implications of the FAA’s decision on CVM technology will be enormous. At the moment, the only other technology at the field testing stage that can detect cracks and debonding is Accellent. However, the company’s technology is not at the same maturity as CVM.

Table 4 compares and contrasts the competing technologies with CVM. Based on attributes such as stage of development and key applications we rank the threat that the technology currently poses to SMS’s market share in aviation. We believe the threat of most technologies to be minimal given the results of a survey performed by Sandia National Laboratory (where CVM is currently being tested), which showed that: • CVM encompasses the needs of airline operators better than

most technologies (see figure 1).• The large majority of technologies are not yet at the field

evaluation stage that CVM is in (figure 2).• Most competitors are developing relatively more expensive

SHM systems (figure 3); which CVM technology can beexpected to be a lower-cost producer given the simplicity ofdesign making it more able to compete on a price basis oncecompetition eventually catches up.

Figure 1: What events should SHM be able to detect?16

Figure 2: Technological Readiness of SHM Products as at 2011 (% of population)16

5/10

6/10

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Table 4: Comparison of Competing Structural Health Monitoring Companies

Company Technology Core Markets Main Functions Stage of

Development

Program

Founded

Key

Collaborators

Threat to SMN

Market Share

Structural Monitoring Systems

Comparative Vacuum

Monitoring

Aviation, Energy

Infrastructure, Bridges Cracks, Debonding Validation 1995

Boeing, Delta

Airlines, Embraer

Accellent (17) Piezoelectric Sensors

(SMART Layer)

Aviation, Civil

Infrastructure

Cracks, Corrosion,

Composite damage Validation 1999

Embraer, US

Army and Navy Significant

Cedrat Technologies (18)

Piezoelectric Sensors

(PULSECHO) Aviation Unspecified defects Proof of Concept 2007 NA Insignificant

Cornerstone

Research Group (19)

Piezoelectric Sensors

(Veriflex) Aviation

Fatigue Failure,

External Damage Prototype 2003 NA

Potentially

Significant

Impact

Technologies Ltd (20)

SIPS, CorrSem Aviation, Energy

Infrastructure Cracks, Corrosion Validation 2004 GE Engines Insignificant

Luftansa Technik (21)

Percolation Sensors

(AISHA II) Aviation Moisture Detection Validated 2008 Lufthansa

Largely

Insignificant

Meggitt Sensing

Systems (22) Piezoelectric Sensors

(EHM) Aviation

Engine Health

Monitoring

Validated; On

Market 2010

Airbus, Boeing,

Dreamliner

Largely

Insignificant

JASTAC (23, 24) Optical Fibre Sensors

(BOCDA) Aviation

Strain, Debonding,

Delamination Prototype 2006 Airbus

Potentially

Significant

Phase IV Engineering (25)

Radio Frequency

Identification (RFID) Aviation, Infrastructure Strain

Validated; On

Market 1992 N/A

Largely

Insignificant

US Navy (26) Integrated Mechanical

Diagnostics System Aviation

Fatigue Life

Expended Uncertain 1997 US Navy

Largely

Insignificant

Moog (27) Optical Fibre Sensors

(Blade Sensing Systems) Wind Turbines Strain On Market 2002 N/A

Potentially

Significant

Physical Acoustics

Corporation (28) Acoustic Emission Bridges, Helicopters

Cracks, Corrosion,

Fatigue On Market - N/A

Potentially

Significant

Pure Technologies (29)

Fibre Optic Sensor

(Soundprint) Bridges, Pipelines

Infrastructure-

specific damage On Market 1993 N/A

Potentially

Significant

Pulse Structural Monitoring (30)

INTEGRIcollar,

SPANASSURE

Pipelines, Offshore

Rigs Structural Integrity On Market 1998 N/A

Potentially

Significant

 

Figure 3: Airline SHM System Costs16 Bridges The SHM market for bridges is already highly competitive, with many technologies already on market (table 2 only provides a few examples). Having said this, the market is still new giving opportunities to CVM; especially if it is to compete on a cost basis. The last two decades have seen governments moving away from building new bridges to extending the lives of existing ones making for strong industry growth that should ease competitive pressures.

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Commercialisation and Licensing of CVM Technology

Given that SMS has been in a pre-commercialization phase releasing only basic information about the development of certain strategic alliances, it is unclear what the company has in mind when it comes to rolling out a full-scale commercialization, for which it could be ready very soon. We investigate the elements of their commercialization model. Buying power of customers Two large manufacturers, Boeing and Airbus, dominate the aircraft manufacturing market. These companies hold significant market power and control over what technologies are adopted onto their aircraft. SMS therefore faces a dilemma that the more powerful manufacturers may capture the savings it creates. SMS has a strong history with Airbus, which has been a major supporter that will, however, increase SMS’s chances of success. In March 2015, the Company signed an MOU with an Airbus subsidiary, TESTIA: a leader in the field of Non-Destructive Testing as well as SHM. The terms of the MOU include: • TESTIA will become the key distributor/reseller and integrator of

SMS’s CVM technology around the world. • TESTIA will be fully integrated with, and exposed to all current

development and production aspects of SMS’s CVM technology. • TESTIA will provide manpower and technical expertise to directly

assist in investigating, and advancing, the current status of CVM technology

• TESTIA will act as SMS’s elongated “workbench” to install, maintain, commercialize and promote SMS’s CVM technology in the global marketplace.

• TESTIA will provide access for SMS staff to the Airbus Verification & Validation Center for structural health monitoring at the Airbus Material & Process department in Bremen, Germany

• TESTIA will support SMS in creating commercially viable business cases for, amongst other things, supplementary type certificates (“STCs”), alternative means of compliance (“AMOC”) with potential customers including, but not limited to, aircraft operators, carriers and aerospace OEMs.

• TESTIA will develop and promote concepts as to how SMS products can be sold, licensed, installed and maintained, worldwide.

In addition to this, by adopting alliances with Delta (and therefore other airline operators further down the track), SMS can place pressure on Boeing and Airbus to adopt the cost-saving technology at a higher price as a requirement of its customers. Furthermore, by diversifying its applications SMS can ensure the relative buying power of aircraft manufacturers is curtailed. Costs of Production – Strategic Partnership with AEM SMS has had a partnership with Anodyne Electronics Manufacturing Corp (AEM), which should see many benefits to accrue to the company in addition to TESTIA. As of 2013, AEM acts as SMS’s key operational division, bearing the exclusive responsibility for manufacturing, engineering, calibrating and repairing all of SMS products. AEM will manufacture the entire line-up of SMS products,

including prototypes and qualification builds. In exchange for AEM initiating and continuing the business relationship with SMS, AEM was granted a 10% equity stake in SMS. This production model is different to most SHM competitors who produce technologies themselves. Reasons for this include: § Cost benefits of the alliance – AEM is well established and

located in British Columbia, not too far from SMS’s key testing facility in Sandia National Laboratories in LA.

§ Faster industry adoption from a credible and Transport-Canada approved Manufacturer and Maintenance organisation.

§ Significant R&D work can now be done to improve the sensor and system designs. This has already seen significant changes to the materials and functionality of sensors and the PM200.

§ Allows SMS to focus on IP development only, which is important given the tight capital structure that it operates with.

The selection of AEM as a key stakeholder in recent years reflects its focus on manufacturing for emerging companies – providing solutions for unique challenges of low volume and highly differentiated production. AEM is also vertically integrated allowing it to remain competitive in this space. Licensing Structure Little is known about the company’s plans to license its patented technology which provides a few concerns for investors; if SMS decides to deliver standardised products with a single price tag it can benefit from economies of scale and crowd out competitors on a cost basis. However, given the significant anticipated difference in the value of CVM to airlines and other markets and the anticipated cost, one could argue a royalty-based system such as a fee per use of the CVM sensing system tied to the value of avoiding human NDT/NDI inspections would capture the greatest per-unit profit while perhaps sacrificing scale as companies paying more expensive royalties would demand more customisable readings. In any case, the licensing structure of the technology is a key aspect of how it will capture the savings CVM creates. Marketing and Distribution To complement SMS’s recent manufacturing agreement, the company has recently entered into a non-disclosure agreement with Cornes Technologies Ltd, involved heavily in the sales and marketing of electronics equipment. This partnership, alongside could bolster SMS’s ability to market CVM technology at a significant premium to costs, and could be considered as a significant stepping-stone towards production. More information is expected on this arrangement. Defence of patents: The company has a vast portfolio of 20 patents in the USA, EU, China and Brazil, with 20 others patents pending for new inventions. This is obviously of great importance as the entry of competitors is a major influence on the SHM market.

Management

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Key Risks

Structural Monitoring System’s earnings potential will depend largely on how well its board of directors can implement a targeted commercialization strategy that overcomes the issues outlined above. SMS entered great trouble in 2008 with the onset of the GFC and was forced to laying off its entire workforce of engineers. The company’s market capitalisation plummeted and progress was stalled on the development of CVM. In response, the company cut its rather large expenditures by more than half and ran a lean program that endeavoured to preserve shareholder equity.

Management’s commitment to this saw members of the board to halve their performance right shares for hitting share price targets in August of this year. One major contributing factor to the recent shift in company dynamics has been the complete overhaul of the board of directors with no members serving on the board before 2011. Other major developments since 2011 include important alliances with airlines (such as Delta), aircraft manufacturers (Boeing, Airbus, Embraer), electronics manufacturers (AEM) and marketing (Cornes Technologies).

SMS’s share price is highly volatile which reflects the speculative nature of the stock. With ten years of negative operational cash flows, the next two years will be telling of the future success of the company, and therefore we expect share price volatility to continue, helped only by greater market liquidity as more investors are attracted to the company. Market Risk SMS’s key markets include aviation, energy infrastructure and others that will be strongly affected by macroeconomic conditions and market risk. These sectors may be unaccommodating of new technologies such as CVM in the event of a market downturn. In particular, commercial aviation is a low-margin business subject to strong macroeconomic fluctuations and market events. Despite this, CVM has a diversified range of applications, some of which are in markets backed largely by public sector spending (such as bridges and military aviation) which may curtail somewhat SMS’s exposure to market risk. It should be noted, however, that SMS was forced to lay off its entire workforce during the GFC, which considerably slowed project development. Regulatory Risk Given the nature of the MRO and NDT/NDI markets across most industries as highly regulated, the approval of CVM technology as a viable and legal alternative to current NDT/NDI is likely to have a significant impact on the value of the technology. SMS expects the results of its FAA evaluation to be completed by year-end; and as previously mentioned the result of this is likely to significantly impact the value of the stock. Product Risk The SHM market is still very far away from maturity; and despite 20 years of CVM development, the prospects of the technology – while generally positive – are subject to a high degree of uncertainty:

§ Undiversified in terms of a product, but diversified across markets.

§ Horizontal approach may protect the company from market risk, but subjects the stock to more influence from outside forces than a vertically integrated approach where production, distribution and sales are all under one house.

§ The conditions of agreements with major partners such as Boeing, AEM etc. are fairly unclear.

§ Lengthy and costly development has seen relatively slow progress, which may suggest issues with management’s ability to develop IP.

§ Competition is a large issue for SMS who must attempt to lead the market and gain first mover advantage.

§ FAA approval does not necessarily mean widespread adoption of the product will ensue.

Financial Risk Continued R&D and product development such as FAA testing means continued dependence on additional capital. The company’s retained earnings are a staggering –$45 million with a negative equity balance. Despite balance sheet issues, we consider financial risk to be low given: § The presence of a significant shareholder (Drake Private

Investments), which has recently been, involved in a $700,000 private placement at 37.5c/share.

§ The company’s commitment to a low cash burn with low net operating cash flow as a percentage of its market capitalisation. The board of directors who took their annual remuneration in shares this financial year echoes this commitment. The company is therefore less reliant further equity capital.

§ The company’s recent dramatic share price increase will make raising capital easier and will not risk the dilution of shares seen before the company’s 10:1 stock split in 2011.

However, SMS does have a very concentrated shareholding, which may cause concerns if one shareholder decides to exit their position.

Anodyne Electronics Manufacturing Corp (AEM) has taken a substantial interest in the company both in the form of shares (7.8%) as well as their founder, David Veitch, acting as non-executive director of SMS. Mr Veitch also worked at Northern Airborne Technology before founding AEM, helping it grow from 10 to 200 employees. He was appointed late in 2012 to non-executive director.

Toby Chandler is SMS’s managing director and head of SEAL Capital, a Los Angeles-based hedge fund. Prior to this he was a Managing Director of Morgan Stanley’s New York Hedge Fund Desk. Mr Chandler has been MD of SMS since 2011.

Andrew Chilcott, a non-executive director, was appointed in 2012 after having worked in sales positions for both SMS and Airbus.

Michael Reveley, chief executive of SEAL Capital, has had extensive international experience in financial markets as founder of Seagate Global Advisors (LA) and director of the syndicate and derivatives group at SBC Warburg (London, New York).

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RESEARCH REPORT MAC EQUITY PARTNERS

Income Statement 06/05 06/06 06/07 06/08 06/09 06/10 06/11 06/12 06/13 06/14

Operating Revenue 543,543 1,128,650 459,625 495,622 327,020 187,751 304,284 113,858 143,977 151,375

Other Revenue 0 997,430 1,627,954 579,080 0 547,540 7,329 1,193 197,472 88,643

Total Revenue 543,543 2,126,080 2,087,579 1,074,702 327,020 735,291 311,613 115,051 341,449 240,018

Operating Expenses -23,798,357 -5,900,760 -5,108,009 -4,523,706 -1,875,400 -1,538,404 -1,566,784 -1,374,868 -1,254,640 881,499

EBITDA -23,254,814 -3,774,680 -3,020,430 -3,449,004 -1,548,380 -803,113 -1,255,171 -1,259,817 -913,191 1,121,517

Depreciation and Amortisation -1,180,035 -142,737 -138,330 -139,045 -46,328 -21,569 -6,842 -8,151 0 -1,885,616

EBIT -24,434,849 -3,917,417 -3,158,760 -3,588,049 -1,594,708 -824,682 -1,262,013 -1,267,968 -913,191 -764,099

Net Interest Expense 163,894 147,303 185,363 216,535 23,747 2,833 8,831 978 104 -108

Profit Before Tax -24,270,955 -3,770,114 -2,973,397 -3,371,514 -1,570,961 -821,849 -1,253,182 -1,266,990 -913,087 -764,207

Tax Expense 0 0 0 0 269,064 0 0 0 0 0

Net Profit after Tax -24,270,955 -3,770,114 -2,973,397 -3,371,514 -1,301,897 -821,849 -1,253,182 -1,266,990 -913,087 -764,207

Weighted Average Number of Shares 176,569,471 202,161,487 226,175,132 254,024,768 290,392,669 362,594,079 446,463,412 56,716,067 70,149,008 90,456,507

EPS Adjusted (cents/share) -13.75 -1.86 -1.31 -1.33 -0.45 -0.23 -0.28 -2.23 -1.30 -0.84

Balance Sheet 06/05 06/06 06/07 06/08 06/09 06/10 06/11 06/12 06/13 06/14

Cash 2,592,737 2,762,052 6,130,140 1,054,682 347,271 179,705 590,543 142,427 326,016 231,727

Receivables 102,308 390,236 115,183 388,282 319,165 84,009 92,775 0 27,415 26,390

Prepaid Expenses 161,464 145,533 33,953 11,232 9,959 1,312 0 2,618 18,881 3,600

Inventories 23,682 58,409 71,812 172,636 115,337 80,513 12,213 0 0 0

Other 0 0 0 0 0 0 0 7,487 0 0

Total Current Assets 2,880,191 3,356,230 6,351,088 1,626,832 791,732 345,539 695,531 152,532 372,312 261,717

PP&E 358,709 319,637 254,428 89,255 29,118 9,554 4,685 -- -- --

Future Tax Benefit 0 0 0 587,020 0 0 0 -- -- --

Total NCA 358,709 319,637 254,428 676,275 29,118 9,554 4,685 -- -- --

Total Assets 3,238,900 3,675,867 6,605,516 2,303,107 820,850 355,093 700,216 152,532 372,312 261,717

Account Payable 208,698 843,397 490,079 478,823 246,901 119,719 218,466 93,009 364,645 267,642

Provisions 213,631 150,615 162,633 159,500 0 13,371 9,080 0 0 0

Other 272,656 0 0 0 0 109,822 0 0 0 0

Total Current Liabilities 694,985 994,012 652,712 638,323 246,901 242,912 227,546 93,009 364,645 267,642

Provisions -- -- -- 587,020 -- -- -- -- -- --

Total Non Current Liabilities -- -- -- 587,020 -- -- -- -- -- --

Total Liabilities 694,985 994,012 652,712 1,225,343 246,901 242,912 227,546 93,009 364,645 267,642

Share Capital 31,086,579 24,841,678 30,499,685 30,499,685 30,648,561 30,794,209 31,617,416 31,668,909 31,783,871 31,815,533

Reserves 0 9,827,587 10,413,926 8,910,398 9,559,604 9,774,037 10,564,501 11,366,851 12,113,120 12,832,073

Retained Earnings -28,542,664 -31,987,410 -34,960,807 -38,332,319 -39,634,216 -40,456,065 -41,709,247 -42,976,237 -43,889,324 -44,653,531

Total Equity 2,543,915 2,681,855 5,952,804 1,077,764 573,949 112,181 472,670 59,523 7,667 -5,925

   

10/10

Disclaimer / Disclosure This “Notes from the Desk” report accurately expresses the personal view of the Author at the time of writing. Mac Equity Partners Pty Ltd (AFSL 338731, ABN 32 126 369 640), its directors, associates and employees advise that they may hold securities, may have an interest in and/or earn brokerage and other benefits or advantages, either directly or indirectly from client transactions arising from any advice mentioned in publications to clients. Directors, associates and employees of Mac Equity Partners Pty Ltd from time to time may hold shares in the security/securities mentioned in this Research document and, therefore, may benefit from any increase in the price of those securities.

This research note has been prepared for and is intended for Wholesale Investors only as defined by Section 761G of the Corporations Act, 2001. In accordance with Section 949A of the Corporations Act 2001, this document contains unsolicited general financial information only. In preparing this document Mac Equity Partners Pty Ltd did not take into account the investment objectives, financial situation and particular needs (‘financial circumstances’) of any particular person and no recommendation (whether express or implied) contained in this document should be considered reliable. Accordingly, before acting on any information contained in this document, you should assess whether the information is appropriate in light of your own financial circumstances or contact your Mac Equity Partners Pty Ltd adviser.

Mac Equity Partners Pty Ltd believe that the information herein is accurate however no warranty of accuracy or reliability is given in relation to any information or information contained in this publication and no responsibility for any loss or damage whatsoever arising in any way for any representation, act or omission, whether express or implied (including responsibility to any persons by reason of negligence), is accepted by Mac Equity Partners Pty Ltd or any officer, agent or employee of Mac Equity Partners Pty Ltd.

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References (1) http://www.ndt.net/search/docs.php3?id=10613&content=1

(2) http://www.engineersedge.com/inspection/inspection_pro_con.htm

(3) http://www.ndt.net/article/wcndt2004/pdf/aerospace/563_henrich.pdf

(4) http://www.ct.upt.ro/users/TamasNagyGyorgy/Tehnici_Experimentale/3_SHM__Nagy-Gyorgy_T_2012_12_03.pdf

(5) http://www.fltechnics.com/en/media-relations/press-releases/fl-technics-training-is-the-success-of-the-airplane-industry-dependent-on-ndt

(6) http://www.bga-aeroweb.com/Aircraft-MRO.html

(7) http://www.eurocontrol.int/eec/gallery/content/public/documents/projects/CARE/CARE_INO_III/DCI_TDD9-0_Airline_maintenance_marginal_delay_costs.pdf

(8) The cost to build a new hangar for an A380 is estimated at $30m. At a rate of return of 5%, daily rent would need to be $4,000. Factor in maintenance as well as the fact that

the hangar will not always be full and you have a bearish estimate of rent at $5,000/day.

(9) World Airliner Census 2014 - Available from https://d1fmezig7cekam.cloudfront.net/VPP/Global/WorldAirlinerCensus2014.pdf

(10) http://www.cme-mec.ca/download.php?file=4yoc7eob8.pdf

(11) http://web.mit.edu/hchin/Public/HAI/AHS_Papers/Implementation%20of%20Structural%20Health%20Monitoring%20for%20the%20USMC%20CH-53E.pdf

(12) http://www.globalfirepower.com/aircraft-total.asp

(13) http://www.infrastructurereportcard.org/a/#p/bridges/investment-and-funding

(14) http://canadablog.cisco.com/2012/12/13/to-modernize-canadas-public-infrastructure-every-bridge-needs-a-switch/

(15) http://structure.stanford.edu/workshop/documents/Keynote%20presentations/IWSHM%202011%20Keynote_Dennis%20Roach.pdf

(16) http://www.acellent.com/

(17) http://www.cedrat-technologies.com/en/technologies/detection-systems/health-monitoring.html

(18) http://www.crgrp.com/rd-center/reflexive-composites

(19) http://www.impact-tek.com/Aerospace/Structures.html

(20) http://sirius.mtm.kuleuven.be/Research/AISHA-II/03-OPM-LHT.pdf

(21) http://www.meggitt.com/?OBH=732

(22) Yari, T., Ishioka, M., Nagai, K., Ibaragi, M., Hotate, K. & Koshioka, Y. (2008). Monitoring aircraft structural health using optical fibre sensors. Mitsubishi Heavy Industries

Ltd Technical Review, 45(4), 1-8.

(23) Takeda, N., Enomoto, K. & Yoshida, M. (2013). Outline of the Japanese national project on structural health monitoring system for aircraft composite structures and JASTAC

project. In Chang, F. (Ed.), Structural health monitoring 2013: A roadmap to intelligent structures: DEStech Publications, Inc.

(24) http://www.phaseivengr.com/wp-content/uploads/2014/02/61-100048-00-Strain-Sensor-UHF-RFID-rev1_1.pdf

(25) Thomas, J., Neubert, C., Little, M. & Fuller, B. (2010). Implementation of structural health monitoring for the USMC CH-53E. Available at

<http://web.mit.edu/hchin/Public/HAI/AHS_Papers/Implementation%20of%20Structural%20Health%20Monitoring%20for%20the%20USMC%20CH-53E.pdf>

(26) http://www.moog.co.uk/PDF/Blade_Sensing_System.pdf

(27) http://www.pacndt.com/products/Remote%20Monitoring/Civil_Structures.pdf

(28) http://www.puretechltd.com/services/soundprint/soundprint_bridges.shtml

(29) http://www.pulse-monitoring.com/products-and-services-4/vessel-platform-and-mooring-66/platform-integrity-monitoring-150

RESEARCH REPORT MAC EQUITY PARTNERS