Hexcel: Only For The Patient
- Hexcel Corp. is a leading supplier of lightweight composite materials in the global aerospace industry.
- Last year, I took a neutral stance. This time, I reiterate that view as the company struggles with ongoing macro headwinds.
- However, the company brings a lot of value to the table, thanks to its business model, which opens up opportunities for long-term investors.
On August 7, 2021, I wrote my last article covering aerospace supplier Hexcel Corp. (NYSE:HXL). Back then, I also used the word "patience" in the title. Unfortunately, that's still valid as the company keeps encountering headwinds. Boeing's (BA) recovery is slower than expected, new economic challenges cause investors to de-risk portfolios, and Goldman Sachs made the case that inflation is another major headwind. While the long-term outlook remains very good, investors wanting to buy aerospace suppliers like HXL will have to be patient a bit longer.
Let's look at the details!
The Recovery Is Slow
I own a lot of industrial stocks. Roughly half of my portfolio consists of industrials. Half of that exposure is dedicated to aerospace & defense. Yet, I have very little commercial exposure. My commercial exposure is mainly coming from Raytheon Technologies' (RTX) Pratt & Whitney and Collins segments.
While I have nothing against commercial exposure - I will add some going forward - I kept it to a minimum as the pandemic continues to weigh on the industry. While most people have gone "back to normal", the industry still continues to deal with headwinds.
Before I dive into the numbers, let's quickly cover what Hexcel is all about as some of you may not be familiar with the company. Basically, this $4.6 billion market cap aerospace supplier is a provider of key materials to all major aerospace companies.
This Connecticut-based company generates close to 80% of its sales from composite materials. This includes carbon fibers, fabrics and specialty reinforcements, structural adhesives, honeycomb structures, as well as pultruded profiles for tubes, rods, and robots.
In this segment, the company sells to all major defense companies, the two large commercial heavyweights Airbus (OTCPK:EADSF) and Boeing, overseas defense companies like Leonardo, and even producers of wind turbines like Vestas (because of its lightweight materials).
The remaining exposure comes from engineered products, which include composite structures like wing panels, flight deck panels, door liners, and rotorcraft blades. This segment also focuses on engineered honeycomb structures used in blades, nacelles, and various surfaces. This segment, too, sells to the "big guys".
The most important thing to remember is that the company produces lightweight materials in all shapes and forms - mainly for aerospace customers. Non-aerospace industrial exposure is just 16% of total exposure. Moreover, the big benefit of these materials is that they tend to outperform growth in the industry. Why? Simply because older planes are being replaced and the industry is increasingly focused on reducing weight. Market penetration is expected to reach more than 60% in the late 2020s. That would be an increase of 10 points in roughly 10-12 years. For now, it's not known what the next-gen narrowbody plane will look like (or widebody, for that matter), but it's an easy call to say that composites penetration will be higher.
Additionally, these materials are much stronger than i.e., glass fiber, steel, titanium, or aluminum - and far less dense. In other words, I expect that Hexcel might also further penetrate non-commercial industrial markets in the future.
With that said, and as we get closer to the financial numbers, the company generates roughly 53% of its money from commercial aerospace customers. 80% of these sales go to Boeing and Airbus and its many subcontractors.
Hence, HXL almost moves in lockstep with Boeing as the graph below shows.
In the past 4 quarters (including 1Q22), the company generated $740 million in commercial aerospace sales. In 2019, the company did $1.6 billion in sales in this segment. Mid-term growth is supported by stronger narrowbody sales as this is the first segment that recovered after the pandemic in the US and Europe. However, A350 sales are also doing well and growth in business jets is rebounding. On a constant currency basis, sales in the commercial segment were up 49% to $219 million in 1Q22.
In this quarter, the company reported an adjusted EPS of $0.22. In the prior-year quarter, HXL reported a $0.10 loss. Analysts expected an $0.18 profit on 26% higher net sales to $391 million. This, too, is roughly $20 million higher than expected. As I already briefly mentioned, commercial aerospace was up 48%. Space and defense were up 6%. Industrial sales were up 5%.
Unfortunately, and the graph below confirms it, the company is far from recovering to pre-pandemic levels. This year, the company is expected to do $304 million in adjusted EBITDA. That's a $100ish million above the pandemic bottom but well-below pre-pandemic EBITDA.
This has to do with one common factor and at least two new developments. The common factor is the slow recovery of long-haul flights and business travel. While short-haul is benefiting from domestic flights (including vacations), long-haul will need a few years to come back to normal as the pandemic hit demand very hard and consumer behavior has changed. The new factors are Chinese lockdowns and high inflation, which are negatively impacting consumer sentiment (and the willingness to spend big bucks on airplane tickets).
Moreover, bad news from Boeing is hurting HXL. As Seeking Alpha reports:
Hexcel said it is supplying parts for the Boeing 737 MAX at less than the monthly production rate of 31 that Boeing has said in regulatory filings it reached, according to the Wall Street Journal, helping send Boeing shares -5%.
With pandemic-related lockdowns hitting airline traffic, Chinese carriers have in recent days cut the number of MAX jets they expect to receive this year, assuming the plane is re-certified, WSJ reports.
The good news is that the company is generating positive free cash flow. In other words, net income adjusted for non-operating cash items and capital expenditures continues to be positive and it did not fall into negative territory in 2020 or 2021. Free cash flow, or FCF, is cash a company can spend on buybacks, dividends, and/or debt reduction.
Using the company's $4.6 billion market cap, we're dealing with an implied FCF yield of 3.3% for 2022 (expected) and 4.5% for 2023. That's not very much, but it does support two of the company's goals: debt reduction and dividends.
On January 26, the company announced a $0.10 quarterly dividend. It was the first dividend since the company cut its payout in 2020 to deal with COVID-related uncertainties. This dividend translates to a $0.40 annual payout or 0.7% per year.
The company started paying a dividend in 2015, which resulted in a $0.64 dividend prior to the pandemic. This gives us a 1.2% yield based on current prices. I expect it to take a while until the dividend is back at these levels, which is why I do not recommend HXL to dividend investors.
With regard to its balance sheet, the company never had an issue with net debt. Net debt peaked prior to the pandemic at roughly $1.0 billion. Since then, it has declined and it's expected to end the 2023 year below $470 million. The only reason why the net leverage ratio surged is that EBITDA imploded. In 2020, the net leverage ratio was close to 3.9x (EBITDA). In 2023 it's expected to be less than 1.2x.
Thanks to a healthier balance sheet, even stock buybacks are back on the table. According to management:
So again, our basic lending agreements did revert back, and I think our next measurement through them is in June. And we're on track of where we expect it to be. So share buyback is back on the table. As you know, we've reinstated dividends last quarter, and the Board approved the second quarter of -- the second quarter in a row of dividend awards. So our fundamental priorities haven't changed. We're investing organically.
Between 2017 and 2021, the company bought back 7.2% of its shares. All of this occurred in 2018 and 2019, which shows the power of high free cash flow. Moreover, it opens up abilities to acquire growth. The company is currently looking into new M&A opportunities. I assume there are still a lot of good deals out there as growth is still somewhat low with new pressure from supply chains and inflation. However, there's no info on potential deals, which will remain behind closed doors until the company makes an offer.
Speaking of inflation and supply chain issues, Goldman Sachs published a list of companies with the worst and best pricing power. HXL was on the list of worst industrial stocks with variable gross margins of 24%.
While some stocks have higher margins, I would not make the case that HXL is in trouble. After all, it does produce key supplies and can use its dominant position in its favor.
Unfortunately, the company is not immune (but not in trouble) as management commented that it had to rely on long-term deals and efforts to mitigate higher input costs - as well as labor market challenges:
Hexcel is not immune to the inflationary pressures currently affecting most economies around the world. We have some protection as a result of our long-term supply contracts to mitigate a significant portion of those pressures. Still, it has now become the norm for our teams to be regularly working to minimize the impact of rising energy, freight, and certain raw material costs as well as working through supply chain logistical constraints as efficiently as possible.
While higher energy costs are impacting Hexcel, over time it also boosts demand for our lightweight, fuel-saving composites as, for example, airlines choose to replace aging fleets with lighter, more fuel-efficient aircraft made possible by advanced composites.
Like many others, we are also faced with a tightening labor market. However, I'm encouraged that our workplace is desirable as many who left Hexcel during the pandemic are choosing to return. That reaffirms what we already know.
So, what about the valuation?
Year-to-date, HXL is up 5%. The S&P 500 is down 13%. The stock hasn't gone anywhere since early 2021 and it's still well below its pre-pandemic levels.
Generally speaking, HXL is in a very tricky spot. The bullish arguments are slow but steady air traffic recovery, penetration in lightweight materials, and the company's ability to deliver value. Hence, investors buy it rather than hot tech stocks without growth in a rising rate environment (most have come down, but you get the point). Bearish arguments are new Chinese lockdowns, high inflation hurting both production costs and airline ticket demand, as well as an aggressive expected Fed tightening cycle.
Year-to-date, HXL is outperforming two peers that I watch as well: HEICO Corporation (HEI) and TransDigm (TDG). It has underperformed companies with high defense exposure like Raytheon (RTX) and Lockheed Martin (LMT).
Using the company's $4.6 billion market cap, $470 million in 2023 expected net debt, and $100 million in pension-related liabilities, we get an enterprise value of $5.2 billion. That's roughly 12.9x 2023 expected EBITDA.
This is a fantastic case of a valuation that makes perfect sense. 12.9x earnings is a good valuation that is well in line with the long-term valuation range (I excluded the pandemic as that messed up the y-axis).
Moreover, the implied free cash flow yield I calculated in this article (4.5% for 2023) is close to the higher bound of the historic range (lower part of the graph above). It means investors are not overpaying to get access to free cash flow.
So, what does all of this mean?
I'm truly impressed by Hexcel. I think management is doing a terrific job given the challenging circumstances. The company is not stuck in a sideways trend well below its all-time because of issues at HXL, but because the market environment is terrible. China is locking down its population again and nobody knows how bad that might get. Inflation is hurting the consumer, and the Fed is expected to hike rather aggressively this year. Moreover, economic growth expectations are coming down.
The good news is that HXL has an extremely healthy balance sheet and high free cash flow, which caused management to bring back the dividend and to announce that repurchases are close to starting again.
The valuation is fine and I have little doubt that HXL will do very well when it gets support from commercial aviation given the rapid penetration of lightweight materials and the company's large footprint in that industry.
However, do not expect a quick rebound. This stock might go sideways for a few more months given the circumstances - or even quarters depending on how the Fed handles the economy.
So, bear in mind that the many qualities this company brings to the table do come with some frustration if you're looking for quick gains. If you buy, make it a long-term holding.
(Dis)agree? Let me know in the comments!
This article was written by
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