Revenue passenger kilometres (RPK), calculated as the number of customers x distance travelled, has been increasing steadily over the past few decades, as a function of broadly increasing global incomes and living standards, this is resilient to cyclicality.
Historical increases in demand have been met at broadly consistent fleet sizes, expanding passenger load factors (PLF). As PLFs approach practical limits (approx. 85%), it is physically impossible to put more people on planes. Airlines now need to buy more planes; analysis points to global fleet growth of 4% CAGR until 2036.
Within this, short-haul and low-cost airlines have come to dominate the industry. Unsurprisingly, this has caused a greater demand for narrowbody planes carrying 100-200 passengers (32% CAGR 14-18 across Boeing and Airbus) and a decline in the number of serviceable widebody planes carrying 200-850 passengers ( -11% CAGR 14-18). Market growth is set to continue at 8.8% CAGR until 2024, and 3.6% CAGR till 2036 according to various sources.
No major upgrades to narrowbody aircraft engines have been released in 40 years since the CFM 56 in 1974. The new class of engines was released in 2017, and is currently a duopolistic competition between the CFM LEAP and P&W 1000G. The new generation of engines reduce fuel consumption by up to 15%, and are so critical that Boeing and Airbus launched their new generation of planes (X-series and neo-series respectively) in response to the new generation of engines. In fact, Airbus’ neo stands for ‘new engine option’.
CFM LEAP uses high-bypass turbofan technology, essentially a modernised version of the CFM56, boosted by the introduction of additive components technology leading to fewer moving parts and a markedly lower failure rate. P&W 1000G uses geared turbofan technology, significantly more complex and facing a variety of teething problems related to its knife-edge seal which has grounded much of its fleet. The numbers say it all: Boeing and Comac have adopted 100% of CFM LEAP, and we project it will seize 70% of the Airbus market.
Isolating the Value Chain
In the downstream, there are more than 200 publicly-listed airlines worldwide, occupying a fragmented industry with consistent threat of new entrants competing on price, scale, cost, and a variety of factors. We do not see evidence that any single airline can benefit asymmetrically from the disruption we highlight above.
Moving upstream, 90% of narrowbody planes are produced by the duopoly of Airbus and Boeing. Neither face serious threats from new entrants, and competition between the two has been stable and consistent for several decades. We believe any industry-wide upside attributed to the disruption we highlight has already been captured by marked share price increases in both stocks since 2017.
Furthermore, we find that 100% of narrowbody aircraft engines are produced by the duopoly of CFM and P&W. CFM is a 50-50 JV between GM and Safran, while GM is a diversified industrials conglomerate, Safran is a pure-play aerospace components manufacturer. P&W is a subsidiary of United Technologies, a diversified industrials conglomerate. We find evidence that CFM will benefit asymmetrically from downstream growth and industry-wide disruption. This informs our isolation of Safran based on disruptions highlighted above.
Safran recognizes revenue from three sources. Propulsion, equipment (multiple subsidiaries, focusing on nacelles and landing gears, acquired Zodiac in 2017 interior manufacturer with 30% market share) and defence (engines for French military, stable). Propulsion is ~59% of revenue and ~68% of EBIT.
Thesis I: Engine Production Ramp Up
The core thesis is based on the aircraft production rates given by Airbus and Boeing, specifically the A320 and Boeing 737, we project the delivery of engines to increase by 8.4% CAGR up until 2022, with a significant shift of the product mix towards new generation LEAP engines. As production becomes streamlined, capex rates will also decrease leading to a higher free cash flow generation from the sales.
At present, Safran has been explicitly reluctant to commit to increased production rates in earnings calls until it can confirm global trends will persist. Markets have taken this to mean it will never increase production rates, this seems patently unlikely given the guidance set by Airbus and Boeing. We predict Safran will raise rates in line with Boeing/Airbus in Q1 2019.
Thesis II: Increasing Aftermarket Sales
A significant part of the revenue, and most of the profits come from the aftermarket services, which are maintenance / service contracts. These are attached on every engine sold and are a high margin business with a huge moat. A consistent increase in the number of engines currently installed will continue to grow with the demand and stable base remains from previous engines. Therefore, we expect the number of outstanding engines to increase from 31,480 currently to over 42,000 by 2022, leading to a 49% growth in aftermarket revenue in the same timeframe.
Thesis III: Margin Expansion
In line with management guidance (see graphic below),we (and The Street) predict significant margin expansion in the medium to long term. We believe that Safran is at coming out of the bottom of the S-curve as the production scales up and after-sales contracts are included, which are a higher margin component. We project the margins to reach similar numbers to those for previous generation engines (20% EBIT margins), leading to a 10.9% EBIT CAGR over the next five years (EUR millions).
We used forward multiples to value Safran, based predominantly on aerospace players and automotive components manufacturers. The median NTM EV/EBITDA, EV/EBIT and P/E are 10.8, 13.2 and 16.5 respectively, with top quartile companies enjoying a 10% premium. However, the median EBIT margin is 7.3% (9.9% for top quartile) and therefore, we believe these multiples are applicable to Safran’s 2020 numbers. Hence, our price target based on a blended EV/EBIT 14x and EV/EBITDA 11x valuation is EUR118.9, a 19% upside over the current share price (and therefore a 19x 2020PE). For a company generating a ROIC of 15%, which is forecasted to increase to 19.5% in 2022, we believe it is certainly a bargain.
To Watch For
Safran would be a much better buy if we are able to discern the effects of the purchase of Zodiac Aerospace concluded this year. We think this smarts of value-destructive empire-building typical for French companies, but we will be unable to confirm this until later. As a distressed operation bought at a relatively low premium, there is significant upside to be found in successful restructuring.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We are a student investment society that tracks our results in a virtual portfolio. However, some members may initiate positions in the stocks we discuss.