The Long Case For Hexcel

By Michael Liu :

Target Price and Rationale

1. Meaningful long-term industry tailwinds set to accelerate in the next few years.
2. Oligopoly status, industry leadership, and non-competitive contracts should allow Hexcel ( HXL ) to capitalize on the majority of this growth.
3. Company-specific cash flow and margin improvement in the next few years.
4. End markets should improve in the near term (1-2 years).
5. ~30% discount to reasonable comps, "pure-play" on secular growth industry, and consolidation premium.

Based on these factors, we are assigning a 12-month price target of $68/share, representing 32% upside, predicated on Hexcel achieving a P/E of 22.5 (mid-point of our estimates) on projected FY17 results.

Relevant Comps

• We don't believe that any company in the comp set is directly comparable to Hexcel. With the majority of comps, composite materials are sub-30% of sales and EBITDA. Further individual analysis is required to identify composite materials segment valuation. Relevant comps: Toray ( TRYIF ), Teijin (TINLF), Solvay ( SVYSF ).
• Toray: sales mainly from a long-term supply relationship with Boeing ( BA ). Composites are ~10% of revenue and 25% of EBIT. The composite segment is Toray's highest-margin and fastest growing one (on both trailing and projected numbers). Toray is also investing substantial amounts into the segment, for example, by acquiring Zoltek in 2013 and by developing a $500 million new facility more recently. Toray's trailing P/E is 20, although we'd argue that the composite segment is worth a premium due to these factors.
• Toray acquired Zoltek for 112x earnings, although granted Zoltek's earnings fluctuated significantly prior to the buyout. More normalized, the purchase price was also for 4.2x sales, which, although arbitrary, is still significantly above Hexcel's valuation of 2.4x.
• Teijin: composites 15% of revenue, 30% of EBIT. High-margin segment. The segment is projected to decline next year. Overall company P/E of 16.
• Solvay: acquired Cytec late 2015. Cytec was perhaps one of the best comps for Hexcel, as major business lines and supply relationships mostly overlapped. Buyout valuation was for 26.5x earnings; three months pre-buyout Cytec traded for 21x. Recent industry developments, such as advancement of next-gen aerospace programs (which utilize far more composite materials) and the results of the presidential election make us believe that Cytec would garner a higher multiple today. We also believe in assigning Hexcel a premium due to its pure-play nature and demonstrated M&A potential. As a whole, Solvay currently trades for 20x earnings, although again composites are only a portion of overall revenue/profit.
• Given the above factors, we see Hexcel trading for anywhere from 20x to 25x earnings, or 18-47% upside from current prices (based on a forward P/E of 17).

Catalyst

End market softness reversals. Substantial ramps in government military spending into aerospace. Margin/cash flow improvement through 2018. Hexcel's pure-play nature should amplify the effects of macro catalysts.

Industry Tailwinds:

• Aerospace segment (70% FY16 sales): Hexcel supplies major aerospace OEMs (mainly Boeing and Airbus ( EADSF )) with composite materials, including carbon fiber and its derivatives. According to various independent studies, carbon fiber is 3-5x stronger and 30-50% lighter than aluminum, its closest comparable. This makes it very valuable in aircraft construction.
• Since the 1970s, the percentage of composites relative to total weight used in new aircraft has consistently increased. Current aircrafts have 50%+ their weight in composite material, and further growth is projected. Boeing recently partnered with Toray, another composite manufacturer, to institute new programs to increase the proliferation of composite material in new aircrafts. This shows that OEMs are committed to further increasing composite material use in their own planes, and that this is a demand-pulled tailwind.
• Global aircraft shipments have also consistently increased for decades. This trend compounds upon composite materials composition growth.
• Reflecting these tailwinds, Hexcel is projecting a high-single digit top-line CAGR through 2020. Longer term, these growth trends should support further consistent growth. Hexcel has grown aerospace sales every year since 2009. Margins have also improved every year since 2009, in part due to FX, but also reflecting Hexcel's advantages and pricing power in the industry.
• On top of this, the Trump administration plans to materially increase military spending in the next few years. A significant portion of this spending should trickle down to Boeing, as it is the dominant force in the military aerospace industry. Boeing was 28% of Hexcel's FY16 sales. Hexcel has not accounted for this development in its projections as new government spending has not yet impacted Boeing's production needs. Once there is more visibility on the subject, management should become more bullish.
• Space & Defense segment (16% FY16 sales): ~50% of this segment's sales are from supplying the rotorcraft end market, mainly in military applications. Military demand for rotorcrafts has declined in recent years. Accordingly, Hexcel's Space & Defense sales have stagnated. Trump's new defense initiative could potentially reverse this trend.
• Industrial Segment (13% FY16 sales): ~50% of this segment's sales are from supplying composite materials for wind turbines. All industry participants have been suffering from demand shortage in recent years. Hexcel management appears confident that this should reverse in 2018. In the longer term, composite materials' substantial advantages over comparables should allow for continuous application expansion into new verticals.
• The majority of the long-term thesis lies with the Aerospace segment. Space & Defense and Industrial applications tend to be more competitive, slower growth, and lower margin, and comprise a smaller portion of Hexcel's overall revenue. Even so, all end markets seem to be at or near short-term inflection points, positioning Hexcel for strong immediate growth. Longer term significant macro tailwinds ensure a continuous growth runway for this industry leader.

Competitive Landscape:

• The composite materials industry is highly consolidated, with only five major competitors: Toray, Teijin (Toho Terex), Mitsubishi, Solvay (Cytec), and Hexcel. Toray is the market share leader, with Teijin and Mitsubishi not far behind.
• There has been some consolidation in recent years. Solvay merged with Cytec in late 2015 for $5.5 billion. Toray acquired Zoltek in 2013 for $583 million. These M&As have made Hexcel the only public pure-play on the composites industry. Other competitors have composites at
• Toray, Teijin, and Mitsubishi are all based in Tokyo, Japan, and are suffering from the recent strengthening of the JPY. Hexcel doesn't face these same margin headwinds in direct competition.
• Having said this, Hexcel's oligopoly has little direct bidding competition. Supply agreements are characterized by multi-year contracts and many sole-source bids, reflecting competitors' unwillingness to cross-compete, and OEMs' unwillingness switch suppliers. For example, Hexcel has a multi-year supply agreement with Airbus for various end products; Toray has a similar agreement with Boeing. Towards ends of contract periods, OEMs tend to renew them and expand the applications to new product lines. Airbus recently added 13 years onto Hexcel's supply agreement and expanded product coverage to various next-gen products. Similarly, Boeing recently added 10 years to Toray's supply agreement and also expanded Toray's product coverage to its new aircraft. The contracts comprise the majority of the respective suppliers' sales to those end customers.
• Operating margins across the industry are high at 15%+ (for composite segments). Aerospace margins tend to be even higher. Hexcel has the highest EBIT margins in the industry at 23% in FY16. Margins have been growing since 2009. This shows that sales are based on quality and reputation rather than price.
• Substantial barriers to entry: design specifications for aerospace are extremely stringent, and OEMs are unwilling to incur the potential liabilities resulting from low- quality/unproven product. All business is therefore typically taken on only by the industry leaders and/or suppliers with existing relationships. Hexcel has entrenched itself as a leading supplier of composite materials to Airbus and Boeing, which we believe gives it a substantial advantage over potential competitors.
• Hexcel's other two segments face more direct competition, but also comprise a much smaller portion of revenue. Our analysis focuses on Hexcel as an aerospace supplier.

Company Specific:

• Over the last few years, Hexcel has experienced a significant ramp in CAPEX spending. It is currently at peak CAPEX spend with $320 million CAPEX in FY16 (~80% operating cash flow). CAPEX is expected to decline to $160 million/year by 2018-19, freeing up ~$160 million in FCF (~3% cash flow yield) for total FCF of ~$250 million. Hexcel has ample reinvestment opportunities, detailed below:
• Returning to shareholders: currently has a $300 million buyback authorized (6.4% of float). Historically, bought back ~$100-150 million/year. Buyback amounts inversely fluctuate with CAPEX spend; management tries to give all FCF back to shareholders. Expect repurchase rate to increase over the next few years, as FCF will increase and the share price remains undervalued. Also recently, instituted a small dividend, currently at $0.44 annually (0.85%).
• Investing for future growth: Hexcel has historically made several acquisitions and partnerships in order to remain on top of industry innovation. For example, between two investments in late 2014 and in early 2016, Hexcel acquired Formax UK, which is developing a new lightweight carbon fiber model for emerging industrial applications. Similarly, Hexcel has invested in/partnered with Carbon Conversions Inc. (carbon fiber recycling/repurposing), Oxford Performance Materials (3D printing), and several other smaller companies in order to best position itself for long-term innovation.
• Hexcel is also in the process of ramping up its production by building two new manufacturing facilities in France and Morocco. Development costs are projected at ~$10 million this year, with revenues and margin improvement expected starting Q4. Completion of this development should allow for an easy comp in 2018, as costs die down and sales/margin improvements surface.
• Overall, management seems willing to sacrifice short-term profits in order to optimize long-term growth and to grow market share. At the same time, margins and cash flow should significantly improve over the next few years as the new facilities start contributing and CAPEX decreases.

Mis-valuation/catalysts:

Several reasons exist for investors potentially incorrectly valuing Hexcel:

• Investors may not completely understand the non-competitive dynamics of the composite materials industry and, therefore, underestimate Hexcel's substantial earnings protection against many larger peers.
• Investors may also be overestimating the extent of end market softness. Hexcel shares initially dropped 9% following the recent Q1 earnings miss due to low aerospace sales. Shares quickly recovered to -3% as management assured investors that the miss was due to one-time issues. This shows how cognizant investors are of potential long-term headwinds, which may be causing them to overestimate the extent of current weakness in Hexcel's markets. As end markets improve as projected, this fear should dissipate.
• Lastly, as we show in the comp section, there is not a current viable comp set for Hexcel. All major competitors trade at an average P/E of 20, implying minimal upside to Hexcel shares from current valuations. However, for most comps, their fast-growth/high margin composite segments are being obscured by weaker business lines, implying that investors are valuing the composite business at much higher multiples.

Conclusion:

Substantial positive factors are coalescing in late 2017-18. New facility costs should die down, margins should improve, CAPEX should decrease, and end markets should improve as projected. We see further medium-term upside to Hexcel's earnings based on these factors. In the long term, Hexcel is at the forefront of multiple secular tailwinds, including aerospace/defense sales and a transition to composite materials, and possesses the industry position to best capitalize on these trends. All of this makes us comfortable in assigning a 12-month price target of $68/share, representing 32% upside, predicated on Hexcel achieving a P/E of 22.5 (mid-point of our estimates) on projected FY17 results.

(Editors' Note: This is a republication of an entry in the Sohn Investment Idea Contest . All figures are current as of the entry's submission - the contest deadline was April 26, 2017).

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.