THLEF - Dassault Aviation: Actually An Interest Rate Story Now

2023-11-15 09:45:09 ET

Summary

• Dassault Aviation's large cash balance makes it eternally solvent and profitable in a higher deposit rate environment in Europe.
• Supply chain issues have affected the company's ability to liquidate its backlog, but it's not a problem given the deposit returns.
• Thales, in which Dassault owns a 25% stake, has completed acquisitions to boost its income contribution and is benefiting from the rebound in commercial aviation as well.
• At a less than 20x PE, technically it's a great deal against deposit rate benchmarks.

Dassault Aviation ( OTCPK:DUAVF ) has been a company that we've followed for many years now. It's always had a very large cash balance, owing to the very tight family control on the company, and the desire to keep the company eternally solvent, despite perennial profitability and obvious structural growth post Ukraine War. Now it is a rate story, and the outlook on ECB rates are a critical earnings driver. Moreover, Thales ( OTCPK:THLEF ) is another important consideration for equity accounted earnings growth, together with rates countering the supply chain issues. Finally, we comment on the possibility of deals with Saudi Arabia.

Key Earnings Comments

We have already commented on the half year results of Dassault, as the company only reports bi-annually. The situation is that supply chain issues have made it difficult for the company to liquidate its backlog. However, there was the emergence of a key new earnings driver due to the company's massive net cash position that eclipses the market cap, which is the prevailing ECB interest rate.

There are new developments. In particular, the emerging realisation that wage growth and the employment market is now going to be the leading indicator and primary driver of inflation, as the pronounced fallout from supply chain issues has been digested by business operations, demonstrated by wide destocking trends that have been affecting a host of businesses.

Wage growth continues to be too strong, and is going to be a factor that will allow inflation to persist and keep the last mile of the inflation race, where it is currently around 2.9% , very tough to complete. Moreover, non-core elements like energy prices remain an important concern, as even if volatile, they still do impact consumer expectations as it really affects a household's bottom line.

Everything points to European rates staying high through 2024, and the conservative ECB is highly unlikely to take risks with a premature pivot. This is really good for Dassault. Its operating markets will continue to improve as supply chain issue wane. Interest income represents currently 25% of overall income for Dassault. A whole year of higher rates, with the higher rate environment possibly having a long tail of declines due to inflationary pressures from deglobalisation, is a major earnings boon for the company.

Thales, which is 25% owned by Dassault, has recently completed acquisitions to bolster its information and intelligence businesses . This will inorganically boost the income contribution. Moreover, Thales has been a company that has been benefiting from the total rebound in commercial aviation, which has been a major idiosyncratic boost to the European economy while other markets somewhat falter. Thales' order intake easily covers a whole year of sales, and should create a sufficient cushion before investment trends pick up in a year and half or so, hopefully when recessionary pressures are more firmly in the rear-view.

Bottom Line

As a potentially much colder winter approaches compared to last year, and with continued pressure on oil markets due to several geopolitical effects, including the heated conflict in Israel as well as Saudi Arabia's geopolitical considerations in keeping prices high, there is more upside to rates than downside for Dassault.

Moreover, Saudi Arabia's geopolitical considerations may see it initiate business with Dassault, potentially for the Rafale . Saudi Arabia is currently a major customer of BAE Systems ( OTCPK:BAESY ), but as the country may want to align itself with more independent actors from the US, such as France which has been more vocal about European independence from the rest of the West's policies around protectionism and China, as well as energy transition considering France depends on massive nuclear power, there is credible speculation that they may become Rafale customers, where the Rafale has been supremely popular among the Gulf Cost Countries.

From a valuation point of view, Dassault trades at a 19x PE, and offers a little more than a 5% earnings yield. Definitely a fair price. Dassault is essentially a cash box and is risk free, so a premium over the ECB rate is actually compelling, especially since the downside on their defense and private aviation businesses are also so limited in the current environment. A 1.1% premium over the 4% deposit rate in Europe, with no real duration risks, actually makes Dassault superior in risk-return compared to a bond. An obvious buy for the conservative value investor.

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