DUAVF - Dassault Aviation: Supply Chain Issues Don't Change Story

2023-07-25 11:45:29 ET

Summary

• EV remains at 0 thanks to ownership in Thales and the very substantial cash pile.
• However, earnings direction is what matters for Dassault Aviation performance, and things look great on the Rafale side with another India win.
• While a large backlog is a comfort to shareholders, supply chain issues are affecting deliveries. Fixed cost cuts and higher rates are helping out the net income at least.
• On the NGF situation, we still think the programme is quite likely to fall apart as European interests and positioning with respect to the Ukraine war are too disparate.
• Valuation provides downside protection, and backlog is great. Markets are being patient, but it needs supply chain performance for an unlock of value.

Dassault Aviation ( DUAVF ) was our greatest success on the market. While we recognised a 0 premium hedge in buying the position ahead of the outbreak of the Ukraine war, the substantial upside from the valuation case has not yet come to fruition despite recognition of the stock. We think it never will. However, markets are responding to the earnings situation of the company in a patient way, recognising that backlog and defense business conditions are structurally improved. Supply chain issues are a problem for unlocking that value, but shrewd cost management and the fact that things will eventually get delivered remains the driver of the price and story. The only negative news we expect over the coming years is around the scope of the NGF project.

H1 Update

The headline figures tell much of the story. Everything is down on supply chain issues except the backlog and the net profit thanks to reduced fixed costs, higher rates on the massive cash balance (almost 50% of market cap) and also a rebound in Thales ( THLEF ) which suffered during the COVID years.

While the backlog is flat at the H1, right after the close of the quarter there was a major new announcement where Dassault had secured Rafale sales with the Indian Navy.

The Rafale backlog grows well ahead of 10% on that news.

Naturally, some of the reason why backlog is building is because of supply chain issues. Dassault has not been performing as well in terms of dealing with supply chain issues as some competitors, at least in the private jet market, with Bombardier ( BDRBF ) managing better in terms of deliveries. It's not the best news for Dassault that Bombardier wants to move into the military market, much like the Falcon jets are used for military purposes, and begin to take some share from Dassault. However, the pie appears to be continuously growing in the B&GA space, also as green initiatives take aim at commercial but not B&GA.

Valuation and Remarks

The valuation continues to be absurd, as it always has been for a coveted defense pick. The non-operating balance is equivalent to market cap. At least the cash is generating income, as is Thales, and this has helped out on earnings growth meaningfully.

Based on our model for the company which you can see here , on more normalised earnings the 0 EV situation would mean a PT of around 260 EUR per share, where the current price is around 170 which is a 52% upside from current levels. The cash balance and other non-operating assets render the downside very limited. Moreover, major changes in the French defense budget, as well as other countries in NATO, are all a tailwind for Dassault's business and can help the price creep up despite delivery slowdowns. However, it is realistic to assume the discount will never fully close, although the company continues to generate cash which at least now yields something meaningful.

While the backlog is valuable, we are still talking about a business that depends substantially on a 4.5th gen fighter in the Rafale. The NGF is what is coming next, being built in a European alliance including Airbus ( EADSF ). The reality is that while the project moves forward to demonstration phases, the alliance between these countries' industrial complexes and political interests are very disparate, and it is possible that the whole project collapses and BAE Systems ( BAESF ) Tempest programme will take precedence in Europe, despite Britain being the subject of ridicule and humiliation as they enacted Brexit. The concern around the NGF alliance for Europe was reignited when further sales of the Typhoon to Saudi Arabia were vetoed by Germany . This approach, which goes against an increasingly Europe-independence line from France, is going to be a problem for Dassault and could get in the way of sales to the long list of countries where issue could be taken with their humanitarian record. It comes down to the fact that Europe is bifurcated by asymmetric effects from the war and the resulting geopolitical changes, and cooperation is not efficient in this context. A risk to Dassault is negative headlines around a programme that is going to be the company's future. The positive take is that markets probably already realise this and are not giving much weight to the programme in Dassault's valuation.

Still, with expanding budgets even just domestically, and a backlog that can be profitably liquidated and then turn into an aftermarket base, Dassault still looks good thanks to its compressed EV.

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