DUAVF - Hexcel Executing On Improved Aerospace Demand

Summary

• Hexcel saw better-than-expected sales growth in the fourth quarter on strong aerospace and space/defense sales, but margins were a little shy of expectations.
• Narrowbody production is on more solid footing, and 2023 will be a year of good growth, but supply chain challenges remain a factor in ramping production further at Airbus/Boeing.
• Hexcel still offers good leverage to a commercial aerospace cycle/theme that likely still has legs, but valuation is not much of a bargain anymore.

I can't fault Hexcel ( HXL ) management for controlling what they can - as aerospace demand has returned, first with business jets (or bizjets) and regional jets and now with commercial narrowbodies, the company returned to double-digit segment margins. Revenue, margins, and cash flow should all increase nicely from here as the aerospace recovery continues with narrowbodies and eventually expands to include meaningful numbers of widebodies as well.

Hexcel shares are up another 12% or so since my last update . While I found the valuation more iffy then, I also thought the shares likely still had ongoing leverage to bullishness on aerospace. I still feel largely the same now, though I'm a little more concerned about when the trend of "own aero for aero's sake" will ease off and whether there will be rotational back to shorter-cycle names later in 2023. That's not to say that the business or stock is at a peak, but rather that future performance will once again become more tied to fundamentals.

Mixed Trends In Q4, But Ongoing Progress Evident

Hexcel's fourth quarter wasn't perfect, margins were somewhat underwhelming relative to expectations, but overall the trend for this business continues to be positive. Commercial aerospace continues to recover nicely, albeit still gated and constrained by supply chains, and I see some positive drivers in bizjets and defense.

Revenue rose about 22% in constant currency, beating expectations by about 6%. Commercial aerospace was once again the primary driver, accounting for almost 60% of revenue and growing 29% in the quarter. Within that, bizjets and regionals (reported as "other") grew 45%. Space and Defense sales rose 22% in the quarter, while industrial shrank again (down 7%) on ongoing weakness in wind power.

Gross margin improved almost four points from the prior year and 70bp from the prior quarter to 23.1%. Adjusted operating income rose 84%, with margin up 380bp to 10.8%, but EBITDA (up 26%) was just in line with expectations. At the segment level, Composite Materials profits rose 79% (on reported sales growth of 23%), with margin up four points to 12.7%, while Engineered Products profits rose 252% (3% reported revenue growth), with margin up about 10 points to 14.4%.

Drivers Still Supportive For The Aero Cycle

Not much has happened to change my general bullishness on the aerospace recovery story. While Airbus ( EADSY ) and Boeing ( BA ) have continued to note supply chain risks and limitations, and some investors may be disappointed that guidance for A320-neo, A350, 737, and 787 production rates in 2023 wasn't higher, the overall trend remains quite positive.

Still, I don't want to just hand-wave past those supply chain risks. I have revised my expectations for Hexcel down a bit in response to guidance from Hexcel management and aerospace OEMs, even though the company is still looking for double-digit commercial aerospace growth in 2023.

Likewise, while the major kinks seem to have been worked out of narrowbody supply chains, ramping up 787 production later this year could involve some further challenges. As Hexcel has traditionally been more heavily weighted toward widebody, that is something to monitor, as a robust recovery in 2024 and beyond has been part of my thesis on Hexcel for some time.

Outside of the majors, my main concern now with Hexcel's commercial aviation business is how long bizjets (and regionals) can maintain the strong growth pace they've been on. There remains a good fleet refresh story in bizjets, but eventually, that will get worked through, and a broader economic slowdown in 2023/24 could perhaps create some turbulence (firing thousands of workers and then taking delivery of shiny new executive jets is a bad look, for those executives who care). Over the longer term, I do see an upside when Dassault 's ( DUAVF ) new F10X enters service late in 2025.

As far as the industrial business goes, my thoughts haven't changed much. There's really not much that management can do here - wind blade production has shifted due to local content requirements, and there just aren't many industrial markets that have similar needs for the material Hexcel producers for wind power blades. Management is trying to drive more growth in markets like autos, consumer products, marine, and so forth, but at best this is a multiyear project.

The Outlook

It would seem that my prior expectations for FY'23 and FY'24 were too bullish, so I'm reining in my revenue growth expectations some - about 3% for FY'23 (to $1.8B) and 5% for FY'24 (to $2.05B). I also note that my new FY'23 number is within management's guidance range, albeit on the high side ($1.725B to $1.825B).

I'm also above management's "140M-plus" guide for free cash flow (at $180M), but then management didn't quantify how much "plus" there could be. Hexcel has been building inventory in anticipation of stronger commercial aerospace demand, so I could see some downside risk there from the inventory build, but that wouldn't have a qualitative impact on my outlook.

Long term, I'm looking for over 9% annualized revenue growth from Hexcel, or about 4% annualized growth from the last revenue peak. I believe Hexcel can generate mid-teens or higher FCF margins during this recovery cycle, but I don't want readers to think that that is a new sustainable long-term level, as this will still be a cyclical business (long cycles, granted, but still cyclical).

The Bottom Line

Between discounted cash flow and EV/EBITDA-based approaches (using a 14x multiple on my FY'24 EBITDA estimate, discounted back), I don't find Hexcel undervalued today. While beat-and-raise quarters are still possible, I do think supply chain challenges likely constrain demand growth on the Airbus/Boeing side.

Likewise, investment themes don't fade out just because of valuation, and I'm not calling a top/end of the aerospace recovery play. I do think it's time to be a little more selective, though, and this is a name I'd revisit at a lower price for my own portfolio, even though I won't be at all surprised if these shares are trading in the $70s the next time I cover them.

For further details see: