HXL - Hexcel: Some Risks EPS Surprise And Innovations Make It Cheap

2023-04-26 06:32:07 ET

Summary

• With an eye toward the future development of the aviation, electronics, transportation, and power generation industries, Hexcel is an American company dedicated to the manufacture of lightweight microcomponents.
• Hexcel Corporation delivered better than expected results in the last quarter, but there are other aspects to like about the company.
• I would expect new innovations coming in 2023. In particular, new high-viscosity infusion resins, HexPEEK, HexPly surface technology, and other technologies recently announced.

Hexcel Corporation ( HXL ) delivered double digit quarterly sales growth and better EPS than expected. The guidance given to investors include double digit sales growth in 2023 along with new innovative products like new high-viscosity infusions resins, HexPEEK, or HexPly surface technology. In my view, even considering risks from supply chain issues, lack of materials, or the total amount of debt, I believe that the stock is undervalued.

Hexcel Corp Sells A Diversified Product Range To Large Clients In Many Continents

With an eye toward the future development of the aviation, electronics, transportation, and power generation industries, Hexcel is an American company dedicated to the manufacture of lightweight microcomponents for electronic circuits.

The products designed, developed, manufactured, and marketed by this company are oriented to occupy the least amount of space possible, without losing performance or hardness for their future application.

Currently, Hexcel Corp has an international presence in Europe, Africa, Asia, India, and Malaysia, where it has offices and manufacturing facilities. The company considers serving and participating in only one market of advanced components. For this, it has two reportable segments in its business model, Composite materials and engineering materials. The first of these segments includes the development and sale of composites with carbon fiber, other fibers, resins, and panels. The second of these segments is dedicated to the manufacture of lightweight and high-strength components for structures, magnetism and radiofrequency instruments, microwave absorption materials, and other specialty products.

The composite materials segment, with manufacturing facilities located between Europe and the United States, seven in total and five of them between Germany, Spain, and France, mainly serves customers in the aeronautical industry, among which are Airbus (EADSF), Aeronova, Vestas (VWDRY), Nordam, Mubea, and The Boeing Company (BA).

The engineering materials segment, on the other hand, has the same number of facilities, all in the United States except for two of them located in Belgium and Morocco respectively, and its largest customers are General Electric (GE), The Boeing Company, and Spirit AeroSystems ( SPR ).

I believe that having a look at Hexcel is a brilliant idea because of its diversification. Its products include productions with carbon fiber, resins, other types of fibers, and reinforcing instruments for applications in both the passenger air transport market and the aerospace and defense industry as well as other industrial applications.

In 2022, 58% of the company's revenue came from sales to the aviation sector, mainly through the segment of composite materials. To a lesser extent, 29% of revenue came from the military and defense industry, which the company primarily serves through the engineering materials segment. Lastly, the remaining 13% of the company's net sales during 2022 were from sales and contracts with companies from other industries and various markets such as the automotive, marine, and recreational sectors among others.

The results for the quarter ended March 31, 2023 did not change as compared to that in the year 2022. Commercial Aerospace continues to be the most relevant market with close to $457 million. It is worth noting that net sales increased in all markets except that related to the industrial customers.

2023 Guidance Includes Double Digit Sales Growth, FCF Growth, And EPS Growth

I believe that the guidance given for 2023 is beneficial. The company expects to deliver sales close to $1.72-$1.82 billion with double digit sales growth, EPS growth, and FCF growth. For those running financial models, management noted that it expects capex of approximately $90 million, and 2023 FCF would stand at $140 million.

In the last quarterly report, the company did not change its guidance. However, management made several optimistic commentaries that market participants may want to read. The company reported an 18% increase in sales. The management stated that the company is well positioned to benefit from production ramps from aerospace customers.

"Our relentless focus on execution and growing demand drove an 18% increase in sales, and we delivered adjusted operating income that was more than double the same period last year. The margin expansion reflects strong operating leverage from higher production levels as our key markets grow. Hexcel is well-positioned to benefit from the multi-year production ramps our aerospace customers have announced, as well as growth in other markets – all of which will lead to significant cash generation and expanding shareholder value." Source: Quarterly Press Release

Solid Balance Sheet Reported In March, 2023

I believe that the balance sheet appears quite stable. The largest asset is property and equipment. Besides, management holds a significant amount of cash, inventory, and accounts receivable. I believe that other competitors may find significant barriers to enter this market, as they have to make meaningful investments in capital expenditures. Accounts payable does not seem that significant, which means that clients do not really finance the operations of Hexcel Corp. The company needs some debt to finance capital expenditures.

The list of assets included cash and cash equivalents close to $105 million, accounts receivable worth $265 million, inventories of $354 million, and total current assets worth $807 million. The ratio of current assets/current liabilities stands at 2x, so I would not really expect a liquidity issue here.

Property, plant and equipment stood at $3.116 billion, and net property, plant and equipment was equal to $1650 million. Besides, goodwill and other intangible assets were equal to $255 million with total assets of $2.9 billion. The asset/liability ratio is more than 2x, so I believe that the balance sheet stands in a very good shape.

The list of liabilities include accounts payable of $122 million, accrued compensation and benefits close to $61 million, financial instruments of $15 million, and total current liabilities of $290 million. Finally, with retirement obligations close to $44 million, which I included in the net debt, non-current liabilities stood at $1.285 billion.

Valuation Assumptions And Financial Model

In my financial model, I assumed that management will successfully focus on specific and specialty products that serve the particular needs of their customers. In this sense, I need to mention that to offer a product of this type in the production phase of another company, it is necessary to carry out a series of adaptations and tests to ensure the operation of the components and devices. This somehow explains why sales are concentrated in the hands of very few customers.

Besides, I would expect new innovations coming in 2023. In particular, new high-viscosity infusion resins, HexPEEK, HexPly surface technology, and other technologies recently announced could also serve as interesting revenue catalysts.

Besides, I believe that the recent announcement of assets held for sale may accelerate the demand for the stock. In my view, if the company successfully sells non-core assets, and reports more cash in hand, Hexcel may receive more attention in the stock market. In the last quarter, assets held for sale stood at $9.5 million, but in the past assets held for sale stood at more than $12 million . In my view, the company may record more assets for sale.

"In November 2020, we closed our wind energy prepreg production facility in Windsor, Colorado and in 2022 we further reduced the carrying value of the Windsor facility by approximately $3 million. The plant assets to be sold have been recorded in “Assets held for sale” in the Consolidated Balance Sheets at both March 31, 2023 and December 31, 2022. The sale of these assets is expected to occur during 2023." Source: 10-Q

In addition, I would expect strategic acquisitions that will likely allow Hexcel to expand its sale to other markets. I see that the company executed transactions in the past because goodwill accumulated is not small. In the past, the company acquired ARC Technologies LLC, Structil SA, and Oxford Performance Materials. With expertise in the M&A markets and expecting double digit sales growth, I believe that bankers would approve new transactions.

"We expect to continue to explore complementary mergers, and acquisitions." Source: 10-k

"During the first quarter of 2019, we acquired all of the outstanding equity interests in ARC Technologies LLC, a leading supplier of custom RF/EMI and microwave absorbing composite materials for military, aerospace and industrial applications, for $163.2 million." Source: 10-k from 2020

"We acquired all of the outstanding shares of Structil SA, which further enhances our technology portfolio with new adhesives prepreg and pultrusion technology. We also acquired the aerospace and defense business of Oxford Performance Materials, bringing thermoplastic, carbon fiber reinforced 3D printed parts to our product portfolio." Source: 10-k from 2020

Finally, long-term changes in the manufacture and use of new materials due to new regulations in relation to climate change could also bring new investors. In this regard, I would like to mention some of the sustainability targets reported by management in the past.

My DCF model included 2033 net income of $598 million, 2033 depreciation and amortization close to $45 million, amortization of deferred financing costs and debt discount of -$2 million, and stock-based compensation of $45 million.

My DCF model also included merger and restructuring expenses of -$132 million, decrease in inventories of -$758 million, decrease in prepaid expenses of -$116 million, and increase in accounts payable and accrued liabilities of $1265 million. My numbers are not far from other figures reported by the company in the past. I believe that I am a bit conservative.

Finally, with 2033 net cash provided by operating activities of $788 million and capital expenditures of -$46 million, the free cash flow would stand at $742 million.

If we assume an EV/FCF multiple of 19x and a cost of capital of 8.54%, the enterprise value would stand at $7.632 billion. Besides, if we add cash, subtract short-term borrowings, long-term debt, and retirement obligations, the implied equity valuation would be $6.978 billion, and the fair price would be $83 per share.

Large Competitors And Several Risks

Competition for Hexcel comes from companies of similar sizes both in the United States and internationally. This market is highly competitive, and manufacturers, in many cases, have products with similar applications in their portfolio as well as great conditions to enter. In this sense, the company has directed its production to the composition of materials to ensure this niche besides achieving developments in that direction.

I believe that it is important to highlight the lack of diversification and the enormous dependence that the company has on two of its largest clients. In the last year, 38% of sales were only to Airbus and its subsidiaries. To this statistic we must add that 14% of net sales in 2022 went to Boeing and its contractors, with similar percentages in previous years. In other words, just over 50% of this company's annual net sales are in the hands of two companies.

To this, of course, must be added the risks inherent to the nature of the markets in which it operates. Also, as it happens for the transport industry in general and the aeronautics industry in particular, a state of exception such as the current invasion of Ukraine could completely stop the activity.

To a lesser extent, all risk factors in relation to supply chain issues such as increases in the price of fuel or future changes in the regulations for the entry and exit of merchandise in the countries where the company has production facilities are always factors of lesser scope that can complicate the common operations.

My Takeaway

Hexcel Corporation delivered better than expected results in the last quarter, but there are other aspects to like about the company. HXL works with large conglomerates, and offers significant international exposure and many different products. If we also assume successful sale of non-core assets, further innovation, and M&A transactions, I believe that the company is well positioned for growth. Management also noted recently that it expects double digit sales growth in 2023 and significant FCF generation, which I believe will sooner or later be reflected in the stock price. Even considering risks from supply chain issues, lack of materials, and the total amount of debt, I believe that the stock is undervalued.

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