THLLY - Thales: Buy On Aerospace And AI Strength

2023-05-19 10:21:55 ET

Summary

• Thales S.A. products are widely applied.
• The company trades at a significant discount compared to aerospace and defense companies.
• Air travel growth, digitalization, and increased defense spendings are all tailwinds for Thales S.A.

Aerospace and defense offers significant long-term opportunities for investors. Especially now, with defense budgets expanding and air travel demand surging, aerospace and defense is positioned well to benefit in the mid to longer term. However, as I found when assessing original equipment manufacturers, airlines, airport names, and big defense contractors, the moment you stay overly focused on just the big companies in the sphere, you might be losing out on a lot of upside. That is why I also look at smaller names and into names that are, for instance, active in South America or Europe. That is a strategy that has so far worked well, enabling investors to achieve market-outperforming results.

An example of looking at smaller names and into other regions is Hensoldt AG ( HAGHY ), an Airbus SE (EADSF) spinoff active in Germany. In this report, I will be analyzing another European company with exposure to defense as well as commercial aerospace, namely Thales S.A. ( THLEF ).

Thales: A Diversified Aerospace Giant

Thales SA is a France-based technology company. It provides a wide range of solutions divided into three segments: Aerospace, Transport and Defense and Security. Aerospace provides onboard electronic equipment designed to increase flight safety and reliability, civil and military aircraft simulators, onboard connectivity and in-flight entertainment, onboard equipment and functions for aircraft piloting, navigation, and control as well as equipment, payloads, satellites, systems, and services for the space sector. Transport offers railway signaling, telecommunications, supervision systems, and ticketing solutions. Defense and Security offers radio communications products, network and infrastructure systems, protection systems, critical information systems, and cybersecurity.

When discussing a company, I always try to describe some of their core end markets or platforms. With Thales, that is difficult for the simple reason that it is such a big company with a diversified platform base. To give you an impression, the company is the #1 provider of air traffic management solutions, over 40% of the world's aerospace is managed by Thales, and the company is the worldwide number 3 in avionics and the number 1 in Europe. In defense, the company says it is the global number one in air C4I (Command, Control, Communication, Computers, and Intelligence) and advanced air defense and the #1 in defense electronics in Europe.

So, it is highly likely that either when traveling by train or airplane you either touched something that was made by Thales, or some electronics either on the vehicle or the associated management system had a product from Thales involved, all while its defense solutions play an integral role in keeping everyone safe. That already sounds like something big that would be interesting for investment.

Key Metrics For Thales In Q1 2023

It is important to keep in mind that French reporting standards don't require Thales to report full P&L results for the first quarter. Instead, order intake and sales are discussed during the odd-numbered quarters, and in the even-numbered quarters, we get a more complete discussion. So, for the first quarter, I will only be able to discuss order intake as well as sales and guidance. I don't quite deem this reporting standard ideal, but we have to start somewhere with the coverage, so I might as well do it starting from the Q1 results that are being shared.

We can actually pick the most boring slide out of the slide deck for Q1, which you can see above, and expand from there. So, order intake grew by 13%, which was driven by 1% growth in aerospace solutions, and you might wonder why order intake is up only one percent while I mentioned before that air travel drives demand. If we look deeper into that 1% growth, then aeronautics are up by double digits. So, that is everything that has to do with air travel, really.

Space had a significant order inflow last year, and these orders are lumpy. So, that skews the comp a bit and masks the aeronautics order intake on aerospace segment level. Defense and security order intake grew by 31%, driven by small order intakes. This already includes orders directly related to Ukraine such as a short-range air defense system as signed in February 2023.

The Digital Identity & Security segment saw 5% total growth and 20% organic growth. The DIS segment includes items like banking payment solutions, but also biometrics for travel documents, 5G, and AI. The field of AI is becoming more and more interesting, and Thales offers real-time analytics driven by AI and Machine Learning. This should give you a bit of an impression of how broadly the capabilities of Thales Group span. When talking about AI as a business opportunity for Thales, we are talking about asking a chatbot to give answers that are not at all correct or asking a bot to draw a purple puppy in a bunny outfit in space. It is actual applied science to drive intelligence and analytics for mobile network operators supporting 5G and The Internet of Things.

Looking at order intake, aerospace accounted for 35% while defense accounted for 42% and the remaining 23% went to Digital Identity & Security. From a sales perspective, aerospace sales grew 12.4% driven by aftermarket sales for civil aviation while space sales were flat. Defense sales grew 6.6% driven by a variety of areas such as air defense, air and marine systems, and communications and cybersecurity. DIS grew sales by 5% where increased air travel drove the biometrics business used for travel documents.

From a book-to-bill perspective, aerospace had a ratio of slightly higher than 1 while defense stood at .7 and DIS at 1 as well for a total book-to-bill of .85 which I think is pretty solid. For the full year, a book-to-bill above 1 is targeted with 4 to 7 percent growth on sales and EBIT margins in the 11.5 to 11.8 percent range. There are two ways to look at this. The first is that order intake fell short of expectations and sales growth exceeded expectations. The second way to look at it is that things will get better in terms of order intake, while year-over-year growth will taper somewhat for the remainder of the year. Whatever way you view it, the backlog is expected to grow for the year, and sales growth is expected as well.

Is Thales Stock A Buy?

What I like about Thales is not just their defense and commercial aviation exposure, but the fact that they also play an important role in connectivity and digital security. The company has a low net debt and pays a dividend. Compared to its median EV/EBITDA, there is admittedly no upside. However, that ignores the prospects the company has in the current defense budget landscape, and compared to peers it is significantly undervalued. So I would feel comfortable putting a $175 target on the stock, representing a 15% upside and a 2% dividend yield.

Conclusion: Thales Is An Attractive Business

I don't view Thales S.A. as a high-growth business, but its aspirations for this year suggest somewhat otherwise. The company is active in many areas that have mid- to longer-term appeal, and while its current enterprise valuation relative to its EBITDA projections might not show an upside, I do think that it should be kept in mind that the company trades at a discount relative to peers and I don't think that is justified. So, I do think that Thales S.A. is a company with a lot of long-term appeal, and I feel comfortable assigning a buy rating.

For further details see: