Description

Description:

Astronics Corporation is an aerospace components manufacturer that manufactures electrical power systems, seat motion systems, and automated test systems for the aerospace and defense industry. At the current valuation and an overly pessimistic commercial aerospace environment, we are provided an opportunity to invest in a significantly de-risked Company at 6x normalized EBITDA. Even after accounting for Boeing build rate slowdowns and continued scrutinization of the commercial aerospace industry, Astronics remains an attractive investment. 

Astronics was previously written-up by Hkup881, and I would direct any readers to that write-up and it’s Q&A for supplementary information on the Company.

Astronics primarily operates under the Aerospace (~88% of revenues) and Test Systems (~12% of revenues) product lines.

• Aerospace: 

  • Inflight Entertainment and Connectivity

    • In-seat power systems

      • Provides power to personal electronics and other displays

      • USB-C ports and seat motion systems

    • Lighting and Safety

      • Provides exterior and cabin lighting systems

    • Electrical Power Generation

      • Provides exterior and cabin lighting systems

    • Avionics Products

    • Aircraft structures

• Test Systems

  • Astronics provides automated testing systems used in airplane production and other transportation-based systems for production and safety testing during assembly and production.

Astronics derives a majority of its revenues from the sale of its aerospace components to both Boeing and Airbus (~64% of revenue) with some additional higher-margin sales to the military (~22% of revenues). The commercial aerospace segment is evenly split between Line Fit/Retrofit and Narrowbody/Widebody. Both the combination of retrofit revenues and widebody optionality provide duration protection with recent 737 slowdowns while increasing the present opportunity for future ASP growth in the widebody market (widebody builds have a higher shipset content than narrowbodies).

Through the historical pursuit of strategic tuck-in acquisitions and FAA-enacted regulations post-9/11, Astronics has been able to accumulate a diverse, protected portfolio of high-quality products with high market penetration in their leading categories.

• A notable example is within Astronics’ IFEC offering that has been a continued source of strength for the business, powering 1mm+ seats on over 280 airlines. This is primarily under their flagship EmPower brand.

• IFEC (~46% of revenues)

  • Market penetration aircraft: ~80% wide body and 25% narrow body

  • Market penetration seats: ~ 60% wide body and ~20% narrow body.

Industry Structure:

The FAA and OEM approval process to attain line-fit status (planes come off the production line with Astronics’ gear) is one that is lengthy and daunting for many aerospace components manufacturers who were not able to attain line-fit status pre-9/11. Although most component standardization and certification was enacted in 1971 with Part 21 of the Federal Aviation Regulations (FAR), which outlined the requirement for certification of aircraft engines, propellers, and parts, 9/11 has hampered the ability for competitors to enter already existing relationships between component manufacturers and airlines.

• Many critical parts may require a Parts Manufacturer Approval (pma) while major retrofit modifications require a Supplemental Type Certificate (STC). Astronics line-fit status is one that would take a competitor years to attain with our estimates citing a higher burden of proof for prospective competitors as an ongoing elongating factor. Management has highlighted 3-4 years as an estimated timeline for a competitor to enter the market, but previous instances like that of Boeing’s BAE is indicative that the approval process often ends… with no approval.

 The process for attaining line-fit status consists of:

• Conduct preliminary design and engineering

• Develop a certification plan

• Submit application

• Testing and evaluation

• FAA inspection

• Certification issuance

• Continued compliance

Due to the increased complexity of the approval process, Astronics has been able to garner 90% market share in their IFEC offering with the other 10% coming from Airbus’ KID offering. Boeing tried to enter the line-fit market, but they eventually left the market. So…why is that so? One might be wondering why Airbus and Boeing have not been able to attract a higher market share with their in-house offering – the reason is multi-fold. 

• Airlines want to right-size their fleet with a single suite instead of having to work with multiple vendors during the production process. In other words, why would an airline hold-out their fleet with already high lead times when they could pay a slight premium to activate their fleet quicker (working with Astronics)?

  • The market structure is not one garnered between the airline and component manufacturer, but the interests of the airline must be aligned as well; hence, the reason why an Airbus offering does not necessarily sell into every Airbus plane (Delta or United must approve as well). 

  • With Astronics’ presence in the retrofit market, it helps to know that airlines will be able to find servicing components and help if they need to refresh their fleet without having to take on additional downtime to find another manufacturer to help instead.

Additionally, as previously noted in other write-ups, line fit status is paid out of airlines’ CapEx budget while a modification made after production is booked in OpEx for the Company. This is increasingly important with the continued prevalence of recent industry incidents. To avoid taking the OpEx margin hit during cyclical troughs and the additional engineering and SG&A spend, the CapEx/Line-fit spend is one that would be incrementally accretive during a period of high SG&A spend and seemingly perpetual restructuring expenses. 

Recent Tegus transcripts with other employees at other aerospace components manufacturers (AstroNova in this case) highlights the additional stickiness of FAA specs. As a preface, I do want to give credit to whoever provided this great information. 

Former Sales Manager, North America at AstroNova, Inc

But I could tell you there's been zero concern for them going away in the near future. And I think even if the FAA was to flirt with the idea of not requiring them or whoever is creating these rules for commercial airliners requiring this at the moment, if they were ever to flirt with that idea, it would take probably a long, long time to implement and get those approvals. So I would imagine there'd be a lot of notice in advance.

Tegus Client

Okay, I understand. But what you're saying, so you would think, even on the next generation I mean, obviously, they're specced into the current generation of aircraft, right? But even the aircraft that launched in, say, 2025, 2030, whenever that might be, you wouldn't have any concerns that they'd get replaced because it sounds like it'd just be a big hassle, and they don't really cost that much relative to the cost of a big airplane.

And so it just seems like it's not going to be, at least in the near term, like you said who knows what happens in '20 years? But at least in the near term, that doesn't seem like a risk you'd be terribly concerned about.

Former Sales Manager, North America at AstroNova, Inc

No. There's been no evidence that, that is going to change in the next 5 to 10 years.

Our thesis is predicated on these facets:

• Even with the recent windfalls of the 737 production rate, we believe that commercial aerospace growth remains an attractive tailwind for Astronics to benefit from.

• Astronics’ recent debt refinancing and lenient covenants provides an attractive opportunity for other companies to acquire Astronics.

• V-280 development, which is conservatively avoided by management, is a procurement win that should prove accretive to Astronics’ defense offering.

• The recent Test Systems 5-year IDIQ contract for HHRTS makes the segment salable… and finally accretive to the business. 

Why don’t we start with the easiest topic to assess… the slowdown in Boeing 737 build rates? (excuse my sarcasm).

• Astronics’ current valuation is an amalgamation of anachronistic concerns that are being misperceived by the market.

  • The 737 Max stopped production in 2019 because of engine malfunctions and Airbus hit the brakes on production during COVID.

  • A series of bad acquisitions (Armstrong, AeroSat, and CCC) contributed $50mm in revenue and $35mm operating loss in 2017, compounding minimal incremental profit on de minimis build rates.

  • Astronics was under one to three year fixed contracts with bad terms and was unable to pass the costs to consumers during the production downcycle.

  • Negative operating leverage from lower ASPs in narrowbody build rates paired with increased input costs and poor WC/AR management. 

737 Alaska Airlines Incident

The recent Alaska Airlines door plug incident within the Boeing 737 has made the idea of understanding the future of their business almost impossible. Boeing, originally, was transitioning their plan of 737 aircraft production to a rate of 38 aircraft from 31 aircraft per month with their long-term goal of 50 aircraft per month in the 2025/2026 timeframe; however, the FAA ordered Boeing to halt any further 737 Max production increases. This, combined with Boeing withdrawing their FAA request for time-limited exemption from current engine de-icing system requirements on the 737-Max, is expected to delay certification of the aircraft by 9 to 12 months into late 2025/early 2026. 

• The recent ATRO call highlights this progression: 

  • “Finally, Boeing rates, I'm not going to tell this crowd on our call anything they don't already know, Boeing is committing to or has the goal to get up to 38 ships a month by the end of 2024. I talked in our last call that they had held us at 30 to 35 ships a month.They're still doing that, so we don't think they're building at that rate. They're building inventory apparently, but they don't want to turn their supply chain down and then try to turn it back up later in the year. We're expecting, although we don't know, that we will stay at this 30, 35 ships per month over the rest of the year. And eventually, they will accelerate beyond 38 a month. I'm sure they're planning that sometime in 2025. And when that happens, our rate probably will not increase accordingly while they burn off inventory. But that's where that arrangement stands for us at this point.

Debating the merits of the 38/month goal is valid considering numerous reports highlighting actual build-rates being considerably lower. Although ~30/month is considerably lower than anything that was forecasted by Boeing, it is important to acknowledge multiple factors that help reduce this headwind.

• The prevalence of buyer-furnished equipment (equipment purchased by the airline from Astronics that is eventually sold into the airplane) for retrofit applications has given airlines the option to allocate from line-fit to retro-fit applications until the Boeing line-fit market improves. 

  • It is difficult to adjust BFE purchasing plans and obligations because of the continuous need of retrofit obligations, so that is an important relationship to uphold. 

• Although sell-through build rates are significantly lower, Boeing is keeping their production hot to disallow Airbus from gaining share in the market. With Boeing maintaining build rates into their inventory, Astronics’ impact from future build rates will be impacted by the sell-through imbalance once Boeing line-fit recovers.

• To quantify the potential downside impact of 737 build-rates, assuming an abysmal 20/month 737 build-rate and average shipset of $95k per 737, ((31-20)*$95,000*3 months until YE) = $3.1mm impact on revenues. Based on our conversations, this impact would still put you in the higher range of provided guidance of $700mm - $800mm for 2024 revenue.

(Note: 2023 Airbus deliveries are 735 commercial aircraft)

Above is a pre-737 incident, forecast for Boeing and Airbus build rates that demonstrate the upside optionality that can be provided in the event that Boeing “delivers” (ha) on their 38/month shipset goal. Although the likelihood of this is very low, the upside optionality that is provided on higher content aircrafts like the 777F provide accretive optionality in the widebody market. 

• Additionally, ATRO’s correlation to Airbus and Boeing production rates help contribute to the 40-50% contribution margin during production cycles because of their FAA-certification. We believe there are plenty of levers to pull in allowing for the Company to reach $1bn of revenues in the coming years without dependency on Boeing’s goals for 737 build rates.

We believe that Astronics operating in the 30-35 Boeing monthly build rate is a problem if prolonged. With the current expected timeline of build rate recoveries, the prevalence of BFE and Boeing’s hot-production desires allow for Astronics to bear little impact from the continued weakness in the commercial aerospace market. 

Debt Financing

• We believe one of the biggest hindrances in the way of a potential acquirer purchasing Astronics’ business was the high cost-of-debt that was present. The refinancing consisted of;

  • Expansion of 2027 RCF from $115mm to $200mm with an interest rate of SOFR + 250-300 bps. 

    • Astronics currently has $128mm drawn on the RCF.

  • New $55mm term loan at SOFR plus 550-675 bps.

    • Cash amortization costs decreased from $9mm to $550k.

  • Consolidated cash cost savings with the refinancing expected to be ~$10mm.

  • Term loan and borrowings were used to pay $80mm outstanding on previous TL and the call premium.

    • Q3’24 will reflect $8mm of expenses from refinancing and the call premium.

• With Astronics’ CoD previously being in the teens, the probability of ATRO getting credence for their business in the case of an acquisition was a rare possibility.

  • With the weighted average interest rate >10%, the salability of the business is increasingly more attractive for acquirers like TDG. 

V-280 Bell Contract

• The most attractive aspect of this unfolding story are those that are often hidden by management and other related parties. The Bell V-280 contract is the largest helicopter procurement program in U.S. history in the past forty years. 

• The Future Long Range Assault Aircraft Program:

  • The United States has attempted to find a potential suitor to replace the UH-60 Black Hawk helicopter, which has been used for more than forty years.

    • Bell Textron just won the contract in December 2022 with their Bell V-280 Valor offering.

Doesn’t seem that important, why should we care?

• Management hasn’t done a great job communicating the value of the contract, rather opting to describe low-margin contract wins in the Test Systems segment and alluding to commercial aerospace content growth. I believe this overly cautious outlook is unwarranted after the Sikorsky trial described below.

  • Peter Gunderman, CEO, in Q1’23 call, “It's still a little bit in flex but I think I used this line before, and I'll use it again, even though we're not under contract yet, and this isn't formalized, but as our company has grown over the years, our ship set content has grown also.”

• The FLRAA is the largest helicopter procurement program in the U.S. since the UH-60 program forty years ago.

  • Boeing and Sikorsky both filed protest against the GAO’s decision, which the GAO maintained in favor of Bell

• ATRO’s Flight Critical Electrical Power is ~6% of consolidated revenues.

  • There are currently 4,000 UH-60’s with 2,000 being eligible for replacement based on the 2023 GAO Report.

    • Management has commented that CPU on the Bell V-280 would be from $750k to $1m.

      • $200mm EBITDA opportunity over the course of the contract (estimated 2030 completion)

Management has provided some commentary on the program:

“Today, if you were to take a wide-body aircraft and put absolutely everything on it that we could possibly put on it from a lighting perspective, from a safety perspective, from a in-sea power perspective, from antennas and file servers and wireless access points, all the things that we do, you'd probably come up with -- and by the way, there's never been an airplane like this. We've never had one. But if we had one, it would be somewhere in the neighborhood of probably a $750,000 shipset, something like that.

And our FLRAA shipset content as it exists right now is well north of that. So it's a major program. And it's as you know, largely designed to replace Black Hawk or to complement the Black Hawk and nobody is saying they're going to be a one-for-one replacement. But there are 4,000 Black Hawks out there, and many of them have been out there since the mid-1970s.” Q1’23 Call

Based on our read-through of Sikorsky’s supplemental report with the GAO, we believe that there remains a higher burden of proof on supplemental proposals even with Sikorsky being the clear winner on the cost-side of the procurement. Additionally, GAO contracts are recurring so Sikorsky does not want to ruin their relationship with GAO. 

For anyone who still does not understand what the FLRAA contract is, here is a provided image from ATRO’s investor presentation on the components being sold into the program. Currently, electrical power is not a large part of Astronics’ business. The FLRAA contract allows for higher margin aerospace revenue to provide an additional driver for future diverse, protected growth outside of their IFEC offering.

We believe that the FLRAA contract will prove to be highly accretive for ATRO with additional optionality on CPU increases and cost pass-throughs for the Company to capitalize on. It is not hard to see the program having high-teen EBITDA margins on a higher replacement fleet size. We believe that the profile of the FLRAA contract supersedes their commercial offering, and even assuming a profile similar to the commercial business would prove to be highly accretive to the business.

• Current Update on GAO Status

  • Sikorsky and Boeing stated that they won’t file suit on Sikorsky’s proposal rejection

  • Sikorsky tuned its attention to Bell’s FARA contract that aren’t covered by ATRO

    • What’s the common denominator:

    • ATRO provides a free call option on any incremental developments in the development of the V-280

      • What’s that option worth?

        • Not 1:1 replacement parity, but comparable procurement programs conservatively assume $1.3mm for 2,000 replacement vehicles.

Radio Test Contract

• Anyone who has covered or watched Astronics these past couple of years will know about the overhang that is known as the Radio Test Contract. What was once known to be a large procurement spend overhang on the Company’s future has now converted into an approved project that is funded to $215mm. Although details of the contract are limited because of its nature, the contract is expected to bring the Test System segment back to profitability. 

  • Within the Test System contract, the program allows for the military to use Astronics’s testing and measurement offering to test military radios before and during their use. 

  • Testing and measurement is a lumpy business as most of it is dependent on funding and military contracts. The salability of a business is also determined by said contracts and funding. 

• ATRO realized $7.2mm in revenue in Q2 with an additional $10-12mm expected to be received before YE24. Although the contract is not expected to be accretive until mid-2025 to early 2026, the strategic outlook of the business in a potential sale has improved significantly.  

  • ATRO has continued restructuring the business with the consolidation of their Texas facility and the future consolidation of their UK facility, realizing $1mm in restructuring costs this past quarter. 

In the event of a sale, we believe that the pro-forma testing business, assuming core business stability with incremental revenue growth from the Radio Contract, can yield consolidated pro-forma revenue of $120mm (assuming ~$80mm revenue from the core business and an incremental revenue contribution of $40mm a year from the Radio Test contract). 

Other Testing & Measurement business have been subject to M&A activity and sale optionality with the advancement of any future procurement. Comparable company valuations, like that of RF Industries (0.61x Sales) and Anritsu Corporation (1.24x Sales), would provide ~$70mm-$150mm of liquidity for a company with a considerably better balance sheet than before (and a more attractive pipeline). Conversations with management have highlighted that the Test System business is non-core, and that the future of strategic interest of the business lies purely in its aerospace division. 

Margin Uplift

We believe that Astronics’ low variable cost model and FAA-specs allow for them to realize >40% incrementals with additional material upside with any ongoing restructuring and cost rationalization. Management has highlighted material costs as a source for negotiating future pricing increases with expected price increases to be lower than that of past years. 

In totality, it’s hard for us to look past Astronics’ high fixed-cost business that should provide upside optionality past the historical 22% GPM that was seen during the Boeing and Airbus production cycles of 2015-2019.

In adjusting for a normalized GPM base, it is important to note additional credits that were provided in years prior under the Aviation Manufacturing Jobs Program that provided an incremental $14.7mm in proceeds for the Company. 

In years prior, when describing the onset of the commercial aerospace recovery, Management has highlighted 200 bps in near term GPM recovery associated with increased fixed cost absorption, and I believe that there is an additional 200 bps that can be extracted from closer synergies between the legacy test systems (ex semiconductor) and aerospace business. 

In Q1’19, ATRO divested from their low-margin, high overhead semiconductor business for a pre-tax gain of $80.1mm.

• 2017 revenue for the semiconductor business was $32mm and $84mm in 2018.

• Initial offer of $185mm cash and $30mm earnout, but the semiconductor business was deeply impaired from its normalized $84mm peak with many programs failing.

With the immediate shutdown of the commercial aerospace sector along with the immediate exit of the semiconductor business, there are additional avenues for the Company to realize some margin accretion.

Valuation

Aerospace companies have experienced multiple compression paired with decreased earnings power as COVID build rates and supply chain challenges severely hampered companies heavily reliant on Boeing and Airbus production.

• Astronics management team has provided a clear guide to mid teens EBITDA margins, leaving no reason for the five turn discount from peers.

• Consensus NTM EBITDA margins only account for restructuring savings associated with ATRO’s tuck-in consolidations and partial contract repricing being phased in.

  • Additional volumes from Boeing and Airbus should lead to increased pricing/fixed cost absorption and ~400 bps of GPM improvement that the sell-side doesn’t fully account for.

• Aerospace component companies get consolidated with airlines as investors assume historical mismanagement and negative ROIC tendencies are prevalent in any company associated with the commercial aerospace sector.

• Relative to its peers, ATRO’s exposure to Airbus and Boeing’s accelerating build rates can lead to the type of multiple expansion seen post-GFC.

• Aerospace components businesses trade between 10-15x EV/EBITDA and have rarely gone below or above that range barring the GFC and COVID. 

  • ATRO trades at the low-end of that range with open exposure to the moderate multiple expansion experienced by most companies in the space.

With the expected normalization of Airbus/Boeing build rates paired with the expected contribution of Test System and FLRAA sales, Astronics’ has many ways of realizing the discount to peers. Astronics’  LT goal of mid to high teens adj. EBITDA margins and incremental line-fit & retrofit sales provides additional benefit on an already historically high backlog.

In years prior, managements’ backlog realization along with a higher booking environment has allowed for them to materialize numerous beat and raises on tempered guidance. We believe that FY24 will prove no different with a heightened backlog and a strong order environment. Even assuming that $400mm of ATRO’s $633mm quarterly backlog ships in 2H24, you hit $783mm (~$400mm + $383mm 1H24 sales). This lies within management’s $780-800mm assuming no incremental booking growth or lead time normalization. This has been a continuous trend management has opted for in recent quarters, with our expectations that this continous beat and raise... continues.

We believe that with initial procurement of the FLRAA contract and incremental revenue growth from the Radio Test contract, the Company can achieve $900mm of revenues and ~$150mm of adj. EBITDA in FY25. 

To summarize, Astronics provides investors an opportunity to invest in a company that has continued to experience material tailwinds of the commercial aerospace rebound at a steep discount along with a significantly de-levered balance sheet. For a business trading at 8x Fwd EBITDA with a peer leading operating profile, the market fails to assign proper value to the Company’s free “options” like the further procurement of the FLRAA project and the highly likely sale of the Test System segment (following the Radio Test award).

Catalyst

-Continued rebound of commercial aerospace (Airbus and Boeing)

-Continued procurement and production of FLRAA 

-Sale of Test System business

-Debt refinancing