Description

Aviall is a company that dominates its niche business and has shown consistent double-digit organic growth in revenue and earnings despite decreasing industry revenues. The company has a very scalable business model and a huge opportunity to increase its presence as a supplier to the U.S. Military. Despite this growth opportunity, AVL is only trading at about 8.5X FCF.


BUSINESS

Aviall is the leading independent distributor of new parts to the aerospace aftermarket. The aerospace aftermarket is a $50B market that is highly fragmented. Aviall has 2 lines of business: Aviall Services and Inventory Locator Service. Aviall Services, which is the main business and represents over 85% of the profits, focuses on the distribution of new parts to the aftermarket. This business is mostly handled by the aftermarket segment of OEM’s. Aviall is the largest independent player, about 8X as big as its nearest competitor, and the only one with a true global reach.

Aviall’s customers are basically anybody who flies: military, government agencies, commercial and regional airlines, couriers, businesses, and recreational flyers. These groups are broken into 3 segments: Military, Commercial, and General Aviation. Since its competitors are all either captive or small, Aviall’s size, experience, and market knowledge give it a significant competitive advantage in its ability to serve the customer through complete product offerings, leading technology, and a broad sales force. These advantages really shone through over the last year when Aviall gained a lot of market share and kept revenues relatively stable to growing in its Commercial and General Aviation segments despite the overall market in both segments being down as much as 20%. Meanwhile the Military segment, which the company expects will be its main growth arm for the foreseeable future, has grown substantially.

The crux of Aviall’s business model is the ability to acquire distribution rights to new product lines from the OEM’s. Almost all of Aviall’s growth has come from its ability to secure exclusive, long-term contracts from the OEM’s to distribute parts. When such a contract is granted to an independent distributor, Aviall basically always wins it and has substantial pricing power, but the challenge is getting the OEM’s to part with the distribution rights in the first place. Their value proposition to the OEM is that their better technology, strong customer relationships, and deeper supply chain knowledge and forecasting enable them to achieve superior customer service and inventory management. This ultimately means higher sales with less inventory. Typically Aviall will take a product where the OEM’s fill rate on orders was less than 50% and increase it to over 98% with barely any increase in inventory. I have spoken to multiple major customers, all of whom give Aviall the highest praise. New product contracts are very accretive to earnings because of significant operating leverage, but winning a new contract is still a long and political process.

The most important such contract for Aviall has been the Rolls Royce T56 engine parts contract, which is now responsible for about 35% of the company’s revenue. This contract was won in late 2001 and helped diversify Aviall’s revenues by substantially increasing its military exposure. The engine is primarily used in C-130 transport planes, which carry all kinds of things from people to equipment. The Iraq war has clearly helped them achieve some of their growth targets faster but there is still a lot of growth left in this product line.

Aviall’s second segment, Inventory Locator Service, is an electronic B2B marketplace. ILS has been in business for 23 years, and has by far the largest number of users who pay a monthly subscription fee as well as fees for ancillary services. This business got crowded in 1999-2000 during the internet craze and ILS saw some pricing pressure and attrition (it is actually entertaining to go back and read some old research reports where Aviall was being valued at 7X revenues for the ILS plus some nominal amount for the distribution business). But since ILS had 2 decades of experience and customers it emerged the clear winner. There are now only a few players left, pricing has stabilized, and most of the customers who left have returned. I expect this business to start growing again in 2004.


FINANCING

Aviall recently cleaned up a capital structure that was onerous and complicated as a result of September 11th. The Rolls Royce contract was actually negotiated during the summer of 2001, and was set to close in September. The company planned to raise debt to finance the acquisition of inventory for such a huge contract. They were literally days from closing when September 11th hit and capital markets abandoned them. After a few more months they put together a financing package of mezzanine debt and preferred stock led by the Carlyle Group.

In June 2003, Aviall completed a new debt deal that took out the mezzanine debt and left them with almost $200M of liquidity in bank lines to acquire new product lines. At the same time, Carlyle converted their preferred stock and simplified the capital structure. This was a very bullish signal, because Carlyle effectively gave up a lot of downside protection for a little more upside potential, a move that has worked out for them and should continue to do so. Carlyle now owns about 11M shares or 1/3 of the company.


GROWTH AND OUTLOOK

The main driver for industry revenue is the total number of worldwide flight hours. Because of Aviall’s large and global reach, they track this number over the long term. Prior to September 11th, flight hours grew at 5-6% per year. In the last few years commercial flight hours have dropped by about 15% and general aviation has been even worse.

However, Aviall’s market share gains, as well as new product additions like the T56, have caused revenues to more than double in the last 3 years. The CEO believes they can double again in the next 5. Military sales will continue to grow, even as Iraq slows down, as the company continues to improve productivity from the T56 and leverages its new foothold with military customers. Commercial will continue to be uncertain as the industry restructures over the next few years, but most OEM’s are forecasting 4-6% increases in flight hours and aftermarket sales for next year. General aviation tends to track the overall economy. Continued market share gains by Aviall in Commercial and General Aviation will provide growth in excess of the industry average.

Much of the focus this year was on managing through the trough and setting up capital structure. Now focus is on getting new product lines. Negotiating new products is a long process and it became even longer by the prolonged downturn last year. But now there are several coals in the fire with a lot of potential. The economic argument is very compelling, and customers are definitely on AVL’s side because they love the service. In September, the company announced a new $50M/year contract with Honeywell that should have a meaningful impact in 2004. There are several other deals in advanced stages that could add another $100-200 of revenues. By my estimates, depending on product type, $100M of new revenues adds roughly 20-30 cents of earnings. The timing of when something will come through is impossible to predict, but they have a lot of opportunities and I would expect them to hit on a few in the next 12 months.


VALUATION

My estimate for 2004 is EPS of $1.06 from the business and another $0.12 from the new Honeywell deal. By my estimate of $1.18 AVL is trading at a P/E of 13.9X, and including an assumption for $12M of incremental debt for inventory related to the new Honeywell deal, EV/EBITDA of about 7.1X.

However, AVL is really a free cash flow story. Because of a large NOL (worth $14M/year for about 7 years) and about $10M of excess depreciation, free cash flow is more than 70 cents/share higher than net income. The free cash flow number gets distorted by large swings in inventory. Typically a new product line will require a big up-front purchase of inventory, and then that inventory eventually gets reduced as the company gets more efficient at managing that product line. Also, Aviall sometimes takes advantage of opportunities to purchase chunks of inventory at discounted prices (like when suppliers try to stuff the channel at year end) and sells it down over time. But in terms of the real free cash flow generated by the business, the 2004 P/FCF is about 8.6X. Alternatively, including a $60M present value for the NOL, adjusted EV/EBITDA is about 6.5X. There are no great comps, but peer multiples according to one research report are significantly higher, roughly 16-17X earnings, 8-8.5X EBITDA, and 14-15X FCF.

At a more reasonable 8X EBITDA, which still would not reflect a premium for the company’s growth potential, the stock would be $21, which is about a 30% gain from here. This would reflect a FCF multiple of 11. If the company lands any of the other deals in its pipeline, as I believe it will, then run-rate EPS can easily get to $1.40 and FCF over $2.10, which would be a stock price of $24 and a return of almost 50%. These numbers also have a lot of upside leverage to any sort of rebound in commercial airlines, which is the company’s most profitable business.


RISKS

-- A significant drop in worldwide travel caused by terrorism or economic downturn. Though AVL has shown a resilient business model, all valuations would come down in the industry.

-- A complete and rapid end to military operations overseas would hurt C-130 flying hours. But keep in mind that the C-130 is a transport plane, not a fighting plane. The C-130 does as much or more flying in non-combat operations as it does in combat. It would take a complete, clean exit from Iraq and other areas to significantly cut the use of the C-130’s.

-- An inability to secure any new distribution rights would slow the organic growth.

-- Carlyle block could be an overhang.

Catalyst

-- New product line deals - depending on mix, would add 20-30 cents to earnings for $100M of revenues due to scalability of business.

-- Results will likely come in higher than expected because analysts are under-estimating the impact of the Honeywell deal in 2004.

-- Though not priced into estimates, any improvement in commercial or general aviation flight hours would be a big benefit.