Description

Recommending Ducommun (“DCO”) LONG. This stock can compound at ~40% per annum with conservative assumptions for years to come, with a likely kicker of a takeout by private equity or Spirit AeroSystems on the back end driving further upside.

DCO is trading at a ~10% forward FY22 FCF Yield, or 10x cash earnings, remarkably depressed for a business with clear line of sight to HSD+ growth for the next 5 years and blue-chip management pedigree.

DCO is in the middle-innings of a multi-year turnaround with accelerating idiosyncratic revenue growth and margin expansion for years to come. New management (in place since 2017) is excellent and brings extensive large-cap Industrials experience down to the small-cap level. DCO’s improved manufacturing quality has generated highly visible new program wins (e.g., Ducommun content now on the Airbus A320 for the first time ever), benefitting the topline on a multi-year lag. In the medium-term, the re-ramp of Boeing 737 MAX production rates provide clear and quantifiable upside to growth. Profit margins have been improving steadily from a low base, driven by excellent operational execution, and will continue to provide substantial torque to FCF growth, as do already-disclosed defense outsourcing wins. To be clear: the full scale of management’s turnaround has been obscured by COVID-era production rate decreases which are now reversing. New management has been batting 1,000 with respect to bolt-on M&A and most recently generated a remarkable ~$110M in post-tax proceeds from a sale-leaseback of one of their Southern California manufacturing facilities against a current market cap of ~$635M (which they immediately partially deployed into a $70M tuck-in acquisition).

Catalyst

Management Excellence – “Taking A-Rod to the Minors”

CEO Steve Oswald (since 2017) was a ~15-year United Technologies vet prior to running KKR portfolio company Capital Safety. At UTC, he was President of the Hamilton Sundstrand Industrial Division (2006-2009), leading it to over $1B in annual revenue for the first time and selling it to Carlyle and BC Partners in 2012 for ~$3.5B. Then, at Capital Safety, Oswald grew operating profit by 64% over 3-years and more than tripled the value of KKR’s investment. (KKR sold Capital Safety to 3M for ~$2.5B in 2015, marking 3M’s largest acquisition in history at the time.)

Management has consistently punched above its weight in all respects. Ducommun was named to Newsweek’s inaugural Top 100 Most Loved Workplaces list for 2021, alongside blue-chip large-caps including Home Depot, FedEx, and Eaton. The Chairman’s 2021 Letter included robust ESG and DEI disclosure that you would expect of a company with 100x the market cap. Ducommun showed significant improvements in lost time incident rates with 2021 at ~44% of 2018 levels despite ongoing pandemic disruptions.

The executive team beneath Steve was purpose-built. DCO’s head of M&A Suman Mookerji followed Steve from both UTC and Capital Safety. Steve is an exceptional and unique leader for a company of this scale.

Operational Excellence Driving Revenue Growth

DCO has been consistently improving quality and reliability. Operational improvements can unlock material growth for A&D suppliers, as we saw with TransDigm’s acquisition of Kirkhill from Esterline. TransDigm acquired Kirkhill in March 2018 and at the time Kirkhill was a money-losing division. In August 2019, TransDigm management reported making a “solid profit” in Kirkhill, as well as realizing close to 400% increase in F-35 program output and a reduction of overdues by more than 75%. The same thing has been happening here.

OEMs and Tier 1 suppliers crave consistent product quality and on-time delivery. In July 2019, DCO was the first company selected to sign a preferred supplier agreement with Raytheon Missiles and Defense. 1Q21 marked the first quarter of contribution from the Raytheon TOW Missile program, which was a share shift from an incumbent supplier. Other recent wins include at General Atomics where DCO won a major share shift from an incumbent supplier on the Predator UAV drone program, and at Northrop Grumman where DCO realized new wins on the Triton UAV drone program (Steve Oswald remarked that “the sky is pretty high” for share gain on the defense side, and he has been right). In July 2021, DCO was recognized as an Airbus Detail Parts Partner for the first time and awarded a five-year contract to provide a titanium work package for parts on the A320 and A330 programs. At DCO’s scale, they are taking massive share from mom-and-pops that cannot compete on quality, reliability, and cost.

Meanwhile, DCO is also winning outsourcing deals from defense primes who want to focus on their core competencies. On the Q4 earnings call management disclosed that defense sector offloading will add ~5ppts p.a. of total company growth through FY23, with visibility to ~4ppts of growth p.a. through FY25. Management reported $31M of revenue from defense prime offloading in 2021 and expects an incremental ~$60M by FY23 and ~$100M by FY25.

Prior to new management, DCO didn’t even have an outbound sales effort. DCO is still only middle-innings in harvesting this low-hanging fruit, with most of the hard work already behind them.

Strong Beneficiary of Boeing 737 MAX Recovery

Growth will be enhanced by the return to more normalized 737 MAX production rates. In FY21, Boeing dropped to 8% of total revenue (~$50M) vs. 17% in FY19 (~$120M), representing a ~60% decline. Boeing in 4Q21 reported 78 MAX deliveries or ~26/month. Pre-CV19 Boeing sustained production of ~50/month and is guiding to a return to ~31/month in “early 2022”. Assuming Boeing trends to ~40/month by 4Q22 (implies ~30/month average in 1Q22), at ~$200K DCO shipset content per MAX aircraft, DCO should reach ~$85M in Boeing revenue in FY22 easily contributing ~5ppts of growth. MAX margins are higher than overall Structures margins – assuming ~20% incremental Adj. EBITDA margins Boeing could easily contribute over 7ppts of Adj. EBITDA growth in FY22.

Through FY25, assuming steady-state production returns to 40/month implies total incremental revenue of ~$50M or roughly 1/4 of the total ~$200M increase DCO has conservatively guided to through FY25, and we believe there is upside from there.

Disciplined M&A Complementing Unique Existing Product Suite

Ducommun made one acquisition per year between 2017-2019 each within their “sweet spot” of $25-$100M. Each 2017-2019 acquisition was made at under 10x headline EBITDA, accretive even before synergies, and DCO has consistently applied the TransDigm playbook of broadening the company’s suite of higher margin and aftermarket-rich offerings.

DCO acquired Lightning Diversion Systems in September 2017. LDS has an effective monopoly on protecting aircraft from lightning strikes, a mission-critical application with the majority of commercial flights getting struck by lightning at least one time each year (if you didn’t know that, you can thank Ducommun for your blissful ignorance). DCO had fully integrated LDS by February 2018, including bringing LDS’ prior CEO on as part of the leadership team.

DCO acquired Certified Thermoplastics in April 2018. Certified Thermoplastics operates in a duopoly with TransDigm’s Pexco Aerospace. It can produce extruded thermoplastics for use inside commercial aircraft with an extremely high “time to burn/smoke” of ~5 minutes. For a potential aircraft fire, this is mission-critical functionality and the plastic sells at ~$18/pound vs. most plastics between ~$0.50-$1.50.

DCO acquired Nobles Worldwide in October 2019. Nobles is a leader in manufacturing of ammunition handling systems with market-leading aftermarket support and represented another margin-accretive bolt-on. Nobles’ President and all direct reports stayed on at DCO.

As Steve Oswald said in June 2021, “We’re 3 for 3.” DCO paused M&A for over two years during the pandemic before acquiring MagSeal in December 2021 with the sale-leaseback proceeds previously described. Leverage was considered a near-term governor to additional M&A, but through the sale-leaseback trailing net leverage was reduced to 2.3x vs. 3.2x at the end of 3Q21. In other words, there is more to come.

DCO is also the largest non-OEM titanium hot forming and “super plastic forming” titanium provider in the world. DCO invested ~$35M in cumulative technology/capex spend over the past four years into its titanium business and now is addressing a ~$240M super plastic forming market with the #1 market position. The titanium product helped DCO break into Airbus for the first time.

In 2018, DCO announced a $200M 10-year contract producing components using new proprietary VersaCore Composite technology for a leading engine OEM. In early-2019, management described the addressable market for VersaCore as “in the hundreds and hundreds of millions, if not billions…but we’re still in early innings on that.” VersaCore is fully operational in DCO’s Guaymas, Mexico facility.

Revenue Growth Framework

Guidance alone gets you to +7.5% annual growth through FY25. Based on a simple buildup of disclosed growth drivers, management is clearly sandbagging revenue growth. Even with conservative assumptions for FY26 growth, we imply +8% growth p.a. for 5 years.

The revenue build assumes:
1. Defense Prime Offloading reaches management guidance in FY25 before growing at GDP growth in FY26, versus the +43% 4Y CAGR between FY21-FY25
2. Boeing revenue rebounds to $100M in FY23 based on a normalized ~40 aircraft/month MAX build rate at ~$200K content per MAX, and then remains flat through FY26
3. MagSeal acquisition (closed Dec 16th, 2021) grows at GDP growth through FY26
4. DCO Defense ex-Prime Offloading declines at a (3%) 5Y CAGR through FY26
5. DCO Commercial ex-Boeing and MagSeal returns to 30% of total revenues by FY24 in line with pre-CV19 levels, which it maintains through FY26. The rebound in Commercial implies a +22% 5Y CAGR through FY26, albeit only a +3% CAGR since FY2019
6. DCO Industrial remains at ~6% of total revenues in FY22/FY23, returning to pre-CV19 levels on a dollar basis before growing at GDP growth between FY24-FY26

Valuation

You can think of Ducommun as a conservatively-capitalized public LBO compounding EBIT at ~12.5% p.a. organically with a 10% FCF yield. Even with low leverage, net debt is over 40% of the market cap, providing a healthy kicker (and they’ll likely take leverage higher when the next tuck-in acquisition hits). They will obviously keep doing M&A that is highly accretive to both earnings and terminal value (i.e., buying monopoly positions with rich aftermarket contributions). The company recently disclosed that its acquisitions over the past five years have had aftermarket contribution at >40% of revenue, which is very TransDigm-esque.

At a share price of $41.96 as of 5/24/22, we underwrite a +41% ~4.5Y IRR (4.8x MoM). The IRR assumes:
1. 5Y revenue CAGR of ~8% per the previous section’s revenue build
2. 5Y margin CAGR of ~4.5% based on FY25 guidance to 18% EBITDA margins vs. 14.4% in FY21 (assumes flat margins in FY26)
3. Forward FY22 FCF Yield of ~10%, based on after-tax cash earnings of $54M in 2022 and current market cap of ~$530M
4. Leverage benefit of ~5.5% based on ~45% ND:EMC amplifying operating income CAGR of ~12.5%
5. 5Y multiple expansion CAGR of ~4.5%, based on FY21 cash P/E of 12.2x and FY26 trailing cash P/E of 15.3x. FY26 cash P/E is derived assuming exit FCF Yield of 5.5%, 20% of earnings reinvested in working capital, and a ~5% forward revenue growth rate (which likely proves conservative)

We view these growth assumptions as largely de-risked. Defense Prime Offloading and Boeing revenue streams are highly visible. Defense ex-Prime Offloading decline of (3%) through FY26 is likely conservative – it is against the backdrop of increasing national security threats including the war in Ukraine and is several hundred basis points below projected DoD Defense Budget average annual growth of ~+70bps through FY26. DCO Commercial ex-Boeing and MagSeal growth may appear aggressive at a +22% 5Y CAGR, but it assumes the dollar amount exceeds FY19 levels not until FY24 and in FY26 is just +26% above FY19.

Note that historically, Ducommun’s adjusted earnings understated the true cash earnings power of the business because they did not add back acquisition amortization (unlike Raytheon/UTC, TransDigm, etc.). The company evolved its definition of adjusted earnings to more closely align with the true earnings power of the business with its Q1 2022 earnings release.

Risks
There is clearly risk to global supply of titanium right now, but TI supply is something the entire A&D industry will need to figure out, given that Boeing and Airbus source 30-50% of their direct titanium needs from Russia. Ducommun has historically secured 100% of its titanium from U.S. sources.
The liquidity here is not great, but should improve over time as the market cap compounds upwards, and would obviously not matter in a takeout scenario.
Significant key man risk. Steve Oswald is the sine qua non of the Ducommun thesis. But if he goes, private equity or a strategic buyer should swoop in immediately.