Description

Investment Thesis:

• A $16 aerospace and defense company that will add incremental $0.89/share to EPS by YE2017 by reducing debt balance and reducing annual interest expense following recent refinancing.

• TTM FCF yield of 13.4% and an estimated forward FCF yield of over 22% in 2017.

• Strong commercial aerospace dynamics with substantial content on Boeing’s 737 and the 777.  Also has content on Airbus’ A330, A340, A350, and A380. Commercial aero strength somewhat offset by weakness in the defense side of the business.

• US DOD base budget and procurement budget has troughed and will begin small year-over-year gains.

Description of Business:

Ducommun Incorporated provides engineering and manufacturing products and services primarily to the aerospace, defense, industrial, natural resources, medical, and other industries. The company operates in two segments, Ducommun LaBarge Technologies (DLT) and Ducommun Aerostructures (DAS):

• DLT (58% of sales) makes complex cable assemblies, printed circuit board assemblies, and higher-level electronic, electromechanical, and mechanical assemblies. These components and assemblies are principally used for commercial and military fixed-wing aircraft, rotary-wing aircraft, and space programs.

• DAS (42% of sales) makes larger, complex contoured structural components and assemblies and composite and metal-bonded structures and assemblies for aerospace and defense. Products in this segment include fuselage skin panels, leading edges, flight control surface assemblies, and engine ducts.

The company also breaks down their revenue source by end-market:

Total Addressable Market (TAM)/Company’s Market Share:

Total addressable market is tough to define for a company like Ducommon that is a cog in the machine that is the A&D supply chain.

According to Verify (a supply chain specialist that does a lot of work with aerospace and defense companies) the depth and breadth of the A&D supply chain can be summarized as follows:

The industry becomes more fragmented the further down the chain you go.  Ducommun is a tier 2 and tier 3 supplier of various sub-assemblies and components to both aerospace and defense contractors.  Even though Ducommun is lower in the supply chain, it is one of the bigger companies in the industry.  Deloitte does an annual performance study of the industry where they list the top ranked company in various metrics (revenue, revenue growth, ROIC, change in ROIC, employees added, etc.).  They also rank the top 100 companies in A&D by annual revenue. Ducommun ranks in the top 100 at #98 with 2014 revenue of $697M, even though they are not one of the 24 OEMs or the ~120 tier-1 suppliers listed above.

The takeaway is that Ducommun is one of many players with just a small slice of market share in a very large industry. As such, they do not have much pricing power and are more commonly price takers.

Regarding their customer base, Boeing makes ups 20% of sales, Raytheon is 9%, and the top 10 customers account for 59% of sales.

Debt Position and Earnings Per Share Catalyst:

The company has total debt of $260.0M.  DCO acquired LaBarge Technologies for $325M (8.1x EBITDA purchase price) in 2011 and increased their total debt to $390M at the time.  They have steadily paid down their debt in an effort to reduce leverage to 2.25x.  My model has the company getting under 2.50x sometime during FY2017.  Here’s a table showing how the metrics have progressed since the debt was added:

EBITDA dropped due to lower margins in the last couple of quarters and debt/EBITDA increased to 5.1x as a result.  Debt/Cap still declined and will continue to decline.  The company plans to pay off $25-40M of debt annually over the next 2 years.

Just as important as the reduction in the debt balance is the refinancing of debt the company completed in June of 2015.  Prior to the refinancing, the company still had $200M in unsecured bonds that had a fixed rate of 9.75% and a term loan of $80M with a floating rate that was most recently 4.75%.  DCO paid $30M in interest in 2013 and $28M in 2014.  The company was able to refinance the high-priced debt after bringing the total balance down from $390M to ~$290M at the time of refinancing.

The new debt is composed of a $275M secured term loan (balance now at $260M) and a $200M revolving credit facility (currently undrawn upon).  Both the term loan and the RCF mature in June of 2020.  The term loan carries one of two floating rates at the option of the company:

• LIBOR plus a margin of 1.50-2.75% (based on leverage ratio) or

• Base rate (defined as highest of Fed Funds Rate plus 50bps, BofA’s prime rate, or Eurodollar rate plus 100bps) plus a margin of 0.50-1.75% (based on leveraged ratio).

Lastly, as part of the new term loan, DCO is required to make quarterly principal payments equal to 5% of the original principal during the first two years, 7.5% during year 3, and 10% during years 4 and 5 with the remainder due at maturity.  The company has been making voluntary principal repayments above what is required by the loan, but there is some built-in principal paydown if the company decides to slow down on their current pace of debt reduction.

The new rate on the loan will reduce annual interest expense by close to $14M without any further reduction in the balance.  Further, I expect the company will continue to pay down the balance at a pace similar to what they’ve been doing in the past couple of years as they have openly stated a desire to reduce total leverage to below 2.50x.  This will further reduce annual interest expense and the savings will fall to the bottom line.  LTM interest expense is $23.5M.  I have modeled annual interest expense in FY2017 to be $7.5-8M.  Taking the $16M saved in annual interest divided by the estimated 11.3M shares outstanding at year-end equals $1.41/share in annual interest saving.

DCO has traded at a normalized P/E between 10-15x.  Applying a 12.5x multiple to the annual $0.89 in after-tax interest savings ($1.41*(1-37%)) equals $11.13 in value that will be realized over the next two years.  There is some hidden value in the newly refinanced debt structure that has yet to be realized.  An additional $11.13 added to the current stock price would equate to a $27.39 stock price and a 68.5% return.

Catalyst

A $16 aerospace and defense company that will add incremental $0.89/share to EPS by YE2017 by reducing debt balance and reducing annual interest expense following recent refinancing.