Esterline is a specialized manufacturing company serving primarily the aerospace and defense end markets. The current stock price is $107, the market cap is $3.4bn and total enterprise value is $3.7bn. As discussed below I believe that the company has historically been under managed as it has been built through a series of acquisitions (over 30 since 2000) and the businesses were never integrated nor developed lean manufacturing processes. The investment opportunity came about this past October when Curtis Reusser, former VP at UTX and prior to that was a segment president at Goodrich joined the company. My thesis is that Curtis’ background and skill set are ideally suited to “fix” Esterline and by integrating the acquisitions and improving their lean manufacturing processes the current business can generated free cash flow of $10/share in 2 years, up from $7 in 2013. At 15-16x free cash flow I think ESL is worth $150-160 2 years out, representing a return north of 50% from current levels.

Stock Price:   $107

S/O:                31.7m

Market Cap    $3,400

Net Debt        $340

EV:                  $3,700m

Business Segments:

Esterline operates in 3 business segments, as discussed below. These business segments break down into 9 business units consisting of 24 brands. Needless to say it is very complex. From a high level it’s important to note that total revenues are $2bn and are broken down as follows ~45% aerospace, 35% defense, and 20% general industrial. The aerospace aftermarket is 15% of total revenues and 33% of aerospace revenues.

Avionics and Controls ( 39% of revenues, 35% of EBIT): The avionics and controls division consists of 3 business units – avionics systems (CMC electronics), communications and controls, and interface technology. CMC Electronics manufactures cockpit systems, flight management systems, and enhanced vision/GPS for planes such as the T-6B trainer. It has a significant amount of content on the new Boeing/Airbus planes which should provide a tailwind throughout the next few years. The big opportunity in this segment is to retrofit cockpits on older planes and the company sees a big opportunity to retrofit A300s /A310s. In 2011 they had won a big contract with Saudi Arabia and believe there is still a $100mm opportunity with that country alone at 40%+ margins.

The communication and controls unit produces headsets and joysticks primarily for the military. They produce “human-machine interface systems”. Within interface they produce customized input devices and control user interfaces under the brand Gamesman.  This includes reels, buttons, toppers, and such.

Advanced Materials ( 25% of revenues, 35% of EBIT): This segment is evenly split among engineered materials (the crown jewel of the company) and defense technologies. Within engineered materials they produce seals, clamps, insulation and other products for use in high temperature, high pressure, abrasive environments. An example is that they produce the stealth material for the F-35. The seals and clamps business is excellent in that it is primarily an aftermarket business that, once the clamps/seals are spec’d in provide very high recurring revenues and margins.

The defense technologies segment focuses on the development and production of combustible ordnance and countermeasures. This includes infrared decoys, flares, cartridge cases for tank ammunition. These are consumable products that are customized for their customers.  

Sensors and Systems ( 36% of revenues, 25% of EBIT): This segment consists of 3 business units – advanced sensors, power systems, and connectors. The advanced sensor business is quite good as it measures the temperature, pressure, speed, and torque on commercial engines. They are Rolls Royce’s sole partner for the engine on the A400, A380, and A350. The company estimates that on each A400 they will have 250k of sensors. The brands under which these sensors are marketed include Auxitrol, Norwich, and Weston.

The power system business designs and manufactures power switching and control components. These control panels are found throughout airplanes and growth here should be in line with OE deliveries.

The connector business has been dragging down this segment. It was built through the acquisition of Souriau in 2011. ESL paid $715m for the French company with 17% margins (12.5x) and the company was never integrated and suffered with the downturn in the European economy in 2012 and 2013 as only 35% of the business is aerospace (Airbus), with the remaining being defense (29%), heavy industry in Europe (14%), and industrial (22%). The original idea was to have the connectors “connect” with the sensors but this has yet to be implemented. While the company has a leadership in harsh environment connectors which are proprietary they do have some more commoditized products and have suffered due to Europe.

The Opportunity

Curtis Reusser joined in October with the mandate to bring margins up to peer levels through integrating the businesses and implementing lean manufacturing processes. In 2013 EBIT margins were 12.6% and have been stuck between 10%-12% since 2009. Peers are at 15-16%.

Curtis started his career at Goodrich and he served as president of the aerostructure business from 2002 to 2007. During that time the business went from $1.2bn in revenues and 14% EBIT margins to > $2.5bn in revenues and 19% margins. From there he was promoted to Vice President and Segment President of the Electronic Systems segment. From 2008 up to the acquisition of Goodrich by UTX in 2011 that segment grew from $1.8bn in revenues and 13.7% margins to $2.6bn in revenues and 17% margins. Finally, prior to taking the job at Esterline he was leading the $7bn UTC Aerospace segment.

In doing reference checks on Curtis he was widely praised as a phenomenal operator and person that people enjoyed working for. Based on our checks we learnt that he took the job at Esterline as it was an opportunity to be CEO, he is from the west coast, and perhaps most interestingly he viewed it as a “mini-Goodrich”. From 2002 to the acquisition the Goodrich share price (1/1/02 – 7/26/12) the stock increased from $25 to $127.

What is the upside?

If we begin with 2013 revenues and estimate a 15% segment margin that translates into $6.60 of EPS and $8.42 of cash EPS (adding in the $1.81 of amortization expense that runs through the P&L related to historical acquisitions and is non-cash). However, I think that is too conservative and I see a scenario where revenues can grow 10% per year (aerospace mid teens, defense declines low single digit, industrial mid single digits) and margins are between 16% and 17%. That translates into cash EPS of $9.70 - $10.20 per share.

Sales                          $2,000            $2,200

EBIT Margins            15%                16% - 17%

Cash EPS                 $8.42              $9.70 - $10.20

That assumes no share buybacks (the company generates a lot of cash and Relational has 2 board seats), and no M&A. The last point is worth exploring as once the acquisitions have been integrated and given Curtis’ experience with Goodrich I can envision a scenario where bolt-ons can be meaningful to the company. So, with an excellent balance and a proven CEO I think Esterline can trade at 15x my cash EPS target two years out, or $150 - $160 per share.  Given that they will generate ~$15 in the interim my target price is $165, or upside of over 50% from the current stock price..

Finally, I think it’s worth sharing a comment Curtis made on his first conference call in December when asked if he thought he could achieve 15% EBIT margins:

"Well, I've been guided to be very cautious about making commitments but ... my expectation is – I come from a background of continuous improvement and we're going to drive out waste throughout the organization, both really embracing lean, looking at ways we can drive out duplication in efforts. So I think there's a lot of opportunity. So I think they did have a target out there. Internally I'm sure going to drive higher than that, but I've got to work with the team to see what the biggest levers are.”