Description

ESL is entering an aerospace new build cycle that should be much better (for suppliers) than previous cycles.  ESL is trading at only 12.5x FCF—and that FCF is suppressed by a couple of factors.  What’s most exciting, however, is that street estimates for FY08 appear far too conservative, meaning that this high quality supplier is trading at only 10.0x FY08 FCF. 

 

On 12-22-06, another member posted a nice write up on ESL that provides good overview of ESL’s three segments.  In general, however, ESL supplies highly engineered aerospace components.  The company participates on a wide range of platforms and addresses new builds, retrofits and the aftermarket.

 

The Big Picture

Coming out of the cold war, the aerospace industry was burdened with tremendous overcapacity which allowed the OEM’s to continually squeeze their suppliers for better terms.  We are now, however, over 15 years into a consolidation among these suppliers.  A few years ago, ESL’s CEO told me that this had happened gradually, “kind of like the tide going out,” but that with every exit, ESL’s position improved. 

 

During this consolidation, the OEM’s have also begun to rely more heavily on their suppliers for technology and engineering.  (Some observers have described this as OEM’s outsourcing their engineering requirements.)  This has occurred in part because ongoing technological advances have made it increasingly difficult for OEM’s to achieve excellence in every discipline.  ESL has positioned itself for this trend by steadily building the competencies required to “solve our customers tough problems.”  Over the years, the company has invested in R&D and its corps of application engineers to realize this goal. 

 

ESL has also expanded its capabilities through acquisitions that are consistently  intelligent and well researched (i.e. watching the acquisition target for years, talking to its customers, etc).  Many of these acquisitions have incremental benefits that were not apparent when the deal was announced.  These acquisitions are usually adjacent to ESL’s existing operations, and management describes them as “adding tools to our toolbox.”  One example of this was ESL’s FY04 acquisition of Leach.  ESL made cockpit switches, and Leach made the electrical relays connecting those switches.  (At the time of acquisition, Leach had been on ESL’s target list for over a decade.) 

 

ESL’s commitment to internal development and savvy acquisitions has dramatically expanded its capabilities, allowing it to work its way up the value chain.  In the past, ESL supplied individual cockpit components such as switches and displays.  For the 787’s cockpit, however, they are supplying the entire overhead panel.  Similarly, ESL used to supply various engine sensors, but for the TP400 (the A400’s power plant), they are selling the entire sensor suite.  Performing well as a Tier 1 on these programs should open additional doors in the future.  ESL’s recent CMC acquisition should also open doors since it gives ESL the systems integration capability it will need to continue working up the value chain.

 

So as we enter a period when a host of new airframes are moving into production, ESL finds itself with fewer competitors, much larger “ship sets” (i.e. ASP’s), and presumably better margins than in the past.  The company has not formally said that these macro changes will result in higher margins, but I am inferring that the change in the competitive landscape, and the higher value it is providing its customers will translate into improved profitability.  Even if I am wrong about this, margins should benefit as Long-Term Agreements signed shortly after 9-11-01 expire and ESL is able to renegotiate better prices.  (After 9-11-01, OEM’s announced they would be consolidating their supply chains which allowed them to push the surviving suppliers into LTA’s with flat and sometimes lower pricing.)  In addition, ESL’s R&D expenses should increase significantly as a percent of sales as upfront development on their new programs comes to an end.

 

Besides outsourcing their engineering, many OEM’s have also begun to outsource more of their manufacturing.  This is expected to continue in the future in areas such as cockpit components, which should benefit ESL’s Avionics and Controls segment.  ESL is well positioned to capitalize on this trend because its Lean manufacturing programs have increased the efficiency and capacity of its plants.  Lean essentially increases the velocity with which materials can be converted into products, and is especially well suited for medium volume, high mix product lines.  Besides improving quality and on-time delivery, it has also allowed ESL to increase capacity without adding PP&E.  This is one of the reasons that ESL’s Cap. Ex. has been so much lower than its D&A in eight of the last nine years.  (The other reason is that its acquisitions have added Intangibles Amortization which obviously doesn’t have a corresponding element in Cap. Ex.)  Lots of companies talk about Lean, but it is real at ESL.  In the spring of 2006, Harvard Business School even published a case study about ESL’s use of Lean.  

 

As mentioned earlier, we are entering a period when a host of new airframes will start to roll into production.  The A-380 is currently scheduled to start a slow ramp in the fall of 2007.  The 787 will start its gradual ramp in 2008.  In 2009, the A-400 will start to ramp, as will new Russian and Chinese RJ programs.  I don’t think the A-350 XWB has a formal launch date yet, but it will eventually get built.  Given the fuel and maintenance savings of the 787, some observers believe that both Boeing and Airbus will eventually launch high-efficiency successors to the 737 and A-320. 

 

In addition to new builds, military aircraft will create significant demand for replacement parts as they return from service in Iraq and Afghanistan.  Sand has posed a constant menace in these geographies, and the helicopters have seen particularly heavy use, flying 4-6x their normal hours. 

 

Some observers believe that this cycle will be a “super cycle.”  This seems plausible, though I am not counting on it as a part of my thesis.  One thing that is developing differently in this cycle is that it is happening more gradually than previous ones.  In the past, Boeing would increase production schedules much faster than its suppliers could follow.  This time, however, Boeing has been very deliberate about studying its suppliers’ plants to be sure it doesn’t get ahead of what its suppliers can effectively deliver. 

 

A Blemish & An Obfuscation

ESL is an exceptionally well run company with a management team that is very focused on long-term results.  (They occasionally confront sell side analysts on their conference calls for being short sighted.)  In the summer of 2006, however, they were hit with a high profile operational problem. 

 

At the end of March, 2006, ESL acquired Wallop, a UK countermeasures manufacturer.  Then in June, 2006, an explosion at one of Wallop’s plants killed a worker and led to the temporary closure of the entire operation.  While the higher volume part of the operation returned to service after 1.5 months, the more profitable part has yet to come back on line.  (This more profitable facility is expected to produce Wallop’s next generation flare which has particular relevance for the helicopters in guerrilla warfare.)  While ESL has received business interruption insurance for some of the lost business, management has made it clear that income would be higher if the new facility was actually running.  Management currently expects this facility to come back on line in late FY08.  Besides pushing out the some of the benefits of this acquisition, the explosion was a blemish on an otherwise stellar company. 

 

In February, 2007, ESL announced its acquisition of CMC Electronics, a Canadian systems integrator and a manufacturer of cockpit components.  As a Canadian firm, CMC benefits from ongoing R&D subsidies that are part of Canada’s social fabric.  Under Canadian GAAP, these were treated as an offset to total R&D expenditures, thus increasing operating income.  This is very different from the US where R&D is rewarded through tax credits.  US GAAP thus doesn’t show the benefits that the government gives for R&D until the tax expense line.  As a subsidiary of a US company, CMC will report under US GAAP, and its R&D subsidy will thus be classified as a tax credit.  Their operating margins will thus be much lower, but so will their tax expense; net income will be unchanged.  Though better understood now, this accounting wrinkle has obfuscated the actual multiple ESL paid for CMC as well as CMC’s contribution to ESL going forward.    

 

The financial community was at first disappointed to see ESL pay what was technically 20x EBITDA for CMC.  While that 20x was true in a literal sense, it was misleading since it was based on US GAAP and thus failed to capture the benefit of CMC’s large and ongoing R&D subsidy.  An adjusted multiple would be more like 12x EBITDA.  Management acknowledged that 12x was indeed hefty, but that it was justified by all of the revenue synergies.  Both companies can open doors for the other in their respective customers.  In addition, CMC will be required to get bids from ESL sister operations in its systems integration activities.  It won’t be required to use ESL components, but lean has made ESL very competitive, and it is likely that CMC’s systems integration activities will pull along a lot of ESL content.

 

CMC was acquired half way through 2Q07, and I believe that its impact on operating profit will be neutral at best for a number of reasons.  Purchase accounting rules require that ESL write up the value of it CMC’s inventory to market value.  The first inventory turn thus generates negligible gross profit.  Then you add in the customary integration efforts, amortization of intangibles, and CMC’s operating expenses.  This dilution on the operating line is augmented by the interest expense associated with the acquisition. 

 

It is hard to know CMC's precise impact on FY07.  On the call, management said that CMC made a negative contribution to operating income 2Q07 and that the impact will be even worse in 3Q07.  By the end of 3Q07, however, most of the written up inventory will be out of the system, and CMC should make a positive contribution to operating income in 4Q07.  In the earnings release, management said that "the combined strength of Esterline's and CMC's fourth quarter will absorb the short-term dilution of the CMC acquisition."  Combined strength?  Why didn’t they say that the strength of CMC’s fourth quarter will absorb the short-term dilution?  This isn’t definitive, but it suggests that CMC will be dilutive to FY07’s bottom line.  It is too early to say whether CMC will be dilutive to FY07 on the operating line. (CMC will have been with ESL for 60% of FY07.)  

 

Despite a lackluster contribution from Wallop, and what seems to be a neutral or negative contribution from CMC, ESL is still guiding for EPS of $2.50-$2.60 per share.  This translates to $3.82-$3.92 of FCF.  So at $48.31, ESL is trading at only 12.6x. 

 

What is most interesting, however, is that once these CMC headwinds reverse in FY08, it appears that ESL will generate FCF of $4.75, and the stock is only 10.2x that.  My EPS estimates for FY08 range from $3.41-$3.53.  This compares to the street at $3.13.  (I have included a copy of my model at the end of this report for anyone who wants to see how I build up to this estimate.)

 

There is admittedly some guesswork in my FY08 estimates.  Qualitatively, however, I still think the street’s estimates are too low.  They are calling for 14.5% revenue growth and 20.4% EPS growth in FY08.  In FY08, ESL should benefit from natural operating leverage, R&D expense falling as a % of sales, and possibly better pricing.  In addition, the CMC acquisition will at least switch from neutral to positive; it might be switching from dilutive to accretive.  All of this augers for EPS to grow more than 5.0% faster than revenue. 

 

It is easy to see why the sell side would be conservative.  Wallop’s accident was a disappointment, the accounting treatment of CMC is nettlesome, and in the 1Q07 call, management effectively lowered guidance.  (They technically left EPS guidance unchanged, but this was after adding in a $0.08 non-recurring tax benefit.)  On the 1Q07 call, management said that they did not want to change guidance until they got a better handle on the short term impact of the CMC acquisition.  They also sited the uncertainty as to how much they would receive for business interruption insurance.  I’m comfortable with that but can see how not everyone would be encouraged.  Given the uncertainties surrounding CMC’s FY07 impact, I can see why the street would wait for more visibility before updating their models.

 

So ESL looks inexpensive on a FY07 estimate that I have a lot of confidence in, and it looks very cheap on a FY08 estimate that is well thought out but less solid. 

 

In FY09, I expect FCF to be at or above $5.00.  Given ESL’s solid management, and great positioning, I think it warrants a multiple of 14.0x.  This would suggest a stock price around $70.00, representing a 20% annualized return.

 

 

Esterline Technologies
Fiscal year ended: October
In Millions Except for Percentages and per Share Figures
							FY07E					FY08E
		FY03	FY04	FY05	FY06		Ex. CMC	CMC		Consol.		Ex. CMC	CMC		Consol.
Sales
Avionics & Controls		198.2	209.5	261.6	283.0		315.8	132.6		448.4		359.7	213.9		573.6
Sensors & Systems		134.2	180.8	319.5	333.3		371.9			371.9		402.8			402.8
Advanced Materials		216.7	223.3	254.3	356.0		419.7			419.7		459.6			459.6
Total Sales		549.1	613.6	835.4	972.3		1,107.5			1,240.1		1,222.1			1,436.0
% Change in Sales Yr./Yr.
Avionics & Controls			5.7%	24.8%	8.2%		11.6%			58.5%		13.9%			27.9%
Sensors & Systems			34.7%	76.8%	4.3%		11.6%			11.6%		8.3%			8.3%
Advanced Materials			3.1%	13.9%	40.0%		17.9%			17.9%		9.5%			9.5%
Total Sales			11.7%	36.1%	16.4%		13.9%			27.5%		-1.4%			15.8%
Operating Income
Avionics & Controls		29.5	32.1	37.3	45.1		50.4	1.2		51.6		59.0	12.4		71.4
Sensors & Systems		8.3	12.3	34.5	29.3		33.5			33.5		38.3			38.3
Advanced Materials		28.7	28.0	34.0	46.5		64.6			64.6		70.8			70.8
Operating Margin
Avionics & Controls		14.9%	15.3%	14.3%	15.9%		16.0%	0.9%		11.5%		16.4%	5.8%		12.4%
Sensors & Systems		6.2%	6.8%	10.8%	8.8%		9.0%			9.0%		9.5%			9.5%
Advanced Materials		13.2%	12.5%	13.4%	13.1%		15.4%			15.4%		15.4%			15.4%
Corporate Expense		17.4	22.0	23.5	27.3					29.8					29.8
% of Sales		3.2%	3.6%	2.8%	2.8%					2.4%					2.1%
Total Operating Income		49.1	50.4	82.3	93.5					119.9					150.6
Interest Income		0.9	2.0	4.1	2.6					2.5					2.5
Interest Expense		12.0	17.3	18.2	21.3					37.5					29.5
Other Income (Expense)		2.6	3.9	(0.5)	(1.7)					(0.1)
Pretax Income		40.6	39.0	67.7	73.2					84.8					123.6
% Sales		7.4%	6.4%	8.1%	7.5%					6.8%					8.6%
Taxes		12.5	9.6	16.3	16.7					16.9					30.9
Rate		30.7%	24.6%	24.1%	22.8%					19.9%					25.0%
Minority Interest		0.0	0.0	0.3	0.9					0.3					0.3
Income From Cont. Ops.		28.1	29.4	51.0	55.6					67.6					92.4
ex. Non-Rec.		25.6	28.2	49.0	51.8
Income on Discont. Ops.		(5.3)	10.2	7.0
Net Income		22.8	39.6	58.0	55.6					67.6					92.4
EPS, Cont. Ops.		$1.33	$1.36	$2.02	$2.15					$2.60					$3.54
ex. Non-Rec.		$1.21	$1.31	$1.94	$2.01
EPS		$1.08	$1.84	$2.29	$2.15					$2.60					$3.54
Dil. Shares Out.		21.1	21.5	25.3	25.8					26.0					26.1

 

 

Esterline Technologies
EPS Model
Fiscal year ended: October
		In Millions Except for Percentages and per Share Amounts
											Conservative Scenario					Aggressive Scenario
		FY00	FY01	FY02	FY03	FY04	FY05	FY06	FY07E		FY08E	FY09E	FY10E	FY11E		FY08E	FY09E	FY10E	FY11E
Sales
Avionics & Controls		144.1	172.5	171.7	198.2	209.5	261.6	283.0	448.4		568.8	611.4	654.2	700.0		578.2	630.2	683.8	738.5
Sensors & Systems		92.2	101.9	104.9	134.2	180.8	319.5	333.3	371.9		401.7	432.6	465.7	496.4		403.5	438.6	472.1	508.0
Advanced Materials		129.4	151.4	157.4	216.7	223.3	254.3	356.0	419.7		457.5	507.8	545.9	578.7		461.7	517.1	561.1	594.7
Other		6.9	5.1	0.8	0.0
Total Sales		372.6	430.9	434.8	549.1	613.6	835.4	972.3	1,240.1		1,427.9	1,551.8	1,665.8	1,775.1		1,443.4	1,585.9	1,717.0	1,841.2
Sales % Change
Avionics & Controls			19.7%	-0.5%	15.5%	5.7%	24.8%	8.2%	58.5%		26.8%	7.5%	7.0%	7.0%		28.9%	9.0%	8.5%	8.0%
Sensors & Systems			10.6%	3.0%	27.9%	34.7%	76.8%	4.3%	11.6%		8.0%	7.7%	7.6%	6.6%		8.5%	8.7%	7.6%	7.6%
Advanced Materials			17.0%	4.0%	37.7%	3.1%	13.9%	40.0%	17.9%		9.0%	11.0%	7.5%	6.0%		10.0%	12.0%	8.5%	6.0%
Other			-25.9%	-84.8%	-100.0%
Total Sales			15.7%	0.9%	26.3%	11.7%	36.1%	16.4%	27.5%		15.1%	8.7%	7.3%	6.6%		16.4%	9.9%	8.3%	7.2%
Seg. Earnings
Avionics & Controls		23.5	31.3	26.5	29.5	32.1	37.3	45.1	51.6		70.0	76.4	82.4	88.9		72.7	81.3	89.6	98.2
Sensors & Systems		9.1	11.4	12.4	8.3	12.3	34.5	29.3	33.5		37.8	41.1	45.2	48.6		38.7	43.0	47.2	51.8
Advanced Materials		24.8	35.0	21.9	28.7	28.0	34.0	46.5	64.6		70.0	74.7	76.4	79.9		71.1	76.5	81.4	83.3
Other		3.2	1.4	(1.4)	0.0	0.0
Total Seg. Earnings		60.7	79.2	59.3	66.5	72.4	105.8	120.8	149.7		177.8	192.2	204.0	217.4		182.6	200.8	218.1	233.3
									0.39		0.08	0.07	0.02	0.04		0.10	0.08	0.06	0.02
Seg. Earnings Margins
Avionics & Controls		16.3%	18.2%	15.4%	14.9%	15.3%	14.3%	15.9%	11.5%		12.3%	12.5%	12.6%	12.7%		12.6%	12.9%	13.1%	13.3%
Sensors & Systems		9.9%	11.2%	11.8%	6.2%	6.8%	10.8%	8.8%	9.0%		9.4%	9.5%	9.7%	9.8%		9.6%	9.8%	10.0%	10.2%
Advanced Materials		19.2%	23.1%	13.9%	13.2%	12.5%	13.4%	13.1%	15.4%		15.3%	14.7%	14.0%	13.8%		15.4%	14.8%	14.5%	14.0%
Other		46.8%	28.0%	-183.5%
Total		16.3%	18.4%	13.6%	12.1%	11.8%	12.7%	12.4%	12.1%		12.5%	12.4%	12.2%	12.2%		12.6%	12.7%	12.7%	12.7%
Corporate Expense		12.0	13.2	12.3	17.4	22.0	23.5	27.3	29.8		32.0	33.7	34.5	35.2		32.5	34.3	35.1	36.0
% of Sales		3.2%	3.1%	2.8%	3.2%	3.6%	2.8%	2.8%	2.4%		2.2%	2.2%	2.1%	2.0%		2.3%	2.2%	2.0%	2.0%
Interest Income		2.2	3.3	1.8	0.9	2.0	4.1	2.6	2.5		2.5	2.5	2.5	2.5		2.5	2.5	2.5	2.5
Interest Expense		8.1	7.7	7.1	12.0	17.3	18.2	21.3	37.5		29.5	20.5	11.0	11.0		29.5	20.5	11.0	11.0
Other Income (Expense)		2.6	5.4	0.0	2.6	3.9	(0.5)	(1.7)	(0.1)
Pretax Income		45.3	67.1	41.7	40.6	39.0	67.7	73.2	84.8		118.8	140.5	161.0	173.7		123.1	148.5	174.5	188.8
% of Sales		12.2%	15.6%	9.6%	7.4%	6.4%	8.1%	7.5%	6.8%		8.3%	9.1%	9.7%	9.8%		8.5%	9.4%	10.2%	10.3%
Income Taxes		15.8	24.4	10.5	12.5	9.6	16.3	16.7	16.9		29.7	36.5	43.5	46.9		30.8	38.6	47.1	51.0
Effective Rate		34.8%	36.4%	25.1%	30.7%	24.6%	24.1%	22.8%	19.9%		25.0%	26.0%	27.0%	27.0%		25.0%	26.0%	27.0%	27.0%
Minority Interest						0.0	0.3	0.9	0.3		0.3	0.3	0.3	0.3		0.3	0.3	0.3	0.3
Income From Cont. Ops.		29.6	42.6	31.3	28.1	29.4	51.0	55.6	67.6		88.8	103.7	117.3	126.5		92.0	109.6	127.1	137.5
ex. Non-Rec. & G.A.		31.3	43.0	28.4	25.6	28.2	49.0	51.8	65.5
Income on Discont. Ops.		3.0	(9.8)	(25.0)	(5.3)	10.2	7.0
Cum. Effect of Acct Changes			(0.4)	(7.6)
Net Income		32.6	32.5	(1.3)	22.8	39.6	58.0	55.6	67.6		88.8	103.7	117.3	126.5		92.0	109.6	127.1	137.5
EPS, Cont. Ops		$1.67	$2.13	$1.49	$1.33	$1.36	$2.02	$2.15	$2.60		$3.41	$3.97	$4.48	$4.82		$3.53	$4.19	$4.86	$5.24
ex. Non-Rec. & G.A.		$1.77	$2.15	$1.35	$1.21	$1.31	$1.94	$2.01	$2.52
EPS		$1.85	$1.62	($0.06)	$1.08	$1.84	$2.29	$2.15	$2.60		$3.41	$3.97	$4.48	$4.82		$3.53	$4.19	$4.86	$5.24
Diluted Shares Out.		17.7	20.0	21.0	21.1	21.5	25.3	25.8	26.0		26.1	26.1	26.2	26.2		26.1	26.1	26.2	26.2
% Change			13.4%	5.0%	0.4%	2.1%	17.5%	2.0%	0.8%		0.2%	0.2%	0.2%	0.2%		0.2%	0.2%	0.2%	0.2%

 

 

 

 

 

 

Catalyst

Investors will eventually recognize that FY08 consensus estimates are too low. This will happen over the next two quarters as management provides more visibility into the impact of a recent acquisition and eventually issues FY08 guidance. In 4Q07, financial results should start to improve markedly, accelerating earnings and allaying investor concerns.