Esterline Technologies engages in the design, manufacture and marketing of engineered products and systems for application in the aerospace/defense industries. At $41, ESL is attractive because:

ESL is a leading specialized manufacturer principally serving the commercial aerospace (40%), defense (40%) and general industrial (20%) markets.  ESL’s sales are diversified among numerous customers, with no single platform contributing to more than 3-4% of revenues.  Most of ESL’s products are smaller items, but in most cases ESL is the #1 or #2 market leader and designed into existing platforms.  About 35% of the sales are for the OEM market, 45% to service the aftermarket, and the remaining 20% are consumables.

ESL operates in 3 segments:

Avionics and Controls –                Technology interface systems for military, commercial aircrafts and military vehicles; secure communications systems; specialized medical equipment and other industrial applications.  These products include lighted push-button and rotary switches, keyboards, lighted indicators, control sticks, grips/wheels, panels and displays.  These products have been integrated into every Boeing commercial aircraft platform currently in production, most Airbus platforms and most types of military jets and helicopters.

Sensors and Systems –                  High-precision temperature and pressure sensors, electrical power switching, control and data communication devices, fluid control components, micro-motors, motion control sensors and other related systems.  ESL is the sole-source supplier of temperature probes on all CFM-56 engines (100% of 737NGs and 40% of Airbus).

Advanced Materials –                    High-performance elastomer products used in a wide range of commercial aerospace and military applications, and combustible ordnance for military applications.  These products include proprietary formulations for silicone rubber with superior performance in high temperature, high pressure, caustic, abrasive and other difficult environments.  ESL also manufactures molded fiber cartridge cases, mortar increments, igniter tubes, combustible casings, radar ECM chaff and decoy flares.

Secular Tailwind – Both the aerospace and defense sectors are benefiting from secular tailwinds right now.  Commercial aerospace is in the middle of a multi-year rebound, with a LTM 2.8x book-to-bill.  While this ratio is slightly lower than where it was a year ago, it’s still significantly higher than 1.  Based on the current order books at Boeing and Airbus, we do not expect the current cycle to peak until 2010 at the earliest, and possibly well into 2013-2015 once the legacy US/European carriers begin replacing their 737s/A320s with the next generation narrow-bodies.  The defense business, while less robust than commercial aerospace, should continue to benefit from faster-than-GDP growth at least through 2011.  Management has guided to “high single digit” organic growth rate, while we’re conservatively modeling 6.5% organic CAGR for the next two years.

Broad and Stable Product Base – As CEO Bob Cremin likes to describe it, ESL doesn’t hit many home runs but there are lots of singles and doubles.  In other words, most of ESL’s products are smaller items that are ubiquitous in aerospace and defense applications.  The following are characteristics are examples why ESL’s product portfolio is fairly stable

Accretive Acquisitions – ESL has been acquisitive in its past, and will likely continue to make accretive acquisitions going forward (which we have not yet modeled in).  Going forward, Boeing and Airbus will likely outsource more and more of its components, so it’s critical for ESL to establish itself as a relevant Tier 1 supplier in its specific niches.  Historically, ESL has only acquired good businesses with good management teams that stay in place post-acquisition.  ESL had not extracted significant gross margin synergies, given the difficulty of getting new product lines re-certified, and the fact that most of ESL’s products are lower-volume but higher-spec in nature.  On an SG&A level, however, ESL has made good use of cross-selling opportunities and overhead leverage to reduce SG&A as % of sales from 22% to 16.5%.  Going forward, ESL does not expect significant additional SG&A expenses as the sales continue to ramp.

Margin Expansion – ESL’s current EBIT margins are just under 10%, down from the last peak of 15.3% (2001) but higher than the trough of 8.2% (2004).  The current EBIT margins are depressed because ESL won Tier 1 supplier status with the 787, A400M, and Europrop (engines for A400M).  These platforms are expected to have production lives of several decades, but much of the upfront R&D must be expensed immediately.  Thus, ESL’s R&D has risen to 5.5-6% of sales to accommodate these and other programs.  Historically, ESL’s R&D has run in the 3.5-4.5% range, and management indicated that R&D is expected to decline to the “low 4’s” by the end of FY 2007.  This R&D contraction alone will boost EBIT margins by 100-200bps, and management believes that EBIT margins will again reach at least the 15% level during the peak of this cycle.  We are conservatively modeling 12% EBIT margins for FY 2008.

Attractive Take-Out Candidate – ESL’s management team had worked with a private equity firm in the past (Dyson-Kissner-Moran) and continues to run the firm like a private company.  While from a business operations point of view, the management should be lauded for making investment decision purely based on ultimate returns, the public market does not always react well to the volatility of ESL’s quarterly earnings.  The higher R&D spend is one example of this – while most would probably agree that winning additional content on future platforms is good for business, we believe the public market is unfairly penalizing ESL for the upfront R&D spend.  Ironically, if ESL continues to ramp its Tier 1 wins, R&D may continue to stay at an elevated level, sacrificing near-term earnings for long-term gains.  ESL is currently under-leveraged, and our buyout model supports a $50 takeout and 20+% IRR.  Management has publicly complained about the disadvantages of being a public company and we believe they are open to all strategic alternatives.

Attractive Valuation – At $41, ESL is trading at 15.5x FY 10/07 EPS ($2.65) and 12.6x FY 10/08 EPS ($3.25).  We believe our estimates are very conservative, given that we are assuming very little margin expansion, especially considering that R&D will likely decrease materially once the current Tier 1 platforms are fully designed.  In addition, we are leaving the capital structure under-leveraged, and not assuming any accretive acquisitions (even though the likelihood of both events happening together is very small).  Using more baseline assumptions and 15-17x forward EPS ($3.50), we believe the stock is worth mid to high $50’s within the next 12 months.  In addition, ESL generates great free cash flow (despite its under-leverage), which we estimate to imply an 8-10% yield based on our conservative assumptions.

Roll-up Risk – Since ESL has been built from numerous smaller acquisitions, investor always fear a “blow-up risk.”  We believe the situation here is mitigated by the fact that ESL only buys healthy businesses with good management teams that stay on with the business.  ESL does not typically try to integrate production processes due to the lack of economies of scale for smaller-run, highly customized products, and the long process required for re-certifying changes to a production line.

Industry Slow Down Risk – 80% of ESL’s products are sold to commercial aerospace and defense customers.  While we believe the commercial aerospace cycle is in the midst of a multi-year rebound, the industry is susceptible to terrorism risk and order cancellations.  The defense industry is susceptible to spending cuts and the level of military activities around the globe.  According to management, the spending on consumables doesn’t slow down dramatically once a conflict concludes.  The consumption simply moves from combat to restocking to training.  Typical variance of peak-to-trough level of activity is under 10%.

Working Capital Drain – In 2006, ESL used up the bulk of its operating cash flow in working capital increases.  Receivable days have increased as ESL now has a greater number of international customers, and inventories have increased as the entire aerospace supply chain tried to lock up supplies.  Given what’s happened to Airbus in the past 2 years, we’re encouraged to see ESL position itself as a dependable supplier to the OEMs.  We don’t expect this to continue beyond 2006.

Quarterly Volatility – Given ESL’s management style, we expect continued volatility in ESL’s quarterly results.

1.                    Wind-down of the excess R&D spend on future Tier 1 platforms.

2.                    Continued earnings growth driven by the industry tailwind.

3.                    Fixing the under-leverage by either deploying debt capital, or by making cash acquisitions.