Heroux-Devtek Inc. (HRX.T) is a manufacturer of aircraft landing gear that's fundamentals have been obscured by a recent sale of its non-core business.  This has presented an opportunity to buy a quality, niche business at 4.1x EBITDA and 5.5x EBITDA-capex. There are several near-term catalysts, in fact one significant one tomorrow, which should lead to price appreciation. Given this time sensitivity, I apologize that this write-up is not more comprehensive. (Note: CAD used throughout.)

Situation overview

On July 17, HRX announced it was selling its aerostructure and industrial operations to Precision Castparts (PCP) for $300M, equating to approximately 12x EBITDA. Net of all tax and expenses, HRX will received $230M in cash from the sale (more on the usage of this cash below). The ongoing HRX segment will be solely focused on aircraft landing gear, enabling it to compete more effectively and making it more appealing to investors.  Insiders presently own 16% of the shares.  The existing executive team will remain with HRX.

The Company has yet to report financials for the ongoing business and only provided pro forma LTM sales ($258M) and EBITDA ($35M-40M) numbers on a call announcing the transaction three weeks ago. Tomorrow HRX is releasing earnings and has indicated it will provide results for the ongoing business, its backlog and the intended use of the proceeds from the sale. Press releases and conversations with management indicate that the cash will most likely be distributed to shareholders or used to pay down debt upon the closing of the sale this quarter (no shareholder vote required). The stand-alone earnings release and backlog should aluminate investors to the underlying fundamentals of the business and the mispricing that presently exists. Further, the sale of the non-core business demonstrates management’s desire to unlock shareholder value. The likelihood of a sale of the remaining HRX appears quite possible, though this thesis is not predicated on such.

Valuation

Current market cap is $338M ($11.00, 30.5M shares) and PF EV is $166M (net debt=$119M debt from 3/31 BS - $62M cash from 3/31 BS - $230M cash from net sale proceeds). HRX stated the ongoing business generated $35M-$40M in LTM EBITDA with $10M-$12M capex. This equates to 4.7x-4.1x EBITDA and 7.2-5.5x EBITDA-capex. The peer set is limited, but TDG trades at 12.8x and SAF at 8.9x EBITDA. Competitor Goodrich recently sold to UTX for 12.8x (though these three are much larger companies). Regardless, the current valuation appears very cheap for a quality, niche business with historically strong growth (+20% EBITDA CAGR) less cyclical earnings with mid-teens EBITDA margins. The reasons for the mispricing are clear, once fundamentals are cleanly presented the stock should trade at a more appropriate multiple. At 8x EBITDA the implied stock price is $16, 50% upside from current. In a sale scenario the upside is easily +100%.  

Industry

As noted, HRX will now be singularly focused on landing gear. The Company has created a bit of a niche for itself by providing highly engineered components to smaller-to-mid sized aircraft OEMs (<50,000kg). According to management, 45% of sales are to commercial customers and 55% is to defense. They expect to transition this to 50% commercial over the next 1-2 years. 70% of sales are for components (design, assembly and testing), 30% is for the recurring repair and parts.

The ongoing HRX will have six plants, three in Canada, two in Ohio and one in Ontario. Almost all of sales are to OEMs outside Canada, 70% of which is to the US. Based on information available, no single contract accounts for over 10% of annual revenue. Most of the contracts are cost sharing with escalator clauses. Major projects include the C-130J ($22.5M/year to USAF as sub to Lockheed, began 1/12), Boeing 777 ($35M total, joint with Goodrich to begin 1/13), B-1B ($4M/year to USAF), Learjet 85, Dessault business jet and Embraer 450-500. Management noted that there are a number of new products that should add to the backlog in the near-term. Sales and margins have actually not been particularly cyclical historically. Over the last seven year the only annual EBITDA decline was 10% in 2009.

HRX is the third largest landing gear manufacturer after Goodrich and Messier-Bugatti-Dowty (Safran).  After the top three, there are few significant competitors. Goodrich and MBG are primarily focused on larger commercial and defense. Partnerships between manufacturers are common, competition appears to be rational and segmented. HRX differentiates itself by its ability to cost efficiently design and manufacture highly specialized products for mid-to-small aircraft. Barriers are high given FAA certification requirements, qualifications and customer risk/ reward tradeoff. Next generation aircraft and ongoing parts sales generates recurring revenue.