·        ASG is a distribution company focused on “Class C” products – aka all the small, inexpensive parts of the plane

o   The Class C market is an ~$7B annual TAM

§  Fasteners make up about half that market, with small electronics, paint, chemicals, bearings, etc. the rest

o   The markets ASG currently targets are ~$4.5B annual revenues, with ~1/3^rd still insourced by OEMs/Tier 1 & 2 suppliers, and 2/3rds handled by distributors, that largest of which is KLXI with ~$1.3B in annual revenues

§  KLXI could make an acquisition to enter the $2.5B of Class C parts it does not have much presence in, such as electronics

o   ASG is a niche, sticky business. Initially, OEM and airline customers save money by outsourcing to KLX. Overtime, KLX earns their customers’ trust and becomes more integrated with their supply chain. As Class C parts are typically a small part of KLX’s customers’ total costs, but can lead to painful production halts and plane groundings if parts are unavailable, KLXI’s customers have low incentive to switch distributors as long as KLXI does well.

·        Class C parts are an ideal part of the value chain for outsourced distributors. Class C parts are a small portion of OEM COGS (only 3-4% of total plane cost) and even less significant to airlines, but part shortages are a complete headache with real costs, requiring airlines and OEMs to maintain significant opex on in-housed inventory management.

o   Inability to find a certain $20 bearing can halt production/ground a plane the same way an inability to locate a $30MM jet engine can

o   Distributors also benefit from the “80/20” rule

§  80% of all Class C parts needed are 20% of all SKUs made, but 20% of demand is spread across the other 80% of SKUs

§  For the 80% of SKUs that are 20% of volume, most suppliers, airlines, repair shops, etc. lack the sufficient volume to even go direct

·        These are “higher margin” SKUs for KLX, particularly in a shortage

·        “Try asking Kellogg’s for 30 boxes of cereal”…

·        KLXI provides an important service for their customers – simultaneously lowering product costs, reducing headcount/overhead, and limiting work stoppages resulting from stock outs

o   By aggregating orders from across the OEM and aftermarket supply chain, KLX can drive down costs for their customers

§  A big OEM like Boeing, for instance, might be able to secure better prices going direct, but Heico flight support or Cessna isn’t going to able to order sufficient quantities to beat the overall buying power of KLX or WAIR

o   At the same time, to in-house inventory management, the customer must maintain a large procurement staff, a large working capital investment including particularly slow turning emergency reserves, and develop forecasting tools that are developed “in a silo” likely less robust than KLX’s. Outsourcing thus saves customers SG&A expense and results in better outcomes.

§  KLX easily levers procurement staff and investments better than their customers given higher order velocity, volume and experience

§  Further, KLX has years of experience and a more robust data set to predict customer needs

·        Example - If XYZ Airways just bought its first ten A320s, they might not know that after 1,000 flight hours a certain type of seal-coated fasteners on the left wings typically needs replacing. KLX has seen hundreds of customers fly hundreds of hours on the A320… and knows what kind of needs typically arise and when.

·        Even suppliers tend to prefer selling through a distributor

o   The distributors, through years of experience, tend to order in large quantities, which enables fastener OEMs (PCP, Alcoa, etc.) to run their equipment at a high throughput, which improves the fastener OEM margins

o   After Boeing cut out WAIR on certain products, BA required Trimas (TRS) to integrate into BA’s ordering program. Despite “cutting out the middleman,” which theoretically is better for BA/TRS, TRS experienced margin degradation as they were forced to run sub-scale runs of their products as BA is less experienced with inventory management

§  TRS is a small fastener player, so they can’t push back against BA at all

§  PCP/AA/Lisi are ~85% of the market and if BA doesn’t get distribution right they could push back and force business back towards distributors

·        Most importantly, KLX has largely earned the trust and respect of their customers, giving KLX an edge on any competition, particularly in the aftermarket

o   As much as Boeing is trying to squeeze their supply chain (a bit…), KLX is trusted by the majority of their customers.

§  ~60% of KLX’s OEM sales are to customers where KLX maintains a presence on the floor of their manufacturing plant, monitoring stock levels and ensuring adequate supply

§  KLX has a 99% part availability rate and ~60% of product requests are delivered within 24 hours

§  Airbus, UTX, etc. are expanding KLX’s role in their inventory management process

·        KLX has long term exclusive distribution agreements with Honeywell, UTX, and other key customers

§  In this 2012 report, Avascent found that across 60 senior level executives and other stakeholders, the value proposition and ability to deliver on cost saves and efficiency was “widely held”

·        http://www.avascentinternational.com/Files/News/Class%20C%20White%20Paper.pdf

§  In my conversations with a dozen IRs and consultants, everyone, even their competitor WAIR, felt  KLX was a high quality business with excellent management that provides real value

o   Further, KLX is the dominant supplier to the aftermarket

§  KLX is ~40% aftermarket, versus WAIR at 3%

§  The aftermarket customers often don’t know what products they’ll need in advance, and the cost for these products is so low (twenty $14 fasteners, eleven $22 bearings, 100 $3 washers, etc.) that once they trust a distributor, there’s low incentive to change as switching costs are high

·        If anything, airlines and aircraft support generally want to outsource more…

§  Several checks (WAIR, TRS) said KLX had a “monopoly like” position in the aftermarket

·        Outlook

o   Sales

§  ASG sales are split ~60% OEM and 40% after market

§  OEM sales are about 15% defense, 5-10% private jet, and 35-40% commercial

·        On defense and private jet, KLX has recently seen sharp decreases in sales, which weighed on H2 2015 results. The reason for the miss was tough compares (hard to model coming out of BEAV), FX, and likely some share loss to WAIR. However, its only ~20% of KLX’s business and the blow up, which every industrial intermediary business seems to have once every three years, is out of the way.

·        On commercial, record profitability at airlines, increased fuel efficiency in new planes, a supply/demand imbalance stemming from the fall of new plane orders following 9/11 and the early 2000s recession, and 8 year backlogs for Airbus and Boeing are being slowed by FX and production slowdowns at Boeing. I model 2-3% global delivery growth in 2016 which accelerates to 5% in 2017.

§  Aftermarket sales are a bit trickier to track than OEM, as they can be choppy from Q to Q. Further, a surge in retirements following the Great Recession, plus the strength in commercial OEM demand to replace older planes has generally led to a lackluster aftermarket environment, as new planes typically take ~5 years  to enter aftermarket/refurbishment market

·        However, aircraft deliveries spiked after 2009 following the slowdown from 2002-2006. As these planes are starting to hit the 5 year mark, aftermarket sales should benefit going forward.

o   Margins

§  ASG margins have trended in the 18-20% range over the past 5 years, which compares to prior “peak” margins during the fastener shortage of low 20s.

§  What drives ASG margins are price, mix, and volume, and aftermarket sales are higher margin

·        While only 40% of sales, aftermarket is 50% or slightly more of profits

o   Aftermarket players often do not know what kind of SKUs they will need in advance of a check (airplanes have mandated checks, with varying degrees of depth, over time), which puts KLX’s “99% fill rate, 60% within 24 hours” ability in high demand

·        In addition, Boeing, by increasing its share of direct purchases, has ensured a lower lead time for its products and prevented “price surges” which were beneficial to ASG margins in the late 2000s

o   See Boeing section

·        KLX has also extended and improved its handling of customer orders, which gives KLX a larger moat and more order certainty, but again lowers high margin “surge pricing”

o   Basically, it’s a tradeoff. KLX gets a bigger chunk of the company’s business but then KLX’s involvement helps prevent profitable product shortages.

·        KLX also has a cost improvement plan in place, and should receive the spinoff benefit of a more focused management team

§  KLXI guided to ASG margins of “at least” 18% percent in 2016, which is basically flattish with 2014 and 2015

·        KLX had consistently beat margin guidance in H1 2015 and in the year prior to spin. While they clearly missed estimates in H2 due to the decline in bizjet/defense, I believe there is upside to managements 2016 margin guidance.

o   Growth Opportunities

§  I believe there are opportunities for KLX to expand its role with existing customers and to acquire adjacent distribution businesses

·        KLX IR spoke of an interest in adjacent categories such as electronic and paints/chemicals, where KLX has less exposure

§  On recent calls, KLX has specifically commented that they are looking a handful of sizeable acquisition candidates

·        As KLX was built as a very successful roll up story, a sizeable acquisition in aerospace could be a material catalyst

Why Boeing Not a Death Sentence

·        CM Quick Thesis: Basically, Boeing is trying to squeeze its suppliers a bit and WAIR is directly in BA’s crosshairs. The market, seeing WAIR stock implode, has gone “perhaps KLXI is next,” but KLX is much less exposed to Boeing than WAIR and WAIR has three significant additional issues – a failed integration of a substantial 2014 acquisition, >4x leverage, and CEO/CFO turnover – that don’t apply at all to KLXI.

o   Boeing is trying to squeeze its supply chain and, as a distributor to Boeing and Boeing suppliers, that will impact KLXI.

o   However, Boeing is less “trying to kill the distributors” and more “trying to ensure there aren’t part shortages”

o   BA cares less about saving $1MM in costs per $280MM plane so much as ensuring there aren’t stock outs which result in production delays

§  Unfortunately, those stock outs are quite profitable for KLXI and WAIR, as they get to sell their existing inventories for “surge prices” as people scramble to secure more fastener inventory

·        The lead time on a fastener is 40-60 weeks typically, so when the market’s short… it’s an issue

o   I readily concede ASG will not see the 22-23% EBIT margins they saw the last cycle. However, I do not think Boeing is imminently about to destroy KLX’s business, as the sub-10x cash EPS multiple and several sell side notes have implied.

o   Instead, I think ASG will continue to be an 18-20% EBIT margin business with LSD-MSD organic growth as it has been for previous 5 years

·        Why Boeing is Doing What It’s Doing

o   CM Note: Cowen has published good work on this.

o   To understand Boeing’s decision to take a more active role in fastener procurement, it’s important to understand BA’s experience with fasteners in 2007/2008 and BA’s record backlog

§  In 2007/2008, fastener shortages were one of the lead culprits in 787 production delays

§  BA commissioned a bunch of McKinsey types to tell them what to do, and they said “take a more active role in the procurement of fasteners,” which Boeing calls the BASN plan

§  In previous cycles, Boeing and its Tier 1 and 2 suppliers would order fasteners separately instead of combining orders. Boeing really didn’t know how many fasteners were in inventory nor how much upstream capacity (PCP, AA, Lisi) existed.

§  Under the BASN plan, Boeing has gone out to its Tier 1 and 2 suppliers (think UTX, Mitsubishi Aero, SPR) and said “on our business, you have to come and ask our selected distributor (Newbreed) first before going out and asking any other distributors for product.” This gives BA greater visibility into fastener demand so BA can communicate their needs to fastener OEMs and ensure production.

§  A benefit of the BASN plan is that it also gives BA the ability to squeeze its supply chain for greater profits

o   However, there are a handful of issues. First, many Tier 1 and 2 suppliers also supply Airbus, as well as various military, aftermarket, and other players. So even if those suppliers convert 100% of their Boeing fastener needs onto Boeing’s platform, they’re still using WAIR/KLXI/etc. for all their other products. Second, the suppliers actually get value from high quality distributors beyond just purchasing power… they also get the VMI and just-in-time (JIT) inventory delivery that makes the suppliers’ lives easier. Third, the suppliers don’t want BA as both a customer and supplier. The more UTX lets Boeing be involved in UTX’s supply chain, the more leverage BA has over UTX… and that’s not good for UTX’s bottom line.

o   To date, the BASN program has been a modest success, but it’s important to remember: 1) so far only BA has selected this route and Airbus is actually expanding the role of distributors, 2) it only affects the commercial OEM market, and 3) Boeing has not made a major push into being a distributor to the aftermarket, where KLX dominates.

·        Less of an Issue for KLX

o   I estimate KLX is about 20% exposed to BA

§  Per the S-1, Boeing direct sales have ranged ~10-12% over the past three years

§  The remaining 8% is my estimate for BA demand across KLX’s other customers

§  KLX IR said it was under 20%, but I take that with a grain of salt

o   Juxtapose this with WAIR, which is a 97% OEM business that historically had focused on Boeing and Boeing-focused suppliers

§  Half of WAIR is defense OEMs, where trends have been weak for several years

§  The other 50% is commercial OEMs, and assuming a 60-70% BA exposure, implies BA and BA suppliers are 30-35% of WAIR’s overall revenues

·        KLX and several sellside sources think WAIR might be 50% exposed to Boeing

·        WAIR claims its “like 20 to 30%”

§  Boeing, as a directly sourced customer, has fallen from 16% of WAIR sales to sub 10% in past three years

§  KLX’s CEO, when heading BEAV, described BA and WAIR as “battling it out,” but was adamant that KLX is sub 20% exposed to Boeing

§  WAIR’s 10-K lists Boeing’s program as a potential threat a dozen or so times with extensive Risk Factors dedicated to it. KLX’s doesn’t mention Boeing’s outsourcing program as a threat at all.

§  Despite all of this, WAIR has grown organic sales at 5-10% and only see 150-300bps of gross margin pressure since BASN launched in 2012, and recent GM declines are smaller. BA is directly picking a fight with WAIR, and it’s not destroying WAIR, just hurting it on the margin.

o   Basically, if BASN 100% successful, KLX faces more competition on 20% of its sales and a generally more efficient supply chain, which likely results in lower margins than prior cycles

§  At sub 10x EPS and estimates already reflecting the margin issues, I think KLXI stock is adequately discounting the issue

Why KLXI is not WAIR

·        Lower Boeing Exposure – See above

·        Lower Leverage

o   WAIR is ~4x levered and has missed earnings repeatedly

o   KLXI is ~2.6x levered putting the entire debt load the ASG business, and BEAV had beaten guidance for 19 of the previous 20 quarters while ASG beat its first two quarters as a standalone entity, admittedly had a blow up in Q3, and then came inline for Q4.

·        WAIR Having Integration Issues

o   WAIR purchased Haas, a chemicals and paints distributor, in Q1 2014. At the time, WAIR and Haas had SG&A as a % of sales of ~16%. Since the merger, WAIR saw SG&A shoot to 17-20% of sales, which was the primary driver of WAIR’s large earnings misses the last four quarters.

·        WAIR Management Uncertainty

o   Given the blow ups and repeated failures, WAIR lost its CEO of 20 years and CFO at the end of 2014

§  The new CEO hired in April is an unproven entity

o   KLXI saw the long time CEO and CFO of BEAV decide to go with the smaller spin-co

§  Both executives have strong reputations

Downturn Scenario

·        Note: Given the fall in oil, I already consider ESG “in a recession”, and discussion below focuses on the ASG segment

·        2008/2009 Downturn

o   In the 2008 downturn, as part of BEAV, the ASG segment actually grew EBIT significantly y/y due to an acquisition, largely rendering the comparison moot

o   However, the other two segments of BEAV, with significant customer and end market overlap, each saw a 25% decline in EBITDA during that period, and make the basis for my assumption of a 25% drop in EBITDA should the aerospace cycle turn

o   While total planes manufactured was actually flattish during the Great Recession, the falloff in aftermarket sales and depletion of inventories across the supply chain was significantly negative hence I feel a “2009 recession” scenario is an adequate discount for any turn in aerospace

·        Distribution a “Good” Recession Business

o   While aerospace is certainly not an industry to own into a steep recession (what is…), distribution business models are a strong business to own given minimal capital intensity and the ability to unlock considerable working capital in a downturn

o   Once a distribution business has reached sufficient scale, they are basically low capital intensity warehouses and some inventory

o   As a result, the model can generate significant FCF during a downturn by depleting inventories and halting non-essential growth capex

§  For instance, FAST, GWW, and MSM all saw a significant y/y increase in FCF during the Great Recession despite declining sales

o   It is this “generate cash when needed” that has made distribution so attractive to PE funds and the market has often given distribution businesses premium multiples given this “recession resistant” model

Tax Assets

·        KLXI has two tax assets: amortization and a tax-deductible goodwill

·        Amortization Shield

o   Like many rollups, KLXI benefits from tax-shield amortization

o   While KLX is a “serial acquirer”, it is not acquiring businesses to plug a hole in its current model

§  Ex. - certain tech companies (HPQ) outsourcing R&D via acquisition

o   KLXI’s amortization expense is largely a fictional accounting treatment that simply benefits near term FCF

o   Amortization should thus be added back to GAAP EPS to accurately portray cash earnings power

o   KLXI should have ~$30-$32MM in annual amortization expense over the next 5 years

§  Further acquisitions would replenish/increase its amortization shield

·        Goodwill Shield

o   As a result of several large acquisition, in particular Honeywell and UTX’s distribution business, KLX has a large, tax deductible goodwill shield

o   However, unlike amortization, the goodwill shield does not flow through the GAAP Income Statement and is simply an item on the Statement of Cash Flows

o   KLXI should see $37MM in annual cash tax savings from the goodwill shield over the next 10 years, which drops to $30MM in years 10-15

§  This corresponds with ~$105MM in annual goodwill expense

·        Given the length of KLXI’s tax shields, I believe current cash EPS should be viewed as equivalent to run rate FCF

ESG Outlook

·        CM Thesis: ESG is an energy services roll up, operated separately from ASG, that is akin to a PE fund backed by ASG cash flows. KLXI’s debt is fully covered by ASG EBITDA (~2.5x levered, 3.8x interest coverage on ASG EBITDA), KLX could shut down ESG with minimal LT obligations, and management has a strong track record of execution. I think ESG is a “call option” on KLX’s energy strategy rather than a “black hole” that could impair the value of ASG. Instead of getting a $3-$3.50 dividend from KLXI’s ASG annual profits, I am instead buying into a distressed energy PE fund at book value, managed by a CEO who has extensive experience in rolling up distribution businesses, albeit aerospace focused.

·        ESG Strategy

o   KLXI plans to make niche, smaller energy acquisitions that in no way exceed ASG’s cash flows and KLXI’s overall liquidity

§  To date, ESG has spent ~$500MM on energy deals and plans sub ~$50MM in 2016 ESG cash burn

§  To put this in perspective, on a combined basis, KLXI and BEAV should earn close to $1B in 2015 and ASG standalone should earn $285MM in 2016

·        BEAV relevant as the ESG acquisitions took place pre-spin

§  KLX has $428MM of cash on their balance sheet and an untapped $750MM revolver

§  While cash burns are never good, burning $50MM-$75MM over two years to make a contrarian growth investment in the context of >$300MM in non-energy EBITDA, $25MM in non-energy capex, $75MM in whole-co interest expense and $1.2B in available liquidity is a modest investment.

§  This is not a massive levered acquisition story. KLXI is “dipping a toe” and has plenty of liquidity.

o   KLX plans to focus on the smaller, “mom and pop” operators where larger, more sophisticated players, such as BHI and HAL, do not play

§  Wireline services, equipment rentals, accommodations, etc.

§  Over the last year, KLX has been expanding its service offering and improving the “backbone” of its operation – technology capex, hiring talented operators, etc. – while at the same time downsizing the business along with the fall in demand

o   By combining smaller operators, which trade at lower multiples, KLX can cut costs and grow the business to service larger customers, thus improving the EBITDA margin, revenue opportunity, and multiple

§  A “classic” roll up strategy

o   While oil is different from aerospace, KLX management is particularly experienced in distribution roll ups

§  They are in the business of inventorying the proper products and getting them to customers quickly and efficiently

§  I would argue that manufacturing seats and toilets for airplanes (current BEAV’s business) is actually more different from aerospace distribution than energy services distribution

§  KLX CEO Amin has forty years of PE experience and has invested in numerous industries, from semicap equipment to medical devices

§  My point is that while KLX has no recent experience in oil beyond what they’ve purchased, it does not mean that they have no idea what they are doing

·        2016 Targets

o   In 2016, management expects ESG to burn about $50MM in EBIT, probably a bit better than that in cash flow, but there is a great deal of variability in those estimates.

o   EBITDA is held back by declining sales due to a collapse in rig count as well as significant growth investments

§  Incremental margins are completely meaningless here

o   KLX’s acquisition pace will depend upon availability. They are hoping for a big wave of bankruptcies.

·        2017 Targets

o   I assume ESG adds ~$20MM in cash profits for 2016

o   In perspective, ESG earned $21MM in EBIT in Q4 2014 alone

o   This is hard to model, but as long as North American drilling improves modestly in 2017 ESG should return to a profit

§  I don’t think it’s absurd to think $500MM in trailing plus 0-$300MM+ in additional acquisitions could earn $20MM in annual profit

·        M&A Targets

o   Globally, energy services is a $40B TAM, with $16B in North America, where KLX will focus

o   Given the steep selloff, KLX is targeting financially distressed sellers

o   To better understand what KLX will target, please read KLX’s February Cowen conference transcript, both 2015 and 2016, as the CEO spoke for 40-50 minutes laying out their plans and opportunities

Possible LBO Candidate

·        Distribution businesses are popular for PE firms

o   As discussed above, they are relatively recession resistant and there are often opportunities to roll up smaller distribution businesses

o   Low capital intensity, FCF spikes in recession = lots of room for leverage

·        WAIR was PE owned until 2011 and the third and fourth largest aerospace are also PE owned

·        KLX CEO previously managed a PE fund and became BEAV CEO after owning it in one of his funds

·        Assuming 6.5x leverage and an initial 2x interest rate coverage, 8% interest rate, 5% EBITDA growth, a 5 year time horizon, and an 12x EBITDA/17x EPS exit multiple, PE could afford to pay 12x EBITDA for ASG and hit a low 20s IRR

o   12x ASG EBITDA = $50 per share

§  You’d get ESG for free…

o   WAIR was trading 12x EBITDA prior to missing estimates

o   20% EBITDA margin distribution peers often trade well in excess of 12x EBITDA