Description

KLX is a recent spin off from BE Aerospace (December 2014) where I see limited downside and an interesting option on significant value creation. The stock is $39.77, there are 53m shares for a market cap of $2.1bn. There is $1.2bn of debt and $500m of cash, $400m of which I believe is excess cash. The company has 2 segments – the premier aerospace parts distribution business similar to Wesco Aerospace (WAIR), and an energy segment which is a rollup of 7 companies that provide a mix of highly technical services and rentals. While management couldn’t have timed their entry into the energy business more poorly (they started acquiring businesses in late 2013) I think investor focus on that segment overlooks the stability and margin of safety of owning the aerospace distribution business. Furthermore, you are investing with Amin Khoury who built BE Aerospace from a $250m market cap in the early 1990s to nearly $10bn prior to the spinoff. While it is hard to know what the energy business looks like over the next few years, based on the interim cash build up and a conservative 13x multiple on aerospace I see the stock worth $48 by year end.

Aerospace:

The aerospace business offers one of the broadest ranges of aerospace hardware, consumables, and inventory management services to new aircraft manufacturers (2/3) and aftermarket providers (1/3). The scale of the operations is tremendous – they process over 16,000 orders daily of which 60% are fulfilled within 24 hours. Furthermore, their proprietary technology system which cost over $100m to build has direct T1 lines into customers to know when inventory is running low. The business has been built through $2.1bn in acquisitions (which is an important point when considering management’s ability to execute their energy strategy) as can be seen in the following timeline:

2001               M&M Aerospace                                           $100m

2006               NY Fasteners                                               $70m

2008               Honeywell Consumables                           $1,100m

2010               Solair A/S                                                      $162m

2011               LaSalle Lighting                                           $20m

2012               UFC Aerospace                                           $400m

2012               Interturbine                                                   $260m

The business exposure is 87% commercial aerospace, 14% military and 5% business jets.

It’s important to understand that this business is truly about relationships – customers are very sticky and don’t like to change distributors given that items purchases are low ticket in nature and it is quality and speed of service that matters. In fact, in my research I have only found one instance where a customer changed from KLX to Wesco and it was based on price and Wesco has had a very difficult time making money on that contract.

In my channel checks the reason manufactuers hire distributors is to save inventory costs, improve procurement, and reduce labor costs. KLX employees will often be found working on the factory floor which allows for fewer people in procurement. KLX has facilities next to all the major manufacturers and has people filling bins and reordering daily.

The secret sauce in this business is the ad-hoc business. This is where a customer would need a part or specific fastener immediately and KLX would deliver next day. The example I got is that a customer would order a part that may cost KLX .10c and they would sell it for .40c. By providing it next day the customer would be thrilled. Furthermore, many of these parts and fasteners are required to fly the plane (and can’t be substituted) so time and service are of the essence.

Before getting to the numbers a quick comment on Wesco relative to KLX. Wesco grew up close to Boeing and therefore is dependent on Boeing and their supplier network.  KLX in turn built their business primarily servicing the aftermarket manufacturers. There has been a fair amount of turmoil around Wesco given the founder/CEO recently resigned. The resignation came on the heels of the acquisition of Haas, a leading chemical distributor they are having troubles integrating. Furthermore, from industry scuttlebutt several key Wesco people have recently left and joined KLX.

On to the numbers. The base business should grow over time low single digits excluding any new wins. In CY 2014 it generated $1.3bn in revenues and $272m in EBITDA, or a 20.7% margin. Margins in 2014 are depressed due primarily to the ramp of the large UTX contract won in 2014 whereby they purchased all of UTX’s inventory and are making a nominal fee supplying those parts. As those parts run out and KLX can use their scale to improve purchasing margins should revert back to 21.5% - 22%.

In 2015 and 2016 they should earn $300m and $320m of EBITDA and in this business sustaining CapX is $15-20m. WAIR is valued at 11x forward EBITDA – CapX so at a similar valuation KLX Aerospace would be valued $3.1bn.  

Energy:

The energy services group was built through 7 acquisitions from late 2013 through mid 2014 totaling $700m in spending. It is really a service business as 70% of revenues comes from performing a service at the well site and 30% from rentals – primarily tools used to perform the service. Revenues in 2014 were split 30% Northeast (Marcellus/Utica), 20% South Texas, 20% Texas/New Mexico, 17% in the Midcon, and 10% in North Dakota. At a high level the following is a description of the businesses they acquired and what they do:

Vision Tools & Blue Dot: Perform fishing services and tools which means that when something is clogging the well a guy from Vision will come in, diagnose the problem, use specific tools (the capital intense part of the business) and “fish” or fix the problem. Given the cost of the associated hydraulic fracturing and drilling dayrates the speed and expertise these “fishers” have is highly valued out in the field. Furthermore, from checks in the industry its clear people want their guys and there is a lot of loyalty.

Wildcat: Perform Wireline services which is mostly a commodity and is used to plug and perforate the wellbore.

 LTE Energy: provides accommodation services and rental equipment in the Northeast.

All the checks I have got on the people indicate that they are very well respected and liked in the industry. The reality today is that no one knows where the bottom is but there is value in these people and the cost structure is such that over 50% of costs are variable and can/will be scaled down during this downturn.

The historical numbers are irrelevant given the “the new normal” in the oil patch. We don’t know what KLX energy will look like or what normalized earnings power looks like. That said, this is where the opportunity lies and the strategy is clearly to use the cash from the aerospace business plus the excess cash on hand to make acquisitions. It’s instructive to read the Cowen presentation transcript where the chairman said as follows:

“So, for a company that has capital and management and patience and is willing to keep their powder dry, to take advantage of those opportunities when they presents themselves, which I think is going to be the second half 2015, 2016, it's going to take quite a while. I think the first phase is going to be with the tens of thousands of layoffs that have already been announced. The first phase is going to be those folks who are creative, entrepreneurial, have some particular technological expertise. They are not going to wait for the second wave of layoffs or the third wave of layoffs. They're going to go out and try to find someone that will support their activity, bring them on board, wrap some capital around them, systems, procedures, health, safety, facilities, etc., etc., all of which we have. And it's our opportunity to expand our range of services, to add differentiation, some additional unique services and products. And I think that this will be a generational opportunity…. I think the energy services business will be a lot bigger than the distribution business at some point in time, but it is going to require a lot of patience.”

Valuation:

In 2015 I assume moderate growth of 5% in aerospace revenues and margin improvement in the second half of the year. I think the energy segment EBITDA will be down 75% and believe capital expenditure will be at sustaining levels of $60m. That results in net income of $2 and given the excess intangible amortization post the spin of $45m results in another $.90 to get you to $2.90 of free cash flow.

EBITDA                      $335m

D&A                            $(70)m

Incr’l Amortization    $(35)m

EBIT                           $230m

Interest Expense      $(70)m

EBT                            $160m

Taxes                         $(50)m

Net Income               $110m

D&A                            $105m

CapX                          $(60)m

Free Cash Flow      $155m

Per Share                 $2.90

By year end, assuming no cash deployment in the interim the company will have $7.50 of excess cash plus the $2.90 generated for $10.50 per share.

I value the business at 13x as the aerospace business should be a higher multiple and energy clearly much lower. At 13x $2.90 KLX is worth $37.70 and with the excess cash at year end gets you $48. While that is not a terribly exciting return – 23%, the real upside comes from capital deployment. While Amin Khoury’s track record is phenomenal at BE Aerospace we have yet to see how he invests/acquires in the downturn.Downside should be minimal.

Catalyst

Capital deployment.

Margin improvement in aerospace as the new contract wins are fully integrated into the business by the 2H/15.