Steve Carrell and Ricky Gervais are to "The Office" what TransDigm and Meggitt are to the commercial aviation aftermarket. This writeup focuses on Meggitt, though I refer you to spike945's TDG writeup from Dec 2006, much of which is still applicable today.

 

While a wide range given the cyclical nature of aviation, at 10-12x 2012/13E EBITDA, Meggitt should be a 500-600p stock versus 320p today. Downside in a disappointing aerospace cycle may be closer to 300p or 8x a flattish EBITDA number going forward.

 

 

• Sole source nature of most parts with high regulatory and R&D barriers to entry result in a real competitive advantage and pricing power
• Defense-related revenues have sole source nature, recurring aftermarket and innovation to offset fears of declining budgets
• M&A expertise has transformed the company over the past decade
• Very strong management team knows how to allocate capital. They act as shareholders because they are material shareholders.

 

Whether time-consuming FAA certification, expensive R&D to log flight hours, or subpar economics as a second-source supplier there are a number of barriers to entry that keep Meggitt entrenched as a leader on its best products. Again, read spike945's writeup for an extensive discussion of PMA risk and factors which lead to competitive advantage for suppliers like TDG and MGGT. While it is not as extensive as TDG's sole source position, MGGT is 47% aftermarket parts which maps roughly to two-thirds of operating income. With manufacturing facilities in the UK, US, Mexico and China Meggitt should not be viewed as a UK-centric company but an aftermarket commercial aerospace company.

 

The crown jewel of Meggitt's aerospace business is Aircraft Braking Systems (27% revenue, 39% EBITDA, 38% EBITDA margins). These parts are non-discretionary and do not carry PMA risk due to the time and capital required to develop them, not to mention they are designed into the OEMs planes given how critical they are - when copycats try to log takeoffs and landings to test brakes negative results have obvious disastrous and expensive consequences. When it comes to regional and bizjets, Meggitt has a true monopoly here even if it is normal for large jet OEMs to carry more than one supplier (MGGT has a stellar track record on design wins, going approx 17 for its last 20). Note that as we see a pickup in RPMs/miles flown, regional jets are a big beneficiary and require more frequent brake pad replacement. That is, the decline on regional hops like EWR-CLE was probably greater than the decline on JFK-LAX. As that comes back, it's good news for Meggitt's aftermarket business. Finally, a secular shift from steel brakes to carbon-based brakes carries greater value throughout the cycle. Over the course of a cycle, Meggitt should see +2-4% growth in the installed based combined with a +4-6% CAGR on pricing.

 

Sensing systems (17% revenue, 13% EBITDA, 19% EBITDA margins) are an area where Meggitt is a world leader ahead of Rolls Royce. Meggitt has an engine condition monitor that tracks metrics like temperature and stress points and suggests what preventative maintenance to do and when. This is valuable for engine manufacturers like UTX who are shifting to a 'power by the hour' model where the operator pays a fixed cost for engine maintenance and the manufacturer bears the risk of extended downtime or failure. This business is a near-monopoly on key platforms like the 787 and A350, planes near the beginning of their life cycle. Meggitt should see double-digit CAGRs on revenue and EBITDA in its sensors business over the next few years given orders for new planes and maintenance on the installed base.

 

Control systems is another good business for MGGT (16% revenue, 16% EBITDA, 26% EBITDA margins). 

 

Polymers are an interesting business when it comes to innovation and defense (13% revenue, 11% EBITDA, 21% EBITDA margins). Many polymers are made by hand and can't be automated, which makes copying MGGT's book of business difficult.

 

The equipment group makes up the remainder of the business and is a catch-all for other technologies and covers both OEM and aftermarket parts (21% EBITDA margins).

 

 

Note: below segment numbers are not reconciled with 'adjusted EBITDA' but does include corporate OH (e.g. CapIQ at 419m GBP 2012E EBITDA).

 

 

	2009	2010E	2011E	2012E
Aircraft Braking Systems
Revenue	320	317	357	400
EBITDA	116	120	135	152
%margin	36.4%	37.7%	37.8%	38.0%
Control Systems
Revenue	181	188	196	206
EBITDA	43	49	52	56
%margin	23.9%	26.1%	26.5%	27.2%
Polymers
Revenue	149	156	168	183
EBITDA	30	33	36	40
%margin	20.2%	21.3%	21.6%	21.9%
Sensing Systems
Revenue	190	201	215	245
EBITDA	32	38	42	48
%margin	16.9%	19.1%	19.5%	19.6%
Equipment Group
Revenue	312	317	340	370
EBITDA	64	67	74	81
%margin	20.6%	21.2%	21.8%	21.9%
EPS (p)	25	28	33	38
Multiple		14.0x	14.0x	14.0x
Implied Price		392	462	532
EBITDA	286	307	339	377
Multiple		12.0x	12.0x	12.0x
Implied Price		409	464	529

 

Defense: innovation + aftermarket = downside protection

Meggitt's defense business accounts for ~40% of revenue and ~25% of operating income. Given trends in defense budgets in developed markets this might seem like a scary headwind. For a number of reasons including the recurring nature of aftermarket parts, sole source position and product innovation fears of a decline in the defense business as overblown.

• 26% of military EBIT is from Aircraft Braking Systems, the pseudo-monopoly
• 23% of military EBIT is from training systems that may actually benefit as we move troops back home from the Middle East.
• 11% of military EBIT is from jet fuel bladders, a highly innovative product. This is listed in the Polymers division for MGGT as the bladder is a polymer that reseals when punctured to prevent leakage. MGGT has ~85% market share in this product which must be procured in the US (20% EBIT margins). MGGT recently took a small order on Bradley tanks and the incremental opportunity on ground-based vehicles is a nice call option. This is real innovation: most deaths in IED explosions are not from shrapnel or the actual device, but from blown fuel tanks. Moving this from an aircraft-based solution to ground-based vehicles is an example of one way to growth the defense business in the face of difficult budget issues.

 

M&A Expertise

It might not be the same M&A home runs that TransDigm hits, but Meggitt has done a very good job of acquiring very good assets over the years. Perhaps the worst management could be accused of is paying robust prices for great assets. MGGT has completed 18 acquisitions since early 2002 but below are two of the most transformative deals. Additionally, MGGT has made the decision to divest non-core assets. This was mostly done in 1999-2003, but is important to understand the focus on the aftermarket and commercial aviation (i.e. they're not serial acquirers). Since 2001, MGGT has spent a cumulative GBP 1.2bn on acquisitions versus GBP 180m on capex. With prospective net leverage of ~2.2x net debt/EBITDA, MGGT still has capacity should other M&A opportunities arise.

• 1999 Whittaker deal: Meggitt bought Whittaker for $380m. This enhanced MGGT's presence in sensing systems and the aftermarket.
• 2007 K&F deal: Meggitt bought K&F Industries from Aurora in 2007 for $1.1bn. This helped boost MGGT's presence in aircraft brakes. TDG was also involved in this bidding process. It was in TDG's wheelhouse but MGGT outbid them.

 

CEO Terry Twigger has a deep bench of talent and runs one of the best industrial management teams in Europe. He has been with the company since 1993 while a number of divisional managers have been with Meggitt for at least a decade. What was inherited as a hodgepodge of industrial businesses was transformed into a winner in the aerospace aftermarket parts business.

 

The CEO has 32 years of experience in the aerospace industry and is a successful story of an accountant turned manager. Twigger joined Meggitt in 1993, became CFO in 1995 and CEO in 2001. Prior to that, he spent 15 years with Lucas Aerospace and started his career with Deloitte. Management owns a lot of stock and hasn't cashed out or had the big payday over the years. The CEO owns 6x the amount of stock he owned in 2002 and there is no cycle of cashing out options grants. There are some bonus targets based on EPS but as goes shareholder value, so goes management. Management runs the business for shareholders and has acted as such with their financial interest.

 

In addition to a respectable dividend, management may at some point be willing sellers of the company. At age 61 with a few years until mandatory retirement, it's unclear whether Twigger will pass the baton to current CFO Stephen Young or whether there will be a suitor at the right price. A 2004 quote from Twigger may give some insight into how management thinks about capital allocation: "Meggitt is already a potential acquisition target for larger companies. That doesn't bother us - we manage the assets we own and deliver good deals for our customers and shareholders. If anyone thought they could do better, then we'd be open to offers. Fundamentally, we are a public company." 

 

This quote is interesting given MGGT's size as well as how overextended potential suitors might be when it comes to defense. If the UK defence budget or looming program cuts from the DoD are any indication of the outlook for defense contractors, would it make more sense to flush FCF on buybacks or would it make more sense to acquire some high quality assets to help diversify away from defense towards commercial aerospace? It's possible that companies like LMT, NOC, GD, RTN, COL and others would be better served to make a friendly approach. This may sound sensible but is also speculation on my part or just part of the mosaic.

 

It's fair to point out that management executes in addition to making good acquisitions and allocating capital in shareholders' best interests. The team has put cost controls in place and generally held profits flat through out of the worst aerospace downturns in history. 

 

Finally, I like that management sticks to its knitting and is not overly promotional. The management team does not travel to the US to do shareholder marketing, preferring to run the daily operations instead.

 

 

While a number of aerospace-related stocks have moved over the course of 3Q10 earnings season, it is becoming more likely that we at the beginning of a new aerospace cycle. Results from companies like UTX (Pratt & Whitney), TransDigm, Safran an others suggest that aftermarket business is picking up. 

 

What is notable about the 'new' cycle since all of this is largely known?

• Airlines are adding capacity at a rational, measured pace but are looking to maintain profitability. That's not to say stagnant developed-economy growth can't spoil the party, but could changes stemming from the credit crisis and Great Recession result in a healthier customer base? LCC's CEO Doug Parker said on its recent earnings call: "...we're today with oil at over $80 a barrel, an economy that's slowly pulling out of a recession, yet the airline industry is recording record or near-record profits while the rest of US industry is not. That hadn't happened before and we believe it's concrete evidence the fundamental restructuring really has taken place." If airlines are in a healthier place for the time being, it may result in smarter restocking and healthier medium-term growth.
• As airlines 'summer' season ends in October, they are bringing in engines for overhauls now. The last cycle saw engine growth ramp in 2004 and it takes 6-7 years before an on-wing engine is ready for maintenance. Seeing those engines come in for maintenance now is a positive sign for the aftermarket (e.g. Pratt & Whitney spares business +35% yr/yr in Q3, heavy overhaul +14% yr/yr). 
• Parked capacity may not spoil the party, either. If you consider the 2,200+ planes parked in the desert in the US, over 70% of those are over 20 years old. If the useful life of a plane should be 20-30 years, some of this would-be capacity will be scrapped over the early to middle part of this new cycle if it makes it back in service at all.
• The bizjet cycle has been a case of the 'less bads' and there is a sizable inventory overhang from people living to excess before the credit crisis. That said, North America accounts for about 1/2 the 11,000 bizjets worldwide and the longer-term opportunity in Asia and other developing economies will grow off a very small base.

 

Not to oversimplify, but management will grow FCF and earnings through a combination of volumes (more miles flown, restocking at the airline & MRO level), pricing (sole source nature, innovation) and some operating leverage. In a healthy aerospace market, Meggitt can compound growth in FCF at low-teens rate. The GBP 343m that Meggitt reported in 2009 EBITDA could grow to GBP 500m in 2013. At 10x this level of EBITDA, MGGT would be close to a 600p stock. While there is some scuttlebutt that it would be a personal victory for mgmt to sell the company at > 450p, there is no quit in management and a strong cycle could provide decent upside.

 

In a scenario where RPM growth disappoints and stagnates over the next few years, MGGT still has pricing power and some operating leverage. At 8x EBITDA that is flat versus 2010E, MGGT would be a 300p stock. The decision tree seems skewed towards the upside given the current fact pattern.

 

 

• Aerospace cycle disappoints
• Budgets / secular decline in defense spending
• War/terror risk

 

 

• Continued growth in earnings and FCF from the commercial aerospace aftermarket business (+volumes, +pricing, +operating leverage). This is a combination of cyclical (miles flown) and secular (pricing, efficiency) growth.
• Growth in defense aftermarket offsets potential decline in other defense-related business
• Company is eventually sold to strategic or financial acquirer