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Key Messages

Safran is a solid long investment opportunity with ~35% upside today driven by continued strength in the aerospace engine aftermarket, dissipation of Leap engine headwinds, synergy and market share capture from Zodiac acquisition, and a strong aerospace macro that will facilitate NPV positive investments in the highly consolidated tier 1 aero supply market.

1. Aerospace macro still looks favorable. Travel trends remain strong with consistent ~4.5% growth that hasn’t meaningfully dropped off in a recession. Growth trajectory looks likely to continue thanks to travel penetration in China/India. At the same time, the market has materially tightened (highest PLF in recent memory) while narrow body retirements and build rates are set to continue growing at a high level (~8% p.a).

2. Aftermarket likely to keep surprising to upside. Based on significant increase in narrow body supply over last 10 years, the engine market is likely to enjoy large tailwinds over the next 5 years as CFM56 engines enter high value SV1 replacement. This tailwind is likely to support >6% supply growth (plus 4% pricing) at >50% incrementals for Safran over next several years. Moreover, Leap transition has gone smoothly and is likely to turn from a headwind to tailwind over the next 2 years (a trend that has masked favorable aftermarket incremental margins over the last 3 years).

3. PMA manufacturers don’t seem like a thesis destroying risk over next 10 years. It is very unlikely we will see any new PMA entrants in the engine space given airline/FAA safety track record requirements. Moreover, Heico remains a very small part of the engine market with no desire to irritate Safran given push toward RPFH.

4. Zodiac acquisition likely to surprise to upside. Margin targets look highly conservative given implication that core Zodiac business will peak at 11% operating margins (compared to prior cycle peak of 17%). Moreover, with the likely bottoming of wide body production and continued right-sizing of Zodiac operations, the transaction looks likely to surprise to upside (SAF could double synergy target)

5. Boeing 737Max risk isn’t a major headwind. Given 1) SAF was a few weeks behind schedule on LEAPs for BA, 2) BA cut was fairly modest to 737Max build rates (10/month), and 3) there is a potential maintenance tailwind from significant plane groundings, I see minimal FCF risk from BA as long as the program is back on track by fall.

6. Good business operating in a good backdrop with reasonably cheap valuation. Safran looks set to almost double EBITDA over the next 4 years which would result in an ~7.5% FCF by 2022. Given 1) highly concentrated, >20% ROI nature of airspace business, 2) strong growth trends that will enable LT FCF growth in mid single digits, and 3) 8% cost of capital, I see ~35% upside to Safran over the next year (7.5% FCF in 2022 + 5% organic growth=12.5% TSR, on 8% Re implies 56% upside in 2021. Discounted back to today implies 35% upside).

Other Risks Highlighted in Appendix

1. Chinese are investing in engine design. While limited public information is available, commentary from the Chinese indicates limited progress on commercial aircrafts. LEAP engines are still being used on COMAC planes.

2. Electric engines will be required to reach LT emission targets. However, SAF is a leader in electric engine innovation and is in a position to do well if the industry pivots

3. Everyone knows aerospace aftermarket has been a great business model. This is the most challenging other risk. The numbers imply SAF is still cheap enough to own and the macro looks safe enough to invest. However, I struggle to find a good catalyst (other than continued compounding) on SAF.

1. Aerospace Macro Appears Benign as strong travel growth appears set to continue, the market is tight, build rates/OEM backlogs are high and narrow body returns are set to accelerate.

1. History says that we will continue to grow aircraft deliveries at >5% p.a.

2) While the aerospace market has tightened over the last several years

3) Large DM population centers (India/China) still have room to significantly increase travel per capita, supporting large OEM backlogs

4) Narrow body planes have enjoyed strong historical demand and are about to see a wave of retirements

5) ….which leads to a healthy build forecast for narrow body planes

B. Narrow Engine Market 1) is a duopoly that Safran continues to take share in, 2) has seen the successful ramp of the leap engine over the last 3 years, and 3) is likely to enjoy continued tailwinds from growing high margin aftermarket demand

1. Narrow body engine market is an effective duopoly between Safran+GE (CFM56, Leap) and Pratt Whitney (UTX). Both the PW GTF and Leap engines have similar specs; however, since 2003, Safran has meaningfully outpaced other engine OEMs.

Despite similar specs, PW1000 has been plagued with issues since 2016 and as recently as May 31st, the few airlines with PW1000 orders are still looking to switch.

• IndiGo recently announced a bidding process for 280 A320neos. Previously, it was expected that UTX would take all these orders

"With IndiGo now having ambitions to fly to Europe and expand overseas that becomes a bigger consideration, and it's not all about the edge on fuel" (IndiGo was forced to land some plans due to PW engines)

2) Leap is the exclusive engine on the 737max and has 58% share on the A320neo. The launch of the leap engine has gone more smoothly than many believed. Back tests on SAF’s historical financials validates quick leap engine cost reductions.

3) Assuming SV1, SV2 and SV3 cost 3mm, 2mm and 1mm, respectively and happen 8, 13 and 17 years into an engines life, aftermarket grow rates appear stable over the next several years.

4) Margins for SAF propulsion look set to surprise positively. Over last 4 years, we have seen an increase in aftermarket activity (with incremental margins >60%) that has been offset by a 500mm leap transition cost. Over the next 5 years, I forecast comparable aftermarket growth without transition headwind.

C. Long-term threat for PMAs is worth considering; however, doesn’t look like a major threat over next several years. There is only 1 serious PMA engine player and they alone are unlikely to meaningfully disrupt the market over the next 10 years. Moreover, engine players are moving to RPFH models that could potentially crowd out Heico.

Recent IATA agreement optically looks bad for CFM and Heico’s value proposition would be compelling to an airline

Heico is the largest PMA manufacturer and admittedly does have an impeccable 20+ year safety record. My impression is it is highly unlikely new incumbents could enter the space over the next 10+ years as it would 1) take serious time to earn the trust of airlines/FAA and 2) new players would need to accept much lower margins until they scaled.

Heico is a very small part of the engine market (~2%) and doesn’t seem to have a desire in the near-term to upset engine manufacturers

On recent 2Q’19 earnings call, management confirmed that aftermarket parts are <50% engines.

Finally, given we are going to see an increase in SV1/2 (which are less likely to be penetrated by PMAs), we are even less likely to see PMA disruption over next decade.

D. Zodiac transaction gives Safran exposure to the aircraft interiors market. While interiors is a worse business than engines, the market is currently consolidated, requires high R&D, new entrants (ADNT) have failed to take share and the macro backdrop is likely to improve as wide body aerospace orders should improve. Moreover, transaction synergies given by Safran look conservative.

Interior market is consolidated with some moats around higher end products

While barriers to entry are cited as a problem in the interiors market, things don’t appear overly dire.

• Seats require 16g certification, requiring significant R&D spend (Zodiac/BE have 7-12% of sales in R&D)

• New entrants have entered the space (Adient, Lift by EnCore); however, that was mostly in response to failings by some of the current OEMs and they have failed to take significant share due to rigorous interior certification

While Zodiac says ~50% of their interior sales are BFE, the industry is going the opposite direction where airframers are trying to take more control over their supply chain.

While an area of further diligence, widebody aircraft have 5-10x more interior revenue than narrowbodies. 2018 was a tough year for widebodies, but the market looks stable and likely set to rebound over the next few years and 787 and A350 production grow while 777 and A330 production have stabilized.

Despite ~450mm of cost overruns, Safran euro 200mm synergy/15% margin target imply structural cost increases of ~300mm for prior peak

Meanwhile the target looks light compared to peer BE Aerosystems, getting acquired by UTX, with a 5-6% of revenue synergy target (despite less checkered operating history).

In seats, the US operations in Gainesville have recovered and Seats France/UK likewise mostly normally in 2018. Focus now is likely on regaining market share, which Safran acquistion should help facilitate. Meanwhile, A350 lavatories have returned to normal industrial conditions.

E.Boeing risk likewise seems limited. Cutting production from 52 to 42 aircraft per month. Commentary from the FAA has seemingly been supportive of the 737max ungrounding over the next couple of months if the agency finds Boeing’s proposed changes acceptable. However, this is low conviction.

2008 Boeing strike did cause issues for Safran…..

But Boeing cut was small (10 aircrafts) and Safran was already a few weeks behind on Leap engine plan. Moreover, grounding of 737maxes could accelerate maintenance cycle. Impact looks modest at ~270mm (compared to EBITDA of well over 4bn)

F. Valuation- Its tough to argue Safran is cheap. Its fwd EBITDA multiple has expanded from 7x to 13x from 2012 to today. However, given its beta of ~1/cost of equity of 8%, it seems reasonable to value it on a 5% 2021 FCF yield (and then discount back to today) given I expect it to CAGR at ~4%+ for foreseeable future. This still implies ~30% upside to the stock

An alternative way to look at valuation would be to say that Safran grows organically ~5% pa. The market grows 3% (nominal GDP). The market trades at ~18x NTM P/E for a 6% earnings yield. Thus, Safran should trade in mid 20s for a 4%-4.5% earnings yield. I think Safran does ~$8.5/share of EPS in 2021, which would imply at 23x a $196 share price at end of 2020. Discounted back to today, that is $162 or 38% upside.

As discussed at length above, I have expectation that EBITDA for Safran should almost double by 2022. This is driven by ~10% p.a. revenue growth (market grows 6% p.a., they get pricing each year and will see tailwinds from leap) with 50% pass through on profitability.

Appendix

Spending trends favor travel

Aircrafts last about 25 years

Industry might be going toward electric engines, but Safran has first mover advantage here too                 

Electric Engines

Safran is one of only major developers of hybrid electric propulsion. In July 2018, they did first test of a distributed propulsion system. Note: batteriies don’t give up much efficiency when scaled down. Batteries also provide diverisity of locations (9% of flight crashes happen from engine breaks)

There is some longer-dated threats from Chinese aerospace spending. However, threat appears longer dated.

China is spending $16bn on R&D for aircraft engines. However, while progress is being made on mass produced military engines, the Chinese are farther away on commercial engines

Gross LLP pricing has CAGRed at over 6% (likely a bit less with rebates, etc). Aftermarket has grown over 10% since 2011.

Catalyst

-Airspace aftermarket growth in 2019

-Propusion business operating margin surprise

-Zodiac synergy target raise

-Increased buyback/dividend