Description

Note:  All figures in Euros

Investment Thesis:

In an expensive market Safran trades close to a 52 week low. While air traffic is recovering, the pace is slower than many had believed at the start of the year. Furthermore, at its Capital Markets day last week, the new senior management team was quite conservative in some of its forecasts.  Never a promotional company and undoubtedly scarred by the experience of the last two years, this is hardly surprising.  The resulting weakness creates the opportunity to own a world-class industrial franchise at a very reasonable price.

 I estimate Safran should earn €6.50 (above the 2019 prior peak) in 2024, with free cash flow in the same neighborhood. By 2025, the LEAP engine should swing into profitability.  Note that Safran has incurred losses on new-build engines since 2015.  For most businesses, even guessing at earnings several years off is a fool’s errand.  But the dynamics of the installed base and predictability of the aftermarket business make the engine business--the corporate jewel in the crown--different:  In the back half of the 2020’s high single-digit (HSD) profit growth is likely.  And since cash should exceed debt in two years and build rapidly thereafter, returns to shareholders could be augmented. 

The Engine Business:

Safran and GE are 50/50 partners in CFM International, a JV that was recently extended to 2050.  CFM is the dominant supplier of narrow-body jet engines (72% market share vs. Pratt & Whitney), with 100% of the Boeing 737 MAX and 60%+ of the Airbus 320 NEO series.  The barriers to entry are immense:  China has a target of introducing an engine by 2025; in the meantime CFM is the sole source on the Chinese COMAC 919--itself over 5 years delayed and yet to make its first commercial flight. While overall worldwide air miles flown--the key variable in this business--have grown at GDP+ rates historically and should do so again going forward, growth is better in the narrow-body segment and the market recovery from the pandemic is proceeding more rapidly:  In late November capacity was down 28% from pre-COVID levels.  Management forecasts a full recovery by the end of 2022 and 4%+ growth in narrow-body capacity from 2023-2040.

Peak development costs on the current LEAP engine series hit the company between 2016-2018.  Recall that the two 737 MAX crashes were in late 2018 and early 2019.  Impossible to quantify, but 2019 EPS would have been higher with the original plan of over 2000 LEAP deliveries (now the estimate for 2023).  The setbacks in the 737 MAX program--just now approaching final resolution--and COVID were a powerful one-two punch to the company over the last three years. 

While the installed base is thousands of units less than had been forecast three years ago, the LEAP has performed extremely well in the field--better than its predecessor CFM56 to date.  Ryanair, a demanding customer, is very pleased.  United ordered 200 MAXs this summer.  And Indigo, which had a mixed 320neo fleet of LEAPs and the Pratt & Whitney engine, recently ordered 310 planes powered solely by LEAPs. Management anticipates new-build breakeven by 2025 at the latest and OEM engines should be a contributor to profits in the years beyond.

Let’s turn to the aftermarket business which is much more important. At present this business is focused on the CFM56 engine series--an installed base of 23,000 with an average age of 11 years and where half have not had their first shop visit.  Note that the first and second shop visits are the most intensive and profitable. Management forecasts that CFM56 shop visits will recover to 2019 levels by 2024 and peak in 2025/26, when LEAP shop visits start to become the driving force.  Some analysts are focused on the potential for used serviceable material (USM) to become a bigger factor in the market, diminishing highly profitable parts sales for Safran.  I think the threat is overstated:  retirements of planes powered by 2nd generation CFM56 engines (the source of the parts) have been very modest and, given their relatively young average age, unlikely to accelerate.  In all, management forecasts HSD growth in CFM56 shop visits from 2022-2030 and an increase in revenue/visit.

The aftermarket business model will evolve in the future.  With the LEAP engine, Safran is changing from its historic time and materials model to service contracts:  42% of LEAP orders to date have a Rate/Flight Hour agreement and management believes this will rise over time to 60-70%. It should become material by 2026.  On balance I think this is a net positive:  The cash flow dynamics are better and potentially the overall profit opportunity is larger given the larger scope of work (though margins may decline).  Also, management noted that they will be very conservative in recognizing profit on these contracts.  

Eight years passed from announcement of the LEAP engine to first commercial flight in 2016 and it is likely that the next generation will take at least as long.  CFM has not announced a new engine, but rather a technology program with a goal of demonstrating, by 2025-26, an engine marketed in 2035 with 20% fuel savings versus the LEAP (30% for the entire aircraft) and capable of using 100% sustainable fuel.  This will be a very expensive undertaking and Safran rightly seeks to maintain a conservative balance sheet to fund it.  Moreover, it is critical for the company to maintain technological equality/superiority.  And if 2035 is the actual year of the next generation planes/engines, it means the LEAP should be a very profitable program well into the 2040s.  

Balance Sheet/Cash Flow:

Safran has a strong balance sheet and generates abundant free cash flow.  Management forecasts reaching a net cash position in 2023 and generating substantial free flow--targeting a conversion ratio of 70% of EBIT to cash, better than historic levels.  Major acquisitions are highly unlikely and it is possible that the company may sell pieces of Zodiac, the almost €9 billion company acquired in 2018, as 30% of the company was deemed non-core at the investor meeting last week.  The payout ratio is slated to return to 40%. Safran did repurchase stock in 2018-19 and I believe repurchases will be on the table again in a year or two when management gains further confidence in the recovery.

Risks/Concerns:

–Slope of the recovery in air traffic.  

–I have limited access to sell-side research but some estimates seem quite high.

–By management’s account, the impressive margin recovery 

targeted by 2025 (16-18%; I think that’s conservative) is skewed more to the 24-25 period.

–Potential for mispricing of LEAP service contracts.

Further Reading/Other Thoughts:

The deck from last week’s Capital Markets Day.  I didn’t cover major parts of the company as I think about 80% of the overall value is in the engine business but can try to answer questions.

Catalyst

Steady improvement in air traffic and profit margin recovery.