Description

Senior is a Tier 1/2 supplier to aerospace and land vehicle OEMs, as well as industrial clients in healthcare, chipmaking and energy. Boeing and Airbus are critical clients and the 737 MAX is (was?) a core platform in its pipeline. Shares are -66% YTD and -82% from the 2018 highs as the outlook has turned bleak for civil aero delivery volumes.

There’s no doubt Senior’s intrinsic value has been impaired as a result of both the MAX grounding and COVID-19, but -82% is throwing the baby out with the bathwater. Senior is a well-managed business with less than 50% of its earnings coming from civil aerospace. The company is moderately levered and was actually cash generative during the first 6 months of 2020 despite sales declining 30% and margins being “significantly lower” (1H results were pre-announced July 10th). Liquidity is strong and Senior remains a scale player in sectors that are likely to see consolidation. Even if civil aero is permanently impaired, Senior will still be able to generate >10p/share in cash earnings and convert >100% of this into available cash flow. 58p/share appears too cheap.

Business Overview

Senior designs and manufactures specialized components for OEMs in the aerospace, defense, vehicle and power sectors. It has two reporting divisions: (1) Aerospace at ~70% of sales/EBIT and (2) Flexonics at 30%. Across these two divisions are two technological themes for which sales are split 50/50: (1) flow-control and (2) structures.

As a generalization, it’s fair to think of the ~33% of the business that is “aerostructures” as build-to-print work that is low margin and highly competitive -- not an attractive business. The 50% of the business in fluid conveyance represent design-&-build products where Senior owns the IP, often for complex flow control systems that are spec’d into a design and therefore sold for the life of the platform. There is minimal aftermarket revenue across the two divisions. Historically Senior has earned 15% EBITDA margins and converted this to FCF at up to 50% rates, although cash conversion post capex has been low in recent years as Senior invested in capacity expansion to support its 7.5% revenue CAGR over the last decade.

Sales by end-market are broken down as follows:

Management has acknowledged that the ~33% of sales in aerostructures is challenged due to industry oversupply and constant margin pressure from OEM clients. In late 2019 they announced plans to divest this division, and media rumors suggested a £450m price tag (11x-12x EBIT) with multiple interested bidders. A sale appeared imminent before COVID-19 derailed the process. For now it remains with Senior, although a disposal someday is likely.

Within the Flexonics division, 2018-19 were already extremely difficult periods due to a recessionary environment for Truck & Off-highway vehicle sales. Within the Flexonics division sales declined 15% in 2019, dragged down by a 26% decline in sales to vehicle OEMs. Management have stood behind this division throughout, divesting dilutive business lines, lowering the cost base and pointing to the high ROIC generated by these IP-rich products. Margins have remained stable at 9% despite the revenue declines, and should be able to return to low-teen levels with any end-market demand growth.

The future value of the firm lies in flow control for fluid and thermal conveyance. Senior is considered a global leader in ducting solutions and bellows, which are critical components of turbine engines, ICE and EV heat exchangers, and industrial equipment. Prior to Covid-19 the narrative was on how Senior would deploy excess capital to expand into higher margin and higher growth Flexonics end-markets. The attempted sale of aerostructures was meant to accelerate that process.

But for now there’s no avoiding the impact of both the MAX grounding and COVID-19. Prior to the pandemic Senior’s aero division had undergone a multi-year ramp-up of new shipset contracts, with 2019 considered an “unprecedented” peak year for the large number of transitioning platforms. Division margins went from 14.5% in 2014 to 10.6% in 2018 as high startup costs and low order volumes depressed profitability. The MAX production ramp-up in 2019 was set to address this, and management guided for division margins to expand sequentially over the next 3 years. But in 2019 Senior delivered components for just 57 MAX airframes, despite having capacity for 47/month. At an ASP of $267k per shipset, the revenue impact was moderate, but the margin impact was material, and Senior’s cost structure was suddenly years ahead of demand. They have since restructured to cut costs in anticipation of a long runway back to 47/month, but prior guidance of 13%-14% EBIT margins for the Aero segment have clearly been pushed out years. In 2019 this division generated 9% margins vs. averaging 13.5% over the prior decade.

The following table is periodically updated by the company. It provides shipset value, # of deliveries during the prior period, and estimated pipeline for each of the major airframes Senior is exposed to:

You can see that the MAX is a fairly low value platform for Senior, while the A350 and 777X are much higher. These contracts are a mix of life-of-platform and 5-7 year competitive bids, with incumbents typically winning rebids by offering sequentially better terms to OEMs. While it’s possible to do a bottoms-up calculation of Senior’s future earnings based on these platform level estimates, the last 12 months have demonstrated how volatile these future-looking estimates can be. The biggest takeaway from this table for me is that (a) Senior is broadly exposed to almost every major civil airframe platform, (b) Senior is evenly exposed to Airbus and Boeing, and (c) Senior’s ASP per shipset has trended higher over time.

Balance Sheet and Liquidity

Brief comments on the balance sheet and liquidity, both of which are fine:

Senior has pre-announced £155m of net financial debt at 1H20, with £162m of untapped revolver. This is a slight improvement over YE19 figures. THe company has received waivers for the 6/20 and 12/20 covenant tests and is eligible for the UK’s CCFF program. Even without these waivers it appears that Senior would not trigger its 3.0x net debt / EBITDA covenant this year, and operations during 1H20 generated a £3m cash inflow on tight inventory, capex and cost management. Long-term guidance is to maintain ~1.5x leverage, which Senior was well below pre-COVID.

The pension is fully funded and there are no major maturities until £120m in February 2024:

Some basic assumptions around civil aero demand going forward

• In 2018 the global fleet of civil airplanes was 25,830, of which 20,800 were >100 seat planes. The average age was 11 years.
• Boeing (pre-COVID) estimated that this fleet would double by 2038 to 51k thanks to 44k new deliveries: 25k for growth and 19k to replace retiring planes
• Assuming a 25 year life, this implies ~830 new planes/yr are required (at steady-state rate) just to satisfy annual retirements of >100 seat global fleet
• You can haircut this replacement demand estimate as you like to account for either the global fleet shrinking (unlikely) or longer useful lives due to fewer miles flown.
  

Valuation

Let’s assume civil aero won’t bounce back and that 4% growth into perpetuity is ridiculous. On the above assumptions, there will be long-term replacement demand for at least 830 planes annually. Let’s round this up to 1,000 planes/year to account for moderate growth over time in a “bear” scenario where global demand never returns to prior levels, but where underserved markets continue to grow. This is far below current TAM projections from Airbus and Boeing.

To calculate Senior’s exposure, consider as a crude estimate that in 2019 Airbus reported 863 deliveries and Boeing reported 867 planes made (fewer deliveries due to the MAX grounding), totalling 1,730 planes in a year when Senior booked sales of £618m in its civil aero division. This implies £357k per plane in revenue to Senior, which appears reasonable when compared with the company’s disclosed shipset values.

So in a low-growth world where only ~1,000 new planes are made annually, Senior should be able to generate ~£357m in revenue. Assume that lower volumes and OEM pressure means 10% EBIT margins is the best it can ever achieve (versus >14% historically). What multiple is that worth? 5x seems defensible, and is a 50% haircut to recent transactions within the ecosystem (i.e. Spirit’s acquisition of Bombardier’s wing facility, or Senior’s own rumored sale of this division 6 months ago). So maybe the civil aero division is worth £180m. Remember this is the least attractive division at Senior and in this projection is only 40% of group sales and 35% of group EBIT.

Military aero sales have been described by management as “growing” even in 2020 and should continue to generate revenue of at least £165m with 12% margins, which at 10x are worth £198m. Arguably 10x is low for a business whose products are engineered into shipsets with decades-long pipelines and government buyers. Peer suppliers to military platforms trade at much higher valuations.

Finally there is the Flexonics division, which is currently 2.5 years into a recession that could continue into 2021 if heavy vehicle demand doesn’t return. Let’s take management’s guidance from earlier this month that 2020 sales will be -27% and assume no recovery, but a gradual stabilization of margins to 10% on restructuring initiatives. That gives us £220m of (trough) sales and £22m of EBIT, which at 8x is worth £176m. Management would argue this division is much more valuable based on the IP at play, and the whole group has historically traded at 15x EBIT, suggesting investors familiar with the assets agree. Without technical familiarity, 8x seems comfortable.

These divisions together gives the following SOTP: £554m + £34m of dividends over 3 years, +£33m of excess cash generation = £621m less YE20 net debt of £150m = £471m of equity value / 419.4m shares = 112p/share

112p share translates into 13x NOPAT and a 10% FCF yield, for a business that will soon be <1x levered and that has a diverse collection of sticky product pipelines. On 2022 estimates this valuation assumes sales remain 25% below 2019 and EBIT remains 34% below. It will offer an 8.5% dividend yield on a moderately levered enterprise.

On June 4th the CEO bought 100k shares at 93p and on June 5th the Chairman bought 150k shares at 108p.

Also, Senior screens as a take-out target, with a digestible EV of <$500m, no controlling shareholder, no pension overhang and secured contracts on key airframes. A strategic or financial buyer willing to take a view that civil aerospace isn’t entirely dead would certainly look at Senior, which currently screens cheap against peers:

Risks

• Bad momentum and more financial kitchen sinking yet to come. At the 1H20 pre-announce, management flagged “significant non-cash reduction in the carrying value of certain intangible assets” at the half year results.
• Perpetual margin pressure from OEM clients, with a material subset of Senior’s business in fairly commoditized build-to-print “aerostructures” with lots of underutilized and irrational competitors.
• FX translation: 74% of EBIT is in USD and weak sterling has arguably benefited Senior’s reported financials. Mgmt guide that every 10 cent move in USDGBP impacts sales by £55m and PBT by £4m.

Catalyst

• Continued cost discipline leading to best-in-sector liquidity and last-man-standing status.
• Any positive news relating to MAX
• Any positive news relating to COVID-19 vaccine
• Ultimately, >15% FCF yields on still-depressed operations in 2022 should drive a rerating in the absense of any material good news.