Description

Situation Summary

Triumph Group (“TGI”) is an aerospace supplier that is nearing the end of a significant multi-year turnaround led by Dan Crowley and his new management team. The Company recently announced it is pursuing strategic alternatives for its previously struggling Structures division now that management has restructured the segment’s operations by renegotiating or exiting multiple negative margin programs. In recent years the Structures division has masked the profitability of Triumph’s other segments and we believe the market does not yet realize the full earnings potential of Triumph should the Structures division be sold/spun while also underestimating what valuation Triumph will receive for the Structures division if a sale is successful. We believe Triumph is worth over $50 per share, representing over 100% upside from today’s share price should the Structures division be sold within the next year as we expect.

Our investment thesis is predicated upon the following:

1. We believe management will be able to achieve the margin targets set out on their recent February earnings call for both the Systems and Product Support segments as the benefits of the restructuring efforts begin to flow through the P&L over the next two years

2. The multiple should expand over time from Triumph’s historical “Structures multiple” (SPR is the comparable) to a “Systems multiple” (UTX is the comparable). Once Structures is divested, we believe the new Triumph will have significantly higher ROIC, stable topline growth and generate significant excess free cash flow, but that isn’t easily apparent using the current consolidated financials

3. We believe the Structures segment has been “fixed” and the margin targets set out for this segment on the February earnings call are achievable. Investors and analysts do not appreciate the negative margin impact of multiple large programs that have now all been renegotiated in the last 18 months (namely the G650, G280, E2 & Global 7500 programs). As the last negative margin programs roll off over the next 12 months, the healthy margins on existing mature programs will become apparent. The margins of the broader Structures segment will move higher just by removing the negative margin programs from the mix

4. The Structures assets have significant value. There are a limited number of Structures suppliers globally and very few new platforms being developed which makes organic growth difficult. Triumph has been able to recently secure content on multiple new military programs that will ramp over the next few years including the TX Trainer (a multi-decade military fighter program), the Air Force’s 767 Tanker (which begins ramping this year) and the MQ-25 among others which are all higher margin and valuable programs. While these military programs slowly ramp, the commercial programs that will remain are expected to continue stable monthly production volumes and generate positive cash flow which makes Structures attractive to a buyer

Background

For over 20 years TGI grew steadily via acquisition of small aerospace suppliers. It did this using a HoldCo model which allowed the companies it acquired to remain independent. This model was attractive to sellers as their company would remain relatively unchanged once they joined the broader Triumph Group. It also allowed Triumph to grow aggressively via acquisition without having to pause and integrate operations. This model worked until Triumph made the decision to acquire Vought from the Carlyle Group in 2010 for $1.6 billion. At the time, Vought had approximately $1.9 billion in revenues and this acquisition more than doubled the size of Triumph while adding significant debt to the balance sheet. Post the Vought acquisition, Triumph Group reported its financials as three primary segments: Structures (mostly Vought), Integrated Systems, and Product Support. But these labels were misleading as these three segments consisted of 47 independent companies with minimal operational overlap.

Part 1: What Will the New Triumph Look Like?

Most of the recent narrative and sell side literature for Triumph relates to their Structures division which is now being divested (described in detail in Part 2 below). However, it is the highly profitable Integrated Systems and Product Support segments that do not get enough attention and make Triumph an attractive investment opportunity. Based on the press release announcing the strategic alternatives review, TGI expects to keep the Integrated Systems, Product Support and Interiors businesses going forward (together referred to here as the “RemainCo”). These assets have the potential to earn +20% EBITDA margins while generating stable and predictable free cash flow on a diversified group of commercial and military platforms. The strong cash flow profile of these businesses isn’t apparent in their current quarterly consolidated financials since the Structures segment has historically absorbed all of the cash flow these segments have generated (and more).

The largest segment that will remain is the current Integrated Systems segment. This will become the core of Triumph going forward and will generate over 50% of the RemainCo’s sales and EBITDA. The Integrated Systems segment specializes in complicated, high precision assemblies and sub-assemblies such as landing gear and helicopter rotors. Many of these parts are sole sourced from TGI and suffer from wear and tear over time, which also provides Triumph with higher margin aftermarket work, though this aspect of the business is less well known. Integrated Systems has significant intellectual property on its products and provides content on some of the largest and fastest growing aerospace platforms such as Boeing’s 737 & 787 programs or Airbus’ A320. Integrated Systems also has significant military exposure which tends to have higher margins than commercial programs (F-35, AH-64 Apache and CH-47 Chinook helicopters, etc.) According to the proxy filed in May 2018, Integrated Systems generated $163 million of unlevered free cash flow for FY2018 (proxy for most recent fiscal year not yet filed). The annual proxy is the only filing where the free cash flow for each segment has been disclosed as the management teams that lead these segments are partially compensated on cash flow generation, and this is discussed in detail as part of the annual executive compensation discussion (chart from May 2018 proxy copied below).

The Product Support segment is much smaller than Integrated Systems, but earns equally strong margins and is a potential avenue for growth going forward should Triumph decide to pursue growth via acquisition again in the future. This segment specializes in Maintenance, Repair and Overhaul (“MRO”). This segment has facilities across the globe and contracts with some of the largest fleet operators for their ongoing maintenance requirements. End demand for this segment is tied directionally with miles flown as aircraft are required to get regular maintenance by regulators. According to the proxy filed in May 2018, Product Support generated $44 million of unlevered free cash flow for FY2018 (chart from May 2018 proxy copied below).

Lastly, the RemainCo will have Interiors. This segment is less well known as it is currently embedded within the broader Structures segment and wasn’t really discussed until recent earnings calls. The press release indicates that management intends to keep this asset and we don’t know much about it (yet). Management has communicated to the sell side that this business is roughly the same size and profitability as Product Support. Given management has decided to keep this business we can only assume it has an attractive ROIC and similarly attractive free cash flow profile (in the numbers below I assume Interiors is a copy of Product Support for now).

What is the earnings power of RemainCo?

The numbers below are based on the most recent quarterly investor presentation where management provided longer-term margin targets by segment for the first time as well as new pro forma financials to adjust for the small divestitures that closed in calendar Q1’19. We are assuming Interiors is the exact same as Product Support for now. Combining the three segments and using management’s margin targets for FY2021 (FYE 3/31 or ~2 years away) allows us to easily piece together what the RemainCo will look like.

The following slides are copied directly from the most recent February quarterly investor presentation. The assumptions that require management clarification are listed below while others such as segment D&A and Amortization of Intangibles for future years can be found in the 10-K. Key assumptions:

• We are assuming corporate overhead for the RemainCo is equal to 3% of total sales (i.e. some corporate overhead is tied to the Structures segment and those costs will leave with that segment while others will stay behind with RemainCo)

• All current pension related items are going with Structures as our understanding is that most of the pension is tied to that segment based on prior disclosure but given Interiors is embedded within Structures, a small amount of pension may stay with RemainCo

• Interest expense will vary based on proceeds received for Structures division but you will see in the sensitivity below that even if they received nothing for the Structures division and interest expense remains at current levels (~$100mm), the stock is still worth materially more than where it is today

• Current NOLs will stay with RemainCo (and Structures will likely be sold at a loss, potentially increasing the NOLs, therefore RemainCo will not pay cash taxes in the near term)

Taking these numbers above and combining them into a pro forma income statement for the RemainCo is very straightforward. The segment free cash flow disclosure in the proxy statement (copied above) gives us a good sanity check that confirms the free cash flow for RemainCo should be over $200mm or $4.00 per share (~20% free cash flow yield at today’s price of $23.78 for a top tier aerospace supplier).

What Multiple Should RemainCo Trade At?

Historically Triumph has traded in line with its Structures peers (SPR and TXT are highlighted in orange below) since Structures was roughly half of TGI’s revenue (though it generated much less than half of EBIT). Given the majority of RemainCo going forward will be tied to Integrated Systems, its closest peers are likely Hexcel (HXL) or United Technologies (UTX) (highlighted in yellow). We are assuming TGI initially trades at 15x EPS which is slightly below peer levels given it is not pure Systems company, though over time we expect it to trade closer to 18x given the free cash flow profile.

Aerospace Comparables as of 4/30/19

Target Share Price

Combining the two and sensitizing both EPS and PE multiple gives us a range of outcomes where the stock price is materially higher than today in all cases. We have sensitized the EPS given the unknowns around the ultimate price RemainCo will receive for the Structures assets (i.e. how much debt gets paid off) and given we do not know with certainty what an appropriate corporate expense level will be.

The most important takeaway from the sensitivity analysis below shows you that even if Triumph were to “give away” the entire Structures division like they did with the struggling Global 7500 program in January and interest expense remained at current levels (leaving EPS at the lower end of the sensitivity range), the stock would still be worth much more than where it is today if the market is simply willing to apply a “normal” multiple to TGI once the Structures assets are removed. That being said, we believe Triumph will receive significant value for Structures for the reason’s laid out below.

Part 2: What is Structures Worth?

Structures Background

Post the Vought acquisition, Triumph’s stock reacted very positively and went steadily higher over the next few years. However, behind the scenes things quickly began to sour at Vought (now known as Structures) and it soon became evident that some of Vought’s major platforms were nearing the end of their life sooner than expected due to falling demand (Boeing’s 747 for example). A depressed business jet market, driven by a glut of used inventory, also caused Gulfstream to slow production on its G450 & G550 models and lastly, the large C-17 Globemaster military transport plane reached end of life when the military decided it had enough of those massive planes. These programs were some of Triumph’s largest and most profitable programs given the amount of content TGI produced for each plane and as well as how mature each program was (they were fully up the learning curve and earning healthy margins). Taken together, this meant revenue and cash flow at Triumph’s Structures segment were at risk of collapsing.

Given aerospace has multi-year backlogs, management could see some of this coming. They aggressively bid for content on any new program that became available (there weren’t many). TGI’s experience with major wing structures as well as business jets allowed it win major new content on the new Embraer E2 and Bombardier’s Global 7500 programs (then called the Global 7000). They also acquired two struggling Gulfstream business jet programs from Spirit (the programs were so bad that Spirit paid Triumph to take the G650 and G280 programs.) If everything went to plan, the legacy programs would fund the development of the new E2 and Global 7500 programs before volumes stepped down and management would be able to turnaround the G650 and G280 programs using their prior expertise on other Gulfstream programs. This would allow Structures revenue to stabilize and continue to generate significant cash flow for Triumph well into the 2020s.  

Unfortunately things did not go according to plan. Volumes on existing programs dropped faster than expected. Monthly production volumes on the 747, 777, C-17, A330 and Gulfstream G450/G550 programs all fell concurrently causing revenue, EBITDA and free cash flow to step down materially. At the same time, the E2 and Global 7500 development programs were taking longer and burning a lot more cash than initially planned, leaving TGI in a position of declining EBITDA just as cash flow needs for the E2 and Global 7500 were growing. If something wasn’t done, TGI would face a significant liquidity crunch.

The Turnaround

In 2015, the severity of the situation was becoming apparent to Triumph and they sought out a new CEO that could restructure the Company, turn around operations and get Triumph out of the penalty box with its major OEMs. Dan Crowley was appointed in January 2016, and he set out an aggressive 3-year turnaround plan. Dan set out to blow up the prior HoldCo model, consolidate operations, significantly cut headcount, divest non-core assets and improve operations and quality so sales could begin growing again. He hired Jim McCabe as CFO who had significant turnaround and restructuring experience and they replaced the entire upper management team across all three segments. Together the new team set out to “fix” Triumph by consolidating operations and streamlining the supply chain. This turnaround that the new CEO laid out when he arrived over three years ago is now largely complete, and the physical transformation is evident based on the most recent quarterly investor presentation (copied below). However, the real key to the turnaround was stopping the cash burn on a limited number of “problem projects” that were burning cash, namely the E2, Global 7500, G280, G650 and 747 programs, though this wasn’t apparent at first.

Structures Overview

The Structures segment primarily manufactures the large external aircraft “pieces” of an aircraft that you see as a passenger such as wings, nacelles, empennages, etc. Structures work is arguably the least attractive type of work within aerospace as it has minimal aftermarket work and limited intellectual property which leaves TGI with limited leverage when Boeing comes knocking for a price cut. Structures programs require significant upfront investment in tooling and inventory before the program ramps, but once you are up the learning curve TGI can earn decent margins for decades since switching suppliers is difficult for an OEM and the lifespan of many aircraft is over 20 years. Conversely, for this same reason it is very difficult for a firm like Triumph to find new work on other platforms when mature programs reach end of life.

What most investors and analysts don’t seem to appreciate (yet) about the Structures segment is that the whole division is not “broken.” The recent margin profile for the segment is not the margin profile Triumph is earning on every program and many of these older “midlife” programs were earning healthy margins long before Triumph ran into its recent issues. The situation within Structures is very similar to a small retail company where most of its stores are earning normal EBITDA margins but it has a few large stores with negative EBITDA that are dragging down the whole company. If management were to just close the money losing stores, EBITDA would suddenly improve without actually having to do much to improve operations. This is basically what has happened at Triumph’s Structures division.

Margins have been significantly depressed due to the problem projects discussed below but this isn’t easily apparent because management hasn’t laid this all out in a single slide for investors. However, based on quarterly investor presentations and transcripts since the new CEO arrived, we can piece together the severity of the situation on certain programs. Importantly, these problem programs have all been renegotiated in the last year (TGI has issued a press release discussing each one) and these programs will no longer be a drag on Triumph going forward. We believe this is the basis of the new FY2021 margin targets that management disclosed on its February 2019 earnings call and why we believe the targets are achievable. These are not stretch margin targets five years out, they are margin targets less than two years out. By simply taking the negative margin programs away, the positive programs will begin to shine through. For this reason, we believe the Structures segment is worth more to a potential buyer than investors expect. The CEO and CFO have highlighted this fact on multiple occasions:

Jim F. McCabe (CFO) – May 10, 2018 Earnings Call:

“So Triumph's margins reflect the mix of programs that we have today. And some of our larger programs like 747, Global 7000 and, in past, G650 were not generating margin. And so overall company margins have been temporarily depressed. Now as we fulfill our contract obligations on 747, and as we convert Global 7000 from development spending and early production losses to crossover breakeven and profitability, and now with our new contract settlement on 650, all of those headwinds either abate or reverse”

“Problem Program” Specifics

Despite the significant efforts that TGI’s management team has made to streamline TGI as whole, the real key to the turnaround was stopping the cash burn on a handful of Structures programs. The problem with aerospace programs is that they are typically fixed price. If you priced the work wrong when you first bid for it, you can find yourself losing money on every part you ship (G650 & G280). Alternatively, if development takes longer or ends up costing more than expected, you can find yourself taking a very long time to get back to breakeven (E2 & Global 7500). Lastly, when you are on a program that is nearing end of life like the 747 Jumbo Jet, volumes fall and the operating leverage works against you, but you are stuck producing at whatever rate the OEM sets which can make programs very expensive to wind down.

We believe most investors are not aware that the majority of Triumph’s problems have been tied to the following few programs. Instead, investors are looking at the consolidated margins and assuming everything within Structures is broken. Without going into the long history of each troubled program, all a new investor needs to understand is that Triumph was burning massive amounts of cash flow on these negative margin programs and that is why margins within Structures have suffered in the last few years. Critically, all of these programs have been renegotiated or exited and now cash flow and margins will begin to return to historical levels as these programs roll off.

“Problem Program” Specifics:

G650:

• Acquired from Spirit as part of the Tulsa program acquisition (SPR paid TGI to take it)

• Prior management thought they could fix this but could not. Program continued to burn cash for TGI as it did under SPR

• Approximately $100mm in negative cash burn in FY2018

• Source: Dan Crowley (CEO) November 08, 2018 earnings call: “because of the negotiations last year with Gulfstream, you know, we swung that program from a cash user approaching 9 figures to a cash positive program this year”

• Restructured in April 2018 and will be positive EBITDA in FY2020 per transcripts (this year)

G280:

• Acquired from Spirit along with G650 as part of Tulsa program acquisition (SPR paid TGI to take it)

• Like the G650, prior management thought they could fix this but could not. Program continued to burn cash as it did under SPR (though management did manage to improve the cash burn but couldn’t get it positive)

• Approximately $30mm in negative cash burn

• Source: Management has recently disclosed to sell side analysts that this program was burning ~$30mm in FY2019

• Restructured in April 2019. Unclear based on press release what timing of wind down will be but likely calendar 2020 if it is like the G650

E2:

• Won the work from Embraer. Bid incorrectly. New management determined it would only generate roughly breakeven margins once program ramped but would take up critical manufacturing capacity that they could use on new programs

• Negotiated new deal with Embraer to give the work to Korea’s ATSK who was a sub-contractor for TGI (lower cost location)

• Tens of millions in negative cash burn. Less than G280 but specific amounts unknown

• Source: Development costs detailed in quarterly presentations and quarterly filings

• Restructured in 2018 and details finalized in April 2019. Margin lift in FY2020 once program has been exited

Global 7500:

• By far the biggest issue TGI had as part of the turnaround. Almost 8 years of investment and spend by TGI

• Management decided it was no longer willing to invest its capital and cash flow behind this program and gave it back to Bombardier in January 2019

• Over $200 million spent in each of the last two years (detailed in quarterly investor decks and quarterly filings)

• Source: Pro forma financials were provided in an 8-K filed in February 2019 post earnings. Cash flow drag for the program was disclosed frequently in quarterly investor slide decks and quarterly filings

• Negative drag from this program no longer impacting TGI as of January 2019. Immediate margin lift based on February 8-K

747:

• TGI’s contract with Boeing should end in 2020 based on current build rates. Building will be returned to the land lord with some closure costs once last wing set is complete per recent transcripts

• We believe this is currently burning $50mm per year and that will end in calendar 2020

• TGI renegotiated the build rate on this program in May 2017. Program will sunset naturally and is almost done

If you combine these programs together, at their peak they were burning over $400mm of free cash flow per year (FY2018) but is now aggressively stepping down to zero on programs they are exiting or will be positive margin on those they are keeping (G650). These programs were pulling down margins significantly (though some cash flow burn was tied to working capital or capex). By pulling these problem programs out of the Structures division’s historical financials, you can see a profitable core business and begin to understand the basis for management’s recent margin targets.

Structures Healthy Programs

With the problem projects each resolved and winding down, Structures is now a very basic business to understand since ~75% of revenue is tied to just 10 programs and these programs are isolated within less than 10 manufacturing facilities (some of the facilities produce content on only one platform and are highly specialized). The medium term outlook for these remaining platforms outlined below are healthy and well known by the market given regular guidance from the OEMs making it easy to track. Importantly, based on management’s recent commentary it is clear that this remaining set of programs will be cash flow positive.

Structures Financials – How Much Can it Make?

The financials below are based on the most recent quarterly investor presentation. We are assuming the Interiors business is the same as the Product Support business as discussed above. By pulling the Interiors piece out, we are left with what we believe is the asset that is ultimately sold (comprised of Composite Components, Military Structures, and Commercial Structures sub categories).

What is Structures Worth:

This analysis assumes Structures and all related liabilities are sold as a single unit to simplify the discussion. However, as management seeks to maximize value, we believe management will also look to divest the composite components, military structures and commercial sub-segments in a piecemeal fashion to maximize value (similar to how they have divested assets to date). Given the strong financial condition of the RemainCo, we believe they could also choose to keep the last two problem projects (G280 & 747) out of the divestiture process given production will wind down within next 18 months and let the RemainCo absorb any small losses until the programs end by calendar 2020. The benefit of either of these strategies will be to allow potential buyers to focus solely on the good programs within Structures and not taint the story or multiple. That being said, should TGI opt to sell Structures as a single piece with all liabilities associated with it, we believe based on the analysis below that Structures is now strong enough to stand on its own two feet and for this reason is more valuable than investors realize based on the cash flow profile below.

Lastly, TGI was able to recently divest a group of Structures assets that generated minimal EBITDA and cash flow for over $200mm. These assets were commodity machine shop type work with low margins and minimal free cash flow and yet TGI was able to sell these at a sales multiple of ~0.7x ($220mm per most recent earnings call for approximately $300mm of revenue). The remaining Structures assets that TGI is looking to sell will generate $1.2 billion of sales and if they were to receive a similarly depressed multiple then the assets would be worth over $800mm. However, we believe Structures should be valued at a much higher multiple given the remaining programs are cash flow positive and hold much more strategic value to certain buyers.

Key Assumptions:

• Structures P&L based on what remains after pulling Interiors out of segment per above analysis (“Core Structures”)

• Corporate overhead assumes Structure’s takes its share of corporate expense not allocated to RemainCo above (PE buyer likely needs some overhead, strategic buyer would cut this expense)

• Assumes Structures pays cash taxes going forward but depending on structure of TGI’s current NOLs this may be too punitive

• Assumes the entire pension goes with Structures and current cash annual payments remain around current levels

• Customer advance repayments are based on the details provided on the February 2019 earnings call

• The Boeing specific advance discussed below was received last quarter and is broken up over next 3 years but the exact timing of these repayments are unknown (appears not to have been finalized as of the last earnings call based on transcript)

Based on the cash flow profile above, by the time the Structures sale process is completed and regulatory approvals obtained (assumed to be one year from now), Structures will be generating ~$150mm of EBITDAP with a clear path to positive free cash flow. Applying a 6.0x - 8.0x multiple to the business would create a TEV of ~$900 million to $1.2 billion. Importantly, the business is generating positive free cash flow even after paying pension and working capital repayments. We believe it is too punitive to assume they only receive the same valuation for these Structures assets as they did for the commodity machine shop assets which were recently sold (i.e. 0.7x sales multiple is just too low).

What Will They Do with the Proceeds?

The recent cash flow burn of the development programs, particularly the Global 7500 has caused Triumph’s debt levels to steadily grow over the last few years. Had these programs not been restructured and cash burn continued, TGI would have faced a significant liquidity crunch. That risk is now behind the Company and any proceeds received we believe will be used to deleverage. The capital structure as of 12/31/18 is presented below. However, two large asset sales completed in Q1 will provide Triumph with an additional $220mm of proceeds that will be applied against the revolver. Any remaining proceeds that Triumph receives we assume will be used to pay off the two tranches of senior notes due in 2021 and 2022, respectively.

Triumph also has a pension obligation which is primarily tied to its Structures division. While this pension obligation is large at first glance it is worth highlighting that the pension requires limited annual cash flow obligations and the pension is “burning off” relatively quickly (~$18mm per quarter despite minimal cash requirements). At this rate, we estimate the pension obligations will be approximately $338 in one year when we assume a deal is closed using the current quarterly decline rate. In the scenario below we are assuming all of this liability goes with the Structures division however it is likely that a) some pensions are tied to the Interiors segment and b) some of the assets that were divested in Q1 may also have had pension obligations tied to them which would further reduce the liability. Until the 10-K for FY2019 is published the specifics around the pension will not be fully known so for now we are assuming the buyer fully assumes the obligation and deducts this amount from the TEV which may ultimately be too punitive.

Pulling it all together

• We believe the Structures assets will be sold for over $1 billion for the reasons listed above. These proceeds will significantly lower TGI’s current debt of $1.4 billion leaving RemainCo unlevered

• We believe the RemainCo can earn $3.00 - $4.00 of EPS and over $4.00 of FCF per share

• The RemainCo is a highly attractive asset that should trade at a premium multiple based on its ROIC and free cash flow profile

• Together, we believe Triumph shares are worth over $50 (and potentially much higher) once the Structures division is divested

Conclusion:

Triumph has been struggling since 2014 when volumes began to decline. Since then, the name has fallen out of favor with sell side analysts, leaving it poorly followed and misunderstood. While management has been telling investors exactly what is going on, it appears that no one is paying attention, as the historical and pro forma numbers presented above are all sourced directly from Company filings, earnings presentations and transcripts of past earnings calls. We believe at current prices, the risk/reward for an investment in Triumph is skewed heavily to the upside with the Structures sale being an obvious catalyst within the next twelve months. Should the sale be successful, investors will be left with a top-tier aerospace supplier led by a highly-capable management team with a proven operational track record given the herculean effort that has been required to turn the Structures division around over the last three years.

Catalyst

• Divestiture of Structures segment within next 12 months
• Incremental details around Interiors next 6 months
• Pro Form Financials of RemainCo next 6 months
• Analyst day post Structures divestiture in calendar 2020