Hexcel Corp. (NYSE:HXL) is a leader in the production of advanced material technologies, primarily carbon fiber composites.
The company's light-weight, high-performance structural materials are used on virtually every commercial and military aircraft produced globally (Airbus (XPAR:AIR), the company's largest customer, accounts for roughly 40% of its revenue).
The company is vertically integrated from raw materials through finished parts, using roughly 70% of the carbon fiber it produces internally. In addition, as CEO Nick Stanage noted at the 2019 Investor Day in July, "many of our positions are sole sourced and there are significant barriers to entry." The result is a limited set of direct competitors for Hexcel.
The solutions it provides to customers are lighter, stronger and more durable than metals like aluminum and titanium. The benefit to the end customer (airlines) is reduced weight, improved fuel consumption and lower emissions.
Stanage also commented on the appeal of the Hexcel's products:
"What is the attraction to composites? Pretty straightforward, it's five times stronger than aluminum. It's 30% lower weight than aluminum. It's tougher, it's stiffer, it's more durable, it doesn't corrode. It basically provides the end customer life of the vehicle products and ultimately lower life cycle costs. When you take into consideration maintenance and inspection intervals, it provides a lower cost solution. That's why."
As a result of these advantages, adoption of composites has consistently increased over the past 40 years (from a mid-single-digit percentage to more than 50% for models like the A350):
Source: Hexcel Investor Presentation.
As noted in the graphic above, shipset value (the dollar amount of composites content per aircraft model) has consistently increased in recent decades. In addition, while there are now aircraft that are primarily structure composite (greater than 50% by weight), they are less than 5% of the commercial fleet globally. As penetration increases in the years and decades to come, Hexcel will have a steady source of revenue growth to rely upon. At its 2016 investor event, management from Hexcel competitor Solvay (XBRU:SOLB) said that "50 - 60% composites is kind of a natural point where value diminishes," implying there's a cap to composite penetration that's not much above what's being provided on the newest aircraft models.
Jumping to recent results, Hexcel has delivered strong numbers as of late. In 2018, adjusted earnings per share increased by 14%. And in the first half of fiscal 2019, revenues and earnings per share increased 12% and 25% (operating margins expanded by roughly 150 basis points over this period, along with a nearly 5% reduction in the diluted share count).
But there's reason to believe these growth rates are unsustainable. For example, we're already near peak build rates on the A350 and the 787 (those programs collectively account for roughly one-third of the company's revenue). As a result, it is expected that recent growth rates will start to level off (Goldman Sachs analysts estimate the commercial aerospace segment, which accounts for roughly 70% of Hexcel's revenue, will grow 2% to 3% per annum between 2020 and 2023).
In addition, as noted in the 2018 shareholder letter, the company may see outsized capital expenditures. The company wrote, "Beyond 2020, we see multiple opportunities... that likely will lead to our next investment cycle." While these investments expand Hexcel's leadership position and support long-term growth, they are a short-term headwind to free cash flow generation, which impedes its ability to repurchase shares.
Finally, the company's leverage ratio is currently at the ceiling of the targeted range. As a result, we are unlikely to see a benefit from incremental leverage going forward.
As a result, earnings per share growth may suffer in the near term, at least relative to what investors have come to expect as of late. (To be clear, I'm not saying that's a bad thing, particularly on the slowed pace of repurchases due to organic investment in the business.)
This business will continue to benefit from long-term secular growth in air travel and composites penetration. Increasing content on next-generation aircraft will materialize as backlog becomes deliveries. I don't currently own the stock, but would like to at the right price. I hope Mr. Market will be a friendly fellow and give me an opportunity to do so.
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