It may sound contradictory, but Wall Street is often both predictive and reactive. To that end, the stock of carbon fiber specialist Hexcel (NYSE:HXL) has done pretty well since 2009 on the basis of investor expectations for more composite material content in commercial aerospace. At the same time, though, it's well worth remembering that Hexcel has struggled to deliver consistent, impressive margins and returns on capital. If Hexcel can't find a way to establish better peak earnings and cash flow potential, it may be difficult for these shares to outperform.

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

Investor Day Highlights - Still Big on Potential, but Also Uncertainty
Hexcel tells a good story about the future demand for its advanced carbon fiber, prepregs and engineered components. But then, in the 15-plus years I've followed this stock (having owned it in the late '90s), telling a good story was never the problem. The issue was, and is, balancing the potential of advanced materials to deliver value for customers (lower weight, good strength-to-weight ratios and so on) and also deliver value for shareholders, as rivals build out capacity and try to manage the demand-capacity balance.

To that end, Hexcel management's guidance for earnings and earnings growth seemed a bit familiar. Next year isn't going to be quite as strong as sell-side analysts had hoped, but management is bullish on the long-term future for the company.

The midpoint of management's guidance for 2013 revenue ($1.69 billion) is a very modest shortfall relative to the prior sell-side average of $1.71 billion, and the midpoint of EPS ($1.72) is likewise only a bit below the prior average ($1.75). More impressive, though, was the company's projection of $2.5 billion in revenue for 2017 (implying about 10% compound growth from 2011) and incremental operating margins of 23% or better.

SEE: Can Earnings Guidance Accurately Predict The Future?

Commercial Aerospace Is Sold, but What About Other Industries?
The commercial aerospace sector is sold on the benefits of carbon fiber and other advanced materials, and both Boeing (NYSE:BA) and EADS (OTC:EADSY) continue to increase the percentage content of advanced materials/composites in their newest designs. While there has apparently been some push-back on price, this nevertheless remains a solid growth opportunity as the major builders work through their large commercial backlogs over the next decade.

Not so solid, though, are the non-aerospace applications. Wind power has emerged as a big user of composites, and Hexcel counts Vestas (OTC:VWDRY) as one of its largest customers. Unfortunately, while Vestas has a sizable backlog, they're not faring well in this wind power slump, and Hexcel management believes wind power could be down 15 to 20% next year. Though the company is working to build its business with other wind power players like General Electric (NYSE:GE), what Hexcel really needs to see (in my opinion) is greater adoption of carbon fiber and advanced composites from the auto and consumer goods industries.

For Hexcel's other major business category, space/defense, we'll have to see what happens. Hexcel counts major players like Boeing, Lockheed (NYSE:LMT) and EADS among its customer list, but it's an open question as to how major aircraft/rotorcraft programs will fare under new federal budget realities. At the same time, I wonder if Hexcel can do more to generate interest from satellite builders, as Euroconsult has made some pretty bullish forecasts for satellite build rates over the next decade.

Competition Still Concerns Me
It's never been easy to make steady high returns on capital in the specialty materials/components business, and one of my biggest concerns is that that is not about to change. Rivals like Cytec (NYSE:CYT) do limit Hexcel's price power, and I'm not sure that the company has enough unique/differentiated capabilities to really drive high sustained returns. Along those lines, I also wonder if Hexcel would make more sense as part of a larger, more diversified supplier of components and specialty materials, but that's a discussion for another time.

SEE: Evaluating A Company's Management

The Bottom Line
My biggest concern with Hexcel has to do with valuation. While I'm not bothered by the company's current EV/EBTIDA ratio, the long-term cash flow model is another story. Even if the company hits management's target for 2017 revenue, the company needs to produce free cash flow at a rate more than double its previous highs (as a percentage of revenue), and on a sustained basis for many years, to generate a fair value in line with today's price ... let alone leaving much upside to the shares. In my mind, that's a very bold and bullish outlook, and one I'm not willing to bet my own money on today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  2. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  3. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  6. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  7. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  8. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  9. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  10. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!