Will This Aerospace Cycle Finally Let Hexcel Take Off?

By Stephen D. Simpson, CFA | December 14, 2012 AAA

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.

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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.

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