Shareholders in airplane cabin manufacturer B/E Aerospace watched their stock rise more than 75% in 2013, so the recent sell-off
shouldn't come as a surprise. Unfortunately, stocks can't go in one
direction forever. The question facing investors now is whether the
recent fall presents a buying opportunity or not?
B/E Aerospace still headed for a great year
First things first, there was nothing in B/E Aerospace's recent fourth-quarter results to suggest that the company is not going to have a great year in 2014. Although, internal EPS guidance of $4.25 was below analyst consensus of $4.34, it still represents earnings growth of nearly 20%. Moreover, the International Air Transport Association, or IATA, recently upgraded its forecast for airline profitability in 2014.
First things first, there was nothing in B/E Aerospace's recent fourth-quarter results to suggest that the company is not going to have a great year in 2014. Although, internal EPS guidance of $4.25 was below analyst consensus of $4.34, it still represents earnings growth of nearly 20%. Moreover, the International Air Transport Association, or IATA, recently upgraded its forecast for airline profitability in 2014.
The industry backdrop looks positive. More airline
profitability usually means more spending on new planes and retrofitting
of older aircraft too. It's all good news for B/E Aerospace.
Growth initiatives
In addition, the company recently announced a number of growth initiatives:
In addition, the company recently announced a number of growth initiatives:
- A contract enhancement with United Technologies to supply fasteners, hardware, logistics, and consumables to its aviation units. B/E estimates the deal has a value of $950 million to 2022
- A contract with helicopter manufacturer AgustaWestland to provide logistics and consumables. The deal's estimated value is $200 million, and goes till 2018.
- Its modular lavatory system (shaped to create additional seating on planes) is now being shipped to Boeing with 14 Boeing 737s in service with the system. More growth is expected as Boeing's demand is expected to increase.
- In a departure from its core activity, B/E made two acquisitions in the oil and gas consumables market.
The contract announcements were obviously good
news, and the ramp up in lavatory systems shipments (the first system
was shipped as recently as the third quarter) is a confirmation of
strong demand for an exciting new product.
However, the move into the oil and gas consumables
market is more subject to scrutiny. When questioned on the conference
call, B/E's CEO, Amin Khoury, argued that the oil and gas consumables
services business is four times the size of its opportunity in
aerospace, and is growing twice as fast with similar margins. Moreover,
he sees it as reducing the volatility in the business, because prospects
for oil and aerospace are inversely related.
Unfortunately, this argument looks weak. The
reality is that airline profitability is cyclically based on the
economy, and the price of oil is too. Moreover, airlines have got a lot
better at dealing with high oil prices then in the past. All told, the
move looks likely to increase cyclicality rather than reduce it, but
this doesn't mean it is a bad idea!
Valuation, valuation, valuation
All told, BE is headed for a strong year, but the problem is that its valuation has largely priced this in. In order to look at the kind of assumptions made in its stock price, consider that BE only converted 61% of its net earnings into free cash flow in 2013, and management forecasts only around 65% for 2014.
All told, BE is headed for a strong year, but the problem is that its valuation has largely priced this in. In order to look at the kind of assumptions made in its stock price, consider that BE only converted 61% of its net earnings into free cash flow in 2013, and management forecasts only around 65% for 2014.
Assuming that 65% of earnings are converted into
free cash flow on a long-term basis, and plugging in analyst estimates
to 2017, gives the following estimate of its free cash flow. Its current
share price is $79.4 with an equivalent enterprise value (market cap
plus debt), or EV, of $96.
Source: Nasdaq.com
Unless its free cash flow conversion gets markedly
better in future years, or its earnings are better than consensus
forecasts, it's hard to see how B/E is a good value. Indeed, B/E has
struggled with cash flow conversion in the past. The essence of the
issue is that working capital requirements and inventory always goes up
in order to service new orders.
Where next for B/E Aerospace?
The valuation doesn't look cheap and the assumptions needing to be made in order to make it look cheap are relatively optimistic. Based on the IATA outlook, there is certainly good reason to expect commercial aerospace to outperform in 2014, but who can predict where the economy will be in 2017?
The valuation doesn't look cheap and the assumptions needing to be made in order to make it look cheap are relatively optimistic. Based on the IATA outlook, there is certainly good reason to expect commercial aerospace to outperform in 2014, but who can predict where the economy will be in 2017?
Moreover, Fools need to appreciate that even if Boeing and Airbus
have historically strong order books, if the economy turns down then
orders will be cancelled and B/E will suffer. You can never fully
discount risk. As attractive as the company undoubtedly is, it's hard to
make a case for it based on anything other than earnings momentum
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