Friday, February 14, 2014

Triumph Group Equity Research

It's been a wonderful year for investors in the aerospace industry, and the indications are that 2014 will also be a strong year for the industry. All of which could lead you into a false sense of complacency. However, the recent results from aerospace component manufacturer Triumph  $TGI should go some way to dispel that notion. Triumph did anything but, but are its results a warning signal for the sector or merely a company issue?

Triumph lowers guidance
The manufacturers that supply aircraft structures and components to Boeing  $BA and Airbus are always interesting industries. In line with many other heavy manufacturers, they tend to have high fixed costs which means their earnings tend to be super-cyclical to the aerospace sector. In addition, they typically need to ramp up capital expenditures and working capital requirements in order to service new orders that flow when the industry turns. All told, they tend to have highly cyclical cash flows, and also carry a substantive amount of operational risk when they increase production.

Unfortunately, Triumph's recent results reminded investors of some of these factors. The market had priced in good prospects thanks to the strong order book at Boeing (responsible for 44.7% of Triumph's sales in the last quarter), and an anticipated step up in Triumph's earnings and cash flows in future years. Moreover, Fools know why aerospace is set for a good year in 2014. However, Triumph disappointed investors by lowering full-year guidance by $0.50 to $4.75 for three main reasons:

  • Issues relating to building out the new Boeing 747-8 aircraft aerostructure caused a lowering of full year guidance by around $0.22

  • Military aircraft after-market demand has remained under pressure and demand did not come back as expected.

  • The quarter was marked out by a "surprising number of customer deferrals".

It's time to look at these issues in turn.

Did Triumph just wave a red flag?
First, the Boeing 747-8 issue looks like a manifestation of the operational risk outlined above. Moreover, with aircraft getting ever more complex, it wouldn't be surprising to see other manufacturers have such issues. According to its management, Triumph incurred extra costs in replacing parts with "internal quality issues" on the program, because the 747-8 is a "relatively new aircraft". While this problematic for Triumph ( the 747 is its biggest program), it doesn't read across as an industry issue.

The second issue is a bit more of concern for the industry, and serves as a salutary reminder that military aerospace spending remains under pressure. The bifurcation in prospects between military and commercial aerospace is well known to the market. For example, on its recent conference call General Electric  $GE recently outlined that its fourth-quarter commercial aviation spares market was up 16%. Meanwhile, GE's military spares market was down 3%, due to sequestration issues and reduced flying hours. Overall GE reported 11% growth in services demand.

Tuning back to Triumph, its management described weak military spares sales as being "primarily" responsible for the remaining $0.28 taken off full-year guidance. It's obviously disappointing news for Triumph shareholders, but it doesn't represent any new trend in the industry. Moreover, military spending is always lumpy due to political considerations. Its overall aftermarket orders may well bounce in coming quarters.

The third issue is more worrisome. When pushed on the issue on the conference call, CFO David Kornblatt outlined that the deferrals affected programs like the Boeing 737 and 777, and the Gulfstream 650. These are commercial orders, and although Triumph's management believes they will come back in due course, this is slightly a concern. It's one thing to point at Boeing's burgeoning order book and conclude that the aerospace industry is set for long-term growth, but the truth is that customers do defer or cancel orders when the economy turns down. Customer deferrals are about as good an early warning signal as you will ever see.

What does it all mean?
In conclusion, it looks like Triumph stumbled with some operational issues with which it's managing to overcome. Looking forward, internal guidance is for EPS of $5.75 and $6.75 for 2015 and 2016, respectively. In other words, Triumph expects its earnings to grow more than 42% from this year's forecast of $4.75, over the next two years. If you are bullish on aerospace then the current fall might create a good buying opportunity for you.

On the other hand, its customer deferrals are a small warning light for the industry. It's not significant, because bellwethers like GE, Alcoa, and Boeing continue to make positive outlooks on the industry. Indeed, Triumph may well get these orders to pick up again in due course. However, it's something for aerospace followers to keep an eye on.

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