Description

Albany International provides optionality on an aerospace recovery with low downside risk. Aerospace will take many years to recover from the COVID fallout and I am not expecting a recovery soon. However, Albany has some interesting characteristics that will allow it to grow even though build rates will be pressured for some time. More specifically the paper machine business is a cash cow, their cost plus LEAP contract mitigates decremental margin downside in this low volume environment and Albany over-indexes to single aisle planes which should recover more quickly than widebody aircrafts. 

Thesis Summary:

1)      The paper machine clothing business is stable and should generate consistent and predictable levels of cash flow for the foreseeable future

2)      3D woven technology is proprietary to Albany and will be instrumental to next generation aircrafts

3)      Return to some level of production for the 737MAX should be a near term tailwind

4)      Defense programs should remain a growth driver for the company

5)      AEC segment margins & profitability should remain resilient given the cost+ nature of their contract with Safran

6)      Potential for the company to be split into two separate businesses

7)      Strong balance sheet and free cash flow will allow AIN to play offense when pursuing strategic aerospace assets

Albany is comprised of two very different businesses:

Paper Machine Clothing (PMC): This segment produces permeable and impermeable belts used in the manufacture of paper, paperboard, tissue and towel, pulp, nonwovens, fiber cement and several other industrial applications. These belts typically move pulp through the manufacturing process and customized to customer preference with the goal of pulling liquid out of the pulp as it moves through the machine.

Albany currently has approximately a 30% market share (almost double the 2nd competitor) and has transitioned the business with more of a focus on e-commerce/higher growth end markets (80% of sales) vs printing & writing grades of paper including newspaper, magazine etc.. (20% of sales). The bulk of Albany’s products are consumable (depending on the product, the lifespan can range from 45 days to 18 months) and account for only 2% of a paper mill’s cost structure making it unlikely for customers to switch providers (I estimate 90%+ of machine clothing orders are from repeat sales). The closest comp to this business is Xerium (18% market share) which was purchased by Andritz for close to 9x EBITDA in 2018.

Albany Engineered Composites (AEC): This segment provides highly engineered composite structures to customers in commercial aerospace and defense industries. Albany developed the 3D woven capability in the PMC segment and used it to develop composite technology for aerospace. This technology was so unique, that SAFRAN took a 10% ownership stake in the business in 2013 and it is now used for the LEAP engine fan blades. This arrangement is only exclusive for engine parts & landing gear components, and Albany can use this technology to procure new awards on other positions in the aircraft.

Thesis:

1)  The paper machine clothing business is stable and should generate consistent and predictable levels of cash flow for the foreseeable future

This business has been the cash cow that has been funding the aerospace business. The total paper and paperboard industry is not expected to grow much over the next few years, but Albany has positioned the business towards the higher growth segments of the paper market. Paper and newsprint is ~20% of sales and is expected to decline about 4%/year while tissue/containerboard and other grades of paper which makes up 65-70%  of sales is growing about 2-3%/year driven by general economic trends and in part by e-commerce. The remaining ~10% is non-woven production that goes into hospital gowns and other applications such as asphalt roofing shingles or tannery/textile felts and is fairly stable. Albany should be able to maintain some top line growth albeit modest 1-2%/year w/strong EBITDA margins in the 30-35% range given their dominant market share position.

Historical and future performance demonstrates stability of the business but lack of growth:

2)   3D woven technology is proprietary to Albany and will be instrumental to next generation aircrafts

No other supplier has access to this technology as it is a trade secret and the company will not patent it to retain their technology moat. As per the 10K, Albany has a portfolio of over 2,400 patents and typically is granted 250 new patents each year. I do not view Albany as just a sleepy no-growth paper company but an advanced technology business which can use their know-how to further penetrate new areas of the aircraft.

Albany was recently awarded an opportunity in partnership with Airbus to develop the wing of tomorrow. This collaborating research agreement will apply Albany’s 3D fiber technology to the next generation single aisle wing. This new technology will allow for a more cost effective wing that will be lighter, stronger and could be produced more efficiently than existing processes. Although it is early, this win could demonstrate a much greater opportunity for Albany as the wing would have much more content than existing uses for 3D woven applications.

In the medium term, Albany could displace materials on larger designed-in parts that are still metallic in the wing box, tail and empennage where 2 dimensional composites don’t handle as well as 3D. As of now 3D weaving is only in the engines and there are far larger opportunities ahead. Albany is currently in conversations with OEM & Tier 1 suppliers about varying levels of 3D use to displace other parts. I would expect future win announcements could in aggregate become more material to the AEC business.

 3)  Return to some level of production for the 737MAX should be a near term tailwind

The 737Max is a large program for AIN. It accounted for almost 60% of revenues from SAFRAN or about 30% of AEC sales in 2018/2019. After March 2019, Boeing suspended deliveries of the 737MAX aircraft and reduced production from 52/month to 42/month. In December Boeing announced that production would be suspended from January 2020. Today very limited quantities are being produced and there is a backlog of about 450 completed aircrafts yet to be delivered. It is largely expected that once the Max returns to some level of production, it will take about 2 years to fully deliver all the completed aircrafts.

In addition, the suppliers including AIN have been hit by destocking related to the massive decline in MAX build rates. AIN entered 2020 with 737Max finished goods inventory of about 100 aircrafts on hand along with inventory in the channel at various stages. Even when Boeing returns to some level of build rate this inventory needs to be cleared before AIN can start producing a meaningful volume of blades for the leap engine. As a side-note, the A320NEO inventories are close to in balance.

In my view this negative is already priced into the stock and when the MAX gets approved for return of service, AIN’s aerospace revenues tied to the LEAP engine will begin to get sequentially better. 2020 should mark the bottom in engine deliveries and should sequentially begin to ramp as some level of production for the MAX returns (Leap 1B), partially offset by the decline in A320NEO (Leap 1A) and the expectation for Leap 1C deliveries to COMAC beginning to ramp in 2022.

The chart below expectation for total Leap engines produced (Leap 1A + leap 1B + Leap 1C)

Shipset content has increased slightly due to the cost plus contract w/Safran which I will explain in a later section.

4)  Defense programs should remain a growth driver for the company

The company has a unique position on a number of growing defense & other non-leap commercial programs which include the CH-53K, the F-35, Lockheed missile programs and other potential new DoD platforms like the Blackhawk replacement.

The CH-53K program should ramp from about $50 million today to well over $100 million at full run-rate. The F35 should ramp to ~$80 million from about $60 million today. Taking these programs together with announced program wins, I would expect the non-leap part of AEC to grow at a 9% rev CAGR through 2023. This doesn’t assume any future wins or acquisitions which have yet to be announced.

 5)   AEC segment margins & profitability should remain resilient given the cost+ nature of their contract with Safran

Albany’s contract with Safran is a cost+ contract so even though revenues have been impacted due to lower LEAP production, margins are stable given Albany’s ability to charge Safran the cost to operate lines that are on pause. This provides much more stability in this environment and Albany is essentially paid to wait for a recovery. This is also the reason for Albany booking revenue on the LEAP program even though they may not be producing any or very little content. 

When combining revenue from the LEAP program & other AEC programs, profitability will grow sequentially and could be conservative given the assumption of no future acquisitions or new program wins. I do not expect the LEAP program to return to 2019 levels until 2024, but given the growth expected from 2020 levels and the nature of the cost+ contract, I expect profitability to grow at a ~16% CAGR for the next 3 years. Profitability should be higher than 2019 in 2022 even though the LEAP program will remain lower than 2019 levels due mostly to defense growth.

6)    Potential for the company to be split into two separate businesses

Both businesses share technological knowhow, but as AEC profitability continues to grow over the next few years there is a possibility for the businesses to split. In May 2019, the Standish family reduced their controlling ownership of the company from 53% to 35% by converting and selling B shares in a secondary. Although this likely is not the catalyst for a future split, it opens the door for an activist to push for a split since the family does not have controlling ownership.

A split would instantly create shareholder value in excess of the current stock price. I have included a SOP below to highlight what each business could be worth as a separate entity. I used Xerium’s 9x takeout multiple on the PMC business and for AEC I use a turn discount to HXL’s current multiple of 12x. These same multiples on FY20 EBITDA equates to a $60 stock price. In the below chart I used FY23 EBITDA.

7)      Strong balance sheet and free cash flow will allow AIN to play offense when pursuing strategic aerospace assets

The company is only levered 1x on a somewhat depressed EBITDA. I expect the business to generate ~ $300 million in FCF from FY21-FY23 which is almost 20% of the market cap today. This should provide some level of comfort holding the name as you wait for sentiment to turn in aerospace.

Having the stability of the PMC business and the certainty of profitability in the aerospace business, Albany has more flexibility than peers to play offense. If the business were to pursue a more strategic acquisition in aerospace, I estimate Albany could pay upwards of $500 million and still keep leverage below 2.5x.

 Valuation

Earnings should grow at a 10% CAGR through 2023, generating EPS of ~$4 and I apply a 20x multiple (10 year average) to get an $80 stock price or 55% higher than where it trades today. This is also consistent w/my SOP value. There could be upside to this if the recovery in aerospace is faster than I anticipate or future acquisitions drive further earnings accretion. 

In an extreme downside scenario the stock traded to the low 30s in march which is ~35% downside from today’s level. Even if EPS remains flat from 2020 levels and applying 15x P/E for a value/no growth business it would be hard to see the stock trade for <$45 which is another 10% down from today. Clearly the market can misprice this asset lower, but given the strategic value of their 3D woven technology and position on long term programs, it would be hard to see the business trade lower than what we saw in March. In summary, 55% upside vs 35% downside represents a decent upside vs downside opportunity in a business with a strong balance sheet and multiple ways to create shareholder value through opportunistic acquisitions or even share buybacks as they wait out the aero downcycle.

 Risks

1)      737 Max program can take longer to come back given the downturn in the aero cycle and Albany still has to wait for destocking to complete before ramping up new orders

2)      A320NEO production rates will likely come down further

3)      Safran forces a renegotiation of their cost+ contract

4)      PMC business which historically has been stable has been over-earning over the last few years and EBITDA margins may come in closer to 30% vs the higher end at 35%

5)      A split of the business will likely not occur in the next few years as there is no specific catalyst near term

6)      Possible value trap as we wait out the aerospace cycle

7)      ~50% of revenues are exposed to foreign currencies (every 10% move in interest rates = $2.5 million change to net income or 8 cents/share)

Catalyst

1)      Return of 737 max

2)      New awards in defense

3)      Potential Acquisitions

4)      Potential company split and/or corpor