Description

Corporate History

HXL was founded in 1946 and initially focused on making honeycomb composites.  Honeycomb is very light, very strong, provides excellent energy absorption, and it can be shaped, but it is also very expensive which historically limited its use to very specialized applications.  In the 1970's, the composite industry began to move towards pre-impregnated fabrics or "prepregs" which are the basis for modern day composites.  By the early 1990's HXL was one of about a dozen composite manufacturers, and despite being only a regional company, they were also the only publically traded composites firm, and their competitors were subsidiaries of conglomerates.  At that time, HXL was also very focused on the B-2 bomber program which was established carbon fiber composites as the new standard material for military aircraft.  Unfortunately, being overly focused on the B-2 allowed a Japanese composites firm called Toray to compete and secure a position on the 777 which proved especially problematic when the B-2 program was canceled.  In 1993, a liquidity crunch pushed HXL into Chapter 11, though the company was ultimately able to pay the bondholders in full, and the shareholders were not wiped out.  In the mid-90's, HXL began to consolidate the composites industry.  During this period, HXL also had a rapidly growing division that weaved glass for printed circuit boards.  Observing this growth, HXL's CEO decided to borrow over $450MM in late 1998 to buy another company in this area in order to increase HXL's exposure to the electronics industry and also decouple from the aerospace cycle.  Needless to say, this business soon collapsed.  That CEO developed cancer and passed away in 2001.  Two months after his successor arrived, 9/11/01 sent the industry into a severe decline and forced HXL to raise money from private equity, largely in the form of convertible debt that would later dramatically increase the number of shares outstanding.

HXL's consolidation activities in the mid to late 1990's were followed by ten years of restructuring efforts that began in 1998 and ended in 2008.  During this time, management divested non-core divisions, dramatically improved productivity, and gradually de-levered a badly overextended balance sheet.  By mid-2007, management had divested the last of HXL's non-core divisions, and 4Q08 saw HXL's last restructuring charge.  By this time, they were also preparing the company to participate in the tremendous growth expected in aerospace composites.

In summary, HXL was a niche materials company for several decades, made some major mis-steps during the 1990's, and was successfully restructured by current management throughout most of the 2000's during which time they transformed it from a basket case into a consistently profitable and growing business that managed to maintain healthy margins and a respectable ROTC during the most recent downturn.  I mention all of this for two reasons.  The first is that HXL in its current form is a reasonably new entity since the only remaining baggage is an environmental liability that manages to siphon off a bit of earnings every several quarters.  The business is truly "new and improved."  The second is that while I've just begun to follow HXL, management seems to have done an impressive amount of heavy lifting to get the company to its present state.  David Berges, HXL's CEO also served as both President and CEO during most of this restructuring period.

Entering the Mainstream

Aluminum has historically been the material of choice for aerospace structural applications because it is lightweight, easy to work with, continuing to advance (i.e. new alloys), and has had abundant capacity around the world.  All of these factors made it a difficult material to displace, and in the early 2000's, no one would have believed that commercial airplanes with composite fuselages and wings were just around the corner.  Indeed, while composites had been making small inroads for decades, most observers expected composites to be used for wings first and then fuselages would follow by another 20 years.  Four factors emerged in the early 2000's, however, that ushered composites into the mainstream.

The first development was that Boeing had gained experience with composites through military aircraft, and this gave it confidence that composites were ready for greater application on commercial aircraft.  The second development was that Airbus had gained so much ground on Boeing competitively, that Airbus was beginning to outsell Boeing.  This compelled Boeing to consider dramatic changes in order to better compete, and one of those changes was a step function in the use of composites. 

A third development was that the composites manufacturers finally realized that they were ultimately competing with aluminum more than they were competing with each other, and while they enjoyed selling composites for $50 / lb, demand was elastic, and they could realize much higher revenues if they could lower their prices.  This led the industry to focus on lowering costs and expanding capacity in order to realize economies of scale. 

A final development which I believe reinforced the shift to composites was the five fold increase in the price of crude oil during the 2000's.  One of the 787's major selling points is that it uses 20% less fuel, and composites help enable this. 

The resulting step change in commercial aerospace's use of composites should underpin several years double digit growth for HXL's commercial aerospace business as new programs with dramatically higher composite content begin to ramp.  (And this is just based on the new generation of widebodies.  New narrowbodies will eventually come along and the volumes for those will be even higher.)  According to HXL's February, 2011 investor presentation, their Weighted Average Backlog per Aircraft for new programs is roughly 5x higher than it is for their legacy programs. 

What's a Prepreg?

Carbon fiber (CF) composites begin with carbon filaments that are wound into strands of fibers which are then woven into a fabric and "pre-impregnated" (i.e. injected) with a resin.  Contact paper is then applied to both sides of this pre-impregnated fabric ("prepreg") so it can be easily handled and stored.  Because the resins are usually thermo set, the prepregs are usually stored in a freezer to keep them from beginning to cure.  Once a fabricator is ready to use the prepreg, they cut it into a part-specific shape, remove the contact paper, stack up multiple prepregs, and cook this stack in an autoclave for 12-24 hours under heat and pressure.  The pressure compresses the layers together in order to bond them to one another, and the heat cures the resin.  At the end of this process, the composite part has been produced. 

Because composites begin as a fabric, they can be used in myriad designs since the fabric can be bent, pushed into mold, or otherwise fashioned into simple or complex shapes.  Prepregs also come in a tape form which can be wrapped around a "core" material similar to the way a cast is wrapped around a broken leg.  One nice feature of prepreg tape is that it can be wrapped multiple times around areas of greater stress in order to reinforce only those areas.  This offers some advantages over machining Titanium which produces expensive scrap and where you're more limited to Titanium's native strength. 

A prepreg's strength comes from:

1. The fiber's orientation and the weave. In prepreg tape, for example, the load bearing fibers only run in one direction, down the length of the tape. Consequently, tape only bears load along this one dimension. The weave impacts the fiber's ability to receive the resin, which is very significant because while on a basic level, the resin holds the fibers in place, the resins primary job is to transfer load from one fiber to another and from the fibers to the underlying support structure.
2. The nature of the fiber that is used, which includes the fiber's properties and filament count.

Importantly, prepregs can be made with multiple types of fibers, and fibers have evolved over time.  In the 1980's, the aerospace industry used glass fiber prepregs.  In the 1990's, things transitioned to "High Strength Carbon Fiber," and in the 2000's, "Intermediate Modulus Carbon Fiber" (IMCF) emerged as the industry standard.  IMCF also happens to be HXL's sweet spot. 

It's also worth mentioning Industrial Carbon Fiber which, despite its name is not as strong, stiff, or light as IMCF, though it is cheaper.  (Industrial CF sells for $8-10 / lb, whereas IMCF runs $25 / lb and up.)  Industrial Carbon Fiber thus goes into less demanding applications such as the interior spars of wind turbines and some automotive applications.  (The 12-24 hour curing process is likely to make automotive applications difficult to scale since you'd need a lot of large, expensive, energy intensive autoclaves to address automotive volume requirements.)

Industrial Carbon Fiber is relatively easy to make since it only requires carbonizing acrylic (i.e. carpet fiber).  IMCF, by contrast, begins with Acrylonitrile (AN) which is a dangerous liquid that must then be converted into a "precursor" called Polyacrylonitrile (PAN) which is an inert white fiber.  PAN is then carbonized into CF which can be further tweaked to alter its properties.

Barriers to Entry

Converting AN to PAN is highly proprietary, and there's only three companies of scale who can do it (Toray, Toho, and HXL).  (Mitsubishi technically has a small presence.)  Cytec has extensive history and experience in the composites business, and yet after years of trying, has yet to produce commercially viable IMCF.  (Cytec buys its PAN externally and converts it to High Strength Fiber which is an older technology, though it is still useful, and it's already spec'd into older aircraft.)

In addition to the technological challenges associated with converting AN to PAN, carbon fiber is also very capital intensive which serves as an additional barrier to entry.

The greatest barrier to entry, however, comes from the aerospace qualification process.  OEM's such as Boeing begin by considering composites for a given part and issue a spec for a dozen or more properties that they're interested in (i.e. tensile strength, strength around a hole that's been drilled into the part, etc.)  HXL, Cytec, and now Toray will bid and try to meet as many of these properties as possible.  During the process, Boeing may add additional properties, which will require tweaks, new samples, etc.  At the end of this iterative process, Boeing will select one or two suppliers.  If two are selected, however, the primary supplier will receive 85-90% of the volume and the second is really more of a stalking horse and backup supplier.  The qualification process lasts 6-12 months and covers the inputs, equipment, and materials.  Everything is locked in and has to be the same every time, and part qualification is often tied to the aircraft's FAA certification.  The time and expense associated with this process make it prohibitive for an OEM to switch suppliers, so once a supplier is qualified for a new aircraft, they are essentially guaranteed orders for the life of the program, even if they don't have a formal contract.

Toray won the contract to supply the wing and fuselage prepregs for the 787.  Reeling from this competitive loss, HXL scrambled to identify parts that Boeing had originally intended to build with aluminum but HXL thought could be made with composites.  Boeing responded favorably to HXL's ideas, and HXL was able to secure a robust position on the 787 even though they won't supply prepregs for the wings or fuselage. 

In the A-350 competition, HXL developed a new fiber to bid for the wings and fuselage prepregs, while Toray used the same fiber that it had developed for the 787 competition.  HXL's prepregs won in the A-350 competition.

I believe that the experience, reputation, and capacity that Toray and HXL will build through the 787 and A-350 could ultimately position them as the two primary composite suppliers of the future, which could be critical whenever the next generation of narrowbodies is developed.  I'm not an aerospace expert, but I'd conjecture that competitive pressure from the Embraer E-Series and Bombardier C-Series, as well as a competitive opening created by Airbus' decision to re-engine the A-320 will motivate Boeing to announce a new narrowbody that uses composites, and the other players will then have to follow suite.  (High oil prices would help as well.)  Regardless of the timing, however, HXL's presence on the 787 and A-350 should position it well whenever the new narrowbodies come along.

Competitive Landscape

As suggested by the 787 and A-350 wins sited above, Toray and HXL appear to be the leading prepreg suppliers.  The competitive landscape, however, is somewhat difficult to characterize because the supplier / competitor relationships are somewhat incestuous, and the nature of aerospace qualification ensures that this will persist for a long time.  Below are some examples of the complex relationship between these firms:

1. A-380: HXL uses a Toray fiber to make a HXL prepreg. Both are spec'd in, so the related parts will always use that Toray fiber that's made into a HXL prepreg.
2. 787: HXL weaves Toray's fibers into a fabric and then returns that fabric to Toray for further processing into a prepreg. (HXL is better at weaving than Toray, and this is an important step since it impacts the fabric's ability to receive the resins.)
3. JSF: Cytec uses a HXL fiber to make prepregs for the JSF. (Cytec has a strong military presence.)

While this set of relationships is admittedly complex, I derive comfort from the following:

1. HXL is one of the three companies that can convert AN to PAN, and thus one of only three companies capable of producing IMCF.
2. HXL developed a new IMCF for the A-350 which successfully won the prepreg contracts for the fuselage and wings
3. Despite its initial competitive loss on the 787, HXL was nimble enough to find a tremendous amount of alternative content on this new platform, ensuring robust participation.
4. HXL is the most vertically integrated supplier in the industry which allows them to better control their cost, quality, and delivery. In addition, while they consume a portion of their own fiber, fabric, and composite material internally, they also sell these externally which ensures that their costs and capabilities remain competitive along the different parts of the value chain.
5. IMCF production is capital intensive because of the costs required to make the precursor and CF plants. Such investments need to be underpinned by qualification wins which would presumably create something of a chicken and egg problem for new entrants. (You need a qualification win to justify building a new plant, but lacking a track record in running one would presumably disadvantage you in the competition. This is why I think Toray and HXL may have already emerged as the two leaders.)

Segments

HXL reports it's results through two segments (Composite Materials and Engineered Products), but it primarily discusses its business by end market (Commercial Aerospace, Space & Defense, and Industrial). 

Commercial Aerospace is about 55% of total revenue and is supported by highly visible growth coming from production increases of legacy aircraft and the anticipated ramp of new aircraft platforms.  About 17% of this division's revenues come from RJ's and BJ's which are coming up the composites learning curve. 

Space & Defense represents 26% of total revenue and is supported by over 100 active programs.  This segment is pretty well diversified, with the top ten programs representing about 50% of segment revenues.  Helicopter programs represent over half of HXL's Space & Defense revenues and are an area of growth as the industry shifts towards composite rotor blades through new builds and retrofits.  In addition, the military needs more vertical lift capacity which is serving as an additional tailwind.  In 2010, the wind down of the F-22 program created a headwind for S&D, but this has played out, and the division should benefit from the ramp of the V-22 which is composite intensive.  Other noteworthy programs include the JSF which uses HXL fibers, and the A-400M whose wings use HXL prepregs and whose propeller blades use HXL's resin system.

Industrial represents 19% of HXL's revenue, and roughly half of this comes from wind turbines, especially for Vestas.  This is one of my main concerns for HXL as the newfound abundance of natural gas seems to have rendered wind energy uneconomic, and public support for alternative energy subsidies is waning.  HXL's wind revenue declined 20% during 2010, but Vestas had record orders during the year which should underpin a resurgence in HXL wind revenues in 2011.  Market acceptance of Vestas' new V-112 turbine with 55 meter blades would also help HXL since adding 25% to the blade length greatly increases composite consumption.  (The larger blade allows the turbine to generate electricity at much lower wind speeds.)  We'll see how this division develops over time, but I am concerned that a fall off in wind energy could present a headwind a few years out.  (HXL's wind products use glass fibers.)

Valuation

At $18.50, HXL is trading at 18.9x and 16.3x 2011 and 2012 EPS, respectively.  While this may not appear to be a bargain, there is a historic precedence for a premium valuation which is understandable given the company's unique capabilities and tremendous growth potential.  Below is HXL's multiple range since 2007 which is when it finished divesting its non-core businesses.

It'd be nice to have more history than this, especially history that didn't include a huge bear market, but the company has changed so much that I thought the earlier datapoints wouldn't be as relevant.

What's more helpful is to look at how HXL's earnings will grow over the next several years.  Their last few investor presentations provide plenty of datapoints about how their various sub-segments should grow going forward.  In addition, they have said that they expect incremental margins to be 20%, and they hope to eventually achieve an OM of 15%.  (This is partly because IMCF will be growing as a percentage of total revenues, and it carries higher margins since the capital requirements are high.)

My revenue and margin assumptions are a bit more conservative than the long-term forecasts that management has provided, but I'm still arriving at 2015 EPS estimates of $1.62 to $1.83.  (Those assume 2015 OM's of 13.2% to 14.2%, respectively.)  If you then strap on multiples of 17x to 19x, the stock price would be $27.80 to $34.80 by that time which implies an annualized return of 10.5% to 17.1%.  This isn't glamorous by VIC standards, but my estimates are somewhat conservative, and I'm using conservative multiples, especially in my "conservative scenario."  By 2015, Boeing will probably be developing the next narrowbody, and that kind of growth opportunity will likely support a HXL multiple that's closer to 20x than 17x.  At any rate, I think I can achieve a respectable return in a conservative scenario that uses a soft multiple, and a very good return in a scenario that's more aggressive, but by no means swinging for the fences.

Catalyst