Safran is a solid long investment opportunity with ~35% upside today driven by continued strength in the aerospace engine aftermarket, dissipation of Leap engine headwinds, synergy and market share capture from Zodiac acquisition, and a strong aerospace macro that will facilitate NPV positive investments in the highly consolidated tier 1 aero supply market.
Aerospace macro still looks favorable. Travel trends remain strong with consistent ~4.5% growth that hasn’t meaningfully dropped off in a recession. Growth trajectory looks likely to continue thanks to travel penetration in China/India. At the same time, the market has materially tightened (highest PLF in recent memory) while narrow body retirements and build rates are set to continue growing at a high level (~8% p.a).
Aftermarket likely to keep surprising to upside. Based on significant increase in narrow body supply over last 10 years, the engine market is likely to enjoy large tailwinds over the next 5 years as CFM56 engines enter high value SV1 replacement. This tailwind is likely to support >6% supply growth (plus 4% pricing) at >50% incrementals for Safran over next several years. Moreover, Leap transition has gone smoothly and is likely to turn from a headwind to tailwind over the next 2 years (a trend that has masked favorable aftermarket incremental margins over the last 3 years).
PMA manufacturers don’t seem like a thesis destroying risk over next 10 years. It is very unlikely we will see any new PMA entrants in the engine space given airline/FAA safety track record requirements. Moreover, Heico remains a very small part of the engine market with no desire to irritate Safran given push toward RPFH.
Zodiac acquisition likely to surprise to upside. Margin targets look highly conservative given implication that core Zodiac business will peak at 11% operating margins (compared to prior cycle peak of 17%). Moreover, with the likely bottoming of wide body production and continued right-sizing of Zodiac operations, the transaction looks likely to surprise to upside (SAF could double synergy target)
Boeing 737Max risk isn’t a major headwind. Given 1) SAF was a few weeks behind schedule on LEAPs for BA, 2) BA cut was fairly modest to 737Max build rates (10/month), and 3) there is a potential maintenance tailwind from significant plane groundings, I see minimal FCF risk from BA as long as the program is back on track by fall.
Good business operating in a good backdrop with reasonably cheap valuation. Safran looks set to almost double EBITDA over the next 4 years which would result in an ~7.5% FCF by 2022. Given 1) highly concentrated, >20% ROI nature of airspace business, 2) strong growth trends that will enable LT FCF growth in mid single digits, and 3) 8% cost of capital, I see ~35% upside to Safran over the next year (7.5% FCF in 2022 + 5% organic growth=12.5% TSR, on 8% Re implies 56% upside in 2021. Discounted back to today implies 35% upside).
Other Risks Highlighted in Appendix
Chinese are investing in engine design. While limited public information is available, commentary from the Chinese indicates limited progress on commercial aircrafts. LEAP engines are still being used on COMAC planes.
Electric engines will be required to reach LT emission targets. However, SAF is a leader in electric engine innovation and is in a position to do well if the industry pivots
Everyone knows aerospace aftermarket has been a great business model. This is the most challenging other risk. The numbers imply SAF is still cheap enough to own and the macro looks safe enough to invest. However, I struggle to find a good catalyst (other than continued compounding) on SAF.
Aerospace Macro Appears Benign as strong travel growth appears set to continue, the market is tight, build rates/OEM backlogs are high and narrow body returns are set to accelerate.
History says that we will continue to grow aircraft deliveries at >5% p.a.
2) While the aerospace market has tightened over the last several years
3) Large DM population centers (India/China) still have room to significantly increase travel per capita, supporting large OEM backlogs
4) Narrow body planes have enjoyed strong historical demand and are about to see a wave of retirements
5)….which leads to a healthy build forecast for narrow body planes
B. Narrow Engine Market 1) is a duopoly that Safran continues to take share in, 2) has seen the successful ramp of the leap engine over the last 3 years, and 3) is likely to enjoy continued tailwinds from growing high margin aftermarket demand
Narrow body engine market is an effective duopoly between Safran+GE (CFM56, Leap) and Pratt Whitney (UTX). Both the PW GTF and Leap engines have similar specs; however, since 2003, Safran has meaningfully outpaced other engine OEMs.
Despite similar specs, PW1000 has been plagued with issues since 2016 and as recently as May 31st, the few airlines with PW1000 orders are still looking to switch.
IndiGo recently announced a bidding process for 280 A320neos. Previously, it was expected that UTX would take all these orders
"With IndiGo now having ambitions to fly to Europe and expand overseas that becomes a bigger consideration, and it's not all about the edge on fuel" (IndiGo was forced to land some plans due to PW engines)
2) Leap is the exclusive engine on the 737max and has 58% share on the A320neo. The launch of the leap engine has gone more smoothly than many believed. Back tests on SAF’s historical financials validates quick leap engine cost reductions.
3) Assuming SV1, SV2 and SV3 cost 3mm, 2mm and 1mm, respectively and happen 8, 13 and 17 years into an engines life, aftermarket grow rates appear stable over the next several years.