Analyst: Joshua Hung
Thesis: Strong Backlogs and Identifiable Growth Opportunities
We believe that Magellan Aerospace has been undervalued by the market and has been oversold in the 2018 year end sell off. We believe this presents a buying opportunity as Magellan’s business operations are quite stable due to long-term contract agreements, which creates substantial backlogs providing some certainty in future cash flows. With the forecasted growth in the Aerospace & Defence industry, MAL is well positioned to capitalize on new business opportunities.
Magellan Aerospace Corporation (OTCPK:MALJF) is a diversified component supplier in the aerospace industry. Magellan designs, engineers, and manufactures aeroengine and aerostructure components for commercial and defence markets. Magellan Aerospace was founded in 1994 and is headquartered in Mississauga, Canada. The corporation also supports the aftermarket through supplying spare parts, and through repair and overhaul services (“R&O”). Magellan has two major product groupings: aerostructures and aeroengines, both of which are used in new aircraft and for spare/replacement parts.
Exhibit 1: Magellan Aerospace Corporate Structure
Source: FY2017 Annual Information Form
Magellan Aerospace Products
Magellan Aerospace offers manufacturing solutions for gas turbine engines, and global supply chain integration for commercial, defence, and industrial markets. Magellan supplies complex components and assemblies while providing maintenance services, component repair, and engine overhaul services to the world’s leading aerospace OEM’s.
Magellan Aerospace’s core aerostructure products are machined metallic and composite components and assemblies. These products include: Designs for manufacturers, Subsystems integration, Stress Analysis, Testing and certification services. Specific products include: Landing gear systems, Wing ribs and spars, Bulkheads and fuselage components, Tail cone assemblies, Composite wing and fairing structures.
Magellan Aerospace designs and manufactures the Wire Strike Protection System (WSPSTM). The WSPS is a measure of protection for helicopters in the event of accidental contact with wires. Magellan works directly with helicopter OEMs to design kits that interface with each helicopter’s unique airframe.
Magellan Aerospace provides customers with solutions for space missions from sounding rocket and payload to satellite missions. Magellan can develop new rocket motors systems to meet custom applications to meet specific mission requirements.
Magellan Aerospace Products Conclusion
Magellan Aerospace offers a suite of Aerospace & Defence services ranging from design to manufacturing. Magellan’s revenues are dominated by their aeroengines and aerostructures product lines in both commercial and defence aerospace markets. In 2017, 73% of revenues were derived from commercial markets while 27% of revenues related to defence markets.
For the past five years, Magellan Aerospace has compensated its investors with consistent quarterly dividend payments. Magellan consistently pays out quarterly dividends, and has been steadily raising annual total dividends. In 2018, Magellan paid an annual dividend of $0.36 per share, translating to a 2.4% dividend yield. Magellan’s steady and consistent dividend growth compensates investors and reflects the continuous growth in business for Magellan Aerospace.
Exhibit 2: Five-Year Dividend History (Dividend Per Share)
Source: Company Annual Reports
Magellan Aerospace’s management has expressed its strategic goal of fostering steady long-term growth through a focus on: (1) Commercial Aerospace Market, (2) Defence Aerospace Market, and (3) strategic acquisitions. We believe that stable contract wins and fulfillments will contribute to a strong level of backlog and steady future cash flows. Magellan Aerospace has continued to win large contracts with leading commercial aerospace manufacturers such as Boeing and Airbus. Magellan is also continuing to extend its presence in the defense aerospace markets with contracts awarded from Lockheed Martin.
Commercial Aerospace Segment
Commerical aerospace revenue accounts for the majority of Magellan Aerospace’s aggregate revenue. Magellan supplies and services numerous aerostructure and aeroengine components to OEMs in the commercial aersopace market. Magellan’s management team has expressed their goals of further developing their presence in the commercial aerospace market by effectively delivering on their existing agreements with Boeing and Airbus. Successful deliveries could lead to new and increased business opportunities as aircraft production continues to grow. As the demand for commercial air travel and commercial aircraft production grows, Magellan Aerospace seeks to establish themselves as a dependable supplier in the commercial aerospace industry.
Defence Aerospace Segment
Magellan Aerospace’s defence segment includes servicing and supplying components to multiple fighter jet platforms such as Lockheed Martin’s F-35 Lightning II, and Boeing’s F-18 Hornet. Magellan Aerospace recently announced agreement extensions to service the GE F-404 engine of Canada’s CF-18 Hornets. The F-35 Lightning II is a fifth generation fighter jet designed by Lockheed Martin, and has been selected by numerous global militaries. MAL’s contribution to the F-35 program include manufacturing the tail assemblies for the jet and MAL can expect to see growth in business as Lockheed Martin continues to win more procurement contracts to deliver F-35 fighter jets. With forecasted growth in the defence market, MAL looks to capitalize on new and larger contracts.
Magellan identifies strategic acquisitions to extend their capabilities as a components supplier and foster long term growth. Strategic acquisitions has been a core component of MAL’s historical growth both geographically, and in new engineering capabilities. In 2015, MAL acquired John Huddleston Engineering Ltd for $25 million and Lawrence Ripak for $24 million, which expanded their operations overseas in Europe and the US while also securing critical supply chains for their customers. With the recent hire of Jim Powell as their Vice President – Mergers, Acquisitions and Strategy, Magellan Aerospace continues to seek growth opportunities through the strategic acquisitions in the aerospace & defence industry.
Commercial Aerospace – Growing Duopoly
Commercial Aerospace programs continue to be the main driver of growth for the aerospace industry. The growing passenger travel demand led to a solid year for the global commercial aerospace market and is projected to continue growing in 2019. The expected growth is attributed to an increase in commercial aircraft production projections as aircraft backlog remains at an all-time high with about 38,000 aircraft expected to be produced globally over the next 20 years. This growing demand positively affects Magellan Aerospace as the company holds existing contracts and relationships with both Boeing and Airbus – the leading commercial manufacturers in the aerospace industry. With economies continuing to grow globally, the demand for commercial air travel has been on the rise and is forecasted to continue growing. Majority of this economic growth is projected to come from Asia-Pacific followed by North America and then Europe.
Exhibit 3: Commercial Aircraft Manufacturing Industry Revenue
Defence Aerospace – Increasing Geopolitical Tensions and Increased Military Expenditure
With heightened global tensions and geopolitical risks, higher defence spending by major regional powers are expected to drive global defense market growth throughout 2019 and beyond. The Trump administration brought with it increased support for a larger defence budget and increased military spending. This pressure has also influenced many allied NATO countries to counter threats from Russia and the Middle East. The United States has encouraged NATO countries to increase their military spending to 2 percent of their GDP which has put pressure on governments to deepen their military budget and defence expenditure. Furthermore, many militaries are in the process of upgrading or replacing their aircraft fleet leading to increased military spending in the defence aerospace market. Notably, the USA is continuing to further their JSF 35 fighter program, while Canada is expected to outline plans to procure new fighter jets to replace their aging CF-188 Hornet fleet.
New Contract Wins
Magellan Aerospace currently has contracts with the two leading aerospace manufacturers: Boeing and Airbus. Magellan Aerospace provides aeroengine and aerostructure services to a number of different commercial aircraft. In 2017, Boeing and Airbus built backlogs of 8.7 years and 10.4 years respectively, which is the highest of any time. Both Boeing and Airbus are continuing to fulfill record orders, steadily increasing their monthly build rates. Boeing’s B737 MAX program is planning to increase their aircraft production to 60 aircraft a month in 2019 from 57. Magellan won numerous contracts this year which provides security for future cash flows to the firm. For example, Magellan recently announced a six-year agreement with Pratt & Whitney to produce aluminum castings for the engines that will power the Airbus A320neo, Airbus A220, Embraer E2 series and the Mitsubishi MRJ aircraft. This agreement is expected to generate $81M in revenue through 2023. We believe that these existing agreements and relationships position Magellan Aerospace well for future business as commercial aircraft production ramps up. Management has discussed their focus on fulfilling their current agreements and contracts to strengthen their credibility and to best position the firm for future business.
Exhibit 4: Boeing Total Backlog ($B)
Source: Company Filings
Increased Growth in Global Aerospace & Defence
With growing geopolitical tensions, and pressures to increase military expenditure, we believe Magellan Aerospace is well positioned for increased business. Canada’s current CF-188 Hornet fighter jet fleet is aging and is expected to be replaced in the new future. The government of Canada is expected to launch a procurement competition to select a new fighter to jet to replace the existing fleet with the first aircraft to be delivered by 2025. Aircraft expected to be considered include: Lockheed Martin’s F-35, Eurofighter Typhoon, Saab’s Gripen, and Boeing’s Super Hornet. The aircraft that is selected will affect Magellan Aerospace as the company currently operates closely with the Canadian Air Force fleet. For example, Magellan Aerospace currently works on the General Electric F404 engine which is used on the CF-188 Hornet. Magellan Aerospace also supplies parts for Lockheed Martin’s F-35 fighter jet which is used in the US military and has been selected by numerous countries as their next generation fighter jet. We believe that the F-35 Lightning II and the F-18 Super Hornet are the most likely candidates to win the competition and both would positively affect Magellan Aerospace with increased business for aerostructure and aeroengine service.
Phillip Underwood – President and Chief Executive Officer
Phillip Underwood joined Magellan Aerospace in 2003 and was appointed President and Chief Executive Officer on January 1, 2015. Mr. Underwood led Magellan’s UK operations and oversaw the corporation’s manufacturing partnership in India. He held the title of Vice President, European Operations, and was responsible for the strategic and operational direction across six divisions. Prior to joining Magellan, Mr. Underwood held numerous senior positions with GKN Aerospace in the UK and the USA.
Jim Powell – Vice President, Mergers, Acquisitions and Strategy
Jim Powell reports to the President and CEO and is responsible for managing global mergers and acquisitions for Magellan Aerospace contributing to Magellan’s strategic long-term growth. Mr. Powell identifies, analyses, and recommends acquisition opportunities and provides leadership and oversight of the transaction and integration activities. Prior to joining Magellan Aerospace in 2018, Mr. Powell held several corporate development positions in the finance industry advising on mergers and acquisitions.
Management Team Conclusion
We believe that Magellan Aerospace’s management is strong with ample experience in the aerospace industry. CEO Phillip Underwood’s experience in aerospace manufacturing operations will be very influential when leading Magellan’s international operations across Canada, US, Europe, and India. Furthermore, Jim Powell recently joined Magellan Aerospace this year which will greatly bolster Magellan’s ability to identify potential acquisitions, which will contribute to long-term growth of Magellan through new production capabilities and relevance.
Shareholder Base, Liquidity, Capital Structure
Magellan Aerospace has a total of 58.2 million diluted shares outstanding. The majority of Magellan shares are owned by individual insiders. Magellan’s largest institutional investor is Burgundy Asset Management, owning 1.23% of outstanding shares. 74% of outstanding shares are owned by majority shareholder Mr. Murray Edwards who is the Chairman of the board for Magellan Aerospace.
Exhibit 5: Key Shareholders
Magellan Aerospace’s average daily trading volume for 2018 was 18,900 with a volume weighted average price of $14.79. This is quite a low volume for a company with a market capitalization of $1.02B. This can be largely attributed to the large individual insider ownership base. The lack of liquidity is also reflected in Magellan’s low free float percentage of only 22%. This may raise liquidity risk concerns for investors and is to be accounted for.
Exhibit 6: Daily Trading Volume
Our valuation utilizes a 5-year exit multiple discounted cash flow and a FY2019 EV/EBITDA median-based comparable company analysis with a 50-50 split in weighting. Our discounted cash flow model computed an implied share price of $22.23 while our comparable analysis found an implied share price of $20.83. Adjusting for expected dividends results in a weighted applied share price of $21.89.
Discounted Cash Flow Analysis Assumptions
Our revenue growth assumptions are based on backlogs generated from existing agreements with OEMs and expected future agreements with the growing aerospace and defence industry. The revenue growth is segmented by geographic operations: North America, United States, and Europe. We project considerable growth for the Canada revenue segment in 2021 and 2022 of 15% as Canada is expected to have selected the next generation fighter jet to replace their current CF-188 Hornet fleet by 2021. We believe the F-35 and F-18 Super Hornet are the most likely candidates to win the procurement competition and either one would greatly boost business for Magellan as they have existing agreements supporting these platforms.
Our gross margin assumption is in line with historicals and management guidance. Management discussion and analysis outlines management’s goal of increasing gross margins to 20%. This is a priority for Magellan as the consolidation in the Aerospace & Defence industry increases, more pressure is passed on down the supply chain to part suppliers like Magellan Aerospace.
Our capital expenditure forecasts are derived from past historicals as well as management guidance. Capital expenditures have increased over the past few years due to investments in property, plant, and equipment – notably with their new India facility.
Depreciation and Amortization Expense
Magellan Aerospace’s Property, Plant, and Equipment’s useful life averages out to ~ 9 years. We do not expect this figure to change in the near future.
Terminal Growth Rate
We used a terminal growth rate of 2% which is in line with GDP and industry growth.
Weighted Average Cost of Capital (“WACC”)
We calculated the weighted average cost of capital (“WACC”) for Magellan Aerospace to be 6.5%. Our calculation is base on our estimated pre-tax debt interest rate of 6% and an effective tax rate of 25%, resulting in a cost of debt of 4.5%. Our equity portion was calculated using historical market returns of 9% (based on TSE/S&P 500) and a risk-free rate of 2.0%. We used Magellan Aerospace’s five-year beta of 0.66 which was taken from Bloomberg. We believe a “WACC” of 6.5% is reasonable given Magellan Aerospace’s stable operations and certainty of future cash flows from strong backlogs and agreements. We have included a sensitivity analysis to illustrate the effect of changes in “WACC” and growth rates.
In our model, we use an 8.0x EV/EBITDA exit multiple, which is derived from our comparable peers group. A multiple of 8.0x is quite conservative and lower than the group mean EV/EBITDA multiple of 11.1x. We decided on this multiple to account for Magellan Aerospace’s smaller size and illiquid nature.
Discounted Cash Flow Summary
With the stated assumptions, our discounted cash flow model computed an implied share price of $22.23. We believe our assumptions and expectations for Magellan Aerospace’s growth are reasonable based on the outlook for the Aerospace & Defence industry.
Comparable Companies Analysis
Ducommun (NYSE: DCO)
Ducommun is a global provider of engineering and manufacturing services. Ducommun’s solutions have aerospace, and defence applications which include both electrical and structural assemblies and components.
Hexcel Corporation (NYSE: HXL)
Hexcel Corporation is an industrial materials company that develops and manufactures structural materials such as carbon fiber, resins, honeycomb, adhesives, and specialty reinforcements.
Moog Inc (NYSE: MOG.A)
Moog Inc. designs and manufactures motion and fluid control systems for aerospace, defence, industrial, and medical applications. The company operates under four segments: aircraft, space/defence, and industrial control components.
Spirit AeroSystems (NYSE: SPR)
Spirit AeroSystems is the world’s largest tier I aerostructures manufacturer. Spirit builds important aerostructures for almost all of Boeing’s airliner aircraft.
Triumph Group (NYSE: TGI)
Triumph Group is an international supplier and manufacturer of aerospace systems, structures, and services. Triumph’s product and services include: Integrated Systems, Aerospace Structures, and Product Support.
Astronics Corporation (NasdaqGS: ATRO)
Astronics Corporation is leading provider of technology solutions for the aerospace & defence industry. Solutions include: Power & Motion, Connectivity & Data, Lighting & Safety, Interiors, Service & Structures.
AAR Corporation (NYSE: AIR)
AAR Corporation is an independent provider of aviation services. AAR’s MRO services airframes, component repairs, landing gears, and other engineering/technical services.
TransDigm Group (NYSE: TDG)
TransDigm Group develops, manufactures, and distributes components for commercial and military platforms. These components include mechanical actuators, ignition systems.
CAE Inc (TSE: CAE)
CAE Inc is a Canadian leader in training for civil aviation, defence and security, and healthcare markets. CAE manufactures simulation and modelling technologies to airlines, defence customers, and healthcare specialists.
Heroux-Devtek (TSE: HRX)
Heroux-Devtek specializes in the design, development, manufacturing, integration, testing and repair of landing gear and actuation systems for the Aerospace market. Their services apply to both commercial and defence aerospace markets.
We believe that the market has undervalued Magellan Aerospace and that the company has been negatively (and overly) impacted by the market sell off of 2018. We believe this presents a buying opportunity as Magellan’s business operations is very stable due to long term contract agreements which creates a substantial backlog, providing some certainty in future cash flows. With the forecasted growth in the A&D industry, Magellan Aerospace is well positioned to capitalize on increased business opportunities. We assign a target share price of $21.89 based on our discounted cash flow analysis and comparable companies analysis, implying a 25.1% 12-month total return from the current share price of $17.51. We initiate a Buy rating on Magellan Aerospace.
Magellan Aerospace operates in Canada, United States, Europe, and India which exposes them to foreign exchange risk. Appreciation of the Canadian dollar would drag down the profitability of MAL as portions of their revenues are denominated in USD/GBP.
The commercial aerospace market continues to experience continued consolidation as large OEMs vertically integrate by acquiring suppliers in order to decrease costs. This places pressure on suppliers such as Magellan Aerospace to increase efficiencies and to increase their gross margins. Magellan Aerospace faces fierce competition from other suppliers with healthy balance sheets and a strong brand reputation.
One significant characteristic of Magellan Aerospace is its shareholder base. Majority of the shares outstanding are held by close company insiders with only ~5% institutional ownership. With a float rate of only 22% and an average daily volume of 18,900 shares, investors of MAL must account for liquidity concerns.
Management has outlined growth plans through organic growth as well as through strategic acquisitions. These acquisitions allow Magellan to expand their product / service offerings as a supplier to new and existing partners. However, the reliance on these acquisitions and their successful integration presents a risk in the event of a lack of acquisition opportunities, or unsuccessful integrations.
A significant portion of Magellan Aerospace’s revenue comes from the defence aerospace market which means MAL is significantly affected by military spending and budget. The US military budget saw considerable decrease between 2010 and 2013. Despite a slight rebound over the past few years, military spending and budget changes year to year and can depend on the sitting government.
Appendix 1: Model Summary
Appendix 2: Discounted Cash Flow Analysis
Appendix 3: Comparable Company Analysis
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.