market folly

Yesterday we posted on commentary from Children Investment Fund's Q2 letter.  Today, we're highlighting a write-up from Christopher Cooper-Hohn on one of the fund's newer investments: aerospace equipment provider Safran.

Safran: Sum of the Parts Analysis

"70% of the company’s value is in their civil engine business, which is a 50:50 JV with GE, called CFMI.

The engines that they make power narrow-body aircraft (100-220 passengers). This is an attractive business as competition is limited. If you buy a Boeing 737 you have to buy an engine from CFMI and if you purchase an Airbus A320 you have a choice between CFMI or IAE (a company controlled by Pratt and Whitney).

Once an engine has been sold, Safran benefits from spare parts sales. Margins on engines are very low as they are sold close to cost price, but margins on parts are high (60%+) and engines consume roughly 3x their initial value in parts over their lifetime. This parts business is highly protected as the FAA (and other regulatory bodies) prevent the use of unauthorised parts in engines, so the supply of third party parts is low (about 3% of the total) and will likely decline as leasing companies are against their use (they reduce the resale value of the plane). Another attractive feature of this market is that many of the engine parts (so called LLPs, or Life Limited Parts) have to be changed after a certain number of flights as there are strict rules pertaining to aircraft maintenance.

There is a typical 8-10 years lag between when an engine is sold and when it first requires servicing (it is at service that spares are used). After the first service, engines require regular maintenance for the rest of their 25 year life. Safran have sold 10,300 engines over the last 10 years and of these, only 700 have generated spare parts revenues. The total installed base of engines is approximately 18,000 and fewer than half of these are generating spares revenues for Safran. As the age of the engine fleet matures, spares revenues will increase rapidly.

Although it is easy to see the long term spare parts revenue trend, short term forecasts (3-18 months) are difficult as airlines have some latitude as to what kind of servicing to do. For instance, they can minimally service an engine such that it will fly for another 12 months before coming in again or they can service it so that it will remain on the wing for another 4 years. Airlines can also cannibalise their own spare engines for parts and ground engines which require work rather than servicing them.

As the airline industry has been cash strapped for the last 2 years, spares revenues have not grown since 2009 despite the increasing maturity of the fleet. However, there is a limit as to how much maintenance can be deferred and the pent-up demand for the last two years will have to be addressed at some point.

The future also seems bright. The next generation of narrow-body aircraft is composed of the 737 MAX and the A320neo. The 737 MAX will 100% be powered by CFMI and the A320neo will be powered by CFMI and by Pratt and Whitney. It is important to note though that the engine orders that Safran is booking today will likely be delivered in 2018 and first generate profits for the company in 2028. The strong growth that we expect in profits over the next 12 years is predicated on engine sales which have already happened.

Safran’s valuation is very attractive. The company trades on 9x 2012 EV/EBIT and 13.6x earnings, falling to 11.4x 2013 earnings which is a low absolute valuation compared to peers (aerospace companies typically trade on an average of 15x 2012 earnings) and given the growth in spares revenues.

On a Sum of the parts basis, we value the company at €52 per share with 85% upside. The majority of this value is the engine business (€40 per share) and this values the business at €1.4m per engine which is less than the €2.1m per engine that Pratt and Whitney recently paid Rolls Royce for their stake in IAE (IAE engines are directly comparable to CFMI ones). This difference is probably due to our more conservative assumptions as we discount spares earnings back at 10% pa whereas Pratt and Rolls Royce may have used a lower rate. Using our numbers, there is compelling upside and it is more likely that we are under rather than over-estimating the embedded value of the flying fleet."


For more from this fund, be sure to head to excerpts from Children's Q2 letter.