In this week's small-cap spotlight, Frank and Larsen take a close look at Hexcel (HXL) - Get Report, a carbon-fiber company that is up almost 50% over the past year. But is the stock a good buy at these levels, or is it time to take some profits?
Frank: Growth Is Factored In
When I began researching Hexcel, my immediate reaction was "great company." Hexcel is in the business of producing carbon fiber used for airplanes, wind blades, autos, satellites and recreational applications. Carbon fiber is in high demand these days because of its flexibility, strength and light weight, which result in huge cost savings for customers.
When to Build Hexcel Into Your Portfolio
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Hexcel's strongest market is aerospace, which accounted for more than 50% of sales last quarter. The growth opportunity is reflected in estimates from airplane behemoth and Hexcel customer
that say carbon fiber cuts its fuel use by up to 20%. To get a glimpse of the pent-up demand within the aerospace industry, Boeing and
have reported more than 1,800 orders this year; their combined backlog over the next six years stands at more than 6,000 aircraft.
In addition to aerospace, wind power and defense markets offer huge growth, and these industries should see strong demand over the next 12 to 24 months despite the recessionary conditions that some economists are predicting. In response to the huge demand, Hexcel recently announced a two-year carbon fiber expansion program that will raise capacity to 16 million from 9 million pounds by year-end 2009.
So Hexcel's potential is clear, but my job is to determine whether this company is a good investment; with shares trading at $26 -- 27 times next year's earnings -- I believe most of this growth potential is factored into the stock.
According to Capital IQ, Hexcel is expected to grow earnings by 18% annually over the next three years. In fact, while demand in aerospace is highlighted above, sales in this segment grew only 13% from last year. Hexcel's balance sheet is less than stellar too, with $293 million in debt and only $31 million in cash.
The company has been upfront with its growth plans, and it plans to spend $180 million on its expansion program. But this comes on top of an ongoing $100 million program that is expected to be completed in mid-2008. Management is quick to point out that it reduced its debt levels by $75 million in the quarter, but this was from the one-time sale of its electronics ballistics and industrial reinforcement product lines, which yielded about $62 million.
Also, while favorable macro trends, including higher energy prices, bode well for Hexcel, the weak dollar is actually a burden. Management mentioned last quarter that a weaker dollar does not help its bottom line, as it has a fair amount of dollar sales matched with euro and pound costs.
This is significant, given that the
is expected to continue easing interest rates in the short term, which could further pressure the dollar and result in lower earnings for the company.
Finally, there have been 13 separate insider sales totaling 269,500 shares over the past six months, compared with zero buys. Go back further to March 2006, and all you see are numerous sales from insiders ranging from $19 to $24 a share. Given the huge growth potential that's highlighted in its latest 10Q, I'd be more confident in the stock if insiders were buying instead of selling shares at this level.
Hexcel seems to be positioning itself for long-term demand, but on the basis of the current valuation, there is no room for error, and any delays in future orders could be detrimental to the stock price, given its weak financials. So with the stock trading near its 52-week high, I believe the reward is not worth the risk and suggest waiting on the sidelines for a pullback.
Larsen: A Next-Generation Portfolio Name
There's nothing in Frank's opinion that merits an all-out argument, but I see Hexcel as a great fit for small-cap investors. Obviously, investors should keep an eye on entry points, but I would rather start building up a position in Hexcel now rather than waiting for a pullback that may not happen.
Over the short term, Hexcel is highly levered to the commercial aerospace industry, specifically Boeing and Airbus. But I'm more interested in the company's long-term prospects, which stretch into military aircraft, cars and trucks, wind energy and satellites. In addition, Hexcel may be able to gain considerable pricing power over the long term because of the company's status as a market leader in advanced materials.
As I was reading over the current analyst views on Hexcel, I couldn't help but think these analysts are too focused on short-term issues. Obviously, Wall Street research is supposed to closely follow near-term results and developments, but I found the existing research on Hexcel to be very short-sighted relative to the long-term potential in the carbon-fiber arena.
Shares of Hexcel have posted a solid run during 2007 and were recently up about 45% year to date. But a brief review of recent developments shows that the stock has benefited from the short-term aerospace factors that I mentioned earlier. Since taking a 40% hit during the summer of 2006 -- after Airbus announced major delays in production of the A380 "superjumbo" jet -- this year's run is mainly a result of improved expectations for A380 build rates as well as progress in Airbus' A350 program.
I see a number of catalysts in the coming year for Hexcel outside of commercial aerospace. These include increased defense spending on military aircraft that contain a large amount of carbon fiber (such as the V-22), increased demand for carbon fiber in wind-power applications (mainly turbine blades) and other lower-profile opportunities such as the $100 million deal announced in August to provide fiber to
( USEC) for nuclear enrichment tubes.
Down the road, I won't be surprised if investors benefit from a rise in the multiple applied to shares of Hexcel. Frank mentioned that the stock was recently trading around 27 times next year's earnings, which I think is perfectly fair on the basis of the company's leadership status. I don't consider
-- another attractive small-cap carbon fiber company that's more levered to wind power than aerospace -- a true competitor, because its carbon fiber is low-cost industrial grade. As carbon fiber finds its way into more applications, Hexcel could see significant pricing power based on limited competition for its higher-grade fiber product lines.
Automobiles and the Chinese wind power market are two great examples of the long-term side of the Hexcel story. Those who expect fuel consumption to remain an issue for years to come should consider the potential for increasing use of carbon fiber in cars and trucks. Carbon fiber can effectively replace steel parts that weigh about five times as much, leading to significantly lighter vehicles and lower fuel consumption.
On the China front, Hexcel announced in October that it would build a new production facility in Tianjin focused on meeting the increasing demand from major wind-power customers. This is obviously a major source of long-term potential, given China's plan to double its renewable energy capacity by 2020, which I think could prove very conservative in both scope and timing.
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