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We are adding Hexcel ( HXL) to our radar screen. The stock was recently trading at $15.25, and strong demand for carbon fiber and other composite materials used for improving manufacturing efficiencies could drive double-digit percentage earnings growth for Hexcel for at least two more years.

Hexcel appeared on our radar screen in late June when the company said manufacturing delays by key customer Airbus will weigh on 2006 revenue results. Airbus, which is building new jets that contain large amounts of composite materials in the fuselage and other parts, has had production problems as it rushes to meet strong end-market demand for its new A380 jumbo jet.

However, we believe Hexcel's 40% decline since May 11 discounts a large degree of risk to future earnings results, and we will consider adding shares to the model portfolio as we gain more confidence in Airbus' ability to begin deliveries of the superjumbo A380 in 2007.

The company is a leading provider of materials such as carbon fiber and reinforcement fabrics that are used to build both commercial and military aircraft, body armor, automobiles, wind turbines and helicopter blades, to name just a few applications. Rising metal and energy prices have pushed up manufacturing costs and the cost of buying and operating cars and planes. We believe this is a driving force behind a shift in production strategy by large corporations such as Boeing ( BA), Airbus and BMW to incorporate stronger, lightweight and cost-effective composite materials into production.

Hexcel generates nearly half of its revenue from the aerospace industry, with Boeing and Airbus accounting for nearly 41% of its revenue in 2005. As such, the company is well-positioned to benefit from Airbus' A380 planes, which Airbus should begin shipping to airlines in late 2007 and 2008.

Both the A380 and Boeing's soon-to-be-produced 787 Dreamliner contain more than 20% composite materials, and Hexcel will be the primary supplier of composites to Airbus for the A380. For comparative purposes, Airbus' and Boeing's past plane models were built with less than 10% composite materials.

Rushed engineering work on both companies' new planes led to aggressive production schedules for Boeing and Airbus, and recent announcements from Airbus indicate it is running behind by about six months on the manufacturing front. This led to the late-June revenue-growth warning from Hexcel. While not specific, the company indicated that full-year 2006 revenue could fall short of its prior guidance for about $1.27 billion. Even so, the company noted that general demand from other areas of the aerospace market remains strong and could drive 10% full-year revenue growth in Hexcel's aerospace business.

A delay in production of the A380 will weigh on Hexcel's near-term results certainly, but selling the stock at current levels based on this information alone would be myopic. A cut-and-run strategy does not take into account that carbon fiber, and other composite materials, are in short supply and will likely remain in short supply for at least two more years because it takes at least two years to add new capacity.

Such a view also ignores the fact that composite materials are finding new end markets away from aerospace, including the wind power and oil drilling markets. Deep-water drilling requires lightweight and strong materials, and carbon fiber is showing up in more equipment in this industry. Last, composite materials will likely become standard in most new-plane model introductions because of inherent cost and manufacturing time advantages and the resulting lighter plane that is more fuel-efficient.

Ramping Up Capacity

To take advantage of increased demand, Hexcel is focused on expanding its carbon-fiber manufacturing capacity by 50% in 2008. Hexcel currently relies on companies such as model portfolio holding Zoltek ( ZOLT) for a portion of the carbon fiber Hexcel sells. This weighs on margins, as the cost of purchasing carbon fiber in the open market at present is higher than what it costs Hexcel to produce carbon fiber on its own. As such, successfully expanding its own manufacturing facilities will be a key driver of profit growth in 2008 and beyond.

Hexcel also has formed a sales relationship with leading German wind-power companies Vestas and Gamesa, which are both desperate for carbon fiber as a reinforcement material to build longer wind-turbine blades. And military jet orders are on the rise due to surging defense spending, and the percentage of composite materials being used to manufacture jets is on the rise.

With the industrywide carbon-fiber shortage and Hexcel being one of just a small handful of companies with carbon materials qualified by airlines for use in commercial aerospace production, we believe the company will have little difficulty selling its additional carbon-fiber production into multiple end markets.

Doing It Right

Hexcel's operating results over the past few years serve as a testament to a well-run company. Following the Sept. 11 terrorist attacks, the aerospace industry began a multiyear down cycle that led to negative growth in plane production. According to Hexcel's corporate presentation, aircraft deliveries declined some 25% from 1999 through 2004 while Hexcel increased its sales of aerospace materials by 33% over the same period. Also, the company has kept a tight rein on costs through headcount reductions, which management expects will remain relatively flat despite surging end-market demand for composites. As such, the company's operating margin grew to 9% in 2005 from 8.3% in 2004 and 6.7% in 2003.

Hexcel shares are inexpensive based on 2006 and 2007 analyst earnings estimates. The Street is forecasting 69 cents in earnings for 2006, and 88 cents in earnings for 2007, which implies forward P/E ratios of 22 and 17, respectively. We believe that, relative to expectations for 20%-plus earnings growth for the next two to three years, this is an attractive valuation point. On enterprise-value-to-EBITDA, or earnings before interest, taxes, depreciation and amortization, shares trade at 13 times 2005 EBITDA results vs. an industry average of closer to 18.

We believe analyst estimates will likely prove conservative. End-market demand for airplanes should remain strong due to the current replacement cycle and with newer models becoming available. Also, new avenues of growth, such as wind power, will likely continue to take carbon-fiber supply out of the market, creating a supply/demand imbalance that supports higher composite prices.

We will continue to monitor the company's progress and track the production plans of both Boeing and Airbus to gauge when orders will pick up for Hexcel.

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