The third-quarter earnings from Hexcel(NYSE: HXL) were met with a sharp sell-off in the shares. However, I think the market is too hasty in writing off the stock due to a disappointing margin performance in the quarter, and the dip is a good buying opportunity. Here's why.
What happened to Hexcel
The advanced materials company's core market is the lightweight composites that are a big part of the future of the aviation industry. Because the aftermarket demand for its materials is limited, Hexcel is primarily a play on new airplane production and the increasing content of its composites in airplanes. The excellent news is that airplane manufacturers, including Boeing and Airbus, are aggressively ramping up production in response to multiyear backlogs, and the trend is toward using more composites due to their strength and weight advantage.
As such, Hexcel is reporting excellent growth, but the problem is its margin performance. The following table highlights the issue. There's nothing wrong with Hexcel's year-over-year sales growth. While its industrial sales were down 10.2%, its space and defense sales were up 15.9%, and commercial aerospace sales were up 22.1%.
However, note that its adjusted operating margin declined significantly from the same quarter of 2022 compared to the second quarter of this year. As such, adjusted operating profit rose just 3.9% year over year.
Third Quarter 2022
Second Quarter 2023
Third Quarter 2023
Adjusted operating income
Adjusted operating income margin
Down 110 bp
Hexcel is investing to support growth
While it is never good news to see margins narrow, there's a reason for it in this case, and it comes down to Hexcel's management positioning the company for a period of exceptional growth.
As Chief Executive Officer Nick Stanage noted on the earnings call, Hexcel is "bringing back operational capacity, which has been either turned off or running at reduced rates since the pandemic." He continued, "Over the next three years, build rates for narrowbody aircraft are expected to increase by nearly 50% and build rates for widebody aircraft are expected to almost double."
Increasing capacity requires hiring and training workers and reopening production lines in anticipation of future growth.
Unfortunately, as Chief Financial Officer Patrick Winterlich discussed, the efficiency of these new production lines isn't quite what Hexcel would like, and they are not at the utilization level required.
In addition, the margin performance in the third quarter looks terrible because it's typically a quarter of seasonal weakness. Indeed, if you look again at the table above, it's clear that third-quarter sales are lower than the second quarter. While this is normal seasonality for the company, it comes when Hexcel is increasing costs to support long-term growth, putting even more pressure on margins.
What it means to investors
Management is saying it will "take time" to see margin expansion driven by increased sales, but the excellent news is that Hexcel has time. The major airplane manufacturers have multiyear backlogs and are preparing for significant production ramps.
Moreover, as Boeing CEO Dave Calhoun has previously noted, composites are the industry's future, so you can expect any new plane announced by, say, Boeing or Airbus to contain more composite content. As such, the mere announcement of a new plane in development, with more substantive Hexcel content on board, will lead to the market penciling in increased long-term profitability.
Ultimately, Hexcel's management aims to return to the revenue it generated in 2019 by 2025, along with mid-teens percentage margins. That implies about $2.36 billion in revenue with an operating income of about $350 million. That's a near 50% improvement on Wall Street's estimate for $235 million in 2023, and would put the stock trading at 14.2 operating earnings. Throw in an upward shift in the company's long-term growth rate from increased composite content on newer planes, and Hexcel looks like an excellent growth stock candidate.
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