Morningstar | Meggitt’s FVE Raised as Rising Aircraft Deliveries and Growing Shipset Value Fuel Aerospace Profit. See Updated Analyst Note from 18 Jul 2018
After updating our sales and profit estimates for Meggitt, along with an in-depth analysis of the firm’s exposure to our large-jet delivery forecasts, and accounting for the time value of money, we are increasing our fair value estimate to GBX 630 per share (from GBX 530). We maintain our narrow moat rating. Our analysis of Morningstar's proprietary delivery forecasts for manufacturers Airbus, Boeing, Bombardier, and Embraer leads us to forecast an average annual growth rate of jet deliveries with Meggitt content installed of 10.7% over 2018-21, and supports our above-consensus forecast for group revenue CAGR of 4.4%. In our view, the consensus revenue CAGR estimate of 2.5% underestimates Meggitt's strong production and increased dollar value per aircraft, improved outlook for defense, and high utilisation of large jets.Meggitt’s increased equipment sales content on new and growing aircraft platforms like the Airbus A320neo series (20% higher OE shipset dollars versus the old A320ceo series), A350 (250% increase compared with A330), and Boeing 737MAX (up 55% versus B737) will drive increased aftermarket sales for decades. More than 50% of Meggitt's revenue is derived from higher-margin aftermarket services, which we view as evidence of sticky customer relationships, supporting our narrow moat rating. We foresee reinforcement of switching costs, as a 6% CAGR for civil aerospace aftermarket revenue over 2018-22 exceeds the group average. Meggitt's installed fleet is getting younger as a result of success in securing positions on new platforms over the past couple of years. A young fleet is a headwind for Meggitt's short-term aftermarket revenue, but an important driver for long-term aftermarket demand, as a large volume of aircraft are due to move into the aftermarket sweet spot over the next five years. The sweet spot regarding civil aerospace aftermarket services activity and profitability is within the 10- to 20-year range.
Immediate expensing of programme participation costs (or a heavily discounted product sale) due to adoption of IFRS 15 will depress Meggitt's EBIT margin by 130 basis points. Additionally, increased costs as a result of a high level of deliveries of platforms over the medium term, with firms breaking shipsets free of charge, will be dilutive to margins as well. Despite these headwinds, group EBIT margin will strengthen by 90 basis points due to efficiency gains, increasing attribution of higher-margin aftermarket, a lower level of R&D spending, new product introduction costs as a percentage of sales, and successfully addressing production issues with the Meggitt Polymers & Composites business.
Based upon our assumption of a 2018 dividend of GBX 17 per share, Meggitt's forward dividend yield stands 3%. Given strong rising free cash flow generation (defined as cash flow from operations less cash flow from investing), we believe Meggitt's board of directors should return more capital to shareholders. In 2017, the dividend per share increased by 5% to GBX 15.85, equivalent to less than 40% of diluted earnings. We believe that more forceful engagement by shareholders and robust growth in earnings per share would result in substantial dividend per share growth in 2018-27. As such, we model a payout ratio of 70% of diluted earnings.
Meggitt is the parent company of a group whose principal activities are the design and manufacture of components and sub-systems for aerospace, defense and other markets. Co. has five segments: Meggitt Aircraft Braking Systems, a providers of aircraft wheels, brakes and brake control systems; Meggitt Control Systems, which comprised of aircraft fire protection and control systems; Meggitt Polymers and Composites, which comprised of engine and aerodynamic seals, flexible fuel tanks and fuel systems; Meggitt Sensing Systems, a provider sensing and monitoring systems for aircraft; and Meggitt Equipment Group, which include unique heat transfer equipment for hydrocarbon processing.
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