Anatomy of a good company: Safran
David Barker, an Investment Analyst for Henderson EuroTrust, provides a snapshot of the typical analysis undertaken on every company considered for the portfolio. In this case, he explains the rationale behind the inclusion of Safran, a French-listed global aerospace supplier.
7 minute read
- Safran is a leading global aerospace supplier specialising in commercial aircraft engines, equipment, and interiors.
- The company operates in an industry with high barriers to entry due to high safety and regulatory requirements, an oligopolistic market structure and a large aftermarket component, creating the necessary conditions for strong pricing power, high margins, and attractive return on invested capital.
- The industry has strong mid-term growth prospects with a significant order-book for new aircraft, growing demand in emerging markets and ongoing recovery in flying following COVID lockdowns.
There tend to be many features that most good companies have in common, but there are myriad characteristics and features to analyse that will be unique to each and every business. By undertaking a detailed analysis of the 50 or 60 companies we have on our radar (a portfolio of ~40 positions and a watch list of 10-20 names), we try to ascertain whether a business is a good business and if so, whether now is the right time to be invested or not.
Safran is a French aerospace supplier which manufactures aircraft engines, equipment, and interiors. We initiated a position in Safran at the end of 2021 following a period of weak share price performance driven by COVID-19 travel restrictions. Safran has since performed well as travel restrictions have eased but still trades at an inexpensive valuation relative to its quality, in our view.
Safran manufactures a wide-range of safety critical components for commercial and military aircraft. The stringent safety and regulatory requirements of the industry create high barriers to entry, meaning most segments are concentrated between a few global manufacturers. Safran is best known for its aircraft engines business, a segment of the market with a highly profitable aftermarket component. In engines, Safran owns a 50% joint venture (JV) stake in CFM International, a partnership with GE Aviation started in 1974. The JV contributes an estimated 60% to Safran’s total group profits. CFM is one of the world’s largest civil aerospace supplier and supplies engines for the A320 and B737 programmes from Airbus and Boeing, with >40,000 engines in service on >18,000 aircraft as of 2022.
1. Safran’s engine aftermarket business is highly profitable and cash generative
Safran’s engine business is a typical ‘razor/razor blade’ model. In the example of its main CFM International JV, it sells new engines at a loss or breakeven. It then generates profits over the 20/25-year service life of the engine through servicing and spare parts until the engine is retired. Engines must be serviced at specific intervals to be considered air worthy making the aftermarket critical to an airline’s ability to operate their business.
Original Equipment Manufacturers (OEMs) like Safran typically capture a large share of aftermarket spare parts and servicing for the first 2 engine shop visits, whilst third party suppliers and used parts grow share towards the end of an engine’s life. With fuel the highest operating cost for an aircraft, airlines want to ensure efficient and reliable operation of their engines and prolong their life by using genuine spare parts to reduce life-time cost. Aircraft downtime can also be very costly if they lead to cancellations and lost revenue. The cost of spare engine parts is small relative to the total lifetime operating cost of an aircraft.
These market dynamics create very strong pricing power for engine parts suppliers, enabling them to raise catalogue prices every year. As inflation increases, Safran is able to pass through higher input costs in addition to its normal catalogue price increases. This makes Safran’s engine aftermarket businesses one of the most profitable in the industrial sector.
2. Safran has a large installed base of aircraft providing long-term revenue visibility
As air travel normalises following the unprecedented disruption from the COVID pandemic, the installed fleet of aircraft provides strong visibility for aerospace aftermarket suppliers. Engines start to enter their ‘sweet spot’ of aftermarket profits between 10-15 years old as they enter their 1st and 2nd shop visits. For Safran, this means that the previous generation CFM56-5B/-7B engines, (23,000 in-service with an average age of 11.2 years as of December 2021) may start to peak by the mid-2020s. 30% of these engines have had no shop visit, and 50% of them have only had one shop visit.
Although profits from the CFM56 may start to taper off from 2025-26 onwards, Safran’s newest programme, the CFMLEAP will start to compensate, and the installed base should continue to grow from 2026 onwards. The CFMLEAP is the only engine available on the B737 and has >50% market share on the A320neo – giving CFM 78% narrowbody market share overall. Production of the LEAP started in the mid-2010s and as of September 2022, CFM has produced >5,800 LEAP engines, with >13,000 more LEAPs on order for Airbus and Boeing. This has created substantial backlog visibility (the A320neo is sold out for >5 years at projected production rates) providing a strong installed base growth for Safran over the medium term. Safran estimates that from 2022-30, the CFM56/LEAP combined will potentially grow at a high-single digit CAGR, providing an attractive long-term aftermarket annuity.
3. New programmes: long-development cycle creates high barriers to entry
The new aircraft market is a highly competitive duopoly between Airbus and Boeing. New aircraft programmes can take as long as a decade or more from the start of a programme through design, prototyping and initial build phase. The in-service life of a programme can also last multiple decades before it is renewed. Suppliers like Safran are closely involved in the design of an airframe ranging from its engines, landing gear, or thrust reversers and supplier innovation is a key driver of product cycles. For example, the CFMLEAP and competitor GTF engines are the key drivers of better fuel performance from the A320neo, enabling Airbus to launch a new product in the mid-2010s.
Once a supplier has been certified onto a programme it becomes difficult for an airframer to change supplier, as this would require recertification with the regulators. This means Safran’s businesses (engines, equipment, and interiors) are ‘sticky’ with customers. Although the size of Airbus and Boeing and their importance to suppliers means they have a strong negotiating position especially with smaller suppliers, the nature of parts certification into a programme reduces competitive risk present in other industrial end markets with shorter product cycles e.g. Automotive, General Industrial.
4. Safran is an enabler of reduced emissions with its latest products
Safran is a producer of aircraft engines which by nature are emitters of carbon dioxide and consumers of fossil fuels. However, Safran is involved in reducing the carbon footprint of air travel through new engine programmes. In the last 60 years, aircraft fuel consumption has fallen by a factor of 5. 70% of that increased efficiency has come from the engine. Today, the A320neo is 15-20% more fuel efficient than previous generations. Many airlines have spoken about replacing their current fleet with new aircraft to help reduce their carbon footprint and their carbon cost. As part of CFM’s RISE programme launched in 2021, CFM is targeting a further 20% reduction in fuel burn and CO2 emissions based on the use of current jet fuels vs the LEAP or 80% using sustainable aviation fuels (SAF).
5. Strong cash flow generation and balance sheet position
Despite the collapse in commercial air traffic and reduction in aircraft deliveries during the COVID-19 pandemic, Safran generated c.€1.1bn of free cash flow in 2020 and c.€1.7bn in 2021. This partly reflects state support programmes such as furlough and short-time working but also reflects the flexibility of Safran’s cost base and working capital. Consequentially, Safran has emerged from the pandemic with an even better balance sheet position than it entered it with and according to market expectations is expected to be debt free at the start of 2023. With no new commercial aircraft programmes on the horizon (which typically consume cash through R&D and capex) this gives Safran capital allocation flexibility, which management has started to deploy via a share repurchasing plan and resuming its historical practice of a 40% dividend payout ratio following the pandemic.
What is the main risk to the business?
Safran benefits from a very strong demand backdrop. Air travel is still recovering from the COVID-19 pandemic, particularly in countries like China and pent-up demand is driving recovery in Europe/US. However, Safran is not immune to a near-term slowdown in air traffic, which will affect the growth in its aftermarket. This could be a risk in a global recession and consumer income squeeze in 2023 where passengers fly less.
Balance sheet – A financial statement that summarises a company’s assets, liabilities, and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.
Compound annual growth rate (CAGR) – CAGR is the rate of return (RoR) that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each period of the investment’s life span.
Capital expenditure (CAPEX) – Spending on fixed assets such as buildings, machinery, equipment, and vehicles in order to increase the capacity or efficiency of a company.
Free cash flow – Cash that a company generates after allowing for day-to-day running expenses and capital expenditure. It can then use the cash to make purchases, pay dividends or reduce debt.
Emerging Markets – Countries that are transitioning away from being a low income, less developed economy to one that is more integrated with the global economy and is making progress in areas such as depth and access to bond and equity markets and development of modern financial and regulatory institutions.
Inflation – The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.
Payout ratio – The payout ratio is a financial metric showing the proportion of earnings a company pays its shareholders in the form of dividends, expressed as a percentage of the company’s total earnings.
Return on invested capital (ROIC) – Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency in allocating capital to profitable investments. The ROIC formula involves dividing net operating profit after tax (NOPAT) by invested capital.
Oligopolistic – An oligopoly is a market structure with a small number of firms, none of which can keep the others from having significant influence. The concentration ratio measures the market share of the largest firms.
Valuation – Metrics used to gauge a company’s performance, financial health, and expectations for future earnings eg, price to earnings (P/E) ratio and return on equity (ROE).
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