Summary:
- KLX Inc. (KLXI, Financial) provides an interesting case to long the secular growth of aerospace industry with an option on recovery of oil and gas services.
- However, we have concerns on the short term slow growth of ASG segment and management's ability to create value through acquisitions.
- Current valuation does not provide enough margin of safety for us.
Details
What is KLX?
KLX Inc. is a spin-off from B/E Aerospace in December 2014. KLX has two segments, Aerospace Service Group (ASG) and Energy Service Group (ESG). In 2015, ASG accounted for 84% of the revenue and ESG accounted for 16%.
ASG is the world’s leading distributor and service provider of aerospace fasteners and consumables as well as supply chain management. ASG serves commercial airlines, business jets, defense original equipment manufacturers and their sub contractors, maintenance, repair and overall operations, and fixed base operators. ASG provides access to over one million stock keeping units (“SKUs”) and sells products to about 6,000 customers throughout the world. The top five customers accounted for 32% of ASG’s revenue in 2015.
ESG is a result of seven acquisitions of small oil and gas services companies in 2013 and 2014. ESG provides technical services and related rental equipments to oil and gas exploration and production companies.
Both the chairman/CEO and COO of KLX came from B/E Aerospace. Chairman/CEO Amin Khoury co-founded B/E Aerospace in 1987 and served as its chairman. He was the CEO of B/E Aerospace from 2005 to the spin-off of KLX in December 2014. COO Thomas McCarffrey was the CFO of B/E Aerospace from 1993 to the spin-off. CFO Michael Senft was an investment banker at Moelis & Company, CIBC and Merrill Lynch. He had advised B/E Aerospace for 20 years and was a board member before becoming CFO of KLX post spin-off.
Guru trades
Seth Klarman (Trades, Portfolio) has had a small stake since the first quarter 2015, adding to it in the fourth quarter. He now owns close to 4% of KLX.Ă‚
What is interesting
At the current price, KLX stock only reflects the value of ASG. KLX stock has an embedded call option on recovery of oil and gas industry.
The ASG segment could have a bright future. As in the chart below, the world air traffic has had strong secular growth for many years in the past and will likely enjoy strong secular growth for many years in the future.
Global passenger and freight airplane fleet is expected to double the size by 2034. In addition, many of the old airplanes will be replaced by new ones. This means that ASG’s services will likely to enjoy a good 20-year secular demand.
ESG could be at the cyclical trough. ESG was the combination of several ill-timed acquisitions in the oil and gas services industry starting from August 2013 to the second quarter 2014. Oil prices crashed in the second half of 2014. U.S. rig count dropped from 1,700 to close to 500. ESG had to write down $600 million in assets in 2015 due to the severe downturn in the oil and gas industry. Currently the business is cash breaking-even. ESG’s business could have declined too much, too quickly.
What are the worries?
At the current price, there are still several hurdles we could not overcome to consider KLX as a buy. Why?
We do not worry about ESG too much. We think ESG is at the trough of one of the most significant downturns in history. It is more likely than not to recover from the current state, although the size and timing of the recovery is hard to tell.
We worry about ASG.
First, it seems that the aerospace cycle is at the cyclical peak. The net new orders of global commercial aircrafts had been very strong in the last 10 years likely driven by emerging markets, particularly China. Since 2015, the oil price has dropped, and China has slowed down. Many emerging countries are in a cyclical downturn. Is the aerospace industry at the peak of the cycle?
Second, ASG’s growth in recent years is not satisfactory. ASG’s revenue in fiscal year 2016 ending in January was little changed from calendar year 2014. The company’s 2015 10-K reads “although we expect continued weak demand from our business jet manufacturing customers in 2016 and 2017, we do expect a significant upswing in 2018 as numerous new business jet aircraft types enter into service.” There seems to be a long wait until the ASG business shows better growth.
Third, ASG’s return seems low to us and the management does not appear to have been able to enhance returns through acquisitions.
ASG does not seem to have had great returns. In the chart below, we show the pre-tax ROA of ASG (defined as segment operating earnings to assets). ROA had been below 10% after 2007. A sub 10% pre-tax ROA for a distributor with both its suppliers and customers booming does not appear satisfactory.
Why is the return so poor? Westco, ASG’s main peer, has about 10% pre-tax ROA, much higher than KLX. We venture to the conclusion that KLX’s past acqusitions appear to have detroyed value. In the chart below, we show the size of goodwill for ASG and B/E Aerospace’s consumable segment. B/E Aerospace made material acquisitions in 2007 and 2012. The 2007 acquisitions were likely timed poorly, and ROA dipped in 2012. We also know that the mangaement made very poorly timed acquisitions in oil services business starting in 2013. Therefore we have to question the ability of the management to make acquisitions because the same management were the chairman/CEO, CFO and banker of B/E Aerospace.
Valuation
In FY 2016, ASG make an EBITDA of about $240 million. One time spin-off expense is about $46 million and non-cash impairment charges was $29 million. Adding these back the normalized EBITDA is $315 million. ASG’s major peer, Wesco Aircraft, trades at 11.7x EV/ adjusted EBITDA. If we use 11x EV/ ASG adjusted EBITDA, ASG is worth $3.5 billion. Net of $1.2 billion debt, we arrive at equity value of $2.3 billion if we give ESG zero value. The current market cap is $1.7 billion, a discount of about 25%. Given our concerns outlined in the session above, we think the margin of safety is not large enough for a buy. If the pure reason is to bet on the turnaround of oil and gas services, there are plenty of publicly traded companies in that space for potentially better risk adjusted returns.
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