Advanced composite materials company Hexcel (HXL -0.03%) raised its full-year sales and earnings guidance recently, only to be met with an immediate sell-off in its stock. It's now down more than 5% since the report. There are reasons for the decline, not least the reduction in free-cash-flow (FCF) guidance and declining profit margins. Still, I think this is creating an excellent buying opportunity in a long-term growth stock. Here's why.
Introducing Hexcel
Hexcel manufactures and sells advanced composites used in the aerospace and defense industries, as well as in an array of industrial uses such as wind turbines. Its composites offer strength and weight advantages over traditional materials like aluminum.
That's a significant plus in airplane design as it enables greater fuel efficiency, giving planes increased ranges and reduced carbon emissions. As such, the key growth drivers of Hexcel's revenue are increased airplane production (Boeing and Airbus will be aggressively ramping up their production in the coming years) and the growing adoption of advanced composites on new planes -- another strong trend, and one that Boeing CEO Dave Calhoun firmly believes in.
As such, Hexcel is a play on the recovery in airplane deliveries and the secular growth in composite usage in commercial airplanes and military equipment. Meanwhile, the company has growth opportunities in other niche industrial markets.
What happened
Here are the headline details from the second quarter earnings report:
- Sales rose 15.6% year over year to $454.3 million, and adjusted operating income increased 38.3% to $61.3 million.
- Management raised its full-year sales guidance to a range of $1.765 billion to $1.835 billion from a prior range of $1.725 billion to $1.825 billion.
- Management raised its full-year adjusted diluted earnings per share guidance to a range of $1.80 to $1.94 from a prior range of $1.70 to $1.94.
The points above are all positive, but the market was probably worried about the following issues:
- Gross profit margin declined on a sequential basis to 24.4% in the second quarter compared to 27.9% in the first quarter.
- Management cut its full-year FCF guidance to $110 million from the prior guidance for $140 million.
Image source: Getty Images.
Margins should not be a concern
No shareholder likes to see gross margins decline, but as management discussed previously, the first quarter's gross profit margin figure was exceptional. There were two key reasons for this. First, the company enjoyed a favorable sales mix in Q1 with "strong demand for Hexcel fiber-rich products," according to CFO Patrick Winterlich. These products tend to be higher margin.
Second, Winterlich noted Hexcel had "significant overhead absorption from increasing inventory." Without getting too far into the weeds, this means Hexcel produced more finished goods than it had budgeted for over the course of the year. All told, the first quarter's gross margin figure was exceptional.
Data by YCharts.
Looking at gross margin on a year-over-year basis in the second quarter, it increased from 22.8% to 24.4%.
Moreover, there's reason to believe Hexcel's gross margins could improve as energy, commodity, and raw material costs should moderate in line with a cyclical economic slowdown.
Don't worry about free cash flow either
The main reason why management cut its FCF guidance was its decision to spend $38 million on acquiring land and a building it's leasing in Amesbury, Massachusetts. Subtract that $38 million from the initial FCF guidance for $140 million and you're left with $102 million. The fact that Hexcel's full-year FCF guidance is now $110 million implies an all-things-being-equal increase in FCF guidance by about $8 million.
Finally, Hexcel's FCF generation is highly likely to rise significantly in the coming years. As the chart below shows, management increased inventories considerably in recent years -- they are now at a similar level to where they were at the start of 2020, despite significantly lower sales.
Among the reasons for those expanded inventories were the sales slowdown that occurred when pandemic travel restrictions hit the aerospace industry, and management's conscious decision to make sure Hexcel had enough inventory to meet the needs of its customers in the face of well-documented supply chain issues.
As such, Hexcel should see a benefit to cash flow as it can now run down its inventory rather than tying up cash in significant amounts of new inventory.
Data by YCharts.
A stock to buy
The initial market reaction to this Q2 report looks like a knee-jerk response to some superficially bad news that masks good progress for the underlying business. Hexcel presents a decent buying opportunity in a long-term growth story driven by accelerating airplane production and the increasing use of advanced composites in those planes.
