Thursday, April 27, 2006

Hexcel Corporation annual report

Hexcel was mentioned in a March 11 comment about how Jim Kramer's Mad Money hysteria had infected me. I bought a modest amount of Hexcel(HXL) at the time that has been roughly stable. As a consequence I received HXL's annual report a few days ago and dove in to figure out what I had purchased. I know more than I did, but still not enough.

The CEO shareholder letter is either a compelling investment thesis or a masterful PR job. The letter outlines a company that makes a product, carbon fiber composites, that is seeing significant growth in applications as a strong and relatively lightweight replacement for metals used in commercial aircraft, military aircraft and equipment, wind power turbine blades, automobiles, and sports equipment. It's biggest segment is aircraft. As an example the letter states that "as the large commercial aircraft of today, averaging less that 12% of composites by weight, move in the next decade towards the 50% composite content of the Boeing 787, we expect to continue investing in growth". Given the current outlook for the cost of fuel, the move toward lighter materials seems inevitable.

As one of only two leading producers of carbon fiber composites today, HXL seems to be well positioned for strong performance and the CEO letter is extremely confident and enthusiastic. There is no mention of any challenges to their outlook. But what could go wrong for an investor? What are the issues?

1. The stock has appreciated 35% in the last twelve months, and by much more in the two years prior. Does the current value already reflect the potential described in the CEO letter?
2. We know that HXL has a competitive advantage in the production of carbon fiber today, but what are the barriers to entry in this industry and how long would it take other companies to ramp up and compete for this growth opportunity?
3. Why do brokerage and independent securities analysts in the aggregate have more sell and underperform ratings than buy ratings?
4. What, if any, is the significance of and impact of the fact that their private equity investors have either cashed out or are in the process of doing so.

And the envelopes please, one by one.

1. The company had a near death experience in 2001 and became highly leveraged with associated high capital costs after private equity investors came to the rescue. With a successful recovery and refinancing, it makes sense that the trajectory of the stock price would be high. If the CEO enthusiasm for much higher growth in revenues and earnings is on target a higher stock price should follow, but just decent earnings and revenue would likely leave the stock where it is at best.
2. There is no discussion whatsoever of competition or market positioning in the entire annual report. I don't know and can't find in the few research reports that I have access to the answer to this important question.
3. Negative analyst ratings can be a double edged sword. If they are correct, we've been warned. If not, and the companies performance forces upgrades, that will be a catalyst for accelerated growth in stock price. One way or the other this will play out in the next 12 months.
4. The private equity investors came to the rescue in 2001 and again in 2003. They took a risk that the public markets and the bankers were not willing to take, and they have been rewarded in a big way. The top 50 shareholder list of HXL as of year end includes many experienced and savvy hedge fund investors. It will be interesting to see, on or around the May 15, the 13F public reporting that shows whether these investors have stayed around for the future potential or whether they have followed the private equity groups out. If they are still around, that's a good sign.

But one thing here is sort of interesting. The private equity investors filed their S-1(the filing that allows for share issuance to make their investment liquid) on February 28. The lead private investor, with more than 15% of the company, was Goldman Sachs. Jim Kramer pumped the stock big time in early March. As a former hedge fund manager who started his career at Goldman, Kramer is networked with everyone. The possible pressure from new stock issuance was coming and Kramer's mass market investors would generally not know. It doesn't quite look right on the surface, but Jim Kramer's integrity is absolutely crucial to his success. My conclusion---he really does believe in the HXL story.

Time will tell. If the CEO is right, if Kramer is right, and if their competitive advantage in this product is sustainable for 3-5 years, HXL is a bargain today. IF, IF, IF.


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