Héroux-Devtek Inc.

• Acquisition of CESA and Beaver provides an excellent platform for growth and should strengthen Héroux's reputation.
• Bidding pipeline remains strong and Héroux is working to fill its excess capacity.
• Solid free cash flow generation should strengthen the balance sheet for further M&A opportunities.
• Key components in place for a C$32 stock in 2–3 years, in our view.

Héroux-Devtek is the third-largest manufacturer of landing gear in the world. Following the sale of its aerostructure and industrial products divisions to Precision Castparts in 2012, the company focused exclusively on landing gear. On October 2, 2017, Héroux announced the acquisition of CESA, a leading European provider of landing gear and actuation systems. The company now employs more than 1,300 people in 13 facilities around the world. On February 28, 2018, it announced the acquisition of Beaver Aerospace, a vertically integrated manufacturer of custom ball screws, and hydraulic and mechanical actuators.

We believe the recent acquisitions provide an excellent platform for Héroux to grow with Airbus (~50% of CESA's revenue), while also strengthening its exposure to the defence market (~67% of Beaver's revenue). Following the closing of the two transactions, Héroux's revenue mix will remain well-balanced, with 53% of revenues for fiscal year 2018 (FY18) coming from Military and 47% from Commercial. In terms of product mix, 42% of total revenues will be derived from proprietary products and 38% from aftermarket products, which tend to be recurring in nature and more profitable in the long term. Overall, we believe these acquisitions represent an excellent strategic decision for Héroux.

The outlook for commercial aerospace remains solid, with IATA calling for robust growth of 6.0% in the passenger market in 2018, slightly below the very strong performance of 7.5% in 2017. In addition, Boeing and Airbus continue to increase their production rates on narrow-body aircraft, with both now having more than eight years of production in their backlog. Moreover, the bidding pipeline remains impressive, as management is working with several OEMs on additional opportunities such as Boeing's middle-of-the-market option.

On the military side, business is gradually recovering across the globe. The US government is expected to grow its military funding by 9% year-over-year to US$639b in 2018, while the Canadian government is expected to increase its funding over the next 10 years to C$32.7b in 2026–27 from C$18.9b in 2016–17. In addition, Héroux is ramping up key programs (Saab Gripen, F-35, CH-53K and Embraer KC-390) and will continue to benefit from two maintenance, repair and operations contracts (CH-47 and C-130), which should fuel growth in its military segment in the medium term.

We continue to like the company's solid growth opportunities (B-777/777X program and new cross-selling opportunities with CESA and Beaver) and solid free cash flow profile (yield of ~7% based on our FY19 numbers). Furthermore, we believe Héroux has the key ingredients in place (growth opportunities, solid management team and strong balance sheet) to become a C$32 stock in the longer term, assuming C$695m in revenues and an EBITDA margin of 17% by FY21, and an 11x EV/EBITDA multiple.

Our C$19 target price is based on an average of three valuation methods: (1) 19x P/E multiple, (2) 10.0x EV/EBITDA multiple, and (3) a discounted cash flow value of C$21.09.