A merger of unequals
Fairlight Asset Management, a stockholder of Hexcel Corporation (NYSE: HXL), today delivered a letter to Hexcel's Board of Directors expressing Fairlight's concerns regarding the proposed merger with Woodward, Inc., including that it has limited strategic merit and significantly undervalues Hexcel, a demonstrably higher quality business.
The full text of Fairlight's letter to the Board is replicated below:
Letter to the Board of Hexcel Corporation
Dear Nick Stanage, Jeffrey Campbell and Members of the Board:
I am writing to you on behalf of Fairlight Asset Management Pty Ltd (“Fairlight”) and our clients who are collectively minority shareholders in Hexcel Corporation (“Hexcel”).
Fairlight’s investment philosophy is to build a portfolio of the highest quality businesses, as indicated by high returns on capital, predictable revenues and conservative management teams that are responsible stewards of the business and shareholder capital. Businesses that boast these characteristics are rare, and once found we strongly believe the optimal outcome for our clients is to hold them for the long term.
Occasionally, portfolio holdings are acquired away from us as other parties recognize the long-term value that will be generated and are willing to pay a premium today to control the business. Whilst we would generally prefer to own a high quality business forever, provided our clients are being appropriately compensated (remembering the rarity of such businesses) we are amenable to acquisitions. In the case of the proposed ‘Merger of Equals’ between Hexcel and Woodward we believe our clients and all Hexcel shareholders are not being compensated for losing their claim on the significant value Hexcel will generate over the long term.
To be clear:
1. The terms of the proposed merger short-change Hexcel shareholders, who are trading undervalued Hexcel shares for overvalued Woodward shares. Further, the quality of a standalone Hexcel will be diluted in the combined entity.
2. The proposed transaction has limited strategic merit. The suggested revenue and product synergies are in our view specious and are unlikely to offset the poor transaction terms being forced on Hexcel shareholders. In terms of potential product integrations, in our view it is Hexcel who holds the desirable intellectual property which in this arrangement is being transferred to Woodward for free.
3. By agreeing to an onerous transaction break fee (4% of Hexcel’s market capitalization), the Hexcel Board has reduced the likelihood of alternate bidder emerging and pushed minority investors towards accepting the merger. That said, Fairlight intends to vote against the proposed merger, given we believe the value a standalone Hexcel will generate will far outweigh the break fee.
Hexcel a demonstrably higher quality business
When compared to Woodward, we believe Hexcel has superior financial characteristics, organic growth profile and durability. When comparing the businesses across returns on capital, margins and balance sheet health Hexcel is comfortably ahead on all metrics. In addition, Hexcel has an enviable competitive position as the preferred carbon fibre supplier to Airbus and will enjoy a multi decade tailwind to organic growth as the increased penetration of composite materials continues. Even without any aftermarket exposure, the aeroplane construction backlog stretching years into the future gives Hexcel’s revenues unappreciated visibility and durability. In the proposed merger, shareholders trade Hexcel’s enviable financial characteristics for Woodward’s inferior characteristics without any compensation.
Trading undervalued Hexcel shares for overvalued Woodward shares
We believe this merger has been struck at a particularly inopportune time for Hexcel shareholders, given Hexcel equity is trading at historical lows compared to Woodward’s which is at historical highs. Over the past 10 years, Hexcel stock has traded at a premium over Woodward stock (measured as relative forward P/E multiples) 63% of the time. The average premium during this period has been 6% over Woodward equity. Given the superior quality of Hexcel discussed above, this is unsurprising.
However, when the merger was struck Hexcel was trading at an 11% discount to Woodward, a historical anomaly (Hexcel’s current PE of 19.3x is below its 12 month average of 20.2x, conversely Woodward’s current PE of 21.6x is above its 12 month average of 19.9x). Had the Board waited for valuations to return to historical spreads, Hexcel shareholders would have been 17% better off, which we would contend still undervalues Hexcel equity, given it is Hexcel that is bringing the intellectual property that achieves the mergers strategic imperative of product light weighting and enabling customer’s emissions reduction.
The numbers above lend support to another common sense conclusion: Hexcel is currently trading under a cloud of uncertainty from the grounding of the 737 MAX, temporarily impacting the market valuation of Hexcel’s equity. Further, Hexcel is exiting a multi-year period of significant investment in manufacturing capacity, and we expect the business to reap increased cash flow and earnings from these investments over the next 2-3 years, which is not fully reflected in the merger price.
Search for alternate bidder or restrike terms
Given the concerns outlined above, we urge the Board to take the following actions:
1. We believe Hexcel is a high quality business trading at an attractive valuation. The Board should search for an alternate bidder to add competitive bidding tension and ensure Hexcel shareholders are compensated via an appropriate takeover premium.
2. Without an alternate bidder, the Board should restrike terms with Woodward to reflect the historical premium Hexcel has traded at, its superior financial characteristics and competitive positioning.
3. Failing the above, the Board should reconsider the merits of the merger in its current form and return to executing on Hexcel’s successful standalone strategy.
In light of the arguments outlined above Fairlight will be voting against the merger.
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Will is a partner and analyst for the Fairlight Asset Management Global Small and Mid Cap Fund. He has seven years data analytics and investment experience with previous positions at EY and Evans & Partners.