Self-Improvement Could Become A Catalyst For Moog (NYSE:MOG.A)

Despite enjoying a strong reputation as a niche provider of high-quality precision motion and control systems, Moog’s (NYSE:MOG.A)(NYSE:MOG.B) technological and engineering capabilities haven’t really translated particularly well into the financials. Between long-term revenue growth in the low single-digits, virtually no margin leverage, and weak FCF conversion, not to mention mediocre returns on invested capital, there’s not a lot here to get quant-oriented investors excited. Not surprisingly, then, Moog’s long-term annualized market returns aren’t that special at around 8% over the last decade and 5% over the last five years.

In terms of end-markets, I see things to like here – the aerospace recovery is picking up steam, Moog’s specialties are lined up with where defense and space are going, and its industrial end-markets are pretty healthy. I also like the commentary from the new CEO that suggests meaningful margin improvement will be a top priority. Valuation is decidedly more mixed, though, and while I can see a path here to better results, seeing a path and walking a path are two different things.

Margins Take A Bite Again

As was the case in the prior quarter (and has been the case more than a few times), weaker than expected margins, particularly in the Space and Defense Controls (or SDC) segment, undermined the quarterly results and drove a miss. Likewise, management signaled ongoing pressures in free cash flow generation, though I don’t think this should be much of a surprise.

Revenue rose about 9% in organic terms, which was good enough for a small beat versus Street expectations, but a bit below the average for industrials this quarter. Gross margin was flat year over year at 26.8% on an adjusted basis, while adjusted operating income rose 20%, with margin up 130bp to 10.4%, missing by 10bp.

The Aircraft Controls business saw reported sales growth of 2%, with military sales down 8% and commercial sales up 18%. That was consistent with Woodward’s (WWD) report and better than the 5% organic growth that Parker Hannifin (PH) reported from its aerospace business this quarter. Looking more closely at the commercial aerospace numbers, Moog got a big boost from aftermarket (up 58%) as flight hours continue to recover, while OEM sales (up 3%) are still limited by a slower pace of widebody construction recovery relative to narrowbodies.

Aircraft Controls segment profits rose 15% on an adjusted basis, with margin up 110bp to 9.6%, a 30bp miss versus Street expectations.

SDC revenue rose 5% on a reported basis, with Space revenue up 9% and Defense up 1%. Profits declined 10%, with margin down 160bp to 9.4% and missing by more than 2%. Moog is benefitting from the commercial ramp of its reconfigurable turret program, but also taking charges on space vehicle programs – the latter, while margin dilutive for the company, is in my opinion part of the cost of doing business when targeting potentially lucrative new long-term opportunities in orbital vehicles.

The Industrial business saw 17% reported sales growth, with Simulation and Test up 28%, Medical up 7%, Industrial Automation up 9%, and energy flat. That latter result is a little interesting given stronger results from some comps, but the overall performance was solid and management seems more confident/comfortable with the health of its Industrial end-markets. In terms of profits, the segment reported adjusted growth of 66%, with margin up four points to 12.3%, and both revenue and margin beat nicely this quarter.

Management didn’t change core guidance on revenue or operating margin, but did reduce the free cash flow outlook on supply chain issues (driving higher inventory), a decision to build shipsets for 787s in excess of production rates (four shipsets per month vs current production of two per month), and delays in billings for some Space projects.

Stronger Aero Will Help; Stronger Self-Help Would Help More

Moog has long been a strong player in flight surface controls, and that gives the company good leverage to improving aircraft build rates at Airbus (OTCPK:EADSY) and Boeing (BA), not to mention a still-strong bizjet market (General Dynamics’s (GD) Gulfstream business).

The outlook for widebody production is improving, which is good for Moog, though Boeing (BA) is taking it slow, with a target of just five per month by late 2023. International air travel is recovering, but continues to lag domestic travel on a global basis, and it’s the narrowbody side of the sector that’s really driving the aerospace recovery today (at least on the OEM side). I’m not really concerned about the eventual recovery of widebody production, though Boeing has highlighted ongoing concerns about its supply chain as it looks to eventually ramp production there.

What interests me more today than the end-market outlooks (which are generally okay to good) is the company’s capacity for self-improvement. As I said in the open, while Moog gets a lot of respect for its technological and engineering capabilities, translating that into meaningful financial metrics has been an issue for some time.

The new CEO is a Moog veteran, but does appear to be willing to shake things up at least to some degree. Margin expansion and business optimization appear to be key priorities now, and based on the CEO’s preliminary comments, I would expect to see a strategic review cycle that will lead to Moog exiting some businesses or at least pruning its product/customer portfolio. I believe there could also be some adjustments made to manufacturing capacity/overhead, and a more general push toward improved operating efficiency.

All of this should be welcome by investors. Even allowing for some ongoing/residual supply chain and input cost pressures, Moog’s gross margins aren’t anything special, leading me to wonder whether the company struggles to capture its share of the value it offers to customers or whether it simply has excessive structural manufacturing costs. Likewise with operating margin, which hasn’t really improved over the past decade, and free cash flow margin, where the company definitely punches well below its weight – good/great industrials reliably translate 10% or more of revenue into FCF, but Moog struggles to get past 6% on a sustained basis.

One potential issue worth considering is the share class/ownership structure. With the MOG.B shares held primarily by current and former employees, there may be limits on how far management can push cost savings efforts before there is a pushback against them.

The Outlook

I do believe a healthier commercial aerospace market can help drive better revenue growth, and I likewise see Moog benefitting from increased defense and space spending, including efforts in commercial space (satellites, commercial launch vehicles, et al.). I don’t think a 5% long-term revenue growth rate is ambitious, and that may well prove too conservative.

I’m looking for a more meaningful jump in EBITDA this year as various supply chain pressures ease, but I’m holding off on more significant longer-term margin improvement assumptions until I see/hear a more detailed plan from management. At this point I’m modeling a roughly one-point improvement in long-term weighted average FCF margins; the potential to do significantly better is there, but that has been true for a while now and it remains to be seen how much of that potential management can deliver on over the next few years (and/or the long term).

Were Moog able to lift it’s long-term FCF margins more toward the level of Woodward, the fair value of the shares would be over $130 today. As is, I get a discounted cash flow-based fair value more in the area of $100, but with the aforementioned possibility of better revenue and FCF production (and, likewise, the risk of market share losses and ongoing underperformance in margins and free cash conversion).

Moog also looks curiously undervalued on my EBITDA approach. Much as I fault Moog for mediocre margins and ROIC, those still can arguably support a forward EBITDA multiple of over 10x, which in turn supports a fair value of close to $120.

The Bottom Line

Buying Moog as a play on improving commercial aerospace and healthy defense/space spending makes some sense, but the bigger story is in what management can and will do with margins and free cash flow over time. I’m willing to give the company some benefit of the doubt now, but there’s a definite need to execute at a better level for these shares to reverse a long-term record of underperformance.