Moog Still Offers Upside If Management Can Deliver On Margin Targets

Writing about Moog (NYSE:MOG.A) (NYSE:MOG.B) earlier this year, I noted the company's strong business track record and good leverage to growth drivers like commercial aerospace, space (commercial and military), defense, and automation. I also noted, though, that margins were historically lackluster, and the new CEO needed to offer a path toward meaningful improvement. Management has done just that, and coupled with solid top-line performance, the shares have risen about 20% since that article.

Setting out a plan is one thing, executing on it is another. I do believe Moog's CEO is going after relatively easy targets, but I also think 400bp of margin leverage across three years is a tough bar to reach, let alone exceed. I'm still bullish on Moog with the underlying assumption of "close, but not quite there" progress on the margin targets, leaving further upside if management can in fact deliver on those ambitious self-improvement goals.

Margin Targets Are Ambitious, But The To-Do List Doesn't Seem Overly Difficult

In that last article, I speculated that significant contributors to Moog's lackluster margin performance likely included suboptimal value capture from customers and excessive structural manufacturing and operating costs. It would seem that I was on to something, as the plan laid out at the June investor day targets those issues.

On the value capture front, management has explicitly said that they believe they are not getting fully paid for the value they deliver to customers and that they would start addressing this through pricing discussions with customers, particularly in the commercial aerospace market. That sounded like a big ask, as commercial aerospace companies are notoriously tough negotiators on first-fit pricing (arguing that the companies will earn it back with years of lucrative aftermarket sales), but commercial Aircraft Controls sales were up 34% in the last quarter, with management noting progress on pricing.

Management is also looking to prune its product portfolio, and as an old-style conglomerate with a diverse collection of businesses and product portfolios, this should be relatively low-hanging fruit. I expect the company to engage with customers on pricing, but where there's reticence to move on prices and returns are low, I expect Moog will jettison businesses.

Turning to manufacturing efficiency, management wants to reduce its operational footprint and consolidate its manufacturing into more cogent and cohesive centers. As a conglomerate, it's not surprising that there has been some "sprawl" over the years, and management is looking to move from 75 facilities to 65 to 68 over the next three years. Again, this should be relatively low-hanging fruit for the company.

Beyond consolidation, management is also looking to incorporate more automation and a greater overall focus on 80/20 best practices. I've seen this approach (80/20 serial improvement) work for many companies in recent years (Danaher (DHR) perhaps most famously, but also companies like Dover (DOV) and Eaton (ETN) that have executed on meaningful operational improvement drives). I can imagine some disruptions as this process is implemented, and likewise with retrofitting to incorporate more automation, but again I don't feel like this is a fundamentally complicated plan.

All in all, I'm left of two minds on this operational improvement plan. On one hand, 400bp of operating margin improvement from a company that has struggled to show any meaningful improvement feels like a big ask. On the other hand, a 14% margin is still not that high compared to what other companies in the precision motion and control space routinely do (including Eaton and Parker Hannifin (PH)) and the to-do list doesn't seem very difficult. I don't say this to denigrate management or suggest there's no execution risk, but rather just to highlight that these aren't revolutionary changes that other companies have found exceptionally difficult to execute.

Attractive Multiyear Opportunities For The Top Line

I am still bullish on Moog's operating revenue growth leverage across the next five years and beyond.

I'm quite bullish on the global aerospace recovery, and I'd note that the recovery in wide body production really hasn't ramped up in earnest yet - that's something that Airbus (OTCPK:EADSY) and Boeing (BA) are intending to do next year, and that should drive increased growth for Moog. I'd also note that Moog has already made some progress on pricing (and could achieve more) and the growth in aircraft production in the coming years will also generate a long tail of aftermarket revenue.

I'm also bullish on the opportunities in defense. As we've unfortunately seen over the last 18 months, the world is no safer or cooperative and armed conflict is an ongoing reality. In addition to leveraging to newer programs like the V-280, I'd note that Moog has meaningful content on missile programs like the Hellfire - the fate of Western support for Ukraine certainly seems up for debate, but I don't think demand for missile systems (and defense systems in general) is likely to abate soon, and I'd note that projects like the configurable turret (the RIwP) is just starting to hit its commercial stride.

In space, the company continues to advance its capabilities in launch vehicles and orbital systems. The company is absorbing elevated costs in these early days, but margins will improve as these projects scale up, and I like the company's leverage to surveillance satellites.

Industrial is a tougher call given the company's stated intention of pruning sub-scale portfolios. Management is only guiding to 2% to 3% growth over the next three years, but underlying growth opportunities in flight simulators, oil/gas exploration components, and industrial automation (precision motion and fluid control and remote monitoring) are stronger than that guidance suggests.

The Outlook

I'm really not concerned about the outlook for aerospace, defense, or space over the next five years. Likewise, I'm not concerned about demand in oil/gas, medical, simulation/test, or industrial automation, though I do think demand in the latter could fade more noticeably for a few quarters given commentary and guidance from companies like Fanuc (OTCPK:FANUY), Rockwell (ROK), and Siemens (OTCPK:SIEGY).

My estimates work out to a little more than 6% revenue growth through 2026, slightly above the midpoint of management's investor day guidance, and my long-term assumptions lead to a growth rate in the mid-5%'s. I can see opportunities where the company could outperform, but again, portfolio pruning could cap some of the upside.

I've already discussed the margin opportunities, and I think the CEO's long tenure with Moog should facilitate the process (knowing where, and how, to cut or change). I don't think the company will quite reach the 14%-plus target in 2026, but I do see meaningful improvement, and I'm looking for EBITDA margins in the 15%'s and FCF margin around 8% in 2027. Longer term, I've boosted my out-year FCF margin estimate to 10%, which is indeed bullish relative to Moog's history (a long-term trailing average of around 5%), but not all that demanding looking at the company's peers. If Moog can do this, FCF growth will be in the mid-to-high teens.

Between discounted cash flow and margin/return-driven EV/EBITDA, these shares still look undervalued, with a near-term fair value in the $128.50 to $132.50 range and a long-term annualized total return potential in the 8%'s.

The Bottom Line

The biggest risk I see now is coming in too far short of those margin improvement targets. At this point, it's a "they will, or they won't" sort of question; I think they'll get most of the way there, but it's possible that Moog's structural cost/efficiency issues prove more stubborn than I (or management) expect. Given a credible margin improvement plan and a supportive macro backdrop for attractive revenue growth, I think the risk-reward here is still favorable.