Stocks Benefitting from Rising Aerospace Spending
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Boeing (NYSE: BA) gave results recently and highlighted the current strength of the civil aviation market. The backlog rose to a record and the first quarter included $42bn in new orders. It’s pretty much a similar situation for EADS with Airbus. It’s fair to assume that the aviation market is currently firing on all cylinders and, with order books full for years to come, it looks like a good industry to be positioned in.
So what is the best way to invest in it and what are the risks?
To answer these questions, an investor needs to take a view on some key long term trends.
- Economic growth, the civil aviation industry is highly correlated with the global GDP
- Oil prices, which cause huge movements in airline profitability
- Airbus’ large planes to regional hub view vs. Boeing’s mid-size planes to more smaller size airports
- Emerging market prospects and infrastructure, will the BRICs travel inter-city by plane, train or automobile?
- Industry growth, low cost carriers vs. premium passengers
I’ll cover these points and conclude with some related stocks ideas.
Economic Growth and Oil
Despite Boeing and Airbus reporting long back logs and companies like Alcoa talking about positive long term industry trends, the fact remains that the aviation industry is highly cyclical. If you look at a snapshot of 2007, many of the market conditions would have been similar to now. Strong backlogs are one thing, but in a downturn orders get cancelled, delayed, or the purchaser might not even be able to pay. The idea that there is some sort of super-cycle in aviation which is insulated from the wider economy is a myth.
Furthermore, high oil prices reduce airline profitability. Here is a table with data from the International Air Traffic Association (IATA) for global commercial airlines, which adjusts forecasts for oil prices.
The ‘oil price spike’ scenario is assuming a move towards $150 Oil with an average of $135 throughout 2012. So, if oil prices spike, airlines become unprofitable and, when this happens orders get cancelled.
One way to actually benefit from high oil prices is to focus on companies that help aircraft reduce costs and, in particular, reduce the weight of the aircraft. One such company is Hexcel (NYSE: HXL) which provides light weight composites for use in planes.
This is an exciting growth area, but my concern with Hexcel is that the business requires heavy capital expenditure. Ultimately, this eats into cash flows. In a sense this is positive, because Hexcel needs to ramp up capacity in order to meet strong end demand. But when end demand slackens, Hexcel will be left with overcapacity. I like the stock, but it has never been close to the kind of valuation that I would pay for a company with such a business cycle.
Trends within Aerospace
Passenger growth is being driven by emerging markets as well as the necessity for them to build international and inter city transportation hubs. The BRICs are all huge countries, so travel between nodes within these countries is an object in itself, let along considering international routes.
As such, aircraft orders are largely being driven by emerging market travel but also by low cost carriers around the world. Clearly, this affects the type of aircraft coming into demand. As for business jet demand, this is driven by highly cyclical factors and business confidence.
In fact, there is no getting away from cyclicality in the aerospace industry, but if you are looking for ‘aerospace plus’ type growth than the business jet segment is worth a look, as would be a particular company tied to a favorable trend.
For an example of the latter, Alcoa (NYSE: AA) has heavy exposure to Boeing’s 737 and Airbus A320 which, are both midsize airplanes with a significant aluminium component. These planes are very popular with low cost carriers who tend to do short haul flights. Alcoa has recently increased its guidance for aerospace growth this year, and I would expect favorable trends to continue within this division.
For Business jets, Textron has its popular Cessna range, and I would suggest taking a look at a supplier like Ametek, which has good exposure to the business jet market.
Avoid the Military
Of course, whenever you look at aerospace stocks it is almost impossible to avoid significant exposure to military expenditure. This is wonderful in the boom years, but when the Pentagon unveils a plan for $487bn in cutbacks over the next ten years –with more cutbacks likely to come- it suggests that investors should be cautious. One stock that has little exposure to the military is cabin interior manufacturer BE Aerospace (NASDAQ: BEAV) or even its European competitor Zodiac Aerospace of France.
BE Aerospace benefits from retrofit and new build of aircraft, and looks set for strong growth. I also like the developments with their new modular lavatory system which is designed in a way that creates more seating on a plane. BE signed a large deal with Boeing for the next generation 737s, which is a good sign. The management team is being relatively cautious about talking up retrofit opportunities here, so I would suspect it is not baked into analyst forecasts. In addition, if planes are moving towards more wide-bodied aircraft with larger interior cabins, this will benefit BE and Zodiac, because it implies a bigger relative spend on cabins.
A Couple of Little Heard Names
If you are positive in general on passenger growth and civil aviation, I would suggest looking at something like a supplier or logistical firm. The usual suspects are well known, but something like Barnes Group (NYSE: B) or Heico are worth a look.
Barnes is a components manufacturer which has over a third of its revenues coming from aerospace and its transportation division is exposed to similar end market drivers. It is little discussed, but I find stocks that are found off the beaten-path to invariably be more attractive.
In turn, Heico is a provider of aerospace replacement parts and repair services. It is a good way to get exposure to traffic miles rather than new build of aircraft. What I like, is that its aircraft parts are highly regulated by the FAA and they also do not depreciate much. Furthermore, airlines are increasingly looking to cut costs by switching to cheaper replacement suppliers, or outsourcing services. Both of which should benefit Heico.
In conclusion, there are risks here, especially with slowing emerging market growth and rising oil prices, but there are also plenty of ways to navigate the horizon.
SaintGermain has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.