Where is the Aerospace Industry Headed?

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sometimes you have to wonder how much more short term the market can be? AAR Corp (NYSE: AIR) had already pre-announced results at the start of the month but when they formally released them the stock was met with a 6% decline and then a 3% rise the next day; this is after raising guidance as well. The results were actually fairly strong, but there was a lot in the details that revealed the underlying trends in the aerospace industry.

 

Private Sector Good, Public Sector Bad

No, not a eulogy to free market enterprise but a statement of what is currently trending in aerospace. Cuts in public spending and military hardware are reducing end demand on one side. Fortunately commercial aerospace is flying high at the moment and companies with heavier exposure to this side of the industry are benefiting accordingly.

A quick look at Boeing’s (NYSE: BA) order book reveals that it is filled for years to come. Even more interesting is where the orders are coming from. Here are the airlines that have made more than 20 orders in 2012 from Boeing.

 

Aside from the large order from United, all of these orders are being driven by budget airlines and emerging markets. In addition, a large part of the leasing company's orders are for operations in the Far East, and arguably Virgin Australia is an Asian carrier. Essentially the marginal growth in passenger miles flown is being driven by emerging markets. Indeed, the fact that commercial aerospace is actually an emerging market play has been one of the best kept investing secrets of recent years.

 

AAR’s Profit Shift

Turning back to AAR corp we can see these trends play out in its gross profits movements over recent years.

 

Commercial aerospace is heavier weighted in Aviation Services than it is in Technology Products, and there is a clear shift in revenues and profitability here. Commercial revenues now make up 57% of the total and they are currently rising at 25%, although there was a 12% contribution from acquisitions. By way of comparison, defense spending only rose 1%. The company is making the right strategic decisions by acquiring commercially focused companies.

However, the market is clearly concerned with the outlook for military spending, and ever since the Pentagon outlined plans to cut nearly $500 billion in military spending over the next 10 years, the market has been stressing over which programs would get cut.

The result has been to shift investor sentiment on the sector in a fascinating way. Previously investors would favor companies with a balanced mix of revenues between defense and commercial (the argument being that the cyclical commercial side would be balanced with stable defense spending when the economy slowed). However, this year investors have been forced to move away from that idea and focus more on commercial aerospace orientated names.

 

Commercial Aerospace Companies

My favorite stock in the industry is cabin interior manufacturer B/E Aerospace (NASDAQ: BEAV).  The company profits from new and retro fit aircraft cabins. Traditionally, airlines would buy aircraft from Boeing or EADS (Airbus) and then a cabin fitter like B/E Aerospace or its French rival Zodiac Aerospace would kit out the interior. As for the retro fits, this is a market largely determined by passenger miles flown and the financial condition of the airlines. In other words it is cyclical but BE is adding products in order to offer some secular growth prospects. I particularly like the new lavatory system offering which actually adds some more seats to the aircraft. Moreover this activity would see the company working directly at the aircraft manufacturers.

I also like Heico (NYSE: HEI) because of its exposure to some favorable trends within aerospace. Just as the car industry has undergone a revolution in just-in-time manufacturing and outsourcing processes over the years, I think the time is ripe for a similar sort of thing to happen in aviation. Outsourcing servicing and the increasing use of non-OEM spare parts are ways that airlines can cut costs, and Heico offers both these solutions.

Another option would be to look at how strong AAR’s structures and systems revenues have been and conclude that Spirit AeroSystems' (NYSE: SPR) growth will continue in line with OEM order books. Spirit is more aligned to Boeing but also sells to Airbus.  Not only are its revenues correlated to the general order cycle but it also has exposure to the 787. Another key driver is the need for airlines to improve operational performance and profitability by replacing less fuel efficient aircraft with more modern models (although I confess I am not particularly sold by this argument). The truth is that if the airlines' end markets are turning down, they just stop spending.

 

Where Next for AAR?

My picks for the sector would be BE Aerospace, Heico and AAR, but frankly we need greater visibility over long term growth in the industry and in particular a pickup in growth in emerging markets. As Boeing’s order book demonstrates, relying on US passenger growth is not enough, and right now growth estimates in the emerging world are being downgraded.

It’s definitely a sector to watch should China et al manage to stimulate their economies back to growth, but for now a cautious approach works best.


SaintGermain has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend HEICO and Spirit AeroSystems Holdings. 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure