How to Play the Aerospace Sector
Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A couple of small cap aerospace companies reported results recently, and I thought it would be interesting to look at them together. Aerospace is a fascinating sector, because the dynamics of the industry are changing and investors need to be very selective. In previous cycles, defense spending tended to support revenues when the commercial markets turned down but, in the new age of austerity, that opportunity is fast receding for certain companies.
Heico’s Secular Growth Drivers
I think Heico deserves a premium rating in the sector thanks to its favorable long term profit drivers. Heico generates 57% of its segmental operating profit from the Flight Support Group (FSG) and the rest from its Electronic Technologies Group (ETG).
The FSG offers Parts, Repair and Distribution and is well positioned to benefit from the trend of airlines trying to cut costs without compromising quality. Heico is the largest independent provider of Federal Aviation Administration (FAA) approved parts. This is a big deal because Heico can offer airlines cost savings on parts that are expensive to source otherwise. Moreover, the necessity for airlines to buy FAA approval provides an obvious moat to Heico. Its distribution and repair services also allow airlines to reduce working capital requirements by trying to outsource inventory and repair activity to Heico.
Things appear to be working well at FSG. Revenues increased 5.7% for the full year and operating margins improved to 18.2%. I note that overall inventories as a percentage of sales actually decreased this year. This is a key point because companies distributing to airlines have run into inventory difficulties before. As usual, Heico is conservative with guidance and suggests 5-7% top line growth with similar operating margins for 2013.
As for ETG, this segment’s story is one of successful acquisitions that added significantly to top line sales but trimmed margins a bit. No matter, organic growth was at 7% and, again, Heico is predicting similar operating margins for 2013.
Putting this together means Heico is guiding towards a 5-7% increase in net income. This is way below the near 14% increase in EPS that analysts have penciled in, but then again Heico is usually very conservative with guidance. Management even pointed out that it predicted 10-12% this year, but net income finally came in 17% ahead, and this is in an economy whose growth expectations decreased as the year went on.
AAR Corp Manages the Defense Downturn
AAR Corp encapsulates the challenge facing much of the industry. While Heico’s defense revenues have historically been around 20% of total revenues, with AAR the figure (defense & government) remains at 40% despite a 15% decline in the quarter. The share price tells you all you need to know about how the market has gradually priced in these kinds of difficulties; cuts at the Pentagon and Obama’s victory haven’t helped matters either. With that said, AAR increased full year earnings guidance to $1.70-1.80 from $1.60-1.70, and the market sent the stock up over 7%. Nevertheless this is more about downgraded expectations being beaten rather than storming growth prospects.
A Commercial Aerospace Play
Thinking longer term, it makes sense to see commercial aerospace stocks command a premium in the sector. In this respect, my favorite stock is B/E Aerospace (NASDAQ: BEAV). As befitting an aerospace company, it’s been an up and down year for the cabin interior manufacturer. The company is a pure commercial aerospace play and benefits from new build and retrofit of fleet. This doesn’t mean that its earnings aren’t cyclical, they are, but provided air passenger mile growth holds up in places like China and India, the company will have good growth prospects. Analysts have 20% EPS growth rates forecast for the next two years.
If it all appears too good to be true, it may well be. As ever with aerospace, investors need to remember that it is a highly cyclical industry. Frankly, I’m fed up of journalists writing and shouting on TV about Boeing’s order book and how it ensures growth for years to come. The truth is that plane orders get canceled or delayed in a downturn. Airlines do go bust. And there is nothing that Boeing or others can do about it.
The Bottom Line
If you are confident of a decent global economy next year and emerging market growth holding up, then Heico and B/E Aerospace deserve a long look. Both are benefiting from good, long-term drivers and have the potential to outperform in the industry. In particular, I would regard Heico’s guidance as being conservative, and with a forward FCF/EV yield of 5% predicted, I think the stock has upside. Unfortunately there is just the hurdle of good global growth to overcome first.
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. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!