Investing in the Latest Trends in Aerospace

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

I want to take a brief look at some of the trends in the commercial aerospace industry and suggest some stock ideas that could fit in with conclusions reached. Aviation is a cyclical sector, but all cycles are different and I think there are some really interesting geographic and industry-specific trends here. They deserve more attention than just listening to a tv journalist shouting on about Boeing’s (NYSE: BA) order book as if that was the key to all investment decisions.

In summary, the industry is still cyclical, but the growth is coming from emerging market passenger growth. The recession has made it a lot harder for new airlines to get financing, and this could be causing a lessening of the kind of intensely competitive pressures that previously forced the airlines into losing money even when the economy was growing. These are good signs and suggest that the industry could be set for more sustainable long term growth provided the global economy does well and, in particular, emerging markets do well.

It’s Not About Oil

Margins in the industry are low, really low, and that is when they are even positive. This is sometimes blamed on fuel prices, and indeed oil has its part to play; however, the evidence is that the overlying driver of profitability is not fuel prices or oil.

The data in this chart comes from the IATA website. The relationship should be inversely related. As fuel prices go up, profitability should decline. It doesn't quite work out like that. In fact the only period when it did was in 2008 when the global economy collapsed while the oil market was being aggressively bid up by speculators.

If anything, the chart suggests that airlines make more money when fuel is expensive! The answer to this conundrum is that high oil prices are usually an indicator of a strong economy.

Passenger Growth but From Where?

If oil prices are a sign of a strong economy then passenger growth should be too. On closer inspection it is the contribution to top line growth from greater traffic that is the larger factor in determining airline profitability.

All data from the IATA website.

A few remarks about this chart:

  • The traffic data tends to obscure the fact that the larger part of growth is actually coming from passenger traffic in emerging markets.
  • Traffic was pretty good in 2004-07 but the industry was only profitable in the last two years of that stretch.
  • 2012 will mark the only period in the data where the airlines are profitable three years in a row.

Putting these things together it is clear that the industry dynamics have changed, and therefore the way it responds to cyclicality has changed too. Indeed, the IATA has sequentially upgraded its forecasts for industry profitability in 2012. It forecast $3 billion in March then upgraded to $4.1 billion in October and it now stands at $6.7 billion. This is highly unusual in a global economy that slowed as the year progressed and did not recover as many had hoped it would in the second half.

It’s Different This Time

My take on developments is that there are combinations of factors at play here:

  1. Pressure on public finances has held back public subsidy and the defense of national ‘champion’ airlines.
  2. The growth in budget airlines and emerging markets has changed the landscape of profitability.
  3. Financing has become much harder to come by for nascent airlines, so the number of new airlines being formed has fallen dramatically since 2005.
  4. Airlines are becoming much better at cutting costs and reacting to market shifts.

Thinking specifically about the growing importance of emerging markets to the airline industry, we can see that the forecasted profitability in the industry is heavily being skewed towards these regions.

Here is the forecast split for 2012:

Note that Europe and Africa are both forecast to generate no profits in 2012.

Indeed, looking at Boeing’s order book and deliveries for 2012 it is clear that the large orders are coming from airlines (or leasing companies) focused on emerging markets or from budget airlines.

Aerospace Trends?

Having discussed the backdrop, it’s now time to look at some stocks and trends. I’ll develop the stock ideas more in the second article, but for now I think the following are good conclusions:

  • Airlines are more willing to cut costs, so companies that help them do this should see good demand traction. A company like Heico (NYSE: HEI), which makes FAA certified parts, should do well. Heico also has a distribution business, which should enable airlines to improve their working capital requirements via buying from Heico. It also has good prospects from its Electronics Technology Group. Aircraft are becoming ever more complex and increasingly utilizing the kind of electronic devices that Heico sells.
  • The weighting of aerospace demand has shifted towards new planes rather than unprofitable airlines running older planes. This means that new build plays like Boeing or Honeywell look set to benefit in the near to mid term.
  • Airlines are moving increasingly towards luxurious cabins in wide bodied aircraft, and a company like BE Aerospace (NASDAQ: BEAV), which makes cabin interiors, will be a key beneficiary. The company is a rare pure play commercial aviation company that is a preferred seating supplier to both Boeing and Airbus. I like this stock because it can grow via new build and through cabin retrofits. In addition, as the airline industry becomes more stable it may find its customer base is refitting cabins more rather than avoiding it because of a lack of profitability.
  • If passenger growth holds up and airlines are looking to cut costs then AAR Corp (NYSE: AIR) will find its Maintenance, Repair and Overhaul  (MRO) services in increased demand, and it will also benefit from airlines looking to outsource logistics and parts supplies to it. I like the way the company has been investing in commercially (rather than defense-related) companies and therefore diversifying away from reliance on military spending. The one concern with AAR is that it is probably the most exposed to hours flown in the industry. If you like this metric going forward than AAR is well worth a look.

In conclusion, the aerospace industry looks set for decent growth in the years ahead, but I think investors need to be very selective and aware when they are pricing out stocks. A lot of the growth depends on emerging market prospects, and any relative under-performance from the BRICs will have a disproportionate affect on industry growth. On the other hand, the fact that airlines appear to be on a more stable growth path with governments less willing to subsidize loss making competition is a good thing for the industry long term.

 


SaintGermain has no position in any stocks mentioned. The Motley Fool recommends 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!

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