Two Aerospace Names to Buy, One to Sell

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

Demand for aerospace products is on a rise according to different sources. By sources I mean, suppliers of raw materials like aluminum companies, supplier of jet parts and the final manufacturers like Boeing and Airbus.

However, improving industry fundamentals do not mean that every company in the industry is a name to buy. You will always find a wide variety of companies in a similar industry. The source of difference can various ranging from valuations to secular growth stories.

With earnings season beginning it is a good time to have a look at a variety of commercial aerospace players out there. Let’s have a look:

Earnings preview and outlook

The first in line is Embraer (NYSE: ERJ), the Brazilian aerospace manufacturer. KC-390, a twin engine military transport aircraft has been one of the latest products of this company which has received extremely favorable comments from the market. Apart from that the company has two more revenue drivers in its defense and security segment: SISFRON and Super Tunaco

Sistema Integrado de Monitoramento de Fronteiras or SISFRON is the name given to the project of developing 10,000-mile border security cordon in Brazil aimed at beating organized crime, drug and people smuggling and poaching in the forests. Embraer has won the bid for the first phase which is likely to be worth $400 million.

Super Tunaco has been another jet that has received high level attention from the defense authorities. The Embraer EMB 314 Super Tucano, also named ALX or A-29 is a turboprop aircraft designed for light attack, counter insurgency, close air support, aerial reconnaissance missions in low threat environments, as well as providing pilot training.

Embraer is expected to announce an EPS of $0.65 for the last quarter. However, the company might not be able to meet the estimates given its weaker-than-anticipated aircraft deliveries for the quarter. The company is expected to announce 20 Commercial aircraft deliveries (down from 35 a year ago), 24 Executive deliveries (up from 20 a year ago), and 17% revenue growth in Defense & Security.

A 9.3% total company operating margin is expected, which falls at the mid-point of the company’s full-year guidance range, although is down from the 11.5% achieved in the year ago period. Embraer’s book-to-bill in the quarter should be quite strong given the large order announcements Embraer made for multiple aircraft types.

As far as the outlook is concerned, no change is expected to Embraer’s full-year revenue or operating margin targets. There is limited upside to regional jet and business jet production in 2013, and Embraer’s operating margin target is 9.0-9.5% inclusive of a 1Q13 reported margin of 3.6%.

The company is expected to discuss the following items in its call:

  • E-2: investment, timeline, competition (E-2 is second generation of E-jets which are narrow-body, twin-engine airliners)
  • Legacy regional jet order demand.
  • Business jet market trends.
  • Legacy 500 and 450 development and certification update.
  • Brazilian Defense programs update.
  • Operating margin upside potential.

Another defense contractor

For the quarter, Rockwell Collins (NYSE: COL) is expected to produce an Earnings Per Share (EPS) total of $1.16. However, the company might fall short of the consensus given a higher than expected decline in its segment named Government Systems. This segment provides a range of electronic products, systems and services to customers, including the United States Department of Defense, other ministries of defense, other government agencies and defense contractors around the world. The weaker-than-expected results are expected to come as a consequence of budget cuts

For the time being, the Street is assuming 7% organic growth at Commercial Systems and a 10% organic revenue decline at Government Systems. Also, free cash flow is expected to come at $95 million and FCF/NI (Free-cash-flow/Net Income) is expected to come at 0.61, meaning 61% of free cash flow will hit the bottom line. 

As far as the outlook for 2013 is concerned, it is possible Rockwell might lower the mid-point of its full-year Fiscal Year 2013 (FY2013) EPS guidance, by maintaining the low-end but reducing the high-end. During the quarter, Rockwell lowered its FY2013 Commercial Systems growth forecast to +5% from +6% citing weakness in the light end of the business jet market.

Rockwell also lowered its R&D outlook by $50 million, but that is primarily from deferred engineering and therefore that will offer less positive offset on the P&L.

Consensus estimates seem too high for FY2014. Rockwell will provide guidance for that in September,

The company is expected to discuss the following items in its earnings call on July 19:

  • The impact from sequestration.
  • Government margins.
  • Commercial aftermarket trends.
  • The business jet cycle.
  • New competitive threats.
  • Cash flow headwinds.
  • Capital deployment priorities.

On an overall note, Rockwell has been an expensive name to buy. The company is likely to grow EPS significantly slower, and convert net income in to free cash at a lower rate, than its peers in the Commercial Aerospace supply chain, yet it trades at a premium to that group average.

General Dynamics – big cap, big gains?

Embraer and Rockwell both belong to small and mid-cap group. Hence, I felt that discussing a large cap company would round the argument of a variety of ideas in the aerospace world.

General Dynamics (NYSE: GD) is a massive company with a market cap three times larger than Rockwell and about six times more than Embraer. However, the gains on its stocks haven’t been large recently.

GD’s stock was the worst-performing large cap defense stock in 2012. Even in 2013, the stock has only performed at a market pace (17% vs. S&P 15%). This has come as a surprise given that the company has one of the most attractive mixes among the large cap defense coverage (given commercial exposure through the Aerospace segment that should help insulate General Dynamics from shrinking defense budgets).

GD’s G650, ultra-large cabin and ultra high speed business jet, has simply been the gold standard in business aviation. The Street believes in a significant ramp-up at Gulfstream (Aerospace) on the G650 that should drive out-sized earnings growth (relative to defense peers GD has the potential to be the only defense company that is able to grow pension adjusted EBIT over the next several years in our view) as well as a potential re-rating of the multiple to reflect a defense/commercial mix at the EBIT line that will be closer to 50/50 by 2015

General Dynamics should have the best multi-year earnings profile in large-cap defense, which will ultimately make the company's current valuation unsustainable. The recent management changes (a new CEO took over in January) are viewed as a positive development that, over time, will likely compel some investors to take a second look at the company.

Final word

This discussion leaves us with the conclusion that aerospace has a whole variety of companies with different outlooks. Although they share the same global fundamentals (increasing demand etc), their stocks haven’t and will not perform the same given their different mix of products and operational standings.

Embraer and General Dynamics are recommended as buys given their attractive product lines and projects. However, Rockwell Collins has not been able to immunize itself from budget cuts which has not yet been properly reflected in its trading multiple and hence is not recommended. 

Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends Embraer-Empresa Brasileira. The Motley Fool owns shares of General Dynamics. 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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