Why you should invest in aerospace

Growing demand for airplanes means now’s the time to buy into aviation.

 
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(Photo: S. Ognier/Airbus)

Emirates Airline’s massive A380 Airbus attracted spectators when it made its first landing in Canada three years ago. The crowd came to see the largest airplane to ever land at Toronto’s Pearson Airport, a plane that’s 3.2% longer and holds 139 more passengers than a Boeing 747-400; it also boasts 14 luxury first-class suites. Emirates bought 73 of the A380s over the past four years, plus 90 Boeing 777s, in a bid to establish itself as the premier airline in the Middle East. The airline’s spending spree was a rare bit of good news for the planes’ manufacturers as they struggled to thrive in a rough recession.

The aerospace sector had a turbulent ride during the financial crisis. In 2009, airline traffic fell 3.1%, the biggest drop in aviation history, which meant worried companies stopped ordering planes. That year, Airbus received 310 aircraft orders, down 65% from 900 in 2008, and a 78% drop from its 1,458 orders in 2007. Boeing, the other major airplane manufacturer, saw similar drops. The industry’s fortunes have always been directly correlated with economic activity and GDP growth, according to Peter Arment, a senior research analyst with brokerage firm Sterne Agee, based in Birmingham, Ala. If the economy’s doing well, so do airlines. So, it wasn’t a shock that stock prices and valuations dropped during the downturn. Now, though, an improving economy and increasing emerging-market demand for new airplanes have pushed orders back to near decade highs—in 2011 Airbus received 1,419 orders for its planes—and Boeing and Airbus are trying to get through a backlog of about 4,000 aircraft apiece. Still, many company valuations continue to trade at historic lows, which is great for value-hunting investors. But if you’re going to buy, buy now—Arment doesn’t think aerospace companies will be cheap for long. “There’s a big ramp-up in production that’s occurring, and that’s going to start fuelling a lot of interest in aerospace,” he says.

The increase in orders has been partly fuelled by airlines replacing their fleets, which happens every 15 years or so. “A lot of them are really old,” says Dana Cease, senior research officer at Manulife Asset Management. Meanwhile, demand from emerging markets is rapidly increasing, thanks to an expanding middle class. In 2011, China, Brazil and India saw passenger traffic grow in the double digits. Cease points out 50% of Boeing and Airbus’s 8,000-plane backlog is composed of orders from developing nations, with 35% of the total coming from Asia.

Another factor driving growth is what Arment calls the “Southwest model.” (Canadians might call it the WestJet model.) Many low-cost carriers in the Southwest Airlines model, such as WestJet and Dublin-based Ryanair, have popped up in both developed and developing nations. These airlines are forging new routes to cities that don’t typically get regular airline service, which creates demand for more planes.

The high price of oil is also important. Years ago, fuel costs accounted for about 15% of a company’s operating costs. Now, with oil at around $100 a barrel, it’s closer to 40%. Airlines are desperate to own more fuel-efficient planes. Trading in an aging McDonnell Douglas MD-80 plane for a new Boeing 737—a comparable aircraft—can improve fuel efficiency by about 30%.


 

With a rising number of passengers—global traffic climbed 6% year-over-year in the first quarter of 2012—and an increased demand for more planes, it seems the industry’s slump is ending. It’s likely the companies that did take a hit over the past few years will start to see their valuations climb, says Cameron Scrivens, a vice-president and senior portfolio manger with RBC Global Asset Management. So where should investors put their money? With suppliers, says Cease.

If you want to own the big aircraft manufactures, you’ve got two or three to choose from, which doesn’t help diversification. But companies like Rockwell Collins, based in Cedar Rapids, Iowa, United Technologies Corp. of Hartford, Conn., and Triumph Group, based in Berwyn, Penn., make everything from engines and electronics to seats and simulators. And a down cycle doesn’t hit them as hard as it does the manufactures because many of them have robust replacement-parts businesses. “Airplanes have to go in for repairs and replacement parts,” says Cease. “So they’re set up well—they can sell into the order surplus and they have this replacement-parts business. It’s a double revenue stream that’s pretty attractive.” Better still, those companies tend to have higher margins, and, he says, “you don’t have to worry about production schedules.”

There are still some risks in investing in aerospace. Many of these suppliers also sell to the defence sector, where spending is likely to decline in coming years as countries, especially the U.S., try to reduce their deficits. In addition, airlines often purchase more planes than they really need. They then cut their orders when the time comes to pay—usually a year before the plane goes into production. These concerns, plus worries around slower growth in China and the continued European crisis, are the main reasons why valuations continue to be low.

While most aerospace companies will see growth in the future, some companies are better positioned than others. Arment says to look at suppliers that sell to both Boeing and Airbus, rather than just one or the other. Also, look at how much military exposure the supplier has. The majority of these companies do at least some business with the military, but you want more of their revenues coming from the commercial side.

When it comes to metrics, first look at historical price-to-earnings (P/E) ratio to see if the company is in fact cheap, says Scrivens. Not only does this tell you if you’re getting a good deal today, it can also help you gauge where the sector is in the cycle. If it’s in the middle, the valuation will be relatively high compared with the past. If the industry’s just at the start of an upswing, as it is now, P/E will be low.

It’s also important to look at debt, says Turan Quettawala, Scotia Capital’s director of transportation and aerospace research. The entire industry is capital intensive, so most businesses carry something on the balance sheet. He says a debt-to-EBITDA level of two times or more makes him nervous. On the other hand, Cease doesn’t mind seeing a debt-to-EBITDA of up to three times—he says there’s a lot of consolidation in the industry, so additional debt from an acquisition isn’t necessarily worrying—but less than two is better.

No matter which company you choose, it’s likely valuations will rise over the next five to 10 years—the length of a typical cycle. With strong emerging-market demand, that cycle could last even longer. But get in now, when companies are cheap, and then wait for the stock to take flight.

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