Should Aerospace Investors be Worried by AAR Corp's Results?

The aerospace industry is highly cyclical. It always has been and always will be, which is why Fools need to keep an eye out for any early warning signs of a downturn. Given that aviation services company AAR Corp recently reduced its full year guidance, are conditions are about to worsen for Boeing , and its aviation suppliers?

What happened to AAR Corp?
Essentially, the key takeaway from AAR Corp's results is that its problems in the quarter were more stock specific than emblematic of any kind of trend change in the industry. However, the devil is in the details, and there are a few things for aerospace investors to look out for. AAR Corp is a long-term Boeing supplier, so its commentary on the marketplace matters.

 

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Commercial Aerospace Looking Good For 2014

Last year was a bumper year for equities, but it wasn't a great one for the economy. However, the commercial aerospace sector stood out, because according to the International Air Transport Association, or IATA, end market conditions progressively improved through 2013. Moreover, the IATA is forecasting an even better year in 2014, so prospects for commercial aerospace plays like Boeing (NYSE: BA  ) , cabin manufacturer BE Aerospace (NASDAQ: BEAV  ) ,aviation services company AAR Corp (NYSE: AIR  ) and airframe product manufacturer Precision Castparts (NYSE: PCP  ) are looking good, too.

IATA Industry Forecasts
The following graph demonstrates how the IATA's expectations for commercial airline profitability in 2013 progressively got better through the year. Meanwhile, its forecast for world economic growth actually declined over the period. In September of 2012, the IATA forecasted world economic growth in 2013 to be 2.5%, while the latest forecast from December of this year was just 2%. http://www.iata.org/whatwedo/Documents/economics/IATA-Economic-Briefing-Financial-Forecast-December-2013.pdf

Source: IATA.

Moreover, its latest forecast for 2014 sees global net profits expanding to $19.7 billion from 2013, an increase of 52%. Among these improvements, there is a remarkable turnaround taking place in terms of regional prospects.

Back in 2010, Asia-Pacific airlines generated $11.1 billion in profit, while North American airlines only made $4.2 billion. However, the IATA is forecasting North American airline commercial airline profits to increase to $8.3 billion in 2014 from $5.8 billion this year. Meanwhile, Asia-Pacific commercial airline profits are forecast to be only $4.1 billion in 2014.

The obvious answer would be that passenger traffic growth must have gone up, but according to the IATA, North American growth isn't going up by much, and is still noticeably less than in the Asia-Pacific region.

Source: IATA.

So how and why have North American (and to a lesser extent European) airlines suddenly become more profitable, and how can Foolish investors take advantage?

More pricing power, more efficiency
There are two primary reasons for this increased profitability. First, North American airlines are seeing greater pricing power thanks to a slowly improved economy. Second, they are taking substantive productivity measures to increase profitability. These two factors will combine to drive growth in the future.

You can see the pricing power in the fact that the IATA forecasts that global net profit per departing passenger in 2014 will be at $5.94 in 2014 -- a level not seen since the peak of 2007. Western airlines' willingness to improve productivity includes buying more modern and efficient planes from Boeing and Airbus. It's significant that the airlines placing the largest orders for Boeing planes as of mid-December this year were American Airlines and European budget carrier Ryanair, with 143 and 175, respectively, out of Boeing's total of 1074. Furthermore, Boeing can look forward to a strong order book in 2014 because the IATA predicts that overall passenger load factors (a measure of airplane capacity utilization) will rise to 81.3% in 2014. In other words, capacity pressures are likely to encourage more investment in new airplanes.

Source:IATA.

BE Aerospace, Precision Castparts, and AAR Corp BE Aerospace is also a key beneficiary of the upswing in commercial aerospace. Not only does it offer newbuild cabins, but its retrofit orders should also increase as airlines become more profitable. In addition, at its last results, BE Aerospace announced the first delivery of its modular lavatory system on a Boeing plane delivered to Delta Airlines.

Precision Castparts has invested heavily in preparation for the upswing, and appears to be ready to realize the fruits of its investment. Precision bought longtime Boeing supplier TIMET for $2.9 billion in 2013. .  Furthermore, Precision has been investing in ramping up production capacity for the Boeing 737 and 787 Dreamliner. Given that these two airplanes have received 74% and 17% of Boeing's total net orders for the year to Dec 2013, it looks like a smart move.

AAR Corp helps airlines improve productivity by allowing airlines to outsource logistics and spare parts provision. AAR is clearly looking to expand its supply chain activities. According to CEO, David Storch on its recent conference call:

So as we think about the supply chain piece itself, one of the things we'd like to do is build out, and we've talked about this before, geographic expansion. And we are looking at a fairly sizable deal that would expand our presence

However, AAR makes less than two-thirds of its sales to commercial customers  with the rest going to defense and government customers. It's not really a pure-play commercial aerospace company, but it is nicely exposed to airlines seeking to cut costs.

The bottom line
Prospects look good for the commercial aerospace industry in 2014, and provided the global economy holds up, the sector has the opportunity to outperform. North American airline profitability is leading the way, and Foolish investors would we will advised to look at companies servicing demand from them. The commercial aerospace upswing isn't over yet.