Stocks Exposed to the Business Jet Market

It's no secret that the commercial aerospace market has been very strong in recent years, with Boeing and Airbus continuing to build up large backlogs, but one sub-segment has been far slower to recover from the recession: the business jet market. However, it looks as though it's hit bottom, and it could be set to grow in future. Companies like General Dynamics (NYSE: GD  ) , Bombardier (TSX: BBD.B  ) , Ametek (NYSE: AME  ) , and Textron (NYSE: TXT  ) are worth considering in order to play this theme, and Fools should start looking more closely at these companies.



Is the business jet market recovering?
Industry data and historical relationships suggest that the answer to this question should be in the positive. The business jet market has always been super-cyclical, as corporate spending on them tends to lag corporate profitability. However, in the last few years, corporations have been highly reluctant to open the spending floodgates. Indeed, they continue to take a "cautiously optimistic" approach in the light of a moderately growing economy.

The good news is that, according to a Bloomberg research report, the downtrend in business jet deliveries looks to have bottomed, and with corporate profits on the rise, it's reasonable to expect some growth from here.

READ THE FULL ARTICLE LINKED HERE

The Winners and Losers From Alcoa's Recent Earnings

Investors always like to look at Alcoa’s (NYSE: AA) earnings and use them as a guide to the rest of earnings season. In the latest second-quarter results, there were some surprising elements which deserve to be looked at in more detail. In this article, I want to examine Alcoa’s end market commentary and discuss the implications for some companies which you might be looking at.

Alcoa changes guidance, but not for China

I’ve tabulated the updated full-year guidance below. The green segments are where numbers were upgraded, and red is for the downgrades.

Probably the most surprising aspect of these results was that Alcoa didn’t reduce guidance in any of its end markets within China.  A number of companies have reported recently and cited specific weakness in the country. For example, FedEx recently spoke of global trade growing slower than global growth, Oracle cited weakness in China, and filtration company Pall (NYSE: PLL) delivered some disappointing numbers in its industrial filtration results.

Pall’s Chinese industrial sales were down 11% in the quarter. The company spoke of the ongoing changes in the Chinese economy and how they are forcing Pall to adjust its sales focus. In general, China is trying to shift towards more domestic consumption and reduce its dependency on export-led manufacturing.  This is presenting challenges to Pall, and given that nearly 60% of its industrial sales are in process technologies and 20% in microelectronics, it is likely to face some difficulties.

Aside from what companies are saying, China’s own economic data has been weaker recently, with the official Purchasing Managers’ Index registering 50.1 in June. A reading above 50 indicates growth, so clearly China’s manufacturing industry is not growing by much.  However, this is not the way that Alcoa sees it! Indeed, it actually cited Chinese demand for aluminum as remaining strong and kept its 11% demand growth forecast. 

The reason why Alcoa may be seeing relatively better conditions is because aerospace and automotives have been the standout performers within the industrial sector this year. Furthermore, beverage can packaging is relatively non-cyclical, and China’s heavy truck & trailer industry is benefiting this year from some regulatory changes. It looks like a case of good news for Alcoa, but not necessarily for the wider economy.

Winners and losers from Alcoa’s report

Aerospace and automotive have been strong this year for similar reasons. The U.S. consumer is starting to benefit from employment increases, and lenders are more willing to expand credit in the form of car loans. North American auto sales have been improving, while China’s remain strong.

Aerospace has been very solid, and the industry has the potential to outperform in a cyclical recovery because its dynamics have changed.  The need for austerity has forced governments to stop subsidizing national loss-making champions, and airlines are getting much better at dealing with high oil prices and outsourcing unnecessary work. The result is increased airline profitability driven by Asian passenger traffic.

This commentary will interest shareholders in a diversified industrial company like General Electric (NYSE: GE) or Ametek (NYSE: AME). Aviation is GE’s largest industrial profit generator, and it needs strength in aviation, transportation, and health care in order to offset some weaker performance in Europe (particularly within its power & water segment). Alcoa spoke of a 40% rebound in growth in its regional jet business and 12% for its business jet segment.  This is great news for GE, but, on a more worrying front, Alcoa also said that it anticipated a weaker demand from Europe for industrial gas turbines. It looks like GE’s weakness in power & water is set to continue, so this is a mixed report for GE.

However, it was a good report for Ametek shareholders. The company has heavy exposure to aerospace, particularly the business jet sector (Textron is a major customer). Ametek also has customers in the North American heavy truck & trailer market. Indeed, in its most recent results, Ametek had cited some softness in its power & industrial business, thanks to softness in the heavy truck market. My point here is that if Alcoa is talking about order rates being up, then this will surely feed through into Ametek in future quarters.

Other stocks worth considering for the aerospace theme are B/E Aerospace, Heico, and Precision Castparts. Finally, the heavy truck & trailer market seems stronger, so stocks like Cummins could see better prospects.

The bottom line

In conclusion, this was a pretty good report from an end-market-demand perspective. There were no downgrades to expectations over China, and if anything, the news on the aerospace and automotive sectors was a little better. There was even some positive news for the heavy truck & trailer market. Overall, it was a favorable report, but investors still need to remain selective about where they invest in the industrial sector, because the sub-sectors within it are reporting some varied performance.

Ametek Offers Aerospace Upside

It’s been a mixed earnings season for industrial-based stocks and Ametek’s (NYSE: AME) last set of results provided a pretty good microcosm of what has been going on. In short, companies with heavy exposure to industries like automotive and aerospace have done well, while almost everything else has found things difficult. So what makes Ametek interesting and what can we read across for other companies?

Ametek generates growth across the cycle

The company is attractive for a few reasons. Firstly although it is not a pure-play aerospace company, it has heavy exposure and as the industry is looking set for good long-cycle growth, it has good prospects. Secondly, Ametek has long been a company categorized by its management’s ability to make earnings-enhancing acquisitions without damaging its return on invested capital (ROIC).

As the chart indicates, Ametek has done a pretty good job of consistently generating ROIC even when market conditions are not great. An acquisition-led growth strategy does have its advantages and disadvantages. On the plus side, the company can carry on generating growth by getting companies cheaper in the downswing (and benefiting from the hopeful upswing in the economy); but on the downside its management will be under pressure to make the right acquisitions. And making the wrong decision can occur irrespective of where the economy is positioned.

Recent results

The good news is that Ametek’s management has a strong track record in this regard and acquisitions are a key part of the focus for 2013 as well. Even in the latest Q1 results we saw organic sales decline 2% but acquisitions contribute 9% and –even in a weaker environment for aerospace- its sales were up 7%.

As ever with this type of company, cost management and lean manufacturing will be a strong focus. Indeed cost reductions were made in the quarter, without which, EPS would have been up 18%. There was good news on the cost-cutting front with estimates for total full-year savings rising to $95 million from $85 million previously. Operating cash flow rose 11% and full-year EPS guidance was raised at the low end to imply 11% to 13% growth. Moreover the commentary on linearity was positive with April cited as looking ‘good’. Like many in the industrial sector it saw some weakness in March.

Industry background

As usual with earnings season, Alcoa (NYSE: AA) tends to set the tone for the industrials. A brief look at the conclusions from its earnings reveals that areas like aerospace and automotive remain relatively positive. Europe remains weak on the whole and the heavy truck and trailer market is experiencing a sharp slowdown. Moreover much of Alcoa’s growth is predicated on stronger conditions in China. The surprising thing was that Alcoa did not alter its full-year end-demand outlook by much even though the consensus is that Q1 did get weaker overall for industrials.

Alcoa’s trends were confirmed by Ametek when it discussed some softness in its power and industrial business created by the North American heavy truck market, so no surprises there. Furthermore within its process business segment the strongest performer was oil and gas while metals analysis revenue was relatively weaker.

The key strength in the business was from aerospace. Its electronic instruments group (EIG) saw aerospace (commercial, business and regional jets) revenue rise by low double digits and growth is expected to remain solid for the rest of the year inline with build-out rates at Boeing and Airbus. Overall EIG sales were up 3%.

It was a similar story in the other segment. The electromechanical group (EMG) saw its differentiated business sales up in the mid-teens with particular strength cited in its aerospace maintenance, repair and overhaul (MRO) operations.  However, overall sales for EMG only rose 3% thanks to a 14% contribution from acquisitions.

Which stocks read across well?

Frankly I think investors should try and stick to the themes that are working well and try and find value in them. If aerospace and automotives are doing well and companies like Alcoa and Ametek are confirming this, then why not stick to the idea? Three names that I like are Heico (NYSE: HEI), Precision Castparts (NYSE: PCP) and PPG Industries (NYSE: PPG).

Heico recently reported strong results and the business clearly has good long term prospects from helping airlines to try and reduce costs by outsourcing flight support activities. Even though Heico argued that its success in the quarter (its flight support group saw sales and income rise 10% and 14%, respectively) was largely a consequence of internal execution rather than industry growth, I think that there are enough positive signs within its performance to suggest further growth this year.

Its space-related sales may well be variable and its defense sales will be subject to sequestration effects so now may not be the best time to buy into the stock. But if you can tolerate these fears, the stock is attractive.

Precision Castparts is attractive because of its heavy exposure to commercial aerospace (75% of its market) and its opportunities to generate synergies from its acquisitions. In addition, it is ramping up production in order to meet demand from Boeing on the 737 and 787.

My one concern with this company is the cyclicality of its cash flows. The aerospace industry is cyclical but there is evidence to suggest that it is likely to experience better conditions in this cycle. However companies like Precision Castparts always need to make significant capital expenditures in order to service demand.

This is great when demand is good but it leaves them exposed should demand start to weaken. You can make the argument for making an evaluation based on assessing its long-term earnings or cash flow performance but in reality I think the market just trades these stocks based on momentum.

My favored play on this theme would be PPG Industries. The company has good exposure to aerospace and automotive and its purchase of Akzo Nobel’s US household paints operation is timely. Costs appear to be moderating and it has some cost synergies coming from the acquisition. Margins are expanding thanks to its restructuring efforts (such as selling some of its commodity-based businesses) and its cash flow generation remains very strong.

Meanwhile the recent court order over the Pittsburgh Corning (a joint venture with Corning) has somewhat de-risked the stock from uncertainty over future asbestos claims. Earnings growth is being held back this year thanks to some of the issues discussed above but, this is a business which has generated an average $1.1 billion in free cash flow over the last three years and trades on an EV/Ebitda multiple of 9.5x. Looks like good value to me.

Where next for Ametek?

This is an impressive company and a real ‘go to’ option for a pick in the industrial sector. Unfortunately its trailing PE of around 22x plus its EV/Ebitda multiple of 13.1x suggest it is largely pricing in the good news. It’s well worth monitoring and hoping for a dip because $42 looks like a fair price for the stock. Given any kind of market retraction it's worth a close look. 
 

Pall Corp Looks Pricey

When looking at a stock it is always tempting to take an initial peek at its share price graph to make a quick and easy assessment. In the case of Pall Corp (NYSE: PLL) and its impressive looking chart, it would be easy to conclude that things are going great, but the reality is that it has been a challenging environment for the industrial sector.
In summary, there are some changes afoot, and investors would be best advised to be selective with investments within the sector.

Structural changes

I have two main observations here.

The first is that it has been a mediocre Q1 reporting season for the industrial sector outside of the automotive and aerospace sectors. This has been a recurring theme in this reporting season whether from a large industrial bellwether like General Electric (NYSE: GE) or a smaller niche player like Ametek (NYSE: AME). I’ve discussed these companies' results in articles linked here and here.

The second is that the nature and quantum of growth in China is shifting. We all know that China is taking up an increased percentage of global manufacturing but we also know that its reliance on export led growth cannot continue indefinitely. Europe’s growth is anemic, and the long term prospects for US growth look hampered given its public deficits. Moreover, the Chinese government knows this and is gradually trying to shift the economy towards domestic consumption. And China matters for the global players. Even a cursory look at Alcoa’s (NYSE: AA) results will demonstrate the emphasis it is placing on growth from China. Many of us that think that China has the reserves in order to ‘buy’ its way to 7-8% growth but we must recognize that its stimulus plans are likely to be different this time around.

What did all this mean for Pall Corp?

It was a tricky Q3 for Pall Corp, and the repercussions of these two changes are being seen in its numbers. Total sales fell $18 million to $640 million and investors can take little solace in the fact that excluding currency effects its sales would have been flat. On the positive side pro forma EPS for the nine months was up 11% to $2.15 with some notable cost savings being implemented while higher margin consumables increased as a part of the mix. Naturally this meant that margins went up. This is good but recall that future consumables sales rely on the system sales being made now.

In order not to cover old ground I have a primer article on Pall Corp linked here. In fact its growth prospects have progressively weakened since that article. The latest numbers imply that sales are still weakening (particularly within industrial), but at least system orders are looking relatively better at the moment.

Digging deeper into the numbers shows that Life Science sales (67% bio-pharmaceuticals,16.3% food and beverage and 16.7% medical) are doing okay with good growth from bio-pharmaceuticals (pharma is still investing) of 9% offsetting a 21% decline in food and beverage sales.

Turning to Industrial sales (59.4% process technologies, 20% aerospace and 20.6% microelectronics) it’s clear that there are some issues here. Ametek recently spoke to strong performance in its aerospace markets and it’s been a strong reporting season for aerospace companies. On the other hand it mentioned some softer than expected numbers in its process industries as well as softness caused by the heavy truck and trailer market. Indeed, this is exactly the sort of thing that Alcoa’s results had presaged when it forecast deteriorating conditions in its heavy truck markets.

Pall Corp’s process technologies sales declined 13%, and it was no surprise to see its microelectronics sales down 14% as well.  The one bright spot was--you guessed it--in aerospace as sales rose 25%; but as it only makes up 9.8% of total sales, it is not enough to make a significant difference.
The conclusions are clear, outside of automotive, aerospace and parts of healthcare, the industrial sector is doing great and investors should be minded to consider factoring this into their decision making.

China?

Similarly with regards to the regional breakdown, Pall stated that its Asian sales were down 11% due to weakening in its industrial markets in China and ‘mature Asia.’ Obviously part of this will relate to tougher conditions within microelectronics and you only have to look at what Intel said to confirm this. However, Pall’s management stated that conditions were changing in China, and I think this is self evidently true from most commentary on the country. Aerospace and automotive should do fine because they are strongly related to the Asian consumer (car buying and air passenger traffic), but some of the major infrastructural markets may see a slowdown.

For companies like Alcoa or General Electric this may cause some problems, but it may cause opportunity as well. Alcoa does have significant exposure to automotive and aerospace but any weakness in China will hit its growth prospects quite hard.

As for General Electric its healthcare, transportation and aviation (which together contributed 61% of industrial profits in the quarter) should do fine this year, but its power & water division disappointed last time around (Europe was blamed), and it’s hard to read what its oil & gas numbers will be for the rest of the year. Both companies' future results are well worth looking at in this context.

Where next for Pall Corp?

Pall Corp is attractive, and it has some good long term prospects from filtration demand promulgated by environmental regulation. My concerns would be more over the short to mid term outlook. This is a stock that trades on nearly 23x full year EPS estimates to July 2013. It is hardly cheap and its outlook has been getting worse even as the share price has risen.

Clearly the market is pricing in a second half industrial recovery here with no knock–on effects from China’s shifting growth path. Even if you are comfortable with these scenarios then Pall Corp does not look cheap.