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One of the largest aerospace and Boeing Co.(NYSE:BA) suppliers, Rockwell Collins, Inc. (NYSE:COL), has released its first-quarter earnings and discussed its outlook for the aviation market in 2017. Let's take a look at what was said and what it means to the aviation industry and for Boeing.
Free cash flow generation is the key to generating long-term value for shareholders, and there are three companies I'd like to look at that are planning on generating strong cash flow in 2017. First, Honeywell International Inc.(NYSE:HON) is set to significantly increase FCF in the coming years as it comes out of a period of high investment. Meanwhile, specialty materials and chemical product company Celanese Corporation(NYSE:CE) looks set to continue its remarkable transformation into a highly cash-generative operation. And finally, Boeing Co.'s (NYSE:BA) stock might sink or swim based on whether it meets its FCF guidance.
At the recent Barclays Industrial Select Conference, The Boeing Company CEO Dennis Muilenburg argued that the aerospace industry was "differentiated" and had different growth dynamics compared to other industrial sectors. Given the industrial slowdown in the global economy, this means he sees aerospace as able to buck the trend. Is he right, or are aerospace investors heading for a disappointment in 2016?
3 reasons aerospace demand will growFocusing on commercial aerospace, you can separate Muilenburg's case into three somewhat related parts:
Ongoing airline profitability will lead to commercial aircraft orders as the two are correlated.
Low oil prices increase airline profitability, and airlines buy new planes for more reasons than just fuel efficiency.
Markets such as China are "underserved" and therefore capable of growing more than GDP.
Let's take a closer look at each argument in turn.
While we don't believe in macroeconomic speculation at the Motley Fool, we admit that sometimes key insights into a company's prospects can be explained by looking closely at an industry or macro economic indicator. After all, it's hard for even the best company to fight against strong economic tides. With that in mind, the information in the following 5 charts give a rough idea of how the underlying industries of the 5 companies in question might fare in the year ahead.
Have you ever wondered how you can make money from behavioral finance? It's a much-discussed topic that often leaves investors floundering for something tangible to invest in. Well, wonder no further, because I have three examples of stocks whose prospects are best understood using a simple understanding of the so-called wealth effect. So let's look at why Boeing , Deere & Company , and The Home Depot are interesting for behavioral-finance enthusiasts
Boeing (NYSE: BA)
investors will be wondering what the stock price has in store for them
this year. After a difficult start to the year, the stock has been
range-bound roughly between $120 and $135. Can it break out in 2015? To
help readers answer this question, I've picked out three of the key
indicators of Boeing's operations and end demand to watch this year.
A few news reports might have led Foolish investors to scratch their
heads with confusion recently. On the one hand, the U.S. trade deficit
came in lower than expected in May -- indicating good global growth. On
the other, it was reported that the managing director of the IMF,
Christine Lagarde, was signaling a cut in the IMF's global growth
forecasts. Although, the two events appear contradictory, there is
actually an explanation, which sees a positive outcome for companies
like United Parcel Service, FedEx , and Boeing.
U.S. trade deficit lower The drop in the U.S.
trade deficit to $44.4 billion in May, was somewhat lower than most
economists had forecast, and turns out to be a good indication of U.S.
growth for three reasons. First, exports grew to a record high --
suggesting that international growth will aid U.S. GDP growth in future
quarters, as American companies export more. Second, nonpetroleum
imports also hit a new high -- an indication that U.S. domestic demand
has picked up. Third, the reason that the deficit fell, partly because
net imports of oil fell, this is a good sign because it indicates that
the U.S. is moving toward self sufficiency in energy production.
The following chart demonstrates the U.S. trade deficit, and the impact of falling net oil imports:
Moreover, a snap-back in U.S. growth is only to be expected following
a weather-affected first quarter in North America. All told, the
strength in export demand is a positive sign, and augers well for
logistics and shipping companies like UPS and FedEx.
One of the key considerations for Boeing
investors in 2014 is whether the aerospace giant can increase
operating margins on its commercial airplanes. Already this year,
suppliers such as Spirit AeroSystems and Triumph Group have faced issues on different Boeing programs, and the increasing
complexity of newer planes appears to be causing Boeing some production
problems, too. All of this could contribute to cost overruns. It's time
to look closer at some of these issues.
Boeing, Spirit AeroSystems, and Triumph Group The
company's full-year 2014 operating profit margin guidance of around 10%
for its Boeing commercial airplanes, or BCA, segment looks a little
conservative in light of the first-quarter result of 11.8%. As such,
Boeing appears to have substantive opportunity to beat internal
guidance, but it won't be plain sailing for a few reasons.
Fools already know that Boeing is still on track to ramp up production of the 787 Dreamliner to a rate of 10 a month in 2014.
However, Boeing has had production issues with the 787, including the
discovery of hairline cracks on the wings of some planes in production.
Moreover, two suppliers have also had issues on Boeing programs. Earlier, in the year, Triumph Group saw its costs increase due to internal quality issues
that required replacement of some parts on the 747-8 -- a relatively
new aircraft that Boeing has had difficulty selling. The aircraft maker
only received 17 gross orders for its 747 planes in 2013, and it only
has one order in the year to date. Boeing made two production rate cuts
on the 747-8 last year.
The aviation sector has been a standout performer for General Electric
in recent years, and the evidence suggests that Fools can expect more
to come in the future. Near-term and mid-term indicators look positive,
even as Pratt & Whitney, a unit of United Technologies , is competing hard with General Electric for new engine orders on the revamped Airbus A320 plane. General Electric's engines remains well placed on Boeing
and Airbus programs, and its services revenues also look set to turn
upwards. Moreover, industry trends remain positive, and the the aviation
segment looks set to be a strong contributor to profits for years to
come.
What aviation means to General Electric A quick
look at General Electric's industrial segment profit in 2013
demonstrates the growing importance of the aviation unit. Interested
Fools can read an article focused on the oil and gas segment here.
Source: General Electric Presentations.
The aviation segment generated nearly $22 billion in revenue in 2013,
with its commercial aerospace-based revenue significantly larger than
its military business
A quick look at aerospace-focused component manufacturer Precision Castparts' share price reveals much about the market's mood in 2014. After a good
2013, the stock is down 6% this year. It's almost as if the market has
already priced in a cyclical recovery in the aerospace sector, and is
now asking, "What next"? Indeed, the share price of its major customer, TheBoeing Company is also down year to date, while its peer Triumph Group is also down. Is the market right to worry, or is this weakness a potential buying opportunity?
Boeing and Triumph Group give mixed results It's
no secret in the investing world that industry peer groups tend to move
together, but that doesn't mean that the movements always make sense.
In this case, Precision Castparts' prospects actually have gotten better
in 2014, while Boeing and Triumph Group have both had issues as the
year developed.
The Boeing Company
gave a mixed set of earnings recently. Its results perfectly
highlighted how its internal operations are adjusting to changes in end
demand. Simply put, for a variety of reasons, the defense market looks
set to go through a sustained period of historically weak demand, while
the commercial aerospace sector is seeing a stronger than usual cyclical
recovery. Naturally, Boeing isn't alone in having to adjust, as
companies like Honeywell International
share the same industry dynamics. With that said, how is Boeing's
business changing? In addition, how should Fools measure the company's
progress?
Commercial aerospace good, defense bad It's
no secret that defense spending is being pressured by public spending
constraints, and particularly with large-scale military hardware.
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.
With the recent difficulties in emerging markets,
it's probably a good time to assess whether there will be any effect on
the current outlook for The Boeing Company in 2014. Moreover, if the aviation market is affected then a major engine manufacturer like General Electric Company will be too.
The Boeing Company's production plans The two key drivers of its share price are its delivery rates and order book. Investing Fools already know about Boeing's plans for 2014.
In particular, Fools will be monitoring Boeing's aim of ramping up
production of the 787 Dreamliner to 10 a month, and the Boeing 737 to 42
a month. In addition investors in General Electric Company and the
U.K.'s Rolls Royce will be interested too, because they
are the engine suppliers to the 787 program. With regard to the 787,
there has been some mixed news recently.
There are two key questions that Foolish investors will be asking after Boeing's
latest results. The first is what is its order book going to look like
in 2014? The second is whether its disappointing earnings per share, or
EPS, guidance of $7.00-$7.20 for 2014 signals a slower delivery
schedule or not?
Boeing's order book prospects in 2014 Essentially,
Boeing's orders are a proxy for global economic growth. However, they
are also guided by industry fundamentals. The good news is that the
commercial aviation sector is in better shape than it has been for many
years. For example, in December the International Air Transport
Association, or IATA, increased its forecast for airline profitability
in the coming years.
Shareholders in airplane cabin manufacturer B/E Aerospace watched their stock rise more than 75% in 2013, so the recent sell-off
shouldn't come as a surprise. Unfortunately, stocks can't go in one
direction forever. The question facing investors now is whether the
recent fall presents a buying opportunity or not?
B/E Aerospace still headed for a great year First
things first, there was nothing in B/E Aerospace's recent
fourth-quarter results to suggest that the company is not going to have a
great year in 2014. Although, internal EPS guidance of $4.25 was below
analyst consensus of $4.34, it still represents earnings growth of
nearly 20%. Moreover, the International Air Transport Association, or
IATA, recently upgraded its forecast for airline profitability in 2014.
The industry backdrop looks positive. More airline
profitability usually means more spending on new planes and retrofitting
of older aircraft too. It's all good news for B/E Aerospace.
Growth initiatives In addition, the company recently announced a number of growth initiatives:
A contract enhancement with United Technologies
to supply fasteners, hardware, logistics, and consumables to its
aviation units. B/E estimates the deal has a value of $950 million to
2022
A contract with helicopter manufacturer AgustaWestland to provide
logistics and consumables. The deal's estimated value is $200 million,
and goes till 2018.
Its modular lavatory system (shaped to create additional seating on planes) is now being shipped to Boeing with 14 Boeing 737s in service with the system. More growth is expected as Boeing's demand is expected to increase.
In a departure from its core activity, B/E made two acquisitions in the oil and gas consumables market.
The contract announcements were obviously good
news, and the ramp up in lavatory systems shipments (the first system
was shipped as recently as the third quarter) is a confirmation of
strong demand for an exciting new product.
However, the move into the oil and gas consumables
market is more subject to scrutiny. When questioned on the conference
call, B/E's CEO, Amin Khoury, argued that the oil and gas consumables
services business is four times the size of its opportunity in
aerospace, and is growing twice as fast with similar margins. Moreover,
he sees it as reducing the volatility in the business, because prospects
for oil and aerospace are inversely related.
Unfortunately, this argument looks weak. The
reality is that airline profitability is cyclically based on the
economy, and the price of oil is too. Moreover, airlines have got a lot
better at dealing with high oil prices then in the past. All told, the
move looks likely to increase cyclicality rather than reduce it, but
this doesn't mean it is a bad idea!
Valuation, valuation, valuation All
told, BE is headed for a strong year, but the problem is that its
valuation has largely priced this in. In order to look at the kind of
assumptions made in its stock price, consider that BE only converted 61%
of its net earnings into free cash flow in 2013, and management
forecasts only around 65% for 2014.
Assuming that 65% of earnings are converted into
free cash flow on a long-term basis, and plugging in analyst estimates
to 2017, gives the following estimate of its free cash flow. Its current
share price is $79.4 with an equivalent enterprise value (market cap
plus debt), or EV, of $96.
Source: Nasdaq.com
Unless its free cash flow conversion gets markedly
better in future years, or its earnings are better than consensus
forecasts, it's hard to see how B/E is a good value. Indeed, B/E has
struggled with cash flow conversion in the past. The essence of the
issue is that working capital requirements and inventory always goes up
in order to service new orders.
Where next for B/E Aerospace? The
valuation doesn't look cheap and the assumptions needing to be made in
order to make it look cheap are relatively optimistic. Based on the IATA
outlook, there is certainly good reason to expect commercial aerospace
to outperform in 2014, but who can predict where the economy will be in
2017?
Moreover, Fools need to appreciate that even if Boeing and Airbus
have historically strong order books, if the economy turns down then
orders will be cancelled and B/E will suffer. You can never fully
discount risk. As attractive as the company undoubtedly is, it's hard to
make a case for it based on anything other than earnings momentum
It's been a wonderful year for investors in the
aerospace industry, and the indications are that 2014 will also be a
strong year for the industry. All of which could lead you into a false
sense of complacency. However, the recent results from aerospace
component manufacturer Triumph $TGI
should go some way to dispel that notion. Triumph did anything but,
but are its results a warning signal for the sector or merely a company
issue?
Triumph lowers guidance The manufacturers that supply aircraft structures and components to Boeing $BA and Airbus are
always interesting industries. In line with many other heavy
manufacturers, they tend to have high fixed costs which means their
earnings tend to be super-cyclical to the aerospace sector. In addition,
they typically need to ramp up capital expenditures and working capital
requirements in order to service new orders that flow when the industry
turns. All told, they tend to have highly cyclical cash flows, and also
carry a substantive amount of operational risk when they increase
production.
Unfortunately, Triumph's recent results reminded
investors of some of these factors. The market had priced in good
prospects thanks to the strong order book at Boeing (responsible for
44.7% of Triumph's sales in the last quarter), and an anticipated step
up in Triumph's earnings and cash flows in future years. Moreover, Fools
know why aerospace is set for a good year in 2014. However, Triumph disappointed investors by lowering full-year guidance by $0.50 to $4.75 for three main reasons:
Issues relating to building out the new Boeing 747-8 aircraft
aerostructure caused a lowering of full year guidance by around $0.22
Military aircraft after-market demand has remained under pressure and demand did not come back as expected.
The quarter was marked out by a "surprising number of customer deferrals".
It's time to look at these issues in turn.
Did Triumph just wave a red flag? First,
the Boeing 747-8 issue looks like a manifestation of the operational
risk outlined above. Moreover, with aircraft getting ever more complex,
it wouldn't be surprising to see other manufacturers have such issues.
According to its management, Triumph incurred extra costs in replacing
parts with "internal quality issues" on the program, because the 747-8
is a "relatively new aircraft". While this problematic for Triumph ( the
747 is its biggest program), it doesn't read across as an industry
issue.
The second issue is a bit more of concern for the
industry, and serves as a salutary reminder that military aerospace
spending remains under pressure. The bifurcation in prospects between
military and commercial aerospace is well known to the market. For
example, on its recent conference call General Electric $GE
recently outlined that its fourth-quarter commercial aviation spares
market was up 16%. Meanwhile, GE's military spares market was down 3%,
due to sequestration issues and reduced flying hours. Overall GE
reported 11% growth in services demand.
Tuning back to Triumph, its management described
weak military spares sales as being "primarily" responsible for the
remaining $0.28 taken off full-year guidance. It's obviously
disappointing news for Triumph shareholders, but it doesn't represent
any new trend in the industry. Moreover, military spending is always
lumpy due to political considerations. Its overall aftermarket orders
may well bounce in coming quarters.
The third issue is more worrisome. When pushed on
the issue on the conference call, CFO David Kornblatt outlined that the
deferrals affected programs like the Boeing 737 and 777, and the
Gulfstream 650. These are commercial orders, and although Triumph's
management believes they will come back in due course, this is slightly a
concern. It's one thing to point at Boeing's burgeoning order book and
conclude that the aerospace industry is set for long-term growth, but
the truth is that customers do defer or cancel orders when the economy
turns down. Customer deferrals are about as good an early warning signal
as you will ever see.
What does it all mean? In
conclusion, it looks like Triumph stumbled with some operational issues
with which it's managing to overcome. Looking forward, internal guidance
is for EPS of $5.75 and $6.75 for 2015 and 2016, respectively. In other
words, Triumph expects its earnings to grow more than 42% from this
year's forecast of $4.75, over the next two years. If you are bullish on
aerospace then the current fall might create a good buying opportunity
for you.
On the other hand, its customer deferrals are a
small warning light for the industry. It's not significant, because
bellwethers like GE, Alcoa, andBoeing
continue to make positive outlooks on the industry. Indeed, Triumph may
well get these orders to pick up again in due course. However, it's
something for aerospace followers to keep an eye on.
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.
China remains one of the great imponderables in the
investing world. Is it about to roll of a cliff or return to 10%-plus
growth rates in the next few years? It's hard to answer these questions,
but we do know that the Chinese government is determined to generate
more growth in 2014. It's time to look at which sectors might benefit.
China to bounce back in 2014 By
now, everyone will have realized that China's growth is slowing.
Indeed, the 7.6% GDP growth target that economists have penciled in for
2013 represents the slowest growth in more than 14 years. Interestingly,
the OECD predicts that China's growth will improve to 8.2% in 2014
thanks to a "small fiscal stimulus." Essentially, China has responded to
slowing growth by initiating a round of stimulus spending, alongside
measures to add liquidity into its system.
This time it's different Old
habits die hard, so whenever there's talk of China and spending, many
investors simply go back to the mining and energy-based plays that
worked so well in the last decade. However, it's different this time.
Following its huge stimulus plan in 2008, China now has overcapacity in
many heavy industries, including shipbuilding, solar energy, and cement
and steel production. In addition, the government is trying to shift the
Chinese economy away from its reliance on housing investment and
exports (which are slowing anyway due to the current austerity in the
West) and toward domestic consumption.
All told, these trends mean that the sectors likely
to bounce in 2014 are not the ones we've seen skyrocket before. Indeed,
the old commodity plays like Caterpillar and mining-equipment company Joy Global
have been under pressure this year. China's demand for base metals
isn't what had been expected. In its latest quarterly earnings, released
back in August, Joy Global reported orders down 28% on a
constant-currency basis, with aftermarket bookings down 7%. Furthermore,
increasing use of gas in the U.S. is holding back Joy Global's core
coal market.
Aerospace and autos However,
there are areas of the industrial sector that are benefiting from this
economic shift. For example, China's plans involve building 70 new
airports in the next few years and expanding 100 existing airports. And
if airports are built, routes usually follow. Indeed, a quick look at Boeing's order book
reveals that net orders of 1,054 (to the start of December) represents
one of its strongest results in recent years. There is little doubt that
Asia has been a major driver of order growth for Boeing. For example,
according to the IATA, the Asia-Pacific region will generate 6.6%
passenger traffic growth in 2014, compared to 5% in Europe and only 2.5%
in North America.
In addition, Chinese car sales have bounced nicely in the second half of this year.
Source: China Association of Automobile Manufacturers.
All of this suggests that aerospace and automobiles
will continue to benefit from China in 2014. In this regard, paintings
and coatings company PPG Industries
is worth a look. PPG is heavily exposed to the automotive and
aerospace sectors, and this year's acquisiton of the U.S. household
paints division of Akzo Nobel is well-timed for the ongoing housing
recovery.
A word of warning All told,
China looks capable of bouncing back in 2014, but investors need to
focus on the long term. There is no guarantee that any stimulus measures
or fiscal loosening will lead to tangible return on investment.
It may turn out that China's economy bounces
slightly and then slips back again as these investments turn sour. The
2008 investment in industries like steel and shipbuilding could end up
simply being mirrored with airports, roads, and transport infrastructure
in 2014. Pause for thought.
Industrial conglomerates like General Electric (NYSE: GE)
make good bellwethers for different sectors of the global economy --
and if its most recent quarter's any judge, the economy's looking pretty
good.
GE reports broad-based strength
With
the sole exception of health care services, each of its six industrial
segments reported growth in equipment and services orders.
The most surprising aspect of GE's report was how
strong its power & water segment orders were. The segment has been
GE's Achilles' heel this year, but wind units posted strong results,
with 477 orders vs. 87 last year. Moreover, GE expects fourth-quarter
power & water orders to come in at the higher end of its previous
guidance.
Source: Company presentations.
While it was posted a strong quarter all around, GE's quarterly
results always need to be put into the context of ongoing trends,
because big-ticket capital machinery sales tend to be lumpy at the best
of times.
The key takeaways from GE's third-quarter results While
this quarter saw broad-based growth, there have been four consistent
areas of strength in GE's results throughout the year.
Commercial aviation
US home appliances
Emerging-market health care
Global transportation
GE's aviation revenue was up 12% in the quarter, but this increase
belies a clear distinction between commercial and military aviation. For
example, its military orders were down 30% in the quarter. In fact,
this story has been replicated throughout the year, as investors have
played a game of trying to find the aviation stocks whose revenue is
weighted toward commercial aviation.
One obvious beneficiary of this trend is a company like B/E Aerospace (NASDAQ: BEAV)
. The company makes commercial aircraft cabins, and the stock has
soared 57% year to date on the back of record order books at Boeing and Airbus.
Moreover, BE Aerospace just reported its own record order book of
$900 million in the quarter, and it announced the first delivery of its
modular advanced lavatory system. While that doesn't sound glamorous,
the toilet gives airlines a few extra seats on their planes, which could
help them increase revenue for each flight for years to come.
GE also announced that household appliances within its home &
business segment increased 11% -- an ongoing source of strength.
Similarly, Whirlpool has twice upgraded its expectations for end demand from the US.
This must be good news for the home improvement stores like Home Depot or Lowe's Companies (NYSE: LOW)
. Not only is the current upturn in the housing market helping out
spending at Lowe's, but investors need to recall that we are coming up
against the 10-year anniversary of the housing boom. In other words,
Lowe's should start to see customers coming in and looking to replace
white goods that they bought at the peak of the boom. Moreover, Lowe's
is strategically resetting its product lines, which is a lot easier to
do when markets are picking up.
The third key takeaway is that emerging markets offer far better
growth prospects for health care companies. Within its health care
segment, GE's developed markets grew 1%, while the emerging markets grew
14% with 33% in China alone. This is a clear sign that investors should
be favoring a company like Covidien (NYSE: COV) , which can outgrow its health care markets.
Covidien's big plus is that its products aren't big-ticket items -- an
important quality when selling to emerging markets. Moreover, it can
demonstrate a tangible return on investment with things like minimally
invasive surgery, and its key endo-mechanical and energy products still
haven't gained much of a presence in emerging markets.
Where next for General Electric?
In conclusion, it was a pretty good quarter for GE, and the return to
strength of its power & water segment confirms it's on track to hit
analyst earnings estimates of $1.63 this year. This would put the stock
at P/E ratio of around 16 -- not a bad value for a stock with a near-3%
dividend yield and a good chance of growing faster than GDP over the
next few years.
Another week and another set of earnings in the industrial space that
confirms the curious bifurcation in the sector. Companies selling to
the aerospace and automotive sectors had a good quarter, while others
found things a lot tougher. Such thoughts came to mind when looking at Precision Castparts' latest results. In this article I want to delve into the reasons why, and suggest some other stocks in the aerospace sector.
Precision Castparts lifts off
The bifurcation that I spoke of above was further demonstrated in
these results. Fortunately for Precision Castparts’ investors, the
company has increased its exposure to aerospace. It now makes up 67% of
revenues, vs. 64% last year. The Timet acquisition has helped while
also allowing it to generate operational efficiencies and synergies.
A quick breakdown of revenues demonstrates the positive effects of Timet on the forged products segment:
And a breakdown of operating income in the quarter shows how it makes its money:
Moreover, there is still plenty of growth to come as it ramps up
production (notably by getting its 29,000 ton press back to full
capacity by the end of the year) for the Boeing 787 this year. It will do similar with the 737 next year. Fortunately,
large commercial aerospace makes up 75% of its market, with military
only at 17%. Elsewhere, its other segments saw less than stellar
performance, with power falling to 18% of sales from 21% last year, and
general industrial remaining flat at 15%.
What the industry is saying
Focusing on the macro aspect of its results, investors need to
understand that the commercial aerospace industry is highly cyclical.
The good news is that in this cycle the airlines have been surprisingly
profitable. I discussed some of the reasons why here.
In summary, I think airline profitability is better this time, due to
a combination of factors. Austerity measures have brought about a
reduction in the willingness of governments to subsidize loss-making
‘national champions'. At the same time, financing has become harder for
new entrants. In addition, the growth in emerging market
passengers has created new growth drivers for the industry. And finally,
the airlines have had a few years to adjust to high oil prices. The really interesting point is that –past the short term- profitability does not appear to correlate with oil prices. All said, it is a better operating environment for the airlines.
We got a good early read on the current strength of the industry when Alcoa reported results. It was a generally positive set of numbers
from its end market perspective. With regards to aviation, Alcoa stuck
to its previous bullish guidance of 9-10% global growth this year, with
particular strength coming from emerging markets. The issue with Alcoa
is not necessarily its end market growth, but rather the state of
overcapacity in aluminum production. Its aviation demand remains strong.
Therefore, it is not surprising that Boeing has been beating
estimates and looks set to continue. Naturally, the aviation industry
will never truly escape being cyclical, but as long as the global
economy remains on track, it is a sector that can outperform. This is
good news for Boeing, Precision Castparts, and other players like cabin
manufacturer BE Aerospace.
The latter is one of the most interesting names
in the aerospace sector, and offers a rare way to get pure exposure to
commercial aerospace. Its growth prospects rely on a mix of retrofit and
new build demand. In addition, it is a key beneficiary of the trend
towards wide bodied aircraft, and has a number of new innovations, like
its lavatory system for the 737 which allows airlines to gain a few
extra seats. However, I think its key plus point relates to the
profitability of airlines. If the industry is on a more sustainable
path, then airlines will be better positioned financially in order to
retrofit planes, rather allow them to depreciate.
Where next?
On a stock specific basis, this means that companies like Precision
Castparts can continue to outperform. It offers a combination of upside
from a ramp-up in production, plus synergy opportunities. Both
activities can increase margins going forward. Similarly, something
like BE Aerospace is going to benefit from more favorable industry
financials. Boeing is an obvious momentum play. If you are
bullish on the global economy and particularly emerging markets, then
all these stocks represent attractive propositions.
