4 Top Aerospace Stocks to Consider Buying Now
Aerospace suppliers have enjoyed strong demand for the better part of a decade, thanks to an airline industry, after rounds of bankruptcies and consolidation, that is finally stable enough to renew fleets and plan long-term. We're late in the cycle, but companies including TransDigm (NYSE: TDG), United Technologies (NYSE: UTX), Esterline (NYSE: ESL), and Hexcel (NYSE: HXL) still offer reasons for optimism for investors looking to buy in.
The airplane business has historically been highly cyclical, and with Boeing and Airbus now eight years into an upcycle in deliveries; some caution is merited. We've already seen a pullback in demand for widebody jets, the larger twin-aisle planes used primarily for international flights, but the market for smaller single-aisle narrowbodies like the Boeing 737 and Airbus A320 remains so strong the companies are thinking about raising production rates.
The supplier base supporting Boeing and Airbus includes a cluster of companies with varying focuses and individual niches. Given where we are in the new plane cycle, it is wise to focus on companies with strong ties to the aftermarket -- or spare-parts – business. The aftermarket can be less predictable than fixed contracts to supply new production, but it has historically produced higher gross margin than new orders and tends to remain stable even when new orders tail off.
Spirit AeroSystems for example has done well to recover from poor business decisions made last decade, but its reliance on new Boeing jets are a reason for caution. Rockwell Collins, meanwhile, has assembled a mix of electronics and seating assets that figure to hold up well should the cycle turn, but that company in September agreed to sell itself to United Technologies.
Here are three stocks that should hold up well throughout the commercial aerospace cycle, and one to bet on if you believe new jet demand will remain strong.
The margin master
TransDigm, formed in 1993, is a rollup of more than 60 aerospace businesses specializing in complex, and often proprietary, parts. It is also the best way to gain exposure to the entire aerospace and defense market, at all parts of the cycle.
The company is involved in nearly every program in the sky, including the complete ranges of Boeing and Airbus commercial models, a number of business jets, and most current active U.S. military aircraft. More than half of its revenue and EBITDA come from the aftermarket. It is also diversified in terms of revenue source: Commercial aftermarket accounted for 37% of 2016 sales, followed by new jets at 29%, defense at 29%, and non-aerospace revenue that was 4% of total sales.
TransDigm is not without some warts. The company had unwanted attention drawn to it last January, after Citron Research's Andrew Left called it "the Valeant of the aerospace industry" because of what Citron believed were related-party transactions. Citron also accused it of price-gouging. Analysts have largely dismissed those claims, and Citron has been silent on the company in recent months, but TransDigm does remain heavily indebted, with $11.13 billion in debt and less than $1 billion in cash on its balance sheet.
Even with a couple of temporary Citron-related dips, shares of TransDigm are up more than 5% year to date.
The big fear with TransDigm is that the company will lose its pricing power, which would eat into its outstanding 42% operating margin and make the company unable to do further acquisitions, leaving it in a precarious position. The bet here is that won't happen. Copying TransDigm's offerings would be no easy task, with the company estimating that 90% of sales come from proprietary products and 80% of sales come from products in which TransDigm believes it is the sole source provider.
Organic sales, which actually fell year over year in the fiscal quarter ending in November 2016, were up 2.7% during the same three months of this year.
TransDigm will continue to benefit from the ongoing demand for new planes, and to be there to provide replacement parts for that fleet of jets long after demand for new jets has faded.
A conglomerate increasingly focused on aerospace
United Technologies is one of the last of the large industrial conglomerates, housing businesses including Carrier HVAC, Chubb Security, and Otis Elevators. But it is its UTC Aerospace Systems unit, which was formed in 2012 after the company acquired Goodrich for $18 billion, along with its Pratt & Whitney aircraft engine unit, that are increasingly the focus of attention at the company.
The aerospace business is a supplier to a range of military and commercial platforms, generating about 75% of 2016 sales from commercial customers and about two-thirds of revenue from the aftermarket. Commercial aerospace, defense, and space already accounted for about 50% of UTC total 2016 revenue of $57.2 billion, and that figure should grow in the years to come assuming the company is able to close its pending $30 billion deal for Rockwell Collins.
UTC's Pratt & Whitney has had issues with its geared turbofan engine design, which has faced technical issues and has fallen behind a rival offering made by a General Electric joint venture. But a combined UTC Aerospace/Rockwell Collins would give the company exposure all over the aircraft, from engines to seats to electronics, and give the company the heft needed to push back against attempts by Boeing and Airbus to squeeze supplier margins to better compete for new jet sales on price.
Rockwell Collins' interior business should benefit from a push by airlines to update the passenger experience with new entertainment systems and power supplies, as well as seats better designed to pack in the crowds.
The bottom line is that UTC's aerospace business alone offers diversification and, if Pratt & Whitney gets its turbofan engine humming, upside. Throw in the added diversification of the building and equipment businesses and a dividend yield north of 2%, and UTC is a good long-term part of an industrials portfolio.
A turnaround opportunity
Esterline Technologies is the rare down stock among aerospace companies, off 19% year to date thanks largely to a 21% one-day drop Nov. 10 after the company reported fiscal fourth-quarter earnings that came in well short of expectations. That sort of a drop is not for the weak of heart, but there is value to be had for those with the courage to jump in.
Esterline, a maker of specialty components including sensors, electronics, and advanced materials, has exposure to a range of commercial programs, including the Boeing 777 and 737 and the Airbus A350 and A320, as well as defense programs including the Eurofighter and both Apache and Black Hawk helicopters. The company also makes components for military ground vehicles, naval applications, training and surveillance aircraft, and air traffic control, and it also sees future opportunities in adjacent markets including rail, nuclear, and industrial automation.
Its recent issues stem from a higher-than-anticipated tax rate and continued operational issues at its Kirkhill Elastomers facility. Kirkhill makes silicone seals for aircraft and missile liner insulation materials, including products that can absorb radar and interfere with electromagnetic signals.
Kirkhill has been a cause for concern for some time, with Esterline earlier in the year replacing the management team there and instituting streamlining designed to boost productivity. But operating challenges, coupled with a defense contract that was priced short of expectations, resulted in a $10 million decline in year-over-year operating results and lowered guidance for 2018.
Despite the Kirkhill mess, the company was able to grow full-year free cash flow by 37% compared to 2016. And while the higher tax rates experienced in 2017 are expected to carry into future years thanks to changes in U.K. tax law, Esterline in 2017 was able to increase its backlog of business in key areas including cockpit electronics and secure communications.
Esterline is in the penalty box for now, but this is a solid business with good assets that will be attractive to an activist or a buyer if current management can't get it sorted out. There's value to be had here for a long-term investor.
Buy the tech behind the planes
If the new jet cycle does have legs to continue for a few more years, Hexcel figures to be one of the top beneficiaries.
Hexcel pioneered the composite materials made popular in Boeing's 787 Dreamliner and heavily used in applications including Lockheed Martin's F-35 fighter jet. The company's HexMC carbon fiber/epoxy tape materials are growing in importance as a low-weight replacement for metal in aerospace applications, with participation on a range of new Airbus platforms and on Boeing's much-anticipated 737 MAX.
Given the nature of the product Hexcel is much less diversified than some of its aerospace rivals, with commercial aerospace accounting for 72% of year-to-date 2017 sales and little exposure to the aftermarket. The company is exploring applications for its products in other industries, including wind turbines and automotive, but for now aerospace, defense, and space account for 89% of revenue.
Hexcel reported mixed quarterly results in October, beating on earnings per share but missing on revenue, with company officials attributing both the beat and the miss largely to the dollar's strength against the euro and the British pound. Execs said that a period of massive capital expenditures is wrapping up, meaning much lower anticipated spending in 2018 and 2019.
The company spent $221 million on capex in the first nine months of 2017, compared with $232 million in the same period a year prior. Investors seem to believe there are better days ahead, sending shares up 18% year to date.
There is risk to buying Hexcel now: The company, as stated, could be in for some turbulence if demand for new jets falters. But this is a good business with good technology that should benefit long-term holders, and any success outside of aerospace could provide a nice unanticipated spark.
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Lou Whiteman owns shares of TransDigm Group. The Motley Fool owns shares of and recommends TransDigm Group. The Motley Fool has a disclosure policy.