A transitional year for Aerospace

Mar 30, 2015

With air traffic growing faster than GDP, a low oil price boosting airline profits and the US dollar outmuscling the pound and euro, it was perhaps no surprise to see shares in commercial aerospace stocks end last year strongly. That momentum has continued into 2015, too, with many pointing to Airbus (FR:AIR) and Boeing 's (US:BA) combined order book of 12,000-plus aircraft as a sure sign of sector-wide prosperity.

Demand isn't expected to be jeopardised either by the recent tragic crashing of an Airbus 320 over France. According to one analyst, unless the tragedy is proved to be related to a design flaw that should have been spotted before, the accident and loss of lives is unlikely to harm demand for Airbus's plane. The view from the City is that, with 11 fatal incidents since the popular aircraft began flying in 1988, it has a good safety record.

Although the long-term trends are positive for the sector, analysts at broker Berenberg expect 2015 to be a "transitional year" led by key new programmes that could present "operational challenges" for manufacturers. In short, the duopoly's new aircraft and engine programmes are likely to translate into another year of big research and development spend that could weigh on margins and cash flow for companies in the supply chain.

Nevertheless, while the rise in capital expenditure to meet growing demand is depressing cash flow generation, balance sheets across the sector remain relatively healthy. Aerospace stocks tend to be cash-generative and this factor, coupled with an historically low level of M&A activity, could even result in a step-up in return to shareholders through increased dividends or share buybacks. Arms supplier BAE Systems (BA.) has been leading the charge on buybacks, along with aerospace component maker Meggitt (MGGT), and engineering giant Rolls-Royce (RR.). However, the companies' largesse could simply be to appease investors following a series of downgrades.

Other companies have bucked this trend, most notably defence contractor Cobham (COB), whose net debt crept up significantly after it splashed out £869m for industry rival Aeroflex, in a move designed to ramp up exposure to more lucrative aviation markets. New York-based Aeroflex, which manufactures components used in aerospace, defence, manufacturing and broadband communications, generates around three-quarters of its revenues from commercial customers, with the remainder linked to defence and security remits.

Airline profitability is also likely to rise significantly off a low oil price”

Car parts supplier GKN (GKN), too, has been capitalising on a steady after-market recovery, as its aerospace margins widened by 50 basis points to 12.4 per cent in 2014. Buoyant demand for commercial aircraft parts, coupled with a strong showing for its auto unit Driveline, took some of the heat off the group's unfavourable ties to troubled defence and agriculture markets.

Analysts at Investec also figure GKN will prosper from an increase in narrow-body plane production. Both Airbus and Boeing continue to see strong demand for more fuel-efficient single-engine aircraft. The manufacturers had received a total of 9,300 new orders for this type of aircraft by the end of February. Aeroplane parts supplier Senior (SNR) also looks set to benefit from this corner of the market, along with European aerospace heavyweights MTU (DE:MTX) and Safran (FR:SAF).

Conversely, if demand for wide-body jets continues to reduce, it could spell trouble for Rolls-Royce. Tepid defence spending, global economic uncertainty and rock-bottom commodity prices saw the market-leading engineer endure a torrid 2014, marred by several profit warnings and underlying revenue plunging for the first time in a decade. In fact, a growing aerospace order book was one of the only bull points for the year, yet now demand for Rolls-Royce's trademark Trent 700 engines used in wide-body Airbus A330 and Boeing 777 planes, too, is expected to falter. 

 

Company Name / Ticker	Price (p)	Market cap (£bn)	NTM forward PE (x)	Five-year historic PE average (x)	Dividend yield (%)	Year change (%)
Airbus Group (FR:AIR)	44	34.7	18.2	25.9	2.0	+16.3
BAE Systems (BA.)	547	17.3	13.9	26.5	3.7	+31.1
Boeing (US:BA)	105	73.7	18.1	16.9	2.4	+26.1
Cobham (COB)	317	3.7	14.9	23.2	3.3	+6.4
GKN (GKN)	375	6.2	13.3	14.1	2.2	-2.4
Meggitt (MGGT)	578	4.6	16.4	17.1	2.4	+23.0
MTU Aero Engines (DE:MTX)	66	3.4	17.9	19.3	1.6	+39.7
Rolls-Royce (RR.)	983	18.2	16.2	51.6	2.4	-8.8
Safran FR:SAF)	48	19.9	19.0	18.4	1.8	+32.5
Senior (SNR)	333	1.4	15.8	15.0	1.7	+11.9

 

 

IC VIEW:

Longer-term growth opportunities in civil aerospace remain attractive, although there are short-term programme risks for the year ahead. Valuations could also be weighed down by an order slowdown, with some analysts speculating that airlines may now start stretching out requests after several years of buoyant demand. That's certainly something that short-term investors should keep tabs on and could, potentially, provide an attractive entry point into shares. Nevertheless, though impressive results and beneficial currency movements led many shares to rally hard towards the end of last year, current ratings don't look too challenging when compared with their five-year historical averages. That, too, could represent an ideal entry point for investors keen to cash in on the long-term structural drivers within aerospace. But as few UK-listed companies are pure plays, investors are advised to consider the other end markets each operate in. Particular attention should be paid to those adversely affected by a low oil price - Meggitt and Rolls-Royce - and muted defence spending in developed regions.

 

SOURCE: investors CHRONICLE