By Mark Yockey
The aerospace sector is one area of the market in which we are seeing attractive long-term growth prospects, as certain air travel-related companies are advantageously exposed to secular growth drivers, which are occurring as a result of the changing global demographics landscape.
When considering an investment in any stock, it is important to assess a company’s ability to sustain earnings growth over the long term. This is best achieved by understanding the company’s competitive advantages, business model and management expertise. It is also advantageous to look for secular growth trends (with the objective of investing in companies that have meaningful exposure to these trends). As such, there are certain pockets of the civil aerospace sector that appear to be positioned well for a period of growth and, as a result, may offer attractive long-term investment opportunities.
The secular growth that we are seeing in the aerospace sector is being driven by several factors including the following:
– Aircraft manufacturers are gearing up for a new wave of growth as global air traffic is forecasted to average approximately 5% growth per annum over the next 20 years. This was confirmed again as recently as November at the Dubai Airshow where almost $200bn in orders for new planes was announced. The growth in air traffic is largely underpinned by growing disposable incomes, urbanisation and an increasing appetite for travel in emerging economies. In fact, air traffic is expected to grow at 6.6% per annum between 2012 and 2031 in emerging regions, outpacing the 3% annual growth rate for advanced economies.
– Increasing fuel costs are a game changer. When the global airline industry’s fuel bill accounts for over 30% of operating expenses, there is a powerful incentive to demand more efficiency. In response, new Airbus and Boeing planes are estimated to be 15-20% more fuel efficient than their predecessors. Given the increased efficiency of the latest generation of aircraft, operators may choose to retire some of their current fleet ahead of schedule, another factor stoking the OEM (original equipment manufacturing) cycle.
– Major aircraft producers Boeing and Airbus are experiencing unprecedented order backlogs. Last year, Boeing’s backlog grew to a record $390bn and the Airbus backlog reached more than $638bn. The companies plan to increase their combined production by 40% to tackle the accumulation in demand and estimate the current backlog will take at least seven years of production to clear. Additionally, the customer base is becoming more geographically diversified which should help to make the backlog less prone to a shock from any one country.
These trends and the current environment are helping to foster top-line and earnings growth, steady cash flow generation and long-term visibility for certain aerospace-related companies. However it is important to examine all parts of the value chain, encompassing upstream manufacturers as well as airline companies. While some airlines have been benefiting from these growth trends, this does not necessarily mean that they exhibit the characteristics of a high-quality sustainable growth company. Instead, companies that act as critical suppliers to the airline industry are the ones proving themselves as high-quality companies that have the potential to sustain earnings growth over the long term, as they are able to demonstrate pricing power and generate steady cash flows through multiple cycles and higher margins.
Additionally, several of these companies benefit from high barriers to entry. The high barriers to entry are driven by long and expensive development cycles, the heavy investment required to develop necessary technological expertise and the stable supplier relationships built around the need for safety and reliability. Ongoing production, repair work and parts suppliers are also subject to extensive regulatory requirements. This includes the necessity for initial certification by the Federal Aviation Administration (FAA) in the US, the European Aviation Safety Agency in Europe (EASA) and other applicable agencies.
The secular growth drivers look well aligned to provide pockets of attractive investment opportunities within the aerospace sector. Therefore institutional investors may want to keep watch as aerospace companies take flight.
Mark Yockey is a portfolio manager at Artisan Partners
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