Air travel growth and pent-up demand from delayed auto sales due to the Great Recession have provided a boom in spending within the commercial aerospace and automotive industries in recent years, respectively. The ever-increasing global population continues to be a driving force behind the expansion and adaptation of power end markets, and innovative solutions to meet growing global energy demand will continue to be a source of growth for industrials despite fluctuations in the energy-price markets. Such drivers in part have propelled the underlying performance of industrial giants GE (GE) and Honeywell (HON), among others.
Winners and Losers Are Developing in Commercial Aerospace
We expect commercial aircraft production and deliveries to continue to increase for at least the next three to four years, perhaps longer if the global economy cooperates. The sharp drop in crude oil prices has also helped with fuel savings at major airlines, and healthy competition from low-cost carriers should spark additional demand from reduced fares. As we’ve stated time and time again, Boeing (BA) and Airbus (EADSY) continue to benefit from record high backlogs of unfulfilled deliveries, and the commercial aerospace supply chain has never been stronger. Boeing ended the second quarter of 2015 with total backlog of $489 billion. To put this into perspective, through the first half of the year, Boeing generated revenue of less than $47 billion.
Others have been reiterating the strength. Aluminum giant Alcoa (AA) expects global sales growth in the aerospace industry of 8%-9% in 2015, and we think such expansion is achievable. The firm’s growth projections for global aero sales in 2016 and 2017 were recently raised to 8% and 13%, respectively. GE and Honeywell also noted the strength of aerospace. At the end of the second quarter of 2015, for example, GE posted the largest-ever backlog of $272 billion; $142 billion of its backlog is in its Aviation segment. Though the segment reported revenue growth of 3% from the year-ago period, its orders grew 30%+ to $7.6 billion in the quarter. The order price profile of aerospace orders was also the best across GE’s portfolio, advancing 2.4% in the period.
Honeywell reported second-quarter organic sales growth of 3% in its Aerospace segment thanks to double-digit volume increases in Business and General Aviation engine shipments. The company also expects robust demand for its engines to continue in the second half of 2015, while its growing installed customer base continues to provide underlying support for the positive outlook. Though Honeywell is not a pure-play on aerospace, the firm has been executing fantastically with wins across several major platforms from the Boeing 737 Max (expected to enter into service in 2017) to the Airbus A350. Honeywell also has multi-billion dollar agreements for content on the Boeing 777X (expected to enter into service in 2020) and China’s COMAC C919 (expected to enter into service in 2018).
Aerospace companies have been jockeying for position as well. Lockheed Martin (LMT), for example, recently agreed to acquire Sikorsky Aircraft from United Technologies (UTX) for $9 billion. The acquisition of the military and commercial helicopter maker will complement Lockheed’s already broad portfolio of aerospace and defense technologies. Alcoa has been transforming its portfolio for some time. Recent acquisitions of TITAL and Firth Rixson have increased its capacity in the structural and rotating components of jet engines, encroaching on an area dominated by Precision Castparts (PCP). Alcoa’s acquisition of RTI International Metals will broaden its multi-material products lineup to meet the growing aerospace demand for titanium.
Though we note strength in aerospace, it’s important to emphasize that not all firms exposed to aerospace are “firing on all cylinders.” Surprisingly, United Technologies’ commercial aerospace aftermarket business could have performed better in the second quarter, and with softer-than-expected demand in Europe and China, the company lowered both its full-year revenue and earnings guidance for 2015. We still like United Technologies and its decision to scoop up aerospace supplier Goodrich a number of years ago, but we also admit that execution since the transaction has been subpar. United Technologies has industry-leading franchises that throw off lots of free cash flow, and from a fundamental standpoint, it remains one of our favorites.
Auto Industry Remains Resilient
The auto industry as a whole has been experiencing a very strong 2015; in fact, US auto sales are likely to reach a ten-year high. We’re hearing a lot of the same things from a few key players. Alcoa’s management, for one, expects global auto production growth of 2%-4% for the full year 2015. Increasing emissions standards, electrification of on-board features, and powertrain efficiency-developments will be part of the changing auto production landscape and will support the demand for innovative products across the broad auto supply chain. Supply chain players levered to tighter emissions standards such as Borg Warner (BWA), improving safety regulations such as Autoliv (ALV), or more advanced electrical auto components such as Lear (LEA) or Gentex (GNTX) will be key beneficiaries.
The performance of Honeywell’s ‘Transportations Systems’ segment during the second quarter is worth noting. The division’s sales advanced 5% on a core organic basis thanks to new platform launches and higher gas turbo penetration across the globe. Honeywell noted that for 2015 ‘Transportation Systems’ sales are expected to be up in the low-to-mid single-digit range on a core organic basis thanks to light-vehicle gas and diesel turbo volumes. Honeywell expects to increase global turbo penetration by an incremental 10 percentage to ~45% points in the next 5 years. The company believes we are in a “Golden Age of Turbos.”
We have two concerns with the strength of the auto industry at the moment, however. The first is China. The country has experienced one of the largest stock market drops in modern-day history, and the fallout on consumer spending has yet to be determined. General Motors (GM) and Volkswagen (VLKAY) are most exposed to weakening auto demand in China, though we note the incremental positive delta to the country is greatest at Ford (F). Our second concern rests with channel inventory, and the gap between sales on the lots versus sales on the assembly line remains somewhat concerning. This is not a new issue, however.
Power & Energy versus Oil & Gas
General Electric perhaps exemplifies the dichotomy we’re witnessing across the Power & Water versus the Oil & Gas markets. The industrial giant generated significant positive momentum in its Power & Water segment during the quarter, with segment orders and revenue growing 22% and 8%, respectively in the period. The global demand for renewable energy has been a solid source of growth at the company; renewables orders advanced 24% from the same period in 2014. GE also launched its Digital Wind Farm software in the quarter, which is expected to generate up to 20% more annual energy production using existing infrastructure. Further driving segment growth was the firm’s innovative Dynamic Positioning (DP) system for maritime operations. DP orders advanced 68% in the second quarter.
General Electric is attempting to grow the reach of its power business with the acquisition of French power firm Alstom. Priced at ~$13-$14 billion, the acquisition will be the largest in GE’s history. The deal, however, has received significant pushback from French regulators who claim the acquisition would give GE too much control over utility rates in the country, as well as impact France’s return on investment in Alstom’s renewable energy business. The deal is expected to close in the third quarter of 2015, though its impact on GE’s earnings will be negligible for the year. The firm is confident the deal will clear the necessary regulations and be significantly accretive to 2016 results.
Though Power & Water remains an exciting area of order growth, the Oil & Gas markets continue to suffer reduced demand due primarily to the collapse in energy resource pricing. In GE’s second quarter, revenue generated from the Oil & Gas segment fell 15% while segment profit dropped 12%. The company’s Oil & Gas ‘Equipment’ and ‘Services’ orders fell 14% and 26%, respectively, while order pricing faced material pressure. Management pointed to solid execution in a challenging environment, and while we agree, such an admission does not alleviate the pain. Energy resource pricing may remain under pressure for some time as global supply increases and as Iran re-enters the fray once sanctions are lifted.
Wrapping Things Up
All things considered, the outlook for global industrials remains positive. The strong demand in aviation, automotive, and power end markets is driving solid organic performance of industry leaders, and both Honeywell and GE have raised the lower bound of their respective earnings-per-share guidance in 2015 when they reported second quarter performance. We don’t plan to miss out on opportunities.
Though results will be messy as GE gobbles up Alstom and sheds its massive financial operations, we think a mispricing is evident in its shares. The company is held in both newsletter portfolios. Precision Castparts remains high on the watch list, though stiffer competition from Alcoa has soured our fundamental view a bit. Honeywell has been off-to-the-races, settling near $105 per share at this printing, and we’d look for a better entry point than “up here.”
GM’s shares are starting to get cheap, but two of our industry concerns pertain directly to it given its heavy exposure to China and potential inventory overhang. We’ve held Ford in the past and aren’t against either domestic auto giant at the right price, which is drawing near at GM. We’re generally cautious on the auto supply chain, favoring the OEMs instead, which generally have pricing power during negotiations.
The global defense contractors, including Lockheed, perhaps represent some of the best “hidden” income ideas on the market today, but if investors prefer large cap defense, Boeing may be the best play. The company’s operations aren’t levered as much to competing budget priorities in Washington given its larger and growing commercial aircraft-making operations.
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