Image Source: Rob Buhlman
Just how healthy is the commercial aerospace market? Very — if the size of Boeing’s backlog is any indication. Let’s have a look.
By Brian Nelson, CFA
In August 2016, we wrote an extensive update on the commercial aerospace market, “Boeing Declares Victory But Farnborough Disappoints,” and we encourage those that are digging into this follow-up note to read that piece first before proceeding. In this note, dated Wednesday, January 25, we’d like to build on that piece and update investors on a few insights we’ve gathered within the aerospace market.
First, what was once a key company to assess commercial aerospace demand is no longer. As of November 1, Alcoa (AA) has been severed into two independent publicly-traded entities, and its new split-off Arconic (ARNC), headed by industry giant Chairman and CEO Klaus Kleinfeld, is now the entity whose performance we expect to offer incremental insight into commercial airplane build rates and overall end market demand. Legacy Alcoa, which reported its first quarter as a separate company January 25, no longer represents an effective lead indicator to assessing end market demand across a variety of industries verticals, in our view. Times have changed, and that role has shifted to Arconic.
According to Arconic’s Investor Day slides from December 2016, it is estimated that roughly 65% of the new company’s business comes from the aerospace and transportation markets, including 22% from commercial airframes and 15% from commercial aero engines. Defense aerospace comes in at 4%. As Arconic puts it, “if it flies, we’re on it,” and the company has content on every Boeing (BA) platform, it has GRB sheets and plates on every Airbus (EADSY) platform, is a prominent supplier to Embraer (ERJ), and has exposure to the Joint Strike Fighter (JSF). We’ll be looking for incremental insights when Arconic reports fourth-quarter 2016 results January 31, 2017.
Very few other industries have greater visibility that the commercial aerospace industry, not to be confused with the commercial airline industry, the latter comprising those that fly passengers from one place to another. Those that are involved in building planes continue to benefit from the burgeoning backlogs (order books) of the commercial airframe makers. In Boeing’s fourth-quarter earnings report, released January 25, the aerospace giant noted that backlog remains robust at $473 billion with more than 5,700 commercial airplane orders. To put this size in perspective, Boeing delivered 748 commercial planes in 2016, 762 commercial planes in 2015, and the company expects to deliver between 760-765 commercial planes in 2017. Translation: Boeing has more than 7 years’ worth of annual run-rate production just sitting in backlog!
We’re huge fans of Boeing, of course, and while the company has considerable flexibility with program accounting to achieve bottom-line targets, we like expectations for GAAP earnings to come in the range of $10.25-$10.45 per share for 2017, putting the company at roughly 16 times current-year earnings at the prevailing market price at the time of this writing. Earnings are backed by strong cash flow from operations generation, too, with the aerospace giant targeting the measure to increase to ~$10.75 billion, slightly better than the mark achieved in 2016. Capital expenditures are expected to decline $300 million in 2017 from the previous year’s levels, to $2.3 billion, so free cash flow should advance this year. Free cash flow came in at $7.9 billion during 2016, up from $6.9 billion in 2015. While many are worried about the contents of President Trump’s next tweet, Boeing’s core commercial business is knocking the cover off the ball.
Whereas Boeing boasts a massive commercial backlog in the hundreds of billions, suggesting increased visibility, Lockheed Martin’s (LMT) entire backlog, on the other hand, stood at ~$96 billion, just shy of 2 times run-rate annual sales. That’s still a huge order book, of course, and we can’t be too upset with the company’s strong performance in 2016—net sales: $47.2 billion in 2016, $40.5 billion in 2015, and earnings from continuing operations: $3.8 billion in 2016, $3.1 billion in 2015—but Lockheed’s outlook for 2017 was quite cautious and probably for good reason. Trump’s ongoing criticism of the costs of the F-35 program seems to have management preoccupied, and buried in the Lockheed’s fourth-quarter press release was language stating that the company “expects to report a material weakness in internal control over financial reporting at its Sikorsky Aircraft Corporation business in its Annual Report.”
Though the notification is probably nothing to worry about, we didn’t like the news, and it seems likely Lockheed will probably make some tweaks to its top and bottom-line targets for 2017 as the year progresses. Right now, net sales and diluted earnings per share are targeted in the range of $49.4-$50.6 billion and $12.25-$12.55 per share respectively, implying that Lockheed’s shares are trading at a lofty 20 times current-year earnings. On a relative value basis, we think Boeing offers a much better big-cap idea than Lockheed, and Boeing’s ties to both the commercial and defense aspects of plane-making offer considerable diversification benefits to handle both the economic and political cycle. Further, we think Trump can impact the fate of Boeing much less than that of Lockheed Martin, given the latter’s heavy defense exposure.
United Technologies’ fourth-quarter report, released January 25, showed sales increasing 2% (all organic) and adjusted earnings per share advancing 5% for the full-year. The company affirmed its adjusted earnings per share target for 2017 in the range of $6.30-$6.60 on sales of $57.5-$59 billion, the former implying shares are trading at ~17 times current-year earnings at the high end of the guidance range at prevailing market prices at the time of this writing. We like United Technologies for its cash-flow conversion prowess, meaning that cash flow from operations of $6.4 billion during 2016 was nearly 30% higher than net income for the year, and 2016 free cash flow of $4.7 billion was an impressive 93% of net income. What this means is that United Tech’s earnings are largely cash earnings and of high quality. As with Lockheed, United Tech’s Pratt & Whitney engine division is focused on reducing costs on the F-35, and we’ll be monitoring that program closely in the months ahead.
All in, commercial aerospace still looks fantastic, perhaps punctuated by Boeing’s strong 2017 delivery outlook and its burgeoning aerospace backlog. Our favorite aerospace supplier had been Precision Castparts, but Warren Buffett scooped up that engine-casting supplier some time ago, and it is now within the Oracle’s portfolio at Berkshire Hathaway (BRK.A, BRK.B). We include Berkshire Hathaway’s B shares in the Best Ideas Newsletter portfolio largely for this reason (as our “play” on aerospace), but Boeing is looking more and more attractive as a dividend growth idea, too. Recently, Boeing raised its dividend 30%+ to an annual payout of $5.68 per share, implying a forward yield of ~3.4% at present prices. Shares of the aerospace giant have been rocketing higher, and in many ways, the company should already be in the Dividend Growth Newsletter portfolio. Look for us to make a move in the coming weeks/months.
Aerospace & Defense – Prime: BA, FLIR, GD, LLL, LMT, NOC, RTN
Aerospace Suppliers: AIR, AIRI, AL, ATRO, COL, HEI, HXL, ISSC, SPR, TATT, TDY, TXT