The aerospace industry is faced with some unusual end market prospects for the next few years. In previous cycles, commercial aviation was characterized by extreme cyclicality and ongoing profitability issues as government sponsorship of national airlines tended to encourage over capacity. By way of comparison, military spending was always more stable and tended to provide a useful counterweight in difficult economic times. How times have changed!
The current situation is different. Commercial airline profitability is coming in better than expected and I think we can expect more upswing in this recovery. For the sake of brevity, I can’t go into the reasons why, but there is a more in-depth discussion on the issue linked here. On the other hand, horrendous sovereign debt issues in many countries are creating the necessity for pro-long term growth measures like cutting public spending (sic), and cutting defense spending (particularly on hardware) is a key component of this.
Which stocks could benefit?
With these kind of industry dynamics, investors should be favoring stocks exposed to commercial aviation and one useful idea is cabin interior manufacturer B/E Aerospace Inc (NASDAQ:BEAV). The company benefits from new and retrofit of cabin interiors. My point is that if airlines are seeing more stable long-term financial conditions, then they should be more inclined to retrofit their older aircraft. As a consequence, analysts have B/E Aerospace on 20%+ earnings growth rates for the next few years. All of that can disappear in a flash should the global economy falter, but for now the stock looks attractive.
Another stock worth looking at for its secular growth prospects is Hexcel Corporation (NYSE:HXL). Hexcel’s attraction is that it is the global leader in lightweight advanced composites. With the trend towards wide bodied aircraft firmly in place, the pressure to increase the usage of lightweight components will only increase. Similarly, if we are in a world of $100+ oil prices, then airplane manufacturers will have to try and reduce aircraft weight (the most effective way to reduce fuel costs). Indeed, I note that Hexcel reported revenue from Airbus and Boeing programs being up 20% in the last quarter with the 787 Dreamliner being a particularly composite heavy airplane.
What about Heico?
Another stock that I think could be a beneficiary is HEICO Corporation (NYSE:HEI). Its operations are split into the Flight Support Group (FSG) and Electronic Technologies Group (ETG).
The FSG is involved with offering parts, repair, and distribution to airlines. It tends to be cyclical, as airplanes will require more servicing as they rack up more air miles. Moreover, it has some interesting secular drivers because airlines are increasingly looking to cut costs and outsourcing this activity offers them the option to do this. The ETG offers various aerospace components to a mix of commercial and government customers. Traditionally, military-based spending makes up around 20% of HEICO Corporation (NYSE:HEI)’s revenue.
Given the changed dynamics of the aerospace industry, I think its long-term prospects are excellent. Provided global growth is good, it can benefit from the increased profitability and financial stability of the airlines.
Heico lifts off
The recent results pretty much confirmed this view, and the stock has taken off since they were released, but is now the time to be chasing the stock price? Before I get into the details, readers should note that I have a primer on the company linked here.
Here are the key takeaways from the latest results
- FSG reported record results and exceeded expectations as sales and income grew 10% and 14%, respectively. However, HEICO Corporation (NYSE:HEI) argued that this was largely a consequence of its group leaders execution rather than any ‘rising tide’ in the industry.
- Sequestration affects have already been felt in its short cycle business and Heico is expecting more of an effectin a ‘6-9 timeframe’ and ‘continued deterioration’ in its domesticdefenserelated revenue.
- ETG saw sales rise 10% and income up 32% as operating margins rose 400 basis points, helped by increased space based sales which tend to be higher margin. This is a positive, but space revenues tend to be variable and contingent upon program funding.
- The Reinhold acquisition is expected to be earnings accretive this year.
- The full year revenue guidance was raised to 8% to 10% growth from its earlier estimate of 6% to 8%, and net income growth was raised to 11%-13% from the previous 9%-11%. My interpolation from company statements is that free cash flow could come in at $120 million for the full year.
In a sense, I think that the full year guidance hike was partly predictable from the company’s statements in the last report. As noted in my link above, management did remark that they tend to be conservative in their guidance.
Where next for Heico?
Putting all of these things together would paint a picture of a company firing on all cylinders amid some favorable market conditions. On the other hand, investing is about finding the best value proposition rather than buying a stock when all the good news is already in the price.
As discussed in the bullet points above, HEICO Corporation (NYSE:HEI) is going to have to deal with sequestration issues which will affect defense-related revenues. The space industry is somewhat variable and the FSG will have to keep executing at the current high level to drive future upside. So, there is some risk here. On a forward free cash flow yield of 4.5% (according to my calculations), I think it is fairly valued and better to wait for a dip before buying into this high quality company.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Heico.
The article Can This Stock Keep Flying High? originally appeared on Fool.com.
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