The commercial aerospace cycle is driven by a multitude of factors, including gross domestic product, airline profitability, new route growth, and aircraft age. With recent improvements in composite materials and upgraded engine designs, the commercial manufacturers have pushed fuel efficiency enhancements to entice customers to replace or add to their fleets. With order books that provide nearly five years of production visibility at maximum announced build rates, Boeing and Airbus appear to hold enviable market positions. However, their main customers are airlines, which are inherently unstable as they operate in a no-moat industry. Here we assess the sustainability of the current book of business in the context of a slowing global economy.
The four major players in the commercial marketplace are Boeing (BA), Airbus (owned by EADS (EAD)), Bombardier (BBD.B) and Embraer (ERJ), but the duopoly of Boeing and Airbus dominates the bulk of the market.
In the following chart, historical deliveries of the four major players are depicted against airline capacity growth, as reported by the International Air Transportation Association. It is generally believed that passenger traffic grows 1.5- 2 times as fast as gross domestic product. Therefore, it isn't a total surprise that deliveries continued to grow through the early part of the decade, as airlines increased capacity by an average of 4.5% per year since 2003.
Still, the capacity decline in 2009 did not stop airlines from taking delivery of aircraft. Demand from Asia, Latin America, and the Middle East drove the robust delivery results as new route initiation in those regions probably compensated for the overall capacity reduction reported by the IATA. We believe this is largely due to regional differences in aircraft uptake.
The installed base--total deliveries of recent production aircraft through October as reported by Boeing and Airbus--is dominated by North America (mainly the United States) and Europe with two thirds of total deliveries. But Asia Pacific is showing significant strength, as it currently represents more than 22% of total deliveries.
The order data show the increasing prominence of Asia, Latin America, and the Middle East for the future of commercial aerospace. Boeing's backlog of unfilled orders is more balanced than Airbus', but both rely heavily on markets outside their installed base in Europe and North America. All in, Boeing and Airbus expect 50% and 60%, respectively, of their growth from Africa, Asia, Latin America, and the Middle East.
Improved airline operator profitability has underpinned order growth from the emerging regions. Total industry net income and total orders show a pretty strong coincident correlation, and emerging regions are driving industry profitability. These emerging regions are able to provide strong orders and then, more importantly, take delivery in a timely manner. Still, we expect lower airline profitability in the near term, driven by stubbornly high oil prices, geopolitical turmoil, and early signs of a weakening global economy.
Visibility or Overbooking?
The bullish story goes like this: With demand from emerging markets strong at nearly 4,400 aircraft, once the North American and European carriers increase their replacement efforts, order books will balloon even further, providing years of visibility and production growth. Bears' concerns arise from the vantage point of overbooking. Do customers offer large orders in order to obtain a position in the production schedule? We have no definite answer, but we can arrive at some reasonable conclusions from the data.
We delineated the order book by aircraft type and estimated years of production available at maximum announced build rates per month. The bulk of the unit backlog is tied to the single-aisle aircraft, the 737 for Boeing and the A320 for Airbus. For the years of production estimates, we used the total backlog and divided it by the maximum future production rate each company has publicly stated.
Average years of production is 5.1, which the bulls argue is visibility and bears call overbooking. The bearish view arises from the fact that most airlines are unable to forecast the next month, yet they have some crystal ball that allows them to order aircraft years in advance. Still, recent history encourages the bulls. Comments by Boeing and Airbus management point to sold-out slots for certain aircraft, providing further credibility to the bullish camp. Still, we do have some data on potential for cancellations.
We reviewed Boeing's originally-reported gross orders and the most updated remaining orders, as of October. During the onset of the recession, a significant percentage of the original order book was cancelled. If we assume that 15% of the current order book is eventually cancelled, that would represent nearly 1,200 aircraft. This represents less than one year of production at maximum announced rates. Nonetheless, we believe the equities would decline much more than 15%, as the implications would be lower production rates leading to lower top-line growth (or even contraction). With the complexities of programme accounting, the operating results are more difficult to ascertain as cumulative catch-up charges could be taken on individual programmes.
Cautiously Optimistic
Cautious optimism is the best way to summarise our view of the order book. We are encouraged by Boeing's and EADS' confidence in increasing production rates, but we worry about the ability of the supply chain to meet the target dates. The order book is extremely strong, but slower economic times have led to cancellations in the past, and this time is no different, in our opinion.
With two thirds of EADS' business tied to Airbus and a similar exposure for Boeing to its commercial aircraft market, we believe investors should consider a downside scenario before jumping into the shares. We believe that near-term share prices are likely to be driven by ordering patterns, which have immensely difficult comparisons for 2012 as orders through October are nearly 1,800 and are likely to exceed 2,000 for the full year. This compares with orders of 2,057 in 2005 and 2,754 in 2007; after both periods, orders retreated. We believe the market will increasingly look to potential order patterns for 2013, as 2012 is likely to be a down year. Compounding the reported orders in 2012 and 2013 could be cancellations, should the world economy slow or decline. In such a scenario, we would expect share prices to decline to more attractive levels, which could present buying opportunities.
Supply-chain companies Precision Castparts (PCP) and Spirit AeroSystems (SPR) provide good exposure to the Boeing production increase. We believe Boeing's 800-plus plane backlog of the 787 represents nearly $5.6 billion in potential revenue for Precision Castparts, assuming $7 million in revenue per aircraft. During 10 years, this represents a 7% compound growth rate to fiscal 2011 sales. Spirit generates nearly $7 million per 737 aircraft, along with large revenue content on other Boeing platforms. The announced production rate increases are likely to drive strong top-line growth over the near term. While Spirit has struggled to improve operating margins over the past few years, increased volume and enhanced visibility could provide the necessary impetus. Both stocks should be on investors' watch lists for attractive entry points.
