2017…the year of the rooster, Trump and flying cars
What does the year have in store for Aerospace & Defence stocks?
The Aerospace & Defence sector has two distinct sides to it, with civil aerospace and defence often proffering very different investment narratives. Historically, terrorism and political instability have tended to cause the two sides of the sector to diverge, with defence valuations surging and civil valuations falling. This happened most notably after 9/11 in 2001. At the end of 2016 though, a year defined by terror attacks and political turmoil, the situation was quite different. Defence stocks were the stand out performers during last year, driven initially by the fact global defence spending is now growing, having been in decline from 2011 – 2015, and more latterly by Donald Trump’s US election victory. However, civil stocks have also performed well. Although there have been a high number of terror attacks during 2016, improved airport security measures have forced terrorists to seek new targets and so aerospace stocks have been largely unaffected, and in fact have continued to benefit from the structural growth of passengers numbers which continues to drive output growth. So what does 2017 have in store for aerospace and defence?
Absolute % change in price for Aerospace & Defence stocks in 2016 and 2017 YTD (Source: Bloomberg)
There have been two themes dominating the January headlines; record production levels at Airbus and Boeing and what impact Donald Trump as President will have on the defence industry. I expect these topics to remain major talking points throughout the year.
Airbus and Boeing both recently held their New Year press conferences which were customarily upbeat. Boeing delivered an industry record of 748 aircraft in 2016, and Airbus set its own company record delivering 688 aircraft. This means we have now had six successive years of production growth as shown in the chart below.
Airbus & Boeing deliveries 2001 – 2020E (Source: Airbus & Edison)
It is almost inevitable therefore that industry and the financial markets are starting to get twitchy about whether the civil cycle is about to enter a downturn. Historically a book-to-bill ratio of below one has been a warning sign. As the chart below shows, book-to-bill in 2016 was 1.0x and this is likely to be lower in 2017 as deliveries should increase again but orders are expected to decline. However, I do not believe there is currently any cause for concern. The main reason fewer orders are being placed is that the wave of demand for new fuel-saving models has run its course. The order backlog is at a record level with 6874 aircraft on order from Airbus and 5715 from Boeing, which equates to roughly nine years of production for each manufacturer. This level of order visibility is the stuff of dreams for manufacturing companies.
Since the start of the century, management mindsets and methodologies have changed due to the adoption of shareholder value creation as a key metric. This has fundamentally changed the way companies deal with customers and operate manufacturing systems. Output no longer varies in response to customers’ lumpy order placement demand. Instead, airframers seek to achieve sustainable output rates and make customers wait for deliveries if necessary. This is a very different approach to the boom-bust, produce to order regime of the last century (the customer was always right). The change has directly induced the record backlogs, overbooking practices and stability in output that we have seen despite substantial air traffic disruptions. It makes the book to bill ratio argument for driving company performances and share prices largely redundant.
My one concern about the backlog is that it is scheduled for delivery over a longer period than previously. Only 70% of the aircraft on order are due to customers in the next five years, so if there is demand weakness, outer year slots can be brought forward. This can be easily monitored though by tracking cancellation and deferral data. The other major talking point this year is likely to be whether the planned single aisle production rates are both achievable and sustainable? Ascend, one of the leading Aviation consultancies believes they are too high even though they look sensible based on current accelerated demand for single aisle fuel efficient and extra capacity in China.
Airbus and Boeing combined orders and deliveries (LHS) compared to the book-to-bill ratio 1970 – present (Source: Airbus, Boeing & Edison)
Civil Aerospace continues to be an attractive industry for investors seeking exposure to growing end markets. However, 2017 will be a capital intensive year for the aircraft and engine manufacturers as they focus on ramping up production of new aircraft. As the rivalry between Airbus and Boeing intensifies, we may see a decision from Boeing about whether it intends to build a mid-range aircraft to compete with Airbus’ A321. In addition, aerospace engineers perennially have one eye on the future and as we hurtle towards the next decade I expect we will start to hear more about what the aircraft of the future might look like. Just this week it was reported that Airbus has established a division called ‘Urban Air Mobility’, through which it is testing prototype self-piloted flying cars. I also expect that we will see some changes in how deals are made in the industry, following Rolls-Royce’s prosecution by the SFO (see my blog ‘SFO shows its metal with £497m fine for Rolls-Royce’), with company’s having to prove their technology more, rather than rely on relationships and goodwill.
M&A activity kicked off yesterday, with Safran’s tender for Zodiac in France. UK companies are suddenly much more attractive to overseas investors due to weaker sterling so I expect a raft of bids, deals and rumours during the year.
Defence stocks have performed strongly during 2016, driven initially by a higher global defence spending (as a result of a more unstable geopolitical situation), and in the closing months of the year by Donald Trump’s election as Presidents. His intent to defeat ISIS and his commitment to increase US troop numbers sent stocks with US defence exposure up 15% after the election. They have pulled back a little now as there is quite mixed messaging coming out of the US, so his first defence budget (due in February but likely to be delayed until March) will be crucial for sentiment. Early reports suggest the Armed Services Committee has recommended a base budget of $640bn for FY18 in order to fulfil Mr Trump’s plans. This would be a 17% uplift from Obama’s current request of $557bn (as per the chart below).
US defence budget 2001 - 2021(E) split by base budget and overseas contingency operation (OCO) funding ($bn) (Source: US DoD Green Book 2016)
Although the budgetary environment may be more positive for the industry, margins which are currently at record highs may start to come under pressure. Throughout his election campaign, Mr Trump vowed to get tough on inflated costs and poor procurement processes in the defence industry. Shares in Lockheed Martin and BAE Systems’ fell yesterday morning on the news that Mr Trump has demanded that the cost of the programme be slashed by at least 10%.
I expect 2017 will continue to see government’s outsourcing more work traditionally done by uniformed personnel into the private sector as has already happened in the UK with recruitment (Serco), aircraft maintenance (Babcock, Rolls-Royce) and running ranges (Qinetiq) to name but a few. There will continue to be a focus on unmanned technology, although unusually civilian technology is leading the defence sector on this. We are also likely to see a step up in the focus on cybersecurity technologies, and if legislation is brought in we may see consolidation of what is currently a very fragmented market.
The Aerospace & Defence sector can often be a paradox; it is one of the sectors with the best long term visibility due to government defence budget cycles and long lead times on aircraft, however it is one of the most impacted by global shocks. The long term indicators suggest the sector should continue to prosper in 2017 but we continue to be cognisant of the risks posed by terrorism and by any economic slowdowns which could affect airline passenger traffic numbers.
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