This time last year analysts and investors were raving about aerospace companies. Stoking that optimism were lengthy order backlogs for next-generation aircraft from Airbus (FR:AIR) and Boeing (US:BA), underpinned by expanding emerging market (EM) travel patterns. Unfortunately, the well-documented economic slowdown in many EM regions means these once hopeful prospects have since been hobbled by uncertainty.
Civil aerospace stocks are historically punished when China's economy wobbles. That's certainly been the case this time around, even though the country's gradual shift from an export-led economy to one focused on consumption was supposed to benefit airlines and the companies supplying them with parts. Interestingly, both Airbus and Boeing have gone on record to say their respective Chinese airline backlogs remain sound. That point has been reinforced by analysts in Shanghai, who note that China's domestic airlines have actually under-ordered and, subsequently, are expected to expand fleets over the coming years.
Cheap aircraft financing under pressure
However, according to analysts at Haitong research, certain issues could conspire to undermine this bullish forecast. One threat could be the potential disappearance of cheap financing. More airlines than ever are selling aircraft and engines to lessors, banks or other financial institutions, only to lease the assets back at an affordable rate.
These types of transactions are coming under pressure as an increasing number of banks react to volatile financial markets by cutting cheap financing. Should lessors become more conservative towards sale-and-leaseback deals, then airlines dependent on this source of capital could be forced to defer or cancel orders.
Passenger numbers dwindling
Appetite for parts and planes might not be growing as steadily as previously thought, judging by recent data from Investec that points to air traffic growth actually slowing. Investec's analysis of future airline flight schedules indicates that traffic looks poised to ease in the second quarter of the year after a very strong run. Rising geopolitical tensions and the questionable health of the global economy were cited as key reasons for this expected deceleration.
This difficult backdrop suggests that book-to-bill ratios (orders received to the units delivered and billed) look destined to continue sliding, along with industry share prices as a consequence. At the beginning of the year, Boeing confirmed that net orders for 2015 had nearly halved compared with the previous year. That news sent not only the US giant's shares spiralling, but also valuations for myriad companies along the supply chain.
Airbus, the other half of the international civil aircraft manufacturing duopoly, has been encountering similar issues. The Toulouse-based planemaker's order intake and book-to-bill ratio also declined in 2015, in what was a year otherwise marred by several major delivery delays. The European giant, which has reportedly been driving a hard bargain from customers such as GKN (GKN) in a bid to boost its operating margins, was quick to blame its supply chain for these hold-ups.
Contrary to prevailing opinion, the plummeting value of Brent crude isn't helping to fuel demand for new aircraft. While the current predicament may boost airline cash flows, recent events suggest that this money isn't being spent on upgrades. Instead, cheaper energy prices have incentivised airlines to keep older, more fuel-hungry aircraft in service, rather than buying newer, environmentally-friendly alternatives.
Servicing old planes no longer so profitable
In theory, such a scenario ought to be benefiting those companies making big profits from the after-market. But judging by recent profit warnings from the likes of Honeywell (US:HON), MTU (Ger:MTX), Meggitt (MGGT), Rolls-Royce (RR.) and UTC (US:UTX), it would appear that demand for spare parts has instead hit rock bottom.
Because parts for older aircraft are relatively scarce, their inherent profit margins are often much wider. That's precisely why Meggitt sells new kit at little or no profit in the hope of making it back in the more lucrative after-market. Rolls has a similar strategy in place via its TotalCare long-term engine support contracts. But lately this strategy has come up short, as legislation gradually forces airlines to take less environmentally-friendly planes out of service in favour of Airbus and Boeing's latest batch of fuel-efficient planes. To make matters worse, Meggitt and Rolls-Royce's other businesses count on cash-strapped oil and gas companies as important customers.
They're not the only ones facing this conundrum. Business activity at Cobham's (COB) satellite communications arm has also come under pressure from the tumbling oil price. Together with waning demand from the US for surveillance products, this resulted in the group posting a profit warning at the back end of last year. Interestingly, the engineer's aerospace operations performed admirably, thanks to steady appetite for the nozzles used to refuel fighter jets.
And while Senior (SNR) is yet to downgrade profit guidance, trading hasn't exactly been smooth sailing, particularly in view of weak energy and industrial markets. Like Rolls-Royce, exposure to regional business jet and commercial helicopters haven't proved to be very fruitful, either.
IC VIEW: Given the barrage of challenges outlined above, the outlook for companies operating in the aerospace supply chain suddenly doesn't look so promising. True, the rise of the EM middle class means that passenger numbers are likely to rise over the long haul. And there will always be countries, such as recently sanction-free Iran, that prioritise the revamping of a creaking domestic airline fleet to attract business and tourism - even during times of uncertainty. But, aside from one or two exceptions, overall it's hard to ignore the general backdrop of slowing growth in the world's all-important consumer regions, particularly emerging markets, which are seen as the engines of 21st century growth. These fears, coupled with the impact of heightened competition on operating margins, suggest that shares in the sector may continue to derate in the year ahead. Equally worrying are the other markets these diverse companies serve, particularly as most have exposure to recession-bound capital goods markets and the struggling oil and gas sector. As things stand, we don't expect the supply-demand imbalance for hydrocarbons to reverse in the near term. We believe the combined effect of the issues outlined could well trigger another series of profit warnings.
