A struggling economy and the terrorist attacks of 9/11 have taken a devastating toll on the travel industry. Hardest hit were the airlines themselves, the airplane makers and the manufacturers of the various subassemblies that constitute a commercial aircraft. But the storm that has depressed these stocks for the past two years has recently shown some signs of breaking. While the Bloomberg U.S. Airlines Index was down 44.8 percent over the intervening two years, the index reversed course this year and was up 24 percent through early August. The best way to play that nascent recovery, at least in the near term, looks to be a wager on the parts makers.
Why the parts makers and not the airlines or the plane makers themselves?
Simple. The airlines, for the most part, are weighed down with excessive debt loads and at the same time are having to cope with higher fuel prices, as well as a slew of costly new security regulations in the wake of 9/11. In short, the airlines took the brunt of the roughly $25 billion in industry losses after 9/11 and, as a result, their recovery will be a little longer in the making.
The large airplane manufacturers, Boeing and Airbus (based in Toulouse, France), are not hurting as badly as the average airline. However, their recoveries are pegged to a variety of factors not in their favor or control. In Boeing's case, it is heavily dependent upon a pickup in its defense and space businesses, which constitute more than 45 percent of its annual sales. Although some may view Boeing's diverse revenue stream as an opportunity, the prevailing logic is that future defense budgets will not be chock full of bomber orders — as spending shifts to surveillance systems and intelligence-related equipment not currently manufactured by Boeing. Airbus, on the other hand, has been hamstrung by the slowing economies of Europe, where its core operations are focused, as well as its intense struggle to gain share from Boeing in the North American markets.
Part of a Different Group
However, the parts makers are in an entirely different boat. Across the board, parts makers' balance sheets are cleaner. Although their shares rise or fall with demand for commercial air travel and the number of new planes built over the long term, parts makers are able to benefit from the ongoing refurbishments and improvements being made to the current fleet of existing aircraft.
Among the most promising prospects, according to hedge fund analyst John Pincavage of Pincavage & Associates, are Triumph Group, a designer of various avionics components, and Aviall, a distributor of general aviation parts. According to data compiled by Reuters' Multex, Triumph and Aviall enjoy more than double the operating margins of Boeing and are only half as leveraged on a debt-to-equity basis. Further, both are expected to post a 15 percent-or-better improvement in earnings over the next 12 to 24 months as the result of a healthy demand for replacement components and ongoing fleet maintenance performed by the major air carriers.
Another company worth a look is B/E Aerospace, which manufactures galley equipment and a variety of other cabin related products. In discussing its second quarter earnings this summer, B/E's chairman, Robert Khoury, said the company had seen “a substantial upturn in price quotations and order activity” during the previous six weeks. Khoury's statement was further bolstered by that company's first reported sequential increase in order backlog since 9/11. Members of B/E management purchased more than 150,000 shares in the open market (at an average price of roughly $1.52) at various points earlier in the year — a bullish sign.
Cash is King
Then there's Fairchild, which sold vast quantities of fasteners (nuts and bolts) to commercial carriers in the mid to late 1980s, but in late 2002 it was forced to sell off that business as red ink mounted. According to Pincavage, the real value in Fairchild isn't its ongoing operations; it's as a longer-term asset play. After the asset sale was consummated, the company paid down virtually all of its outstanding debt and was left with a cash horde of more than $3 a share. What exactly the company plans to do with that capital remains to be seen. But if it can deploy that money in a profitable manner and prove to shareholders that it can attain consistent profits, the theory is that there could be substantial upside to the share price.
Of course, these are big ifs. But theoretically, with its cash horde, the prevailing logic is that the company could easily pick up one or more of a variety of smaller, non-public parts makers on the cheap, and then be in a strong position once commercial air travel rebounds and the number of new builds increases. And there are signs that orders are improving. Boeing and Airbus are expected to deliver 280 and 300 aircraft respectively by year's end and between 270 and 290 aircraft eachin 2004 — and those numbers may in fact prove conservative. That's because Southwest Airlines recently told Boeing that it would like to take delivery on 15 737-700s aircraft (over and above its existing contract with the plane maker) in 2004. Southwest also accelerated two aircraft deliveries from 2005 to 2004, according to Bear Stearns analyst Steve Binder. This alone could add a nickel to Boeing's 2003 earnings, and a dime or more to the bottom lines of the smaller parts makers.
Other regional carriers, including Toronto-based Westjet, which continue to fare well in spite of horrific market conditions, have made similar requests. In Westjet's case, it's in the process of both adding to and renewing its existing fleet. As part of that process, Binder expects it could take deliveries on roughly 15 Boeing aircraft by 2005. That's at least two or three deliveries over and above what most in the analyst community had been expecting earlier in the year. And it could have a substantial impact on earnings at the parts makers.
In short, blue skies and a turbulence free operating environment may still be a year or more out. But there are clear signs that a recovery for the entire industry is already underway. And the parts makers, with their ability to reap profits from both ongoing maintenance and new builds, appear to be one of the safest, yet most potentially lucrative ways to invest in the group.
Nose Upwards
Stocks of airlines and plane manufacturers are poised for a rebound.
| Company | Ticker | Price | 52-Week Range | Fwd P/E 2003 | Expected Growth Rate 2003-2004 | |
|---|---|---|---|---|---|---|
| Aviall | AVL | $11.96 | $6.39 - $13.50 | 12.9 | 21.50% | |
| B/E Aerospace | BEAV | $3.70 | $1.23 - $11.45 | N/A | N/A | |
| Boeing | BA | $32.42 | $24.73- $42.99 | 24.5 | 83.20% | |
| Continental Airlines | CAL | $14.45 | $3.59 - $15.95 | N/A | N/A | |
| Delta Airlines | DAL | $11.23 | $6.10- $20.14 | N/A | N/A | |
| Fairchild | FA | $4.07 | $3.99 - $5.71 | N/A | N/A | |
| Triumph Group | TGI | $29.39 | $20.71 - $42.20 | 13.1 | 19.10% | |
| N/A=Company has either posted a loss (growth rates, P/E not definable) or, there is no current sell-side research on the firm. | ||||||