Premier’s Robbins: Global aerospace – investments that will take flight?

Jake Robbins 450 Index FW

Ahead of the industry’s flagship Parisian Air Show, Boeing recently boosted their 20-year outlook for commercial airplane demand and passenger growth.

Unsurprisingly for one of the dominant global aircraft manufacturers, they are rather bullish. They expect air passenger growth to average 4.1 per cent per annum, and with longer flights, total airline travel is expected to rise by 5 per cent a year. To meet this demand, Boeing estimates a need for 35,280 new planes over 20 years, valued at today’s prices at $4.8tn. Just over 40 per cent of these will be to replace the ageing fleets of today, but almost 60 per cent will be for fleet expansion with the main drivers anticipated to be the emerging markets and “innovative airline business models”.

A cynic might point to overconfidence by the industry leader as reason enough to shy away from such figures, and given the previous boom and bust cycles in the aerospace sector then that would be understandable. However, in this cycle there are some very good reasons to believe that the outlook for Boeing and Airbus, and all the industries that have built up to support them, is in fact very good.

Two main drivers have converged to create an extremely positive outlook for commercial aircraft demand. A new product cycle is generating considerable demand as both Boeing and Airbus have developed several new, fuel efficient planes with greater range that save operators large amounts of money per flight. Even cash strapped airlines have little choice but to refresh their fleets as their competitors will undercut them if they are still running the older, less efficient models. Secondly, the vast majority of new plane demand comes from emerging market airlines. They have the advantage of operating in growing economies, are very profitable and crucially have strong balance sheets to fund their capital expenditure. They also have none of those legacy labour agreements that have cost some Western airlines so dear. Together, the new products and new customer base is what makes this cycle much stronger and potentially longer than prior periods.

So, how best to benefit from these dynamics? The obvious answer would be to invest directly in either Boeing or EADS, the parent of Airbus. However, developing new planes is a long, risky and very capital intensive business. Returns are thus quite patchy and prone to delays and mishaps, Boeing’s Dreamliner was grounded for four months because of exploding batteries being a case in point. Also, both have sizeable defence businesses, which in an age of government cuts is not an attractive area to invest.

Maybe suppliers might be more interesting? Again though, the manufacturers of engines and fuselages face the same high R&D commitments and lengthy project risks. They also tend to have a large exposure to the aftermarket, which involves selling spares to the airlines and is a very profitable business with high margins. Sluggish Western economic growth however has seen some airlines cut capacity and reduce their miles flown, reducing demand for spares and cutting into these profits.

At Premier, we’ve found the best direct exposure to the industry is through the makers of commercial aircraft interiors. We own shares in both BE Aerospace and Zodiac, a US and a French business that both produce various products to fit out the insides of jets. Their main products include the seats, galleys, in-flight entertainment systems, toilets, oxygen equipment, escape chutes, etc. As an effective duopoly with relatively high barriers to entry, potential competitors need to pass lengthy testing periods, they both achieve high margins and generate very attractive returns on capital. Indeed, so favourable is the current operating environment that BE Aerospace recently forecast 20 per cent earnings growth in 2013, with an expected acceleration in growth thereafter. In the current economic environment, there are not many businesses that can be quite so confident and positive about their outlook!

More conceptually, over time a surge in air travel will be positive for airport operators, retailers within those airports, the hotel industry, tourism, etc. Witness the rapid passenger growth in new international hubs, such as Turkey, with 21 per cent growth, Dubai with 19 per cent and Panama’s 19 per cent growth. These hubs offer a far more convenient transition to access global growth regions, such as Africa, southeast Asia and Latin America, than older European and US airports.

Airlines that count airports like these as their headquarters will thrive, as they take the majority of this growth. Western carriers probably won’t. Within all these industries as always there will be winners and losers, good investments and bad, but wherever you choose to invest, Bon Voyage!

Jake Robbins is manager of the Premier Global Alpha Growth fund