Three aviation stocks with long runways for growth

Brazilian aircraft manufacturer, Embraer (ERJ) produces regional aircraft, business jets, defense and security products, aircraft systems and structural components. The firm generated 60% of its 2018 revenue from regional jets, about 25% from business jets, while defense and other sales made up the rest.

Embraer recently struck a partnership deal with Boeing where the latter will acquire 80% of the former’s commercial aircraft and services operations. “Within this business, Embraer boasts the number-one position in the market for commercial aircraft between 70 and 130 seats,” says a Morningstar equity report, noting the Embraer and Boeing tie-up will fending off the challenge posed by Airbus’ majority stake in the Bombardier C Series program.

Embraer has also been pushing to beef up its defense and security business with support from the Brazilian government. The company has entered into another joint venture with Boeing to promote and develop new markets for the multi-mission medium airlift KC-390. “The KC-390 transport aircraft is the company's flagship defense program and although the company has faced some challenges, the aircraft will ultimately be a success, thanks to [the partnership],” says Morningstar equity analyst Chris Higgins, who puts the stock’s fair value at US$23 per American Depository Receipt (ADR).

The Boeing deal, he adds, will take the bulk of the debt off Embraer’s balance sheet, which will result in a windfall of US$3 billion or more for the Brazilian company, says Higgins, adding that “Embraer plans to make a special dividend of around US$1.6 billion after deal close (probably in early 2020).”

A diversified industrial conglomerate, United Technologies Corp (UTX) sells aerospace and building components and systems. The company clocked US$66.5 billion of sales in 2018 generated through the parent company and its subsidiaries including Pratt & Whitney, Collins Aerospace Systems, and Otis. The firm’s aerospace businesses manufacture engines for both military and commercial aircraft as well as breaks, landing gear, flight-control systems, avionics, and other aircraft components.

“United Technologies is poised for growth as secular tailwinds in aerospace drive the industrial conglomerate’s top line,” says a Morningstar equity report, adding that “similarly, aerospace systems is enjoying a booming market.” The report cautions, however, that the company will need to “translate this into margins, particularly in Pratt & Whitney.”

United Technologies’ sustainable competitive advantage is built on intangible assets, switching costs, and cost advantage. “The value inherent in United Technologies’ intangible assets--its active and historical patent portfolios, long-term customer relationships, and collaboration assets shared by joint ventures--springs from the strength of the firm’s engineering expertise, a core competency supported by average yearly spending of 3.5% to 4% of consolidated sales on research and development,” points out Higgins, who recently raised the stock’s fair value from US$144 to US$147.

Boeing (BA) manufactures commercial airplanes (70% of sales) and provides defense equipment (30% of sales) as well as owns a small captive finance division. The Chicago-based firm rang up more than US$100 billion in sales in 2018.

The recent groundings of the Boeing 737 Max fleet, which could last for three months and cost nearly US$2 billion, may have a short-term impact on the company’s balance sheet. However, the wide-moat firm’s fundamentals remain strong and suggest the financial fallout of the recent crash will soon be in the rear-view mirror.

Boeing’s revenue growth rebounded in 2018 after stalling in 2017 as the company delivered 806 commercial aircraft in 2018 (up from 763 in 2017). “We anticipate this growth trend to continue as the 737 and 787 ramp up and the newly formed services business hits its stride,” says a Morningstar equity report.

The sizeable backlog of deliveries provides long-term growth visibility for Boeing’s commercial airplanes unit, the primary driver of earnings growth and cash generation. “Commercial airplane growth is powered by a backlog of nearly 6,000 aircraft, which will enable Boeing to boost future production,” says Higgins, who recently lowered the stock’s fair value from US$337 to US$334 to reflect the impact of aircraft groundings.

Boeing’s defense business got a boost from recent U.S. defense budget increases while the revenue growth is expected to be driven further by the company’s wins on high-profile defense contracts, including the T-X trainer, MQ-25, and the UH-1N replacement.

The aviation behemoth’s robust competitive advantage is built on customer switching costs in both commercial aerospace and defence where to cost of failure is enormous, says Higgins, who forecasts 5.5% annual consolidated revenue growth over the next five years.