These aviation stocks look ready for takeoff

Cheaper jet fuel, robust demand and strong economic performance in key markets have the aviation industry booming again.

Vikram Barhat 11 February, 2016 | 6:00PM

Geopolitical events, poor economy and a weak dollar have buffeted the aviation sector for years. However, the precipitous drop in oil prices that sent many industries reeling has served to correct the course and cash flow for the airlines and related industries.

In addition to cheaper jet fuel, robust demand for passenger travel and strong economic performance in key markets have got the aviation industry booming again. The International Air Transport Association (IATA) recently forecasted aviation industry profits to grow from US$33 billion in 2015 to US36.3 billion dollars this year, generating an average net profit margin of 5.1%.

However, the industry's stock market performance is clearly trailing the earnings growth of its constituents. The Dow Jones U.S. Airlines Index is down nearly 18% year over year, as of Feb. 2, 2016. The S&P Composite 1500 Airlines Sub Index has lost more than 16% while the NYSE Arca Airline Index has fallen nearly 25% since this time last year.

As airlines rake in greater profit, they expand by adding new routes and aircraft to their fleet. This, in turn, creates a tailwind for aircraft manufacturers and component makers. Some of these companies maintain strong balance sheets, are exposed to faster growing markets, and have diversified businesses supporting long-term growth through various economic environments, according to Morningstar equity research.

Embraer SA ADR
Ticker ERJ
Current yield 0.10%
Forward P/E 11.7
Price US$28.56
Fair value US$36
Data as of Feb. 8, 2016

Sao Paulo, Brazil-based  Embraer (ERJ) manufactures commercial, corporate and defence aircraft, structural components, as well as security products and maintenance services. The firm generated half of its 2014 revenue from regional jets, while business jets and defense accounted for the rest.

At a time when aircraft makers are struggling with purchase order declines, Embraer registered a 24% increase in its 2015 orders, according to a Morningstar equity report.

"Embraer's leading position in regional jets, a comprehensive line-up of business aircraft and a growing defence business should drive sales and profit growth," said the report. "Total backlog of US$23 billion at the end of the third quarter of 2015 represents a nice rebound from US$12.5 billion in 2012."

Morningstar equity analyst Chris Higgins forecasted Embraer to capture about 50% of the market for aircraft between 70 and 130 seats in 2015, which, along with continued growth in demand for regional aircraft, prompted him to raise the stock's fair value from US$$32 per American Depository Receipt (ADR) to US$36.

Embraer has delivered more aircraft than its main competitor,  Bombardier (BBD.B), each year since 2006. The company's competitive advantage is primarily driven by barriers to entry in its commercial aviation business, as well as the firm's engineering know-how and a solid reputation, said Higgins.

United Technologies Corp.
Ticker UTX
Current yield 2.95%
Forward P/E 12.5
Price US$86.78
Fair value US$120
Data as of Feb. 8, 2016

 United Technologies Corp. (UTX) is a diversified conglomerate that sells a range of aviation products through the parent company and its subsidiaries -- Pratt & Whitney, UTC Aerospace Systems and Otis. The firm makes engines for both military and commercial aircraft, breaks, landing gear, as well as elevators and escalators.

UT recently lightened its portfolio to reduce exposure to a difficult military market and focus on the commercial aerospace market that drives nearly 75% of its sales, according to a Morningstar equity report.

The firm's sustainable competitive advantage springs from new product development, and is further strengthened by maintenance and repair services that boost long-term revenue growth.

Pratt & Whitney is ramping up production of its innovative geared turbofan engine, for which it has secured more than 6,000 orders, said Morningstar equity analyst Barbara Noverini, who pegs the stock's worth at US$120. "This new installed base will secure a long runway of lucrative aftermarket services that will plump segment cash flows for decades."

That as much as 44% of UT's consolidated revenue comes from high-margin recurring aftermarket maintenance and repair services is a sign of "sticky relationships sustained by customer reliance on the original-equipment manufacturer," said the report.

Noverini forecasted a compound annual revenue growth rate of 4% during the course of the next five years, and consolidated revenue of about US$68 billion by 2019.

Boeing Co.
Ticker BA
Current yield 3.05%
Forward P/E 12.5
Price US$119.47
Fair value US$141
Data as of Feb. 8, 2016

Chicago-based  Boeing Co. (BA) makes commercial airplanes and provides defense equipment, which generate 70% and 30% of total sales, respectively.

Boeing's earnings power derives primarily from its commercial aircraft business, where operating margins are projected to expand to double digits by 2017-18, said a Morningstar equity report.

"Commercial sales growth is powered by new aircraft demand from emerging markets and replacement demand from the U.S and Europe," said Higgins. "A backlog of over 5,800 commercial aircraft provides growth visibility."

Boeing exploited its competitive advantages to deliver 22% returns on invested capital from 2005 through 2014. "Boeing's ability to achieve these returns--in the face of increasing capital intensity stemming from [technical issues surrounding] the 787, a declining defence budget, and a weak macroeconomic environment--provides quantitative evidence to support our wide moat rating," said Higgins who considered the stock worth US$141.

Moreover, Boeing benefits from customer switching costs in both commercial aerospace and defence. Buyers in these markets steer clear of unproven products and companies due to the high costs of failure, added Higgins.

He forecasted an average of 4% annual sales growth over the five-year period ending in 2020, during which operating margins will average just over 9%.

Southwest Airlines Co.
Ticker LUV
Current yield 0.82%
Forward P/E 7.9
Price US$34.72
Fair value US$47
Data as of Feb. 8, 2016

Texas-based  Southwest Airlines (LUV) is the largest U.S. carrier by passenger volume. The airline provides short-haul, point-to-point service to 98 destinations, with an all-Boeing fleet of around 700 aircraft. It generated US$18.6 billion in revenue during 2014 and has plans to expand its international footprint and frequency.

Southwest has delivered operating profits for 41 consecutive years, which is considered exceptional in the airlines industry beset by bankruptcies, said a Morningstar equity report.

Strong air travel demand and low fuel prices are likely to continue to buttress the company's bottom-line. "The firm is well positioned to execute its growth strategy," said Morningstar sector director Keith Schoonmaker. "The reasonable sales growth combined with low fuel costs and limited growth in all other expenses, driven by newer aircraft that allow for more seats, should bolster profitability."

Schoonmaker forecasted a 4% revenue growth and 20% annual operating margins while raising the stock's fair value from US$43 to US$47.

Southwest, he added, has also done a good job of allocating shareholder capital. Through the first three quarters of 2015, the firm generated a strong US$2.9 billion in operating cash flow and paid dividends of $180 million. The company recently announced its 158th consecutive dividend to be paid in March.

Complete access to Morningstar's research on equities, mutual funds and exchange-traded funds is available to subscribers to Morningstar Canada Premium.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Boeing Co379.39 USD-1.31
Bombardier Inc1.88 CAD-2.08
Embraer SA ADR18.71 USD-0.32
Southwest Airlines Co54.49 USD-1.07
United Technologies Corp135.57 USD-1.43

About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.