As featured in this month’s issue of Master Investor Magazine
Since the dawn of civilisation humans have been fascinated with the concept of flight. From the legendary flight of Icarus in Ancient Greece and the Renaissance sketches of Leonardo da Vinci, to the Wright Brothers’ first successful manned flight in 1903, we have literally reached for the skies in order to fulfil our ambitions. Yet after more than a hundred years of aviation history, our enthusiasm for air travel shows no sign of abating. In fact, the aviation industry looks set to enter a glorious new era. The world is indeed getting smaller. Here’s how to profit from it…
The world is spreading its wings
The logistics of airline travel are truly astonishing. Every day close to 100,000 flights take off around the world carrying approximately 10 million people per day. This effectively means that a plane takes off somewhere around the world every second of every day of the year. This adds up to over 3.5 billion individual aircraft journeys every year provided by the current global fleet of more than 25,000 commercial passenger aircraft.
World GDP growth may be slowing, but the $1.8 trillion global aviation sector shows no sign of losing altitude. Last year passenger numbers rose by 6.5%, surpassing the 5.5% average annual growth of the last decade, according to the International Air Transport Association (IATA). Incredibly, the demand for air travel will likely double by 2035, according to PwC’s recent annual report on the state of the worldwide airline industry.
While much of this growth will be accounted for by the major jet-setting nations of today, what’s really striking about these predictions is the growth in air travel to and from developing nations. According to ADS Group, the organisation which represents the UK’s aerospace, defence, security and space industries, passenger numbers on UK airlines will grow by 80% over the next 20 years, to 218 million. However, drilling down into those numbers, we find that the UK airline share of the Rest of the World Market (that is flights to and from the UK to markets outside N. America and Europe) is set to grow at an annual growth rate of 5.5%. This means an increase of 27 million passengers by 2034, with regions such as the Middle East, Far East and Indian Sub-Continent set to drive such growth.
In global terms, 2015 saw Asia Pacific carriers record a demand increase of 8.2% compared to 2014, which was the largest increase among the three largest regions. Meanwhile, Latin American carriers’ traffic rose 9.3%, and Middle-Eastern carriers exhibited the strongest annual traffic growth at 10.5%. Even the European market, which is otherwise mired in stagnation, saw traffic growth of 5%, while the North American market put in a more modest 3.2% rise.
The higher growth rates in developing markets look set to continue to be a feature of the aviation industry for some time. China’s government recently announced plans to build more than 500 airports by 2020, with total aircraft (helicopters, private jets as well as passenger and freight aircraft) forecast to rise from 1,874 to about 5,000. Aircraft makers clearly have Asia in their sights, with Boeing (NYSE:BA) bagging an order for 100 of its 737 Max aircraft from Vietnam as part of Barrack Obama’s visit in May.
Airline profitability takes off
It has often been claimed that, in its entire hundred year history, the US airline industry has made a net profit of zero. However, airline profitability has risen markedly of late. At its annual general meeting in Miami last year, the IATA forecast that the industry would reap a $29.3 billion net profit in 2015, up from $16.4 billion in 2014.
Clearly, the strong performance owes a lot to the weakness in the oil price, which has more than halved over the past couple of years, but there are other factors in play here too. Mergers and acquisitions (M&A) have helped increase the efficiencies of the major airlines, reduced the number of competitors, and thus decreased the overall supply of options for the customer. Other reasons for the strength of the airlines industry include strong demand, sticky airfare prices, and lower input costs which haven’t all been passed down to the consumer. On top of all that, the icing on the cake is that cheaper fuel prices mean that airlines collectively spent around $70 billion less on fuel in 2015 than they did the year before.
According to the IATA, the industry’s cost of capital is just under 7 percent, and its expectation is for airlines to achieve a return on capital of 8.6 percent in 2016. So finally, after years of destroying capital, the airline industry as a whole has begun to generate a return for investors. However, we note that even with today’s elevated levels of profitability the spread between the cost of capital and the return on capital is negligible. For this reason we believe that investors should look elsewhere to invest on the back of this growth.
But the pressure for more energy efficient technologies isn’t letting up
Although airlines may be enjoying a windfall from lower fuel prices at present, there is every chance that the oil price may rebound in the coming years. However, should it do so, the impetus for more efficient technologies would certainly continue to gain momentum. In any case, fuel remains one of the biggest costs for airlines, which puts fuel efficiency savings at the forefront of the minds of aircraft manufacturers.
One major area of growth is the market for carbon fibre composites, which are gradually replacing sheet metal as the key material in aircraft body construction. In 2014, the global market for pure carbon fibre products was estimated at $1.8 billion, but that is forecast to reach $3.5 billion by 2020. The market for composite carbon fibre materials of the kind used in airplane design was $17.3 billion in 2014, and is set to grow to $34.2 billion by 2020.
For now, aircraft manufacturers are choosing not to make the fuselages of smaller, narrow-bodied aircraft from carbon fibre as designs will need significant modification, but usage is increasing in components such as engine blades and containment cases. With the composite industry dominated by a small number of large manufacturers, and with projections for 2020 suggesting a CAGR (compound annual growth rate) of 11.4% for carbon fibres and 12.3% for reinforced parts, the composites sector looks likely to enjoy a strong performance in the years to come.
How to Invest
Clearly the most obvious place to begin is with the airplane manufacturers themselves. This space is dominated by the titanic struggle between the duopoly of Boeing and Airbus (EPA:AIR). Airbus claimed to have edged ahead of its rival last year as it won orders for more than 1,000 new planes, although Boeing made and delivered more aircraft. Airbus said it had 57% of the market overall by units ordered, with the 1,036 orders in 2015 making its cumulative order book total more than $1 trillion, securing production for a decade to come. Airbus seems to have the upper hand in the market for single-aisle short-haul aircraft, whereas Boeing is doing better in the widebody market – despite the fact that its rival now numbers the largest passenger plane in the world, the Airbus A380, in its arsenal.
While Airbus and Boeing boast gargantuan order books and are very obvious beneficiaries of the growth in air travel, both are already very large companies and are unlikely to see a transformational impact on their share prices. We believe there are less obvious ways to gain exposure that could be more lucrative over the long term, as the impact of the growth in demand is being felt much further afield than Boeing and Airbus. Both of these titans have huge supply chains with literally thousands of companies involved in the production process. Aircraft production is also a global affair, with Boeing 787’s composite carbon fibre body shell, for example, made in the US, Japan, Italy, Korea and Australia.
Toray Industries (TYO:3402), the largest composite producer, has a multi-year contract with Boeing, and prompted by growing vehicle applications, it bought US carbon-fibre maker Zoltec for $584 million last year. Other major players include Hexcel Corporation (NYSE:HXL), which manufactures everything from carbon fibre to finished aircraft structures; and Victrex (LON:VCT), a leading supplier of a plastic polymer called PEEK, one tonne of which goes into each 787 aircraft.
Ever advancing technology means that aircraft aren’t getting any cheaper – which brings us to another niche area of the aviation sector: aircraft leasing. These days, airlines choose to lease every second new aircraft that is manufactured, as a means of helping them maintain efficient balance sheets and manage risk. Companies such as GECAS (a subsidiary of General Electric (NYSE:GE)) and Air Lease Corp (NYSE:AL) have built highly lucrative businesses offering hire purchase agreements similar to those available to consumers on privately owned cars. Aircraft, like a house or an apartment, are typically funded by bank debt at loan-to-value ratios of around 75%. Airlines will sign long-term leases on aircraft – up to 12 years – and provide all maintenance, crew and fuel throughout the term of the lease, effectively providing the lessor with a rent cheque per month for use of the asset.
Another way airlines are becoming more efficient is through outsourcing their MRO (maintenance, repair and overhaul) activities to companies like AAR Corp. (NYSE:AIR). Analysts expect the aviation MRO sector to grow at a compound annual rate of 4% over the coming decade, which should see companies like AAR continue to secure a greater share of the market. As well as helping airlines to become more capital efficient and cost effective, AAR is also at the forefront of implementing numerous fuel-saving aerodynamic improvements, such as winglets and body strakes, for all types of aircraft. As such, it should continue to see steady growth as airlines continue to seek to cut costs and become more environmentally friendly.
And what about the passengers themselves? Global passenger numbers grew by 6.1% in 2015, well ahead of global GDP growth of around 3%. This makes airports a great place to sell things as they are effectively a captive market and therefore allow much higher profit margins than would be available on the high street. One well known British company that is in the middle of repositioning itself as a travel retailer is WH Smiths (LON:SMWH), whose convenience newsagents are ubiquitous in UK train stations and airports. Although the firm’s legacy high street business continues to be a drag on overall performance, it has long ceased to be the main profit centre for the business. Profit growth has been strong in recent years and the firm is also looking to expand into overseas airports.
Finally, if you find yourself compelled to invest in the airline sector in spite of its chequered past, we believe that the budget operators remain the best bet due to their lean cost structures and the notion that consumers are likely to ‘trade down’ to them in the event of any increase in fuel prices. Of all the budget airlines there are only two major players that can claim to have multi-hub networks servicing most destinations in Europe: they are Ryanair (LON:RYA) and easyJet (LON:EZJ). Of the two, we prefer easyJet, which sits on a single-digit PER, boasts a net cash pile of c. £300 million and offers a chunky dividend.
Rolls-Royce (LON:RR.) – Streamlining Operations
Rolls-Royce shares have more than halved since January 2014 after the firm issued no fewer than five profit warnings in under two years. The firm has been hit by falling demand for corporate jets in emerging markets, cuts to defence budgets and plunging oil prices that have prompted energy companies to scale back investment plans. In response, CEO Warren East is spearheading a cost-cutting campaign which is targeting savings of £150-200 million per annum, not least via streamlining Rolls’ byzantine management structure.
While there is certainly a lot left for management to do here, we note that Rolls’ Civil Aviation segment – which accounts for more than half of revenues and profits – has continued to exhibit a robust performance, with underlying revenue up 3% and the order book up by £3.8 billion in 2015. Notably, 50% of Rolls’ £67 billion Civil Aerospace order book is for the XWB engine, touted by Rolls as “the world’s most efficient large aero engine”, which puts it in good stead to capitalise on the drive for greater fuel efficiency.
A break-up of Rolls, which could entail the sell-off of the troublesome Marine and Power Systems divisions can’t be ruled out, especially now that US activist investor ValueAct has a seat on the board. At its core, the business model of selling state of the art technology with “Total Care” servicing agreements providing considerable repeat custom is a strong one. If and when Rolls is nursed back to health, there is likely to be scope for considerable share price appreciation.
B/E Aerospace (NASDAQ:BEAV) – A Permanent Fixture of the Aviation World
Along with French company Zodiac, B/E Aerospace pretty much has the market for aircraft fixtures and fittings sewn up. The firm manufactures everything from seats and in-flight entertainment packages to oxygen systems, kitchen galleys and toilets. Although these might not be the most hi-spec parts of the aircraft, they are nevertheless the product of rigorous testing and are produced to demanding criteria. The decades-long relationships B/E has built up with airplane manufacturers acts as another significant barrier to entry to this market, which is something of a sweet spot in the sector. B/E exhibits high levels of profitability as R&D costs are low compared to other parts makers and pricing power is relatively strong.
Full-year results for 2015 saw B/E report a 5% increase in revenues and an 8% increase in operating income, with operating margins of 18.4%. Free cash flow has been held down in recent years by spending to build out direct-to-manufacturer sales capabilities and the lavatory business, but management expects free cash flow to move towards 100% of earnings next year. With the shares trading way off 2014 highs, a prospective 10% free cash flow yield for 2017 leaves shares in this market leader looking rather good value.
Inmarsat (LON:ISAT) – Aviation Drives Growth at Satellite Operator
Satellite communications provider Inmarsat has had a torrid time of late as downturns in both the energy and marine markets have hit revenues. This has seen the shares lose around a third of their value, which could prove to be a buying opportunity for investors prepared to take a longer-term view.
The demand for satellite data capacity is growing exponentially along with our insatiable appetite to consume an ever larger amount of data. Increasingly, more of us are using mobile devices while we’re on the move – and that includes while we’re in the air. In its Global Xpress (GX) Aviation solution, Inmarsat has created the world’s first high-speed passenger in-flight connectivity solution with end-to-end global coverage, delivered through a single operator. Meanwhile, Inmarsat’s European Aviation Network (EAN) will be the first aviation passenger connectivity solution across European airspace to integrate an advanced satellite network and LTE-based ground network (the latter will be operated by Deutsche Telekom). Aircraft will switch automatically between satellite and terrestrial connectivity using an onboard network communicator for optimal service delivery. The first commercial EAN trials are expected in mid-2017.
In its recent first-quarter results, Inmarsat posted a 15.1% rise in revenues at its Aviation division, which it said remains a major growth market, with broadband connectivity – particularly into the cabins of commercial aircraft – expected to see strong growth over the coming years. It argues that this will be driven by the increasing number of aircraft in the sky, the rapidly expanding demand for passenger connectivity and the need for more capable and sophisticated operational and safety services in the cockpit. Moreover, the combination of GX and the EAN is expected to provide Inmarsat with the global coverage, high bandwidth and price competitiveness necessary to compete effectively in this market. As such, short-term problems could be an opportunity for investors to make long-term gains.