Commercial Aerospace and Defence: are dislocations leading to mis-priced opportunities?

Airlines face an uphill battle

The demand shock on the back of the COVID-19 pandemic has seen the Services sector hit particularly hard in this downturn, not least the Commercial Aerospace industry. It’s difficult to read the latest headlines without encountering a story on potential airline bankruptcies, mass job losses and urgent bids for government assistance. Some governments including the US and France have been more forthcoming here, but targeted rescue funds have come with strict conditions attached.

In the UK, the government has been reluctant to provide specific bailouts for the airlines so far, but says it remains ‘open’ to providing bespoke solutions if companies have exhausted all other support and funding options. To date, a number of airlines have accessed the government’s (non-sector specific) emergency corporate financing facility.

Since April, when widespread global lockdowns were enforced, commercial airlines have been forced, or have chosen, to largely ground their planes and flights have been brought to a near standstill. As this results in near-zero revenue and working capital outflows, it’s no surprise that airlines have tapped this facility to boost liquidity given the ‘cash burn’ scenario they find themselves in today. In the medium term, however, balance-sheet strength will play a vital role in determining the industry survivors, as well as relative winners and losers.

Deepening crisis for airlines feeds through to Commercial Aerospace

Airlines face severe revenue loss and a permanent lost wedge as many cancelled holidays won’t be rebooked. The near-term ‘cash crunch’ is being exacerbated by (i) the return of unearned revenue –  the cash received for future flights in advance of the service being provided – much of which is being directly refunded as flights are cancelled, and (ii) residual operational costs even after planes are grounded and staff furloughed. This clearly feeds into capital expenditure decisions on planes, parts, and maintenance, as companies seek to preserve cash at all costs: if facing bankruptcy, companies are unlikely to take planes from Original Equipment Manufacturers (OEMs) no matter what their long-term prospects are, and planes that are not flying require far less maintenance.

As a result, the wider Commercial Aerospace industry is in for a tough ride given the nature of the current crisis. Although aeroplane and aeroplane ‘parts’ makers are one step removed from the airlines themselves, exposure has been punished heavily by the markets as bankrupt, or near bankrupt airlines, will not be able to take new planes and will defer maintenance of non-flying planes. The International Air Transport Association (IATA) predicts up to an 80% reduction in global flights from normal levels, and 50% fewer flights this year than last, as the US and Europe remain largely in shutdown mode.

China is the notable exception; flights are running once again, with the country adding 500 flights a week at the start of the month, but recent evidence of a resurgence in virus cases could curtail this progress.

The divergence between the Commercial Aerospace and Defence sectors

There has been a significant divergence in outcomes between companies with Commercial Aerospace exposure and pure Defence stocks. Defence has traded down, largely in line with the market, while any exposure to commercial aviation has been penalised to a far greater extent.

Defence spending should be relatively unlevered to the current cycle and, particularly in US, is more typically driven by the ‘threat’ environment. Therefore, beyond the very short term, Defence companies should recover to prior levels, and feel less impact through results than many other industries.

There are, however, some links to the current crisis to be mindful of:

  •  In the short term, the impact of factory shutdowns from quarantines; although the effect of this should be limited over the whole year, especially when including a ‘catch-up’ phase. In contrast to the airlines, there is unlikely to be a permanent chunk of lost revenue from the COVID-19 crisis, as air forces won’t suddenly need fewer fighter jets.
  • Over the longer term, when government budgets become increasingly stretched, there is the potential for a reduction in defence budget allocations. However, there is a good chance that there will be less opposition to increasing borrowing to fund spending (including defence), in line with the response seen so far – with historically-low interest rates further strengthening this scenario.

As Defence and Commercial Aerospace companies need the same skills, and have similar products, many Defence companies sell to the Commercial Aerospace market and vice versa, giving us a spectrum of Defence/Commercial Aerospace exposure.

On the commercial end, there are large OEMs, as well as some ‘parts’ companies, that are heavily exposed to the weakness in airlines and travel, and have sold off significantly through the dip.

In contrast, there are several large defence contractors whose sales are almost 100% defence related. These companies, with revenues linked to stable defence budgets, have fallen to a lesser extent (largely in line with or less than the market) reflecting the general risk-off environment.

…but what of the ‘inbetweeners’?

There are companies that do not sit neatly at either end of the spectrum, which have fairly balanced revenue streams between Defence and Commercial Aerospace. This group of companies have experienced a wide range of share price reactions, often not reflecting the underlying Defence/Commercial Aerospace split but, rather, market perceptions of a company as a ‘Defence contractor’ or an ‘Aerospace manufacturer’. It is among this group of companies that opportunities have arisen from this dislocation with reality. Active managers have the ability to be selective here. By drilling down and  fully understanding a company’s underlying exposures and growth drivers, managers can better assess companies with more defensive businesses models that are likely to display greater resilience over the medium term.

The aerospace industry will be hoping that the COVID-19 outbreak is effectively contained sooner rather than later, following the lockdown phase. Commercial airlines will be looking to take advantage of any pent-up demand, but the seismic shock to the industry may also usher in some longer-lasting structural shifts – leaving the future landscape for the industry looking very different to the post-war, pre COVID-19, boom phase. Certainly, until an effective and widespread treatment is available, the hardship looks set to continue. Companies with defence exposure, and revenues tied to stable defence budgets, should be relatively resilient through the uncertainty, but being able to sort the wheat from the chaff will be key.


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