Pair Trade: Aerospace and Defense

For my explanation on pair trading, please see here.

Aerospace and Defense Industry

Aerospace and Defense stocks have been hurt by the Boeing (BA) strike for the past few months, but now with that out of the way and a Democrat being elected President which is generally good for defense spending, there is some real long-term value in this group. The companies with backlog that can withstand the rough times will come out of the recent mess better than ever, and many of these stocks become pure valuation plays, so the simple pair trade is long the undervalued stock and short the overvalued stock within the group.

Long: Triumph Group (TGI), $42: Triumph Group has the healthiest mix of fundamentals among the group after diving into the numbers. At a price/book ratio of 0.97, it trades at a 50% discount to the industry average ratio of 2. The price/sales ratio of 0.58 is also below the group’s average of 0.74, and Triumph has one of the highest operating margins in the industry at a healthy 12.12% and an impressive ROE of 13%.

Today will be a good day to get long as shares were but from buy to neutral at UBS. With the Boeing strike coming to a close, margins will get back to higher levels, and business will also benefit from the election of Democrat Barrack Obama. The robust backlog at Triumph, about $1.2bln, gives a clear picture of earnings stability, and new growth initiatives should allow the company to continue to beat expectations. Organic growth rates are much higher than its peers and many segments of business are seeing sequential growth. On a technical basis shares need to break through $48.5 to give a strong buy signal, as this would break the downtrend. A pullback to the $40 support level would provide a nice reward to risk trade. Shares are down 43.2% on the year and it is likely Triumph will outperform the group.

Short: TransDigm Group (TDG), $34: TransDigm shares appear overvalued relative to the group with a P/B of 2.54, P/S of 2.25, and a forward P/E of 11. Although the company is expected to grow a bit faster than its peers, there is a lot of debt on the books and shares have the highest percentage of the float short in the group at 11.38%. 

Recent announcements of job cuts of up to 10% of the force are likely signs that after-market growth rates may come down from current projections which are priced into the shares. UBS upgraded shares this morning, which will provide a better entry to go short. $35 should be a key resistance level as shares approach overbought conditions. TransDigm shares have fallen 27.28% this year. TransDigm has an EV/EBITDA of 8.73 which is much higher than Triumph Group’s rate of 5.5.

“Fight Card”

 

 

(click to enlarge image)

 

The Trade

TGI: Long 1 March ’09 Vertical Call Spread $40/$50 for a debit of $4

TDG: Short 1 Feb. ’09 Vertical Call Spread $30/$40 for a credit of $4

Disclosure: none