In this, the follow up to my analysis of the narrowbody airplane market, let's dive into just how robust the delivery upswing will be in commercial aerospace during the next few years and highlight a couple interesting, diversified ways to play the coming boom. We'll also dive into one of the best aerospace names to own for the long haul, but leave open for part III of this saga, an in-depth look at this firm's valuation and the analysis of yet another intriguing play to capitalize on this multi-year cyclical upswing.
As one can see, the expected growth rate of aircraft deliveries during the next five years is truly remarkable. Both Airbus and Boeing are ramping up production of their workhorse A320 and 737 programs to thwart potential cancellations as competition heats up from global rivals -- Bombardier (OTCQX:BDRBF), etc. -- in the narrowbody market. Boeing has resumed a target of producing seven 777s a month (from five before), while planning to roll out the first 747-8 jumbo jet and 787 Dreamliner this year. Airbus is increasing rates on its A330 platform and is targeting increased production of its A380 double-decker in the years ahead. And once growth begins to slow in 2014-2015, we'll be witnessing increased production rates of Airbus' A350, which is scheduled for first delivery in 2013 (though a 2014 target is more likely), buoying expansion in the years beyond. Needless to say, investors should be expecting a boom in aerospace deliveries during the next half-decade -- at levels we haven't witnessed in the past 20 years.
How Should Investors Play This Upswing?
First, for diversified plays, there are two ETFs, which despite their defense and industrial holdings, represent decent, albeit imperfect, ways to gain exposure to this coming aerospace boom.
1) Powershares Aerospace and Defense ETF: PPA
As of the end of May, this ETF's top three positions -- Boeing, United Technologies (NYSE:UTX), and Honeywell (NYSE:HON) -- represented more than 20% of fund holdings. Key aerospace suppliers Precision Castparts (NYSE:PCP), Goodrich (NYSE:GR), and Rockwell Collins (NYSE:COL) were in the top dozen, together representing nearly 13% of fund assets. Though this ETF has defense, non-aerospace industrial, and information technology exposure, it's still a nice vehicle to use in your portfolio to capitalize on the coming boom. And while one should be nervous about owning Boeing and Airbus beyond the middle of this decade (given heightened narrowbody competition), it would not be unlike the market to give them and their key suppliers inflated multiples on peak earnings attained during the coming upswing (check out this report). The PPA has a total expense ratio of 0.69%.
2) iShares Dow Jones US Aerospace and Defense Index Fund: ITA
This ETF's top holdings of United Technologies, Boeing, and Precision Castparts seem to suggest a more direct play on aerospace than the PPA. Roughly 60% of fund assets are aerospace with the balance defense, as opposed to the PPA, which is 80% industrials (aero and defense), 17% information technology, and 3% materials. Also, Goodrich and Rockwell Collins are in this ETF's top 10 holdings. Year-to-date (through April), the ITA has performed marginally better than the PPA and sports a lower total expense ratio at 0.47%. If a diversified ETF is your preference, the ITA represents a more compelling play than the PPA, in my opinion.
Let's move on to one of the best long-term plays on rising aerospace demand.
3) Precision Castparts: PCP
This metal-bender has long been a favorite of mine. The firm's investment cast products segment (about 34% of sales) makes the structural castings (metal blocks) and the rotating airfoils (blades) that form aircraft jet engines. Though a structural casting has a longer useful life, a jet engine's airfoil components frequently need to be replaced upon maintenance (think razor, razor-blade model). The firm's forged products (about 41% of sales) are used in landing gear, bulkheads, and other airframe components, while its fasteners (about 25% of sales) are used in such critical applications as wing-to-fuselage and engine-to-wing connections. Precision's components are crucial to flight safety, particularly its metal castings, which preserve engine integrity during intense thermal conditions.
Plus, and perhaps most important, Precision Castparts makes these castings for every jet aircraft engine program in production or under development by its key customers -- GE, Pratt & Whitney (a unit of United Technologies), and Rolls Royce. Its products are ubiquitous and do not depend on future market share in the narrowbody market or on which jet maker delivers more planes in any given year. The firm is also a trusted, low-cost supplier -- it has been delivering castings to the above jet-engine makers for over 20 years (40 years in GE's case) -- and is one of a few manufacturers in the world that can produce the largest metal castings in sufficient quantity to satisfy demand. Further, Precision Castparts' dollar content per engine has increased significantly in recent years due to more advanced technology in the powerplants used by the 787, A350, and A380. And thanks to greater throughput and continuous cost reductions, the firm's operating margins are among the best in the aerospace supply chain -- after all, GE or Rolls, for example, wouldn't want to seek out unproven suppliers just for the sake of cutting costs (as you can imagine, the consequences of jet engine failure could be disastrous).
The firm's story can be summed up in the following: more planes (for growth and replacement), more dollar content per plane, and more opportunities in the aftermarket (airfoils, etc.). Precision Castparts represents one of the most compelling long-term opportunities in commercial aerospace, in my opinion. Although its valuation may seem rich to the naked eye, we'll put to numbers what the firm is worth and highlight yet another intriguing play to capitalize on this boom in Part III of this saga. Stay tuned!
Disclaimer: I have no positions in any stocks mentioned, but may initiate a long position in ITA over the next 72 hours.