Commercial aerospace has moved from a state where investors worried about whether orders would materialize to worrying about the profitability and delivery timelines for those orders. More recently, though, the CEO of a major aircraft leasing company has sounded a warning that aircraft order rates may be unsustainable and suggested that the rich order books at Boeing (BA) and Airbus may end up being something of a mirage.
Warnings From Someone Who Ought To Know
Late in February, Aengus Kelly, the CEO of AerCap Holdings (AER), warned in an interview that the order books at Boeing and Airbus may never be fully realized. For those not familiar with AerCap, it's the third-largest aircraft lessor in the world and presently the largest publicly-traded lessor.
Put very simply, AerCap is in the business of buying commercial aircraft and leasing them to airlines that cannot afford (or otherwise don't want) to take possession for themselves. It's also worth noting that AerCap has little to gain from this warning - they arguably benefit from buying discounted aircraft from airlines that cannot afford them.
A Book With Some Unfamiliar Names
It's not too hard to see where Kelly may be coming from. Take a look at Boeing's order book and the largest customer is American Airlines - currently in bankruptcy. The number two in the order book, Lion Air of Indonesia, has a 230 plane order on the books (for more than $22 billion) - more than triple its current fleet of 74 aircraft.
Things are similar over at Airbus. Their top top customers are AirAsia and IndiGo - each with over 200 planes on order against current fleets of 54 and 43, respectively. Kingfisher is also just narrowly outside of the top ten orders on Airbus's books.
Now, here are a few other points to consider. Lion Air has big plans to grow, but its safety record is so poor that it's banned from the EU and has been rejected from membership in the IATA. Worse still, pilots at Lion Air have recently been arrested for possession of, and/or tested positive for, crystal meth.
With Kingfisher, the company recently handed two planes back to AerCap because they couldn't agree to new terms, and other lessors have sued for nonpayment. The airline has reportedly had to cancel numerous flights in an attempt to preserve capital, salaries to employees fell into arrears in late 2011, the airline has never been profitable, and the State Bank of India has refused to provide more funding without the company raising equity capital.
So, are those the companies you want near the top of your order book? Now, to be fair, AirAsia and IndiGo are both profitable and well-regarded, but that is a huge amount of expansion and veteran emerging market investors know to be skeptical when that sort of ambition is in the market.
Still Room To Grow
To be fair to Boeing, a few bad apples won't necessarily spoil this cyclical upswing. The large majority of Boeing orders are from relatively stable companies like Delta, Southwest, and Air China. The real question for Boeing may actually come down to the breakout between its platforms - the 737 and 777 platforms are more profitable, while the 787/747 are presently more dilutive, though the expectation is for capacity and profitability on the 787 to really ramp over the next few years.
But this certainly isn't just an issue for Boeing or Airbus. With every Boeing airplane on the books and analyst expectations of a 2.0 book to bill, there's a follow-through impact for companies like General Electric (GE), United Technologies (UTX) and Honeywell (HON). That impact is even larger for companies like Rockwell Collins (COL), Precision Castparts (PCP), and Spirit Aerosystems (SPR).
Are there enough solid orders (from solid companies) on the books to satisfy expectations for Rockwell, PCP, and Spirit investors? Probably … but there's a real risk to the perception of this sector (particularly these smaller players) if orders start evaporating due to inadequate funding. And funding really could be an under-appreciated risk factor - many European banks have had to leave the business entirely and there's a real question about whether there's enough available capital in Asian banks to fund these incredible growth plans from Asian airlines.
Balancing Risk And Reward
Boeing isn't going to publicly cast doubt on its order book, so it's an open question as to whether Boeing discounts any of these orders as being unlikely to come to complete fruition. The risk is that if that overbuild and the cancellations come, they'll have a lot of unused capacity that will weigh on margins. Of course, there's the flip side as well - if Boeing doesn't build to accommodate those orders and they prove real, they could lose share to Airbus or COMAC.
Investors tempted to say that these airlines need planes to grow and won't back out of orders need only look at the housing industry. Back in the day I got plenty of emails about how homebuilders never saw cancellations and their order books were solid - lo and behold, the economy changed, money dried up, and orders vanished.
Right now it looks like the Street doesn't completely buy Boeing's book either. If you run the sell-side's numbers through a discounted cash flow model, Boeing ends up looking cheap enough to be a bit suspicious for a company of its size and renown. The good news is that the loss of a few orders won't crush the financial outlook here and Boeing looks like an interesting stock. That said, investors in Boeing and the smaller parts/components makers should just be a little wary of all the hype and hoopla over the growing order books - not all customers are equally reliable, so don't get too carried away with what some of these orders may mean for earnings in 2014 and beyond.