Smallcap Aerospace Suppliers: This Flock Should Fly Again

Everyone is likely familiar with the Boeing 787 “Dreamliner” delays. This radical new design, which, more importantly, was a change in the design process, has hurt the reputation of Boeing (BA), causing the stock to plunge earlier this year. The good news is that the company appears to be on track to meet a pushed-out schedule, which has allowed the stock to recover a large portion of its losses. There are so many drivers for a replacement cycle in the commercial aviation industry, including safety issues, fuel economy and passenger comfort, and it appears that investors have reawakened to this theme, at least for large-cap companies. Down in the supply chain, though, there are some tremendous opportunities in companies that are leveraged to the theme though perhaps less familiar to investors. Because so many of these smaller companies have less diversification and more operating leverage, they have been punished significantly by the delays. Though top-down investors have begun to buy into the promising long-term theme again, the smaller names haven’t yet benefited, as these investors typically favor larger-cap companies for implementing their strategies due to their superior liquidity. In the tables below, I have divided the universe of companies highly leveraged to commercial aerospace into 2 groups by size.

click to enlarge images

Data source: StockVal

To summarize some of the major differences between the two groups, the larger ones are down for the most part just slightly so far this year, but are up strongly thus far this quarter. The smaller ones are down an average of 20% in 2008 and, though rallying this quarter, are still significantly lagging the larger names. The big companies are all down more than 20% from the 52-week highs, but the smaller names have been hammered, with most of them down 30% to 50%. The earnings estimates are now rising for the larger, more widely followed companies, but they are generally declining still for the smaller ones. Finally, the earnings growth for 2008 is expected to be quite strong for the larger names and modest, though varied by company, for the smaller ones.

My thesis is rather simple: The market will soon begin to realize that in the long-run, these smaller suppliers actually offer the potential for higher returns. If you review some of the individual companies, you will find that the delays have slowed sales and, in many cases, resulted in excess inventories. Ultimately, these inventories will be consumed. I had been negative on the titanium suppliers, which include Titanium Metals (TIE), RTI International (RTI) and the more diversified Allegheny Technologies (ATI). My article on TIE last year provoked quite a negative response from a few Seeking Alpha readers, no thanks perhaps to a provocative title change that the editors employed. I believe now that this group may be one of the very best ways to play a Boeing rebound. I am long TIE, which I believe has the most exposure to BA due to supply agreements with them, large direct aerospace end market exposure and a high percentage of spot-market titanium pricing exposure. I did a 180 ultimately on the name when it dropped to 15 or so and find it to be of exceptional value still at 17. Perhaps a more interesting group is the companies that provide “conversion services”. TIE has agreements with both of the ones I included, Haynes (HAYN) and Carpenter Technology (CRS). After CRS reported, I purchased that company as well below 50. While it has rallied sharply despite the bad news, I expect that after a consolidation it could move to 75 over the next year. Ladish (LDSH) looks quite interesting to me, though I don’t know it well, as it appears to be a smaller version of Precision Castparts (PCP). Esterline (ESL), which one of my clients has owned for a long time, is a great company and should do well, but I don’t believe that it is particularly leveraged to BA new-build. In fact, it may be benefiting from the delay to some degree. Hexcel (HXL) has specifically addressed the delay and appears to be doing quite well on other fronts. I don’t really know the other two smaller names at all. In general, I think that the market is beginning to realize that some of these companies have been punished too severely for short-term disappointment that is largely outside of their control, as evidenced by the bounce many are enjoying in excess of the overall market rally this quarter. I expect that the top-down investors that appear to be plowing into the larger names probably have the right idea and would anticipate that many of the smaller names could perform exceptionally in the coming years.

Disclosure: Long TIE and CRS

Comments

[AlanBrochstein]

A reader brought to my attention two other names that should be included: LMIA and ATRO

[MichaelFilloon(legmaker)]

Great call on the stock, DCO really popped today.