Aerospace & Defence Sector

Capital International Group
March 12, 2018

The aerospace and defence sector, which has long been a popular sector among investors, is now reaching a critical point. For the last five years, the Standard & Poor’s Aerospace & Defence index has delivered an average annual total shareholder return of 31% (at time of writing), comfortably outperforming the S&P 500’s total return of 15.6%. However, these returns have come less from exceptional performance and more from higher future expectations. With investors pricing in steady increases in earnings and cash flows, such expectations have accounted for approximately two-thirds of the sector’s returns in the last few years and have resulted in record high valuations. Between 2018 and 2021, investors expect aerospace and defence companies to double their growth rate and continue expanding their margins at much the same rate.

The higher expectations can be attributed partly to an anticipated increase in defence spending and expectations for lower corporate tax rates. Nevertheless, these factors alone will not deliver the anticipated level of performance improvement. To meet, let alone exceed, these great expectations, companies will need to accelerate profitable growth. The necessity to deliver shareholder value through improved operational performance and increased earnings will place pressure on these companies to change the way they have deployed cash in recent years.

For some time now, the sector has opted to return capital to shareholders via share buybacks and dividends, rather than to increase capital investment in research and development. In other words, the industry has been spending more on gratifying shareholders than investing for future growth. This capital deployment strategy seems sensible in the context of a challenging and uncertain defence environment. Over the past few years, there has been a dearth of significant new projects, especially from the UK and US, and few such projects are on the horizon. Military budgets have been under pressure, and it remains unclear how quickly or dramatically that might change in the face of continuing fiscal constraints. Given the evolving global threat environment and subsequent shift in spending priorities, a degree of paralysis has set in.

As one might expect, aerospace & defence companies have been taking a conservative approach due to the current backdrop, possibly jeopardising the growth and innovation needed for the military to maintain a technological advantage going forward. However, the recently passed corporate tax cuts in the US could present the sector with an opportunity to change this by increasing investment in growth and innovation.

Given the expectations of investors, companies are likely to fall short if they remain risk-averse.  The legacy industrial base faces disruption, both from commercial technology entrants that can innovate more rapidly and from a gradual erosion of the technological edge that the west has historically enjoyed.

Client expectations are also changing. In the past, defence departments typically funded research and development, specifying the weaponry needed, and working closely with contractors on developing product specifications. Today, they are seeking partners, be they legacy players or non-traditional entrants that can invest in new technology solutions and deliver them faster and cheaper.

The resulting pressures mean companies will have to change how they use their capital and develop new products. Instead of relying on annual planning cycles to create financial forecasts, the industry will have to adopt a more rigorous approach to evaluating and making strategic investment choices that yield long-term value. Companies in the sector will also have to avoid relying on overvalued acquisitions to compensate for the lack of organic innovation and growth.

The sector will probably have to generate demand for new requirements by becoming more innovative in developing technology solutions, although working this way involves accepting uncertainty, usually by taking risks. Even though commercial companies do this routinely, it represents a different mindset for many defence companies. Some adaption to this new paradigm has taken place. Rather than waiting for governments to fund programmes, some companies have embraced uncertainty by self-investing in new systems, upgrading older ones, or investing indirectly through ventures. At the same time, new privately funded entrants are making major inroads.

Concerning commercial aviation, the airline industry has had a turbulent past. Effected by uncontrollable external costs and regular swings in traffic demand, it has struggled at times to achieve even modest profitability. However, over the past three years, almost every facet of the industry has excelled. Profits have been at record levels and load factors have been high. 2017 was a very good year for the industry with airline profitability and traffic growth as good as it has ever been. Helped by globally synchronised growth, with historically low fuel prices and interest rates, airlines have lowered fares and in the process added extra stimulus to passenger traffic growth. Although the main components of this growth may be at risk in what is a highly price sensitive market, current conditions remain supportive at present.

Boeing recently provided a twenty-year forecast for the global economy, travel trends and the resulting demands for aircraft. The main takeaways from this were:

  • World economic growth projected to average a robust 2.8% per year, pointing to a 4% average annual growth in airline passengers, 4.2% growth in cargo and 4.7% in passenger traffic.
  • The world’s airlines will need 41,030 aeroplanes over the next twenty years, valued at $6.1 trillion. Just under half will be replacements and more will be needed to handle increasing demand.
  • Half of all air traffic growth will be in the Asia-Pacific region.
  • The market for aircraft sales is large, but the projected market for aviation services is bigger ($8.5 trillion over twenty years). Boeing has created a Global Services division two years ago to grab a bigger share of this market.
  • For this year, Boeing projects higher than average growth in the world’s economies (3.2%) and in passenger air traffic (6%).

According to Boeing, the world’s airlines carried an estimated 4.3 billion passengers last year and they expect that to increase to in excess of 9 billion travellers in twenty years. Boeing is endeavouring to stay on top of this, with the first 737 MAX 9 and the first 787-10 Dreamliner due to be delivered this year. Production of Boeing’s 777X wide-body plane began last October, in readiness for deliveries in 2020. Only last month, the first 737 MAX 7 was rolled out at Boeing’s Renton plant. The company’s order backlog stands at 5,864 aircraft, valued at $421 billion, which represents enough work to keep production lines ticking over for the next seven years. However, sales of Boeing’s biggest passenger jet, the 747, are expected to be so low that the figures are no longer broken out as a separate category in its reporting. Going forward, the 747 is being marketed primarily as a cargo freighter, as shown recently by UPS’s decision to order fourteen more of the 747-8 freighters.

Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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