For entirely different reasons, the aerospace and defense markets are looking good in the near and long term. Moreover, stocks like Raytheon Technologies (RTX -0.29%) and lesser-known companies like Moog (MOG.A 7.22%) (MOG.B -1.23%) and Woodward (WWD 0.56%) look like a good value now. To appreciate why, it's essential to understand some of the underlying dynamics in the industry. Here's the lowdown.
Aerospace and defense end markets are excellent end markets
Aerospace is usually split into two end markets: the original equipment manufacturer (OEM) market and the aftermarket. Both markets are in growth mode.
Aircraft production rates drive the OEM market at companies like Boeing and Airbus --both striving to ramp aircraft production and deliver on multiyear backlogs. For example, Boeing plans to ramp up production of its 737 MAX (3,653 planes in backlog at the end of 2022) from 31 per month at present to 50 per month in the 2025/2026 time frame. Meanwhile, Airbus plans to hit a production rate of 50 per month on its A320neo family aircraft leading to 65 per month by the end of 2024.
Image source: Getty Images.
Meanwhile, the aerospace aftermarket is driven by increasing flight departures as the commercial aerospace industry returns to 2019 levels (the last year before the pandemic hit) and beyond. According to the International Air Transport Association (IATA), industrywide passenger traffic volume was at 42.9% levels of 2019 in 2021 and 68.5% in 2022, with a full recovery expected in 2014.
Turning to defense, due to the unfortunate circumstances of the conflict in Ukraine and geopolitical tensions in Asia, there's a heightened sense of awareness of the need for security and the necessity of replenishing supplies sent to Ukraine. It's an environment that should lead to increased defense spending. Indeed, back in September, Raytheon's CFO Neil Mitchill upgraded his estimate for Raytheon's defense business sales over the medium term to mid-single-digit growth to high-single-digit growth from mid-single-digit growth previously.
Raytheon, Woodward, and Moog
All three have extensive exposure to these markets.
Aerospace and defense giant Raytheon's Pratt & Whitney is one of two engine manufacturers on the Airbus A320neo. Its Collins Aerospace segment is a major OEM supplier to Boeing and Airbus. Turning to the aftermarket, Collins Aerospace's aftermarket grew 21% in the fourth quarter, with Pratt & Whitney up 11%.
Meanwhile, Raytheon Missiles & Defense (RMD) backlog soared to $34 billion at the end of 2022, compared to revenue of $14.9 billion.
Image source: Getty Images.
Woodward, a designer and manufacturer of control systems, generates 63% of its sales from aerospace (with a 50/50 split between defense and commercial aerospace) and the rest from its industrial business. Unsurprisingly, its three key customers (each generating more than 10% of its sales) in aerospace are General Electric, Raytheon, and Boeing. As we've just seen, Raytheon's growth prospects look excellent, Boeing is aggressively ramping production, and General Electric (the world's leading aircraft engine manufacturer with exposure to the Boeing 737 MAX and the Airbus A320neo) has a low double-digits to mid-teens annual revenue growth outlook to 2025.
Moog, a manufacturer of high-performance motion control and fluid systems, also has heavy exposure to these themes. Around 42% of its sales go to the defense market, with 17% to commercial aircraft and 11% to space. However, its primary focus is on the OEM market, with representation on all Airbus and Boeing major aircraft and a host of military programs. As such, it counts Boeing, Lockheed Martin, Airbus, and Raytheon as significant customers, among others.
Why Raytheon, Woodward, and Moog are a good value
All three saw an unusual combination of business conditions in 2022. End markets are picking up, but supply chain pressures persisted throughout the year, leading to excessive demands on working capital and the need to build inventory. As such, profit margins and free cash flow (FCF) generation were constrained.
That said, Wall Street expects the supply chain pressures to ease, leading to all three expanding their profit and FCF margins over the next three years. The chart below shows how the increased FCF generation plays out in their valuations and indicates the FCF issues in 2022.
Data source: marketscreener.com. Author's analysis.
As noted earlier, commercial aerospace should return to 2019 levels in 2024, with an opportunity for further aftermarket growth. Meanwhile, OEM production will continue ramping (Boeing and Airbus), and defense will likely remain solid. Everything points to an ongoing recovery, and valuations look attractive for these three stocks.
