Commercial aerospace stocks have taken it on the chin this year as the coronavirus pandemic has wiped out demand for air travel and caused the airlines to scramble to cut costs.
That means fewer planes in the air and weak demand for both new airplanes and airplane parts. With the airline industry not expecting travel to recover to pre-pandemic levels until 2022 at the earliest, their suppliers are bracing for the worst.
Shares of Boeing (NYSE:BA) have lost more than half their value year to date, likely tempting bargain hunters to buy in and wait for the eventual rebound in aviation demand. But Boeing has a lot on its plate, and is ill-positioned for the recovery when it does happen.
Here's why I believe TransDigm Group (NYSE:TDG) is a better choice for investors interested in commercial aerospace right now.
TransDigm's profit machine is holding up well
TransDigm doesn't make airplanes, but it does make a range of parts that are vital to keeping planes in the air. The company has exposure to new planes and defense, but its most important business is the commercial aerospace aftermarket, or sales of replacement parts to users rather than new parts to manufacturers.
That business has fallen along with the rest of the market, with aftermarket revenue down more than 50% in TransDigm's fiscal third quarter. But TransDigm was still able to generate an earnings before interest, taxes, depreciation, and amortization (EBITDA) margin of 41.5% in the quarter.
That sort of margin is almost unheard of among aerospace manufacturers, but relatively weak for TransDigm. The company for years has operated almost like a private equity firm, buying up small aerospace businesses focused on spare parts that are either patent-protected or have characteristics that make them hard to commoditize. That in turn gives TransDigm significant pricing power, allowing margins to hold up during the pandemic.
About 90% of TransDigm's net sales are generated by proprietary products, and about 75% are from products for which the company is the sole-source provider. And nearly 80% of TransDigm's costs are variable, allowing the company to adjust spending based on demand.
TransDigm isn't the bargain Boeing is. Its shares have recovered much of what they lost in the initial March sell-off and are now down only 14% for the year. The company trades at a fairly rich five times expected sales, in range with its average over the past 10 years. That's four times higher than Boeing, but still more affordable than rival Heico's 7.8 times multiple to projected sales.
Is Boeing a buy?
For Boeing, the pandemic has made an already difficult situation worse. The company has floundered since the March 2019 grounding of the 737 MAX after a pair of fatal crashes. Investigations into those crashes have revealed unsettling cultural issues inside Boeing, and this has led to questions about the company's manufacturing prowess across its product lines.
Boeing seems to be losing market share to archrival Airbus (OTC:EADSY), and although there is still an ample backlog for its planes, customers have considerable leverage in negotiations to defer or cancel orders due to the 737 MAX issues.
Boeing also needs to commit cash to supporting its supply chains or risk losing specialized manufacturing expertise. It has a fleet of more than 400 737 MAX jets that have been built but not yet delivered that will need to be placed once the grounding is lifted.
As air travel slowly returns, airlines that have taken on billions in new debt to survive the COVID-19 crisis are likely to focus on getting their existing planes flying again instead of aggressively adding new planes to their fleet. That favors exposure to spare parts over new equipment, which means TransDigm is likely to recover faster than Boeing.
TransDigm is the better investment
TransDigm, thanks to those sky-high margins, was one of the top-performing aerospace stocks of the last decade. Critics for years have questioned whether those margins were sustainable, but the company's ability to remain highly profitable through this downturn speaks to the durability of the business.
Prior to the downturn, TransDigm was the first stock I'd recommend to investors interested in commercial aerospace, and the company has done nothing during this crisis to make me change that view.
It is going to be difficult for any commercial aerospace stock to really soar higher until aviation recovers, but TransDigm -- because of its $4.55 billion in cash on the balance sheet and continued profitability -- has the opportunity to go bargain hunting in the months to come, assuming valuations remain depressed.
Investors interested in buying into an aerospace recovery should look past Boeing and focus on TransDigm instead.