Anyone investing, or thinking of investing, in the aerospace sector doesn't need to be reminded of the risks involved. There's no guarantee that flight departures will recover in line with expectations, and no way to know how the COVID-19 crisis will play out. That said, there's no doubt that the appetite for flying remains, vaccines work, and the sector remains a critical part of the global economy. As a result, commercial aviation will recover, and stocks like aviation giant Raytheon Technologies (RTX 0.07%), training services company CAE (CAE -0.38%), and aviation services company AAR (AIR 0.10%) are well-positioned to benefit. Here's why.
As you can see in the chart below, based on performance relative to the S&P 500 index, it's been a difficult summer for the aviation sector and all three of these stocks. There are no prizes for guessing why. But, first, rising speculation around the impact of the delta variant and governments' reaction to it in terms of travel bans caused a sell-off in the aviation sector.
The share price weakness in the summer might surprise Raytheon investors because management actually raised full-year sales and earnings guidance on its second-quarter earnings call in July. The guidance hike is indicative of the underlying strength of the company and its long-term potential.
The company was created in 2020 out of the merger of the commercial aviation-heavy businesses of the former United Technologies and the defense-heavy Raytheon Company. Over the long term, the defense businesses will provide a solid stream of earnings and cash flow to support the more cyclical commercial aviation business -- a point that's become incredibly important due to the COVID-19 pandemic.
As for the commercial aviation market, CEO Greg Hayes sees a full recovery to 2019 levels returning by the end of 2024, and Raytheon's commercial aviation businesses (Pratt & Whitney and Collins Aerospace) making a gradual recovery leading to around $10 billion in free cash flow. That figure would put Raytheon at 12.5 times FCF in 2025, making the stock a great value.
As counterintuitive as it may sound, there may well be a pilot shortage coming up in a couple of years. That will be great news for the simulator and pilot training company CAE.
The reason a shortage could come about relates to shortage looming before the pandemic started. But, equally importantly, many pilots have been retired by airlines to manage the slowdown in commercial traffic, while other pilots came up for mandatory retirement age.Meanwhile, aspiring pilots have foregone training due to the crisis, and many have switched careers.
A pilot shortage would be good news for CAE down the line. Still, CAE looks set for a strong period in the near term, too. Discussing civil aviation guidance on the fiscal first-quarter 2022 earnings call in June, CEO Marc Parent said he expected "strong year over year growth in fiscal year 2022," and that "notwithstanding disparate global vaccination rates and volatile border rules which obscure normal market visibility, we still expect strong growth in Civil [aviation]."
Meanwhile, CAE was busy gaining share through consolidating the market via acquisitions during the pandemic. For example, CAE bought L3Harris Technologies' military training business for $1.05 billion and Textron's simulation and training business for $40 million.
Considering that AAR is a provider of aviation services (parts supply, repair and engineering, and integrated solutions), it's hardly surprising that the stock sold off in the summer. After all, aviation services demand follows flight departures, and any negative speculation on the matter will cross over into a lowering of expectations at AAR. Similarly, airline bankruptcies could hurt future demand and AAR's ability to collect receivables from troubled customers.
That said, there does appear to be a lot of pessimism already built into the stock's valuation. For example, the company generated $94 million in FCF in the fiscal 2021 year ending on May 31. And Wall Street has another $187 million penciled in over the next two years. Given that the company's market cap is only $1.17 billion with net debt of just $83 million the company looks set to generate a significant amount of its market cap in FCF over the next few years.
A sector to buy?
All told, it's tough to know what will happen over the next few quarters, but the argument seems to be over the pace of the recovery rather than its eventuality. Of course, that might mean exercising some patience and waiting for the dust to settle for cautious investors, but for long-term investors looking for entry points into attractive stocks, now looks like a good time to invest in the aviation sector.