Stocks in the aerospace sector remain subject to developments in the ongoing pandemic, and more importantly, how governments react to events. With that in mind, it's not hard to understand why the sector has had a challenging year. That said, recovery is still in place, even if its pace varies and is unpredictable. Moreover, the sell-off in the sector is creating buying opportunities for long-term growth stories like Raytheon Technologies (RTX -0.35%), Hexcel (HXL -0.52%)and CAE (CAE 0.16%). All three are worth picking up for investors willing to close their eyes and ears to near-term negative news. Here's why.
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Raytheon Technologies
Raytheon is a company executing excellently in a challenging operating environment. The company was created out of the merger of the aerospace businesses of the former United Technologies and Raytheon Company. The good news from the third quarter is that the cost synergies from the deal carry on rising and now stand at an expected $700 million, compared to a previous estimate for $600 million. Meanwhile, management expects $10 billion in free cash flow (FCF) in 2025.
So, execution is excellent, but trading conditions are challenging. For example, management guided toward full-year organic sales growth at the bottom end of its prior 1% to 3% range.
The $10 billion in FCF in 2025 target may appear to be a long way off for many investors. Still, it's necessarily so because it's tough to predict the exact timing of the recovery. However, we know the vaccines work, people want to travel, and air travel remains an indispensable part of the economy. Recovery will occur.
In addition, Raytheon's aircraft engines, structures, avionics, cabins, airplane interiors, etc., are an indispensable part of the commercial aviation industry. Meanwhile, there's downside protection from Raytheon's defense business, which generates around 45% of its revenue in normal conditions.
If you believe that the narrative around the commercial aviation industry will change through 2022 and beyond, then the current price of Raytheon Technologies is an attractive entry point. After all, $10 billion in FCF in a few years represents around 8.1% of its current market cap. Just be aware it's not going to be an easy ride to get there.
Hexcel
The composite material and engineered products company is another stock likely to take a hit on any bad news on air traffic. A slowdown in flight departures puts pressure on airline profits, which puts pressure on airplane orders and ultimately on deliveries.
That's where Hexcel comes in. The advanced materials supplier is primarily focused on the aviation original equipment manufacturer (OEM) market as there's little aftermarket demand for its products. In reality, that means when there's doubt around Boeing and Airbus production schedules, investors will start pricing in bad news for Hexcel.
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The case for buying the stock rests on the idea that Hexcel's advanced composites (stronger and lighter than metals) will increase their penetration rate and content per aircraft on newer aircraft over time. Indeed, that's what's happening. For example, Hexcel's shipset (the items of Hexcel equipment per aircraft) value on the Boeing 737 and Airbus A320 is $300,000 each. However, on the newer Boeing 737 MAX and Airbus A3320 NEO, it's $400,000 and $1.05 million, respectively. Newer widebody aircraft like the Boeing 777X and Airbus A350 have a shipset value of $1.5 million and $4.8 million, respectively.
Turning to valuation considerations, in its last "normal" year of 2019, Hexcel generated $287 million in FCF. While it may take a few years, say at least until 2024, to recover to 2019 aircraft levels, the outlook still looks bright for Hexcel. For example, with more shipset content on the newer planes, Hexcel is likely to generate significantly more than the $287 million FCF from 2019 when aircraft unit volumes return to 2019 levels. Given that the company's market cap is only around $4 billion, that scenario (minimum of $287 million in FCF) makes the stock look attractive at these levels.
CAE
Pilot training and simulator company CAE is another stock that will suffer when sentient sours on commercial aviation. While that's understandable as a knee-jerk reaction, it's less forgivable if you take a longer-term view.
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There was a looming shortage of pilots going into the downturn, with Boeing noting that "many airlines had begun using cadet pilot programs to build their talent pipeline." While that issue has been resolved in the near term, a future shortage is brewing. For example, pilot programs were canceled during the downturn, experienced pilots took voluntary retirement, and many junior pilots switched careers altogether.
As such, as flight departures recover, there's every possibility of a pilot shortage kicking in. That would be good news for CAE. Indeed, as management noted on the last earnings presentation, the company went on offense after the pandemic started and raised $1.5 billion in equity to make nine acquisitions and consolidate an industry that it already leads. It's a brave strategy and one that's likely to pay off handsomely when flight departures return to former levels.
