The aerospace industry has the potential to be one of the most exciting industries to invest in over the next several years. A commercial aviation rebound, a defense industry that's stretching further into space, increased use of satellites for internet and telecommunications, and even space tourism are major market catalysts that could fuel big gains for aerospace companies.
For all the exciting developments in the field, though, some of the most successful investments come from the most boring aspects of the industry: parts and servicing. So while Heico (HEI -2.38%), TransDigm (TDG -2.09%), and Ball Corp. (BALL -0.81%) may not be the most exciting sounding investments in the industry, they have proved to be solid investments that investors should consider in a buy-and-hold portfolio.
Hecio and TransDigm: Winning in the background
There isn't a flagship product or something similar that would make investors familiar with the work Heico does in the aerospace industry -- that is, unless investors are deep into the industry. Heico's business is centered on niche and highly engineered components and services. A large component of the business, for example, is repairing, servicing, and overhauling jet engines for commercial and military clients.
One of the advantages of taking on these specialty and niche products and services is that it tends to create a high barrier to entry. As a result, Heico has some incredible pricing power that generates high margins and free cash flow. Over the past decade, the company has maintained a gross margin of around 40% and its free cash flow to assets -- a measure of how efficiently a business generates free cash flow -- has been around 11%.
Much of Heico's growth over the years has come from acquisitions. Since 1990, it has acquired 82 separate businesses and integrated them into Heico's suite of offerings for its clients. Acquisitions can make growth lumpy, but the proof is in the pudding that Heico has made it work for decades and will probably be able to keep using this winning formula for years to come.
Much of what can be said about Heico can be said about TransDigm as well. A lot of the company's revenue comes from aftermarket parts rather than original pieces, and the company looks to focus on high-margin niche products where competition to build these products is rather low. About 50% of its revenue comes from the defense industry, too, which has helped mitigate the impact of the downturn in commercial aviation over the past couple of years. Finally, like Heico, much of the company's growth comes from acquiring other players in the space that fit its portfolio. This acquisition-focused growth has been like rocket fuel for the company's returns, as it has posted an incredible 1,060% return over the past decade.
If there's one knock against TransDigm compared with Heico and others in the aerospace industry, it carries a much higher debt load, which it has accumulated over the years from making acquisitions. At the worst point of the pandemic for the aerospace industry, TransDigm's ratio of debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) was as high as 12. Typically, a debt load that high is a signal of a company in deep distress. But that number has come down in subsequent quarters and stands at a not-great-but-sort-of-manageable level of 9.9 times EBITDA. Management also refinanced much of its debt such that there aren't any major debt maturities until 2024. That's a decently long time to get its financial house in order.
Obviously, buying a company that has hit a tough patch and is carrying a large debt load isn't ideal, but TransDigm has proven in the past to be a fantastic wealth creator over the long term.
Ball Corp.: An aerospace company hiding behind the pickle jar
OK, so it's probably cheating a little bit to say that Ball is an aerospace company, since more than 90% of its operating earnings come from consumer packaging such as aluminum cans and glass jars. Ball, however, has been investing heavily in the aerospace and defense business and currently has $7.9 billion in contracted awards for future space work, such as building spacecraft for NASA and optics systems for the recently launched James Webb telescope.
What is most is particularly compelling about Ball in regard to aerospace is the growth management is forecasting over the coming years. In its 2020 investor day presentation, management revealed plans to invest in aerospace such that it will grow its contract wins and project backlog at 4 times its historical growth rate. This will be a key driver in management's forecasts to double free cash flow from 2020 to 2025.
On top of these ambitious growth plans is the company's stellar balance sheet and history of shareholder returns. Over the past decade, the company has increased its dividend payout by 200% and has been buying back shares at a modest pace. In addition, shares of Ball are considerably cheaper than the other two on this list. As of this writing, Ball's P/E ratio is around 35. Compared with Heico's P/E ratio of 63 and TransDigm's of 59, Ball looks incredibly cheap.
With the added backdrop of a stable, modestly growing packaging business fueling growth in aerospace, Ball is an interesting addition to a long-term buy-and-hold portfolio.