3 Top Aerospace Stocks Ready for a Bull Run

Instead of thinking about commercial aviation as a damaged industry suffering high sensitivity to potential resurgences of COVID-19 cases, it's better to think of it as an industry making a multi-year recovery. Of course, the industry won't recover in a straight line, and investors will have to tolerate negative news flow from time to time. Still, stocks like Raytheon Technologies (RTX), AAR Corp (AIR 3.28%), and Hexcel (HXL 1.31%) are all excellent ways to play the recovery. Here's why.

A few connected markets

The aviation market can be considered two separate markets, split into two highly connected submarkets. First, there's defense and commercial aviation, and within these two markets, there's the original equipment market (OEM) and the aftermarket.

Commercial aviation got hit hard by the pandemic, and all three of these companies leaned into their defense and space businesses during the worst periods of the pandemic. That said, the industry dynamics right now are fascinating. The key points can be summarized as follows.

Image source: Getty Images.

Having outperformed during the pandemic, the defense industry now faces headwinds from slowing spending on military hardware. Moreover, the fact that defense spending held up in the pandemic means the defense industry is operating at high capacity. Hence, it's more sensitive to the supply chain issues dogging the global economy. 

Turning to commercial aviation, both the OEM and the aftermarket are in growth mode, but they are far from uniform. In general, the aftermarket is recovering first -- led by a recovery in flight departures -- with the OEM following as airlines become more profitable and order planes, and Boeing and Airbus ramp up production.

Moreover, as you can see below, U.S. domestic flights are recovering much faster than global commercial flights. This means the OEM and aftermarket for narrow-body aircraft are recovering more than for wide-body aircraft. Finally, the business jet market is firing on all cylinders and trending 30% above 2019 levels.

It's important to note that, although flight departures are recovering strongly on a global basis, they are still significantly down compared to 2019, implying there's much more growth to come in the next few years.

Data source: radarbox.com. Chart by author.

How these stocks play in these markets

The dynamics discussed above play out in the current trading patterns of all three stocks. For example, aviation giant Raytheon Technologies combines the commercial aerospace OEM and aftermarket and defense businesses. While Raytheon's defense businesses carried the load during 2020 and 2021, its commercial aerospace businesses will take over the growth baton in 2022.

Raytheon's full-year 2022 guidance calls for low double-digit growth in its commercial aerospace-focused businesses (Pratt & Whitney and Collins Aerospace) compared to low to mid-single digits in the defense-focused businesses. In addition, management sees a combined operating profit improvement of $1.15 billion to $1.4 billion at Pratt and Collins in 2022, compared to just $150 million to $250 million from the defense-focused businesses.

Raytheon's management believes a multi-year recovery in commercial aerospace will lead the company to $10 billion in free cash flow (FCF) by 2025. Given that the current market cap is $141 billion, it suggests significant upside potential for the stock. 

AAR Corp and Hexcel

These two companies are discussed together because the former is a play on aerospace and defense aftermarkets, while the latter is almost purely an OEM play.

AAR offers aftermarket parts supply, maintenance, repair, and overhaul services and integrated solutions to commercial and defense customers. Its sales to commercial customers grew 33% in the last reported quarter but were offset by a 15% decline in government/defense sales.

Wall Street analysts have AAR's sales growing at a high single digit over the next few years, and based on consensus analyst estimates for FCF in the next couple of years, AAR looks like a good value. 

Data source: marketscreener.com, author's analysis. P/FCF = price-to-free cash flow multiple. 

In contrast, Hexcel's advanced composites make it a play on OEM -- there's very little aftermarket demand for its solutions. The case for buying the stock is a powerful one. Its advanced composites help reduce weight and add strength, and are used more on newer generation planes, particularly wide-body aircraft. As such, Hexcel's recovery will take longer, and the valuations shown above reflect that.

However, note that Hexcel generated $287 million in FCF in 2019, and repeating that figure would put it on a P/FCF multiple of 16.7 times based on the current market cap. Throw in the potential for growth from increased adoption of carbon fiber composites on planes, and Hexcel looks like a good value.