With bell weather indicator, the S&P 500, down nearly 25% this year, it hasn't been easy to find industries that have bucked the market's trend and have performed well in the stock market. However, commercial aerospace has been a bright spot. Shares of advanced-composites manufacturer Hexcel (HXL -0.21%), for example, are in positive territory. In addition, shares of aerospace and defense giant Raytheon Technologies (RTX -0.38%) have remained relatively flat this year. The good news is, based on what Delta Air Lines (DAL 1.07%) management recently said, there's every indication the commercial aerospace industry's outperformance can continue. Here's why.
The key to the commercial aerospace industry
In a nutshell, it's airline profitability. Airlines will run more routes if they are profitable, which means more revenue for services and aftermarket parts companies (Raytheon) as flight departures pick up. Moreover, if airlines feel confident in their financial future, they will order more airplanes, meaning more future revenue for aircraft manufacturers and suppliers like Hexcel and Raytheon.
Simply put, airlines like Delta need to grow earnings and cash flow. Otherwise, all companies lower down the industry vertical will face challenges. Fortunately, Delta's recent third-quarter earnings presentation contained everything you would want to hear if you invest in the aerospace sector.
What Delta Air Lines management just said
There are three critical takeaways from Delta's earnings that should give confidence:
- The industry still has plenty of room to grow because it's still significantly behind historical metrics in relation to the economy at large.
- End demand remains strong; airlines have pricing power; and demand is returning in the more profitable business travel market.
- Delta's earnings are improving significantly, and the airline will turn cash flow positive this year.
CEO Ed Bastian said on the earnings call that "the airline industry revenues are still $20 billion to $30 billion below the historical trend against GDP." This is a highly relevant point in the current economy, characterized by recessionary fears and concerns that discretionary spending (such as on travel) will decline. In a nutshell, Bastian is saying the airline industry is still significantly below the kind of revenue it usually generates as a share of GDP based on trends. As such, it can continue to grow even if overall GDP growth stalls.
A recovery in progress
Speaking of a weakening economy, there are genuine concerns that it will drop down into a decline in end demand. However, the contrary appears to be true. Bastian described the industry as undergoing a "countercyclical recovery." He explained that "Global demand is continuing to ramp as consumers shift spend to experiences, businesses return to travel, and international markets continue to reopen." While the idea of an ongoing "countercyclical recovery" is open to question if the economy worsens significantly, there's little doubt that conditions remain favorable for now.
For example, Delta's revenue was 3% above the same amount in Q3 2019 (the year before the pandemic struck), even though its capacity is currently only at 83% of the level it was in 2019. Clearly, there's plenty of room to expand capacity, and management plans to restore full capacity by the end of next summer.
Moreover, Delta's profit margins should expand in the coming years as business travel returns and the airline's share of revenue from premium revenue streams increases; management aims to increase it from 54% to 60% by 2024. With management expecting to turn free cash flow (FCF) positive in 2022 as it builds toward a target of $4 billion in FCF by 2024, it's clear that the underlying fundamentals are improving for airlines.
An industry with mid-term solid growth potential
If repeated across the industry, Delta's outlook for more flight departures and cash flow usually translates into more aftermarket sales and aircraft orders. That's music to the ears of original equipment and aftermarket parts manufacturers like Raytheon. However, it also speaks to a huge potential opportunity for Hexcel's advanced-composite technology, which is increasingly used on newer planes due to its weight/strength advantage.
There are winners and losers across every market condition. Fortunately, for aerospace investors, it looks like there's more room to run for stocks in the industry as it continues its long march back to 2019 levels of activity and beyond.