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I love commercial aerospace -- a sector that includes not only Boeing and Airbus, but also many suppliers that make everything from engine parts to landing gear to evacuation slides. The business has barriers to entry in the form of engineering knowledge, customer relationships, and regulatory certifications, and it enjoys a steady stream of profitable service revenue from the aftermarket.
But as appealing as these traits are, the business is cyclical, and right now we're definitely in an upcycle. While this has been great, these stocks have become very risky, and I'll show you why. But first, let me explain how cyclicality works in this industry.
Commercial aviation is cyclical because demand for travel often hits speed bumps as a result of economic downturns, wars, or unpredictable events. When that happens, airlines stop ordering planes, and manufacturers reduce production to meet demand. Because of the long lead times to build airplanes, this is a multiyear process. Therefore, investors bail out of aerospace companies because they don't want to own them while earnings falter for several years. This causes valuations to contract and stock prices to plummet.
On the flip side, commercial aerospace stocks perform fantastically as orders increase, because investors look ahead to when those orders will translate into deliveries (and profit). This is the current situation. Boeing booked 625 orders last year, more than the 462 planes it delivered. This suggests demand is high, and indeed, delivery forecasts bear that out. Goodrich expects about 1,300 aircraft deliveries in 2013, up from 972 deliveries in 2010, which was itself almost the all-time high. This works out to a 34% growth rate from current levels, so you can see why investors and Wall Street analysts are bullish.
This bullish outlook has pushed aerospace supplier shares to all-time highs and rich valuations. I've listed some in the chart below. The important thing to note is that these multiples are double the multiples these companies typically receive at their lowest point.
Source: Capital IQ, trailing multiples.
Here's why the consensus is wrong
I have several problems with "the future is rosy" outlook. First, as we can see with the robust valuations, a lot of the expected growth is already priced in. Thus, all the growth expected in the next few years is meaningless; only growth after, say, 2013 will now drive the stock's performance. That growth probably won't be as good as what the industry expects right now, between the pile of planes poised to enter the market and the lurking risk of another economic downturn.
Second, the stocks' stratospheric rise increases potential investors' downside. Many suppliers' price charts look like the Himalayas (check one out yourself), with steep ups and downs, so why would you want to buy a cyclical company at an all-time high? If the industry has suffered contractions in the past, it will likely do so again. Therefore, it is much better to buy the shares when they've fallen to more reasonable levels. You'll make money as a long-term owner over time, but you'll make even more money by picking your entry points carefully. Buying when the industry is in the dumps is a far better strategy than buying when all is rosy.
Third, I'm not convinced this recovery is for real. Not much has fundamentally changed to ease the massive bubble of credit and debt overhanging Western economies. And most commentators fail to notice that all of the economic growth in the United States has been due to government stimulus; the private sector is still contracting, not a good sign. Finally, geopolitical issues could flare up and disrupt air travel.
The bottom line is I believe a lot of the future growth of commercial aerospace suppliers is priced in given the robust equity valuations. Therefore, one must be confident of even more growth in the future to see significant stock performance from here and in a cyclical industry, this is not at all certain. I suggest selling commercial aerospace and buying defense stocks like SAIC or L-3 Communications
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Andrew Sullivan, CFA, owns shares of no companies listed above. SAIC is a Motley Fool Inside Value pick. The Fool owns shares of L-3 Communications Holdings and SAIC. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.