Given an avoidance of a major slowdown in the global economy, the aviation industry looks set for another good year. The commercial jet order book stands at nine years' worth of last year's delivery rates, and aluminium supplier Alcoa just forecast 8% to 9% global sales growth for the industry. Meanwhile, a leading industry body, the International Air Transport Association (IATA), recently predicted 10% net profit growth for the worldwide airline industry in 2016. However, many leading aerospace companies are giving modest outlooks for 2016. Why is this so, and could there be hidden upside in the sector?

Leap

GENERAL ELECTRIC COMPANY'S LEAP ENGINE WILL GENERATE STRONG LONG-TERM REVENUE. IMAGE SOURCE: CFM INTERNATIONAL.

2016 outlooks
Simply put, there are three main factors:

  • The increased costs of ramping up production of new engines, in the case of General Electric Company (NYSE:GE) and United Technologies (NYSE:UTX).
  • New aircraft platforms that are pressuring margins at aerospace companies -- for example, Honeywell International (NYSE:HON) is giving incentives to get on new platforms.
  • The aircraft sales boom, which means that more newer aircraft are in service and tend to require less maintenance, so aftermarket and service revenue could be relatively subdued compared to flight hours.

All of these factors are likely to act as headwinds in 2016, and anyone looking superficially at these companies' aerospace earnings outlooks could easily make a negative conclusion.

That would be a mistake, because throughout 2016 each company will be building a base for long-term recurring revenue and cash-flow streams.

A brief summary of each company's outlook shows the impact of headwinds in 2016.

CompanySegment2016 OutlookMajor Headwind
General Electric GE Aviation

Operating profit growth to slow from double digits in 2016 to between single and double digits in 2016

Production costs of ramping up LEAP engine production

United Technologies

Pratt & Whitney

Operating profit growth to be flat to negative $50 million Commercial OEM mix to reduce operating profit by $225 million
United Technologies

Aerospace Systems

Operating profit growth to be flat to negative $50 million Volume/mix to reduce operating profit by $300 million to $325 million

Honeywell International

Aerospace 1% to 2% core organic revenue growth Commercial OEM sales down mid-single digits because of incentives on new platforms

DATA SOURCE: COMPANY PRESENTATIONS.

New engines, new costs
United Technologies' Pratt & Whitney and GE Aviation have rival, and new, engine programs, and they both face rising costs as they ramp up production. Pratt & Whitney's PW1000G geared turbofan engine competes strongly with CFM International's (a joint venture between General Electric and France's Snecma) LEAP engine on the Airbus A320neo.

Here is United Technologies CFO Akhil Johri speaking on the issue, and about Aerospace Systems, on an earnings call:

"The negative engine margins story at Pratt is well known at this point. We have also talked about the mix impact at Aerospace Systems as production decreases on higher margin fully learned-out current platforms and increases on new platforms where the margins on early units are pressured by the learning curve."

By "negative engine margins" he simply means the losses taken from the costs of growing production on a new aerospace engine. As you can see in the following diagram, the company expects engine unit costs to fall dramatically in future years. In addition, Pratt & Whitney has 80% fleet management coverage on its geared turbofan orders -- implying a large amount of recurring aftermarket revenue in the future.

Utx Page

IMAGE SOURCE: UNITED TECHNOLOGIES PRESENTATIONS.

Similarly, General Electric plans to cut the unit cost of the LEAP engine as production ramps up, but it will clearly hold back margin growth in the near term. Here is CEO Jeffrey Immelt during the 2016 outlook meeting: "We think this is a business that even with the Leap is going to be able to grow gross margins and grow margins for the year, so that's aviation."

New aircraft, new platforms
Pratt & Whitney ($15 billion in 2015 sales) and Aerospace Systems ($14 billion) generate around half of United Technologies' revenue. However, Aerospace Systems also faces headwinds in 2016. As you can see in the table above, management expects volume/mix issues to reduce segment operating profit by $300 million to $325 million. Essentially, the company is moving production to newer, lower-margin aftermarket products -- older products tend to carry higher margin, and the transition is set to damage profitability and volume. 

In addition, commercial aftermarket sales are only expected to be up by the low single digits -- newer aircraft tend to generate less aftermarket revenue. However, aircraft will mature in time, and margins on aftermarket parts are likely to increase as the company cuts unit production costs in producing more of the newer products.

It's a similar story at Honeywell International, where commercial aftermarket sales are only expected to grow in the low single digits. Moreover, Honeywell's expected commercial OEM mid-single-digit sales decline would actually be a low-single-digit increase without the OEM incentives given to get Honeywell on new aircraft platforms -- an act crucial to growing long-term recurring revenue.

The takeaway
All told, a deeper look at the dynamics in the commercial aerospace industry reveals a "short-term bad, long-term good" scenario for 2016. In truth, all three are building a base for strong long-term growth, but it won't show up in their earnings just yet.The headline numbers don't look great, but great investors don't buy on headlines.

Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. 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.