Jet fuel prices are soaring, capital markets are drying up, Western economies at best are stalled and defense budgets are under threat as shrinking tax bases swell national debts to unsustainable levels. But you won’t find many prophets of doom among the top aerospace executives gathered here for the 2008 Farnborough International show.
The air of backlog-fueled optimism seems hard to reconcile with the grim tidings to be found in each day’s financial news. So is the industry deluding itself over prospects for the next few years? On the eve of this week’s show AIN asked three independent financial experts for a reality check.
The consensus among them seemed to be that the industry isn’t in complete denial and does have valid grounds for optimism. At the same time, there are real grounds for concern too.
“Perception [of a downturn] has filtered through to [aerospace and air transport] companies and stock prices are now at a post-9/11 low,” said Alex Hamilton, senior analyst with New York-based investment bank Jesup & Lamont. “But the reality is not as bad. People are losing sight of [the industry’s] good fundamentals. There are seven-year backlogs and two major new aircraft coming into the market [the Airbus A350 and the Boeing 787]. Commercial aerospace is driven by global [airline] traffic, but much of the macro-economic news has been U.S.-centric in terms of oil prices, the weak dollar and recession. The fact is we haven’t seen recession worldwide and Asian forecasts are still going up.”
Airlines Get Leaner
Even with oil priced above $140 per barrel, flying is still relatively affordable in many markets, argued Hamilton. “Even U.S. airlines are in the best shape they have been in because they have stripped out costs and have high utilization rates. Fuel has gone from being 15 percent of all costs to 30 percent, and this is pushing airlines to take less fuel efficient aircraft out of service. This is good for aerospace.”
So what does all of this mean for the financial community’s attitude toward aviation and its appetite for further mergers and acquisitions (M&A), which have been a powerful vehicle for consolidation in recent years? Hamilton acknowledged that the purchase prices for aerospace firms up for sale is probably not as high this year as last, but he reckons that values are holding up fairly well, apparently because not everyone is convinced that the current trading cycle has peaked yet. By way of example, he pointed to BE Aerospace’s recent acquisition of Honeywell’s spares distribution business and suggested that the buyer is essentially gambling on continued strong sales in the aftermarket, which could be diminished by lower airliner utilization rates.
“It does appear that we will still have good short-term earnings,” concluded Hamilton. “Investors are trying to look at 2009 and beyond. But the [stock] market is going through some repricing and there could be a change in investor appetite.”
In Hamilton’s view the much-heralded credit crunch has yet to impact aerospace’s ability to raise capital. “The [loan] rates haven’t really changed,” he stated. “Most companies have a lot of cash and bonds are even better rated now. The only issue was that Eclipse Aviation had to go overseas [i.e. outside the U.S. to find new investors].”
Michael Richter, the newly-appointed, U.S.-based managing director and co-head of financial group Lazard’s aerospace and defense investment banking group, also took the view that the industry’s glass is more half full than half empty.
“Manufacturers feel above it [the economic downturn] because of the over-stuffed order books,” he commented. “Orders from international carriers continue to be strong, unlike [those from operators] in markets such as the U.S. While fuel costs present new challenges [for all operators], markets like China, the Middle East and India present very significant market forces.”
Richter maintained that there have been no significant airliner order cancellations, but conceded that these have to be considered a possibility–especially if fuel costs continue to rise and the U.S. dollar remains weak, since these factors could reduce air travel, at least in Western countries. “If we do see cancellations, there will be a trickle through [in terms of reduced income for airframers and suppliers],” he told AIN.
Effects of Credit Crunch
In Richter’s view, the aerospace industry has not been immune from the credit squeeze. “This has clearly impacted the industry but not as much as might have been expected,” he said. “The underlying strength of the business is still there. Strong order books create earnings predictability and enhance company value.”
The sector’s strong order books have also fuelled M&A activity with investors eager to get a piece of the action in what has been a fast-growth sector. However, Richter added the caveat that aerospace firms that are not achieving such impressive earnings could find themselves struggling to get fresh capital for investments and may therefore find themselves being forced into mergers or becoming unwelcome takeover targets.
“Capital is available but not to the same extent,” explained Richter. “In the heydays, companies could get six times their leverage or better and this has gone away. Now they might still get [four] or 5 times leverage, so really it is closer to pre-bubble norms [i.e. to rates that were available before aerospace’s latest boom period].
“We have seen a reduction from peak volumes in terms of number and dollar value of [M&A] deals,” Richter added. “This is especially the case with mega-deals due to the lack of credit for highly-leveraged buy-outs, but the middle sector still very healthy.”
Also very healthy, according to Richter, is the defense sector. Regardless of future combat requirements in Iraq and Afghanistan, he predicted that the U.S. and other leading militaries will continue to make large investments in long-term, high-technology programs in fields such as command, control, communications, computers and intelligence. “It is a tale of two cities; the strategic areas will still receive funding and support and the others will be cut,” he said.
Remaining competitive in today’s shifting climate remains one of the biggest challenges for established western leaders in aerospace. “Companies in both Europe and America are being forced to be as lean and efficient as possible,” concluded Richter. “They should be able to make up for the financial shocks that have hit the system [such as the weak dollar and the credit crunch]. They need to continue to weather the storm because there are many shocks, and they are sustained and significant.”
Paul Edwards, the London-based head of aerospace and defense investment banking with Jefferies International, told AIN that while the industry’s continued optimism isn’t without foundation, the rosy prognosis may not prove to have staying power. He believes that the impact of economic downturn could yet have a delayed and negative effect on the sector.
On the commercial air transport side, many airlines are still insulated from the oil price shock by having hedged prices. Future hedged pricing now has to be negotiated on the basis of oil that has effectively doubled in price in barely a year.
“Sales have still been increasing simply because of the momentum of airline growth, but if the oil price stays where it is there will be long-term implications for the sector,” said Edwards.
In his view, U.S. carriers are more vulnerable to these economic forces than those in emerging markets like Asia and the Middle East, where state-backed sovereign wealth funds are increasingly giving financial stability to local companies. At the same time, the so-called legacy carriers are likely to find it harder to endure tough times than the better-established low-cost carriers, which are much leaner to start with in cost terms and have different expectations in terms of profit margins.
“The [airliner] order intake is already lower this year than last year,” said Edwards. He pointed to the fact that, as of the first week of July, Airbus has had 35 cancelled orders in 2008, compared to one at Boeing [although this total appears not to take into account 65 A320s that had been ordered by U.S. carrier Skybus before it ceased trading in April]. Nonetheless, the world’s top two airframers have still logged some 1,000 new orders between them this year so far.
“The financial community already has priced in a degree of downturn [in terms of share values] and stocks are off peak from their position early to mid last year,” said Edwards. He explained that the market’s M&A appetite is still very hearty, but now there is less private equity involved. In his opinion, this is because with credit only now available on less attractive terms, private equity groups are bidding less aggressively and are being more selective in which firms they target. The good news for cash-rich aerospace firms looking to expand is that prices are softening.
“For deals above $1 billion it is more difficult from a credit perspective,” said Edwards. “Debt is still available but you have to do more work to get lenders on board.” This means more presyndication of debt in which banks spread their risks before concluding loans, rather than doing it later as was a contributory factor in the sub-prime mortgage debacle, and also there is more rigorous due diligence.
Edwards maintained that for European aerospace firms, the weakness of the dollar against the euro will continue to be a serious short-term headache, because most of them are locked into dollar-priced contracts with Airbus and Boeing. And, these companies now have a much worse situation when it comes to hedging against currency losses. In the longer term, he predicted that the suppliers will increasingly shift their cost bases into dollar-based economies.
The Jefferies executive concluded that while a downturn in demand has long been forecast for 2009, it is now open to question whether higher-than-expected oil price rises and the prospect of an even tighter squeeze on credit could mean that this turns out to be deeper than anticipated and whether worse could be to come in 2011 and 2012.