Aviation industry faces more turbulence

Jun 17 2009 by Andrew Miller, The Journal

OF all the industries affected by the recession, it’s perhaps of little surprise that civil aviation has been among the hardest hit. Commercial airlines had barely got to grips with the surge in the oil price to nearly US$150 a barrel last year when the sub-prime storm hit, pushing the financial system close to collapse.

In the UK specifically, demand for air travel has been hurt not only by the recession but also by the weakness of the pound, which has all but ruled out foreign travel for many UK families this year.

In terms of the future for the sector, the Paris Air Show (which opened yesterday) should give some indication of what is in store for the industry over the remainder of this year and 2010. Typically, air shows include bunches of orders for civil planes and engines, and so provide a useful barometer of industry conditions. Military orders are announced when they are signed, so are not usually a feature of shows.

The bad news for investors with exposure to the sector is that very few aircraft orders are expected to be announced this week. Airbus has targeted 300 gross orders before cancellations in 2009 compared to 777 net orders last year. However, it expects to make deliveries of around 480 units, flat on 2008. Boeing’s deliveries should grow as the company continues to catch up with the delays resulting from last year’s strike. Indeed, the lead times in civil are such that this year’s output is largely set.

The real worries are on 2010 and 2011 where order cancellations, deferrals and a lack of new orders mean that visibility on deliveries, and thus profitability and cash flows, is low. There are already indications of 15-25% production cuts over what would be expected in better times, but this could be optimistic given the ongoing weakness in aviation demand, which has resulted in excess capacity for airlines. In military, with the US defence budget peaking, export orders and M&A are likely to be the main areas of investor interest in the short term.

The poor outlook for civil is well known and consequently no change to guidance is expected at the numerous analyst presentations this week. In any case, these only cover 2009, so companies are likely to avoid saying anything about 2010, apart from it remaining clouded. Undoubtedly though, the uncertain outlook will weigh on sentiment. The main share price driver for civil, in our view, will be monthly airline travel statistics, as any pick-up in aviation volumes would help. Unfortunately airlines currently remain gloomy about any revival in demand.

By contrast, defence companies are expected to remain confident about their outlooks for 2009 and 2010. The deteriorating budget outlooks have been anticipated by company managements and should already be reflected in earnings guidance. The relative certainty of its defence outlook means we continue to favour BAE Systems within the sector.

However, the stock does seem to be suffering from sector rotation into more cyclical names whenever there are periods of heightened confidence on economic recovery. So, even with relatively healthy aerospace names such as BAE, investors requiring nearer-term returns might like to factor this effect into their portfolio weightings, particularly if evidence of a recovery begins to mount.

Andrew Miller is regional office head of Barclays Wealth