Industry Thesis

Often we get pressured into thinking we need exposure to certain industries, even when they offer challenging returns. Furthermore, investors tend to invest in the "loudest" business within the supply chain, not the best. By scanning the supply chain within an industry, you can identify where the money is going and maximize your returns.

Airline Industry Growth

A recent Deloitte study indicated the demand for air travel will continue to grow:

In two recent articles (Delta; Airline Busines Model), I highlighted that the passenger airline business is still a tough business to make profit. In spite of great seat occupancy performance in the last decade, most passenger operations barely break even. Investing in airlines today is really about their ability to generate other revenue, outside selling tickets, which is the cause of their recent profitability.

If you're hesitant of investing directly in an airline, I don't blame you. They have on occasion shown glimmers of hope, only to be ravished by economic downturns and terror events causing a drop in revenue. Airlines are trying to switch to a variable cost structure so they can adjust to these events, but I believe it will remain a challenging industry.

In order to get decent return, I suggest you look into other segments within the aerospace industry.

Airline Supply Chain

The airline supply chain is made up of many different types of businesses, each offer different value, resulting in vast differences in business fundamentals. The following figure shows a theoretical snapshot of some of the various stakeholders within the supply chain (note: the cash flow follows the arrows):

Notice that airline operators have the most people to pay and are the most at risk of getting squeezed by suppliers. They are also largely affected by switching costs in the supply chain. It's very expensive to make modifications to aircraft. Modifications also drive additional switching costs related to pilot training programs. Changing IT systems is risky and expensive. The list goes on and on. In spite of this, air travel is growing, causing increased demand for products within the industry:

Options

There are many great options to get exposure to the aerospace industry. A great source is the annual Deloitte study on Aerospace and Defence. This annual report provides lots of insights into the industry and highlights which businesses are experiencing good performance. For example, here are the top 20 aerospace and defence companies by operating margin (2015):

Note that systems suppliers top the list and you don't see many aircraft manufacturers like Boeing (NYSE:BA) or Airbus (OTCPK:EADSY). The aircraft manufacturing business is not a horrible business, but competition is growing and the complexities involved in R&D and aircraft certification will increasingly cause more financial pressure. For instance Bombardier has needed significant bail out capital from the Canadian government to keep the C-Series alive.

Let's look at two of these businesses:

TransDigm (NYSE:TDG) is a designer, producer and supplier of aircraft components for commercial and military aircraft under three segments: Power & Control, Airframe, and Non-aviation. This business is involved in creating key aircraft systems. Since theses suppliers usually hold the intellectual property for these systems, they often get into long term publication, engineering support, and upgrade contracts. I like the stickiness of critical products like that. TDG is currently trading at about $240/share with a free cash flow of about $11/share and an average of about 12% FCF growth per year. It's pretty reasonably priced. TDG has intermittently paid a 10% or $24 annual dividend (missing 2015). I think this business is worth looking into.

Crane Co (NYSE:CR) is a diversified manufacturer of engineered industrial products, operating under four segments: Fluid Handling, Payment & Merchandising Technologies, Aerospace & Electronics, and Engineered Materials. This business does not only serve the aerospace industry. It provides fiberglass-reinforced plastic panels and coils for the manufacturing of recreational vehicles, truck bodies, truck trailers, for applications in commercial and industrial buildings. Currently CR is priced at $74/share based on a FCF of about $4.50/share. FCF has grown at about 3% per year.

Next let's have a look at the companies that topped the free cash flow growth list:

I'm always careful to not pay too much for historic growth. Companies have a habit of not experiencing extreme growth forever, causing investors panics. Here are two from the list:

Spirit AeroSystems (SPR) is an equipment manufacturer, aircraft parts designer, and manufacturer of commercial aero-structures. The Company is also a supplier of aero-structures. The Company operates through three segments: Fuselage Systems, Propulsion Systems and Wing Systems. Over the last 3 years, the company has grown its FCF from under zero to over $3.60/share. It's currently trading at over $60/share.

Moog (NYSE:MOG.A) is a designer, manufacturer and integrator of precision motion and fluid controls and systems for a range of applications in aerospace, defense and industrial markets. The Company has five segments: Aircraft Controls, Space and Defense Controls, Industrial Systems, Components and Medical Devices. These systems are often critical to the aircraft design and require reliable performance. In addition, if any part needs to be replaced, the aircraft operator will usually get an OEM replacement part, unless they have an alternative part list. Although, Deloitte's report showed 21.6% FCF growth, at the end of 2016 Moog saw a reduced FCF. The 3 year compound FCF growth is now flat or zero. In spite of the 2016 results, I believe the business is reasonably priced at $65/share with a little over $4 FCF per share. Moog hydraulic systems are used in many applications and are definitely an industry staple.

To continue your search, I recommend you look at the other metrics from the report. I'm sure there are plenty of great businesses to chose from. Also note the Berkshire Hathaway (NYSE:BRK.A) recently bought Precision Castparts (NYSE:PCP), which was highlighted in the 2016 Deloitte report.

Happy hunting,

Wayne

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Addicted To Airlines? 4 Aerospace Alternatives - Seeking Alpha