Amid defense headwinds, such as substantial budget cuts designed to shrink the U.S. Army to pre-World War II levels, conglomerates in the aerospace sector like General Electric Company (GE) and United Technologies Corp. (UTX) are flourishing on lucrative contracts for jet engine replacements and fresh demand for helicopters in the public services sector.
Undeterred by budget cuts, these major defense contractors are expanding their operations through organic as well as inorganic growth. The companies are also investing heavily in technological innovation to come up with new products to fend competition. The aerospace sector, thereby, is witnessing healthy growth and industry consolidation as the individual companies restructure and streamline their operations to achieve cost efficiency.
Jet Engines: Propelling the Giants
As the aerospace industry undergoes robust expansion, leading players like The Boeing Company (BA) and Airbus Group (EADSY) are opting to replace their aging fleets with new fuel-efficient composite material-laden aircrafts. Both these players have achieved significant headway in aerodynamics over the years. However, steep rise in aviation fuel expenses remain the most prominent component of variable costs and have forced these aircraft manufacturers to restructure their fuel-guzzling fleet.
As a probable solution to this dilemma, both Pratt & Whitney, a unit of United Technologies, and CFM International, General Electric’s joint venture with Snecma of France, have developed new-generation engines that reduce at least 15% fuel consumption compared with their older counterparts. These premier manufacturers of jet engines are vying for contracts which are reportedly worth a whopping $20 billion.
Both United Technologies and GE Aviation are involved in the design, manufacture and sale of aerospace components like landing gears and actuation systems and provide maintenance, repair and overhaul (MRO) services in the global airline market. These manufacturers contest hard for initial sales of units, since a large installed base of engines ensure continued cash streams down the road via parts replacement and routine maintenance. About 70% of the world’s jetliner engines are manufactured either by General Electric or by CFM International.
Over the next decade, the market for jet engines is expected to skyrocket to around $500 billion. Single-aisle planes are expected to constitute 70% of the 35,000 new commercial jets in the next couple of decades, with a market valuation of nearly $2.3 trillion. While CFM International has been a prominent provider of engines on narrow-body, single-aisle planes, Pratt & Whitney has a relatively humble presence in commercial aircraft. Pratt & Whitney’s forte rather lies in the military contracting field.
Of the 2,610 Airbus A320neo orders as of Jan 2014, CFM International and Pratt & Whitney have secured about 32% each. Consequently, the contest seems pretty open with either of the player possessing the capability to outwit the other.
Chopper Prospects: Far From Choppy
While Sikorsky, a unit of United Technologies, is the Pentagon’s leading helicopter supplier, Pratt & Whitney is a dominant player in the worldwide helicopter market and is recognized for outstanding reliability, durability and exceptional operating economics.
Another industrial giant, Honeywell International Inc. (HON), is a leading global provider of integrated avionics, engines, logistics, systems and surveillance solutions for the aerospace industry. It has an impressive portfolio of turboshaft engines for light, medium and heavy lift helicopters. The company’s forte lies in sustained investment in technological upgradation to provide increased power, reliability and fuel efficiency to helicopter operators.
Even GE Aviation is pondering to enter into the helicopter market in an effort to explore new adjacencies. General Electric is also contemplating the push into helicopter leasing in order to capitalize on the growing popularity of copter usage in the lucrative oil and gas exploration industry.
The key demand drivers for helicopters are the expansion of exploration and extraction of natural resources, rising demand in the public sector (for law enforcement, emergency services, patrol activities and search and rescue missions) and boost provided by higher corporate demand.
In a recent survey of the global helicopter industry, Honeywell predicted a buoyant five-year outlook for the global helicopter industry, with considerable demand from high-growth regions such as Latin America and China balancing the steady growth in Europe and North America. Honeywell anticipates that 4,800–5,500 civilian helicopters will be delivered during 2014–2018.
Pratt & Whitney’s profitable helicopter-engine business marked several major milestones in 2013, including reaching 50 million turboshaft flying hours. The company is gearing up to expand its operations even further. Honeywell’s fleet operations are also set to expand this year, with primary contributions from operators in Latin America, Asia and Europe.
In addition, another growth driver is a steady replacement of aging helicopter fleet. A majority of the helicopters in use around the world are estimated to be over 20 years old. Helicopter replacement cycles and increased operating hours in the law enforcement and oil & gas industries contribute to sustained demand in those sectors. With increased demand for utility helicopters, especially from Latin American countries and China, the market is poised to rise from the 2013 level.
Although sequestration is expected to slash around $1 trillion from the defense budget over the next decade, the aerospace and defense industry is holding up well this year due to international contracts, technological innovations, acquisitions and growing commercial demand.
With an established international customer base, the aerospace sector is favorably positioned to overcome inherent macroeconomic challenges and derive benefits from the booming commercial markets of Asia Pacific and defense markets in the Middle East and Asia. Furthermore, supply chain markets for the aerospace sector are opening up in India, Brazil, Mexico, Turkey and China.
Robust expansion in the aerospace sector will in turn fuel growth opportunities for the manufacturers of engines and parts, and service providers of the industry. Consolidated defense titans such as General Electric, United Technologies and Honeywell are fortifying their aerospace operations with a view to capitalize on the increased demand from public as well as private sector across both domestic and international frontiers.
Per the Zacks Industry Rank, the aerospace industry currently ranks among the top one-third, implying that the outlook remains positive on this sector for 2014, backed by a steady surge in air travel demand. For the aerospace sector, both earnings and revenues "beat ratio" stood at an impressive 88.9% in the fourth quarter of 2013.
Total earnings for the companies in this sector grew a healthy 20% year over year. General Electric’s CFM International, United Technologies’ Pratt & Whitney and Honeywell, being dominant players in the sector, are well-positioned to reap benefits from this impressive industry performance, going forward.
Consequently, we bet big on these Zacks Rank #3 (Hold) stocks.
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