It has been a difficult start of the year for commercial aerospace, as the COVID-19 pandemic has sunk global travel demand and sent airlines scrambling to cut costs and avoid liquidity issues. Airlines are grounding jets and canceling expansion plans, putting the companies that build planes and supply spare parts under pressure as well.
Aerospace shares have underperformed the broader market and seem likely to remain under pressure well after the pandemic is contained and the broader markets have a chance to stabilize.
The fallen stock prices also have bargain hunters on the lookout, with aerospace giant Boeing (BA +2.19%), down 60% year to date, of particular interest to potential investors. Boeing shares are certainly cheaper than they were a few months ago, but even after the fall, they do not strike me as particularly inexpensive. Here's why a lesser-known aerospace company, Heico (HEI +3.42%), is a much better buy even though its stock has fallen only half as much as Boeing shares have.
HEI vs. BA data by YCharts
Revenue diversity is a plus
Part of what makes Heico such an attractive aerospace stock in this environment is the large portion of its business that is not tied to aerospace. About half of the company's revenue is generated from defense, space, medical, and electronics end markets.
Heico's defense business makes antenna systems, power amplifiers, and other components for defense applications, and components that go into CT scanners, x-ray machines, and lasers used in medical applications. Those businesses could face short-term disruptions due to the pandemic but should be immune to the multiyear slowdown airlines are expecting.
Some of those businesses, including defense and medicine, have been exempted from local shelter-in-place orders. And Heico electronic components are used in much-needed medical equipment like ventilators, sterilization equipment, and personal protective gear. That added demand might not be enough to move the needle on 2020 sales in a material way, but it could help offset any near-term pandemic-related shutdowns.
The noncommercial aerospace businesses were also growing faster, and posting better margins, prior to the pandemic. The company's flight support group, its collection of commercial aerospace assets, grew revenue by 13% in 2019 and generated net income equal to 19.5% of sales. The electronics segment, meanwhile, grew revenue 19% last year and reported net income equal to 29.4% of total sales.
Boeing too has a defense business that will likely account for about one-third of total revenue this year, but the unit has long played second fiddle to the company's commercial operations. Boeing Defense has scored a number of big wins in the past two years, including a $9.2 billion contract to build the Air Force's trainer jet, but those awards are in the early stages and will not offset the near-term revenue losses caused by a commercial slump.
Bet on the aftermarket
Even on the commercial aerospace side of the business, Heico seems a better bet for a quick rebound than Boeing. When air travel demand eventually does return, expect airlines to be conservative in their expansion plans, bringing parts of their existing fleets back into service instead of buying new planes. Low oil prices should only add to the push to use older planes instead of buying new, as fuel efficiency is one of the major selling points of new aircraft.
That plays well into Heico's offerings. In 2019, aftermarket, or spare part, sales accounted for 54% of total flight support revenue, and repair and overhaul accounted for another 24%.
Image source: Boeing.
Heico in a mid-April update argued that its aerospace business will hold up better than others because many of the products it offers help reduce the operating costs of older aircraft.
"We believe our commercial aviation aftermarket revenues will recover faster than the overall market because aircraft operators will need to avail themselves of our cost-saving solutions and because of our robust product development programs," the company said.
Boeing in recent years has tried to build its aftermarket sales -- at times in conflict with its supply chain -- by offering parts that compete against parts made by suppliers. Its Boeing Global Services unit is among the fastest-growing parts of the overall business but was dwarfed by new-plane sales, and is unlikely to provide nearly the same boost as Heico's aftermarket-focused operations.
The "cleanest dirty shirt" in aerospace
Let's not kid ourselves: The commercial aerospace downturn is going to be severe, and no one, including Heico, is going to be unaffected. The airlines are drawing up plans to be much smaller at year's end than they were heading into 2019, and it is likely going to take years for commercial travel volumes to return to pre-pandemic levels.
But the long-term trajectory for global air travel remains upward, fueled by a growing global middle class and globalization. The top-performing companies will eventually pay off for patient investors, even if it does take time for a recovery to take hold.
In Boeing, you have a company that had credibility issues even before the pandemic and whose fortunes are largely tied to the new-plane market. I was skeptical about Boeing well before COVID-19 was a household term and see no compelling reason to buy in now, even after the stock has fallen.
But I remain bullish on aerospace for the long term and expect aftermarket-focused companies to see a recovery ahead of new-equipment manufacturers. During the up portion of the cycle, I preferred TransDigm Group to Heico due to TransDigm's outstanding margins. But given the near-term outlook for aerospace (and Heico's revenue diversity), Heico looks like the top choice for investors who want to buy into a nascent aerospace recovery.
