Clipped wings

With a 4% fall over the last five trading days, the Aerospace sector retains the baton for the ytd worst performing sector at –48%. Even Banks do better. To put things into perspective, the AlphaValue Aerospace coverage (nine companies) weighs only €127bn today with Airbus at €40bn or so. Last summer, when investors were concentrating on top quality liquid names with a certain future, Airbus’s market cap was above €100bn.

The most famous planet-wide duopoly – Airbus and Boeing – has been humbled by another planet-wide invisible celebrity, aka COVID-19. The following chart shows that Boeing’s own set of 737 Max related issues has become a comparably marginal problem as its share price is in lockstep with that of Airbus. To some extent, the virus may be a positive as no client will come to regret delayed 737 Max deliveries.

Humbled Boeing (blue) and Airbus (pink)

For the record, Boeing’s market cap is still 75% above that of Airbus, presumably due to the higher proportion of Defence-related sales. BAE and Rheinmetall’s ytd relatively better share price performances point toward the same conclusion.  

As individual companies comprising the sector are unlikely to go bankrupt as they are all strategic to some degree, the only question is shareholders’ dilution in funding rounds. Funding is required to match a working capital issue (missing clients and thus missing deliveries now and in the future) magnified by the fact that those companies tend to act as the banker of their very unique supply chain (pre-payment of suppliers whatever the lack of demand) as they cannot afford to see one key provider go belly up.

The pre-COVID world while keen on financial ratios optimisation – outsource and squeeze suppliers – knew that there was a problem in pushing too hard as the aerospace industry is ultimately dependent on supplying safe products. In many respects, outsourcing was a financial trick not reflecting the economic reality of dependency. COVID has made that observation a more pressing one which means that the Airbuses of this world should not be regarded as a capital-light proposition that farms out a big proportion of its value added but as a capital-intensive one when the risks associated with the supply chain are properly accounted for. This is bound to be made worse by declining advance payments from exhausted clients, not to mention bringing back on the balance sheet soured leases. Capital employed is set to zoom and ROCEs to crash.

The following chart describes sector ROCEs after considerable earnings downgrades for both 2020 and 2021 (about -40% for both years over the last three months). The 10% + ROCEs will not be at hand for a while which is a weird comment for what is essentially an oligopoly-based industry.

Aerospace ROCEs

On paper, the expected rise in capital employed could be matched by a higher gearing as the sector is hardly geared nominally with a 0.27x 2021 net debt/EBITDA ratio (1x median). That is nominal as the prime source of funding is advance payments that will fade with vanishing clients. As banks and governments fulfil their obligations to backstop coming funding issues, it is reasonable to expect shareholders to be asked to stump up too.

As debt markets are functioning courtesy of the Fed buying credit, even junk ones, it is not excluded that convertible issues will do the trick. Shareholders not participating will feel the pain anyway as this amounts to preferring coupons to dividends. An old story in dire times.

The above piggybacks on a sector review (Aerospace, entering a new paradigm) released in late April 2020.