Thematic Alpha: Return of Capex: Aerospace & Defense
Our “Return of Capex” series looks across industries at what capex historically means for fundamentals, what’s driving capex now, and how stocks are pricing these trends. In A&D, BA’s inventory remains an overhang; we like TXT for medium jet exposure and NOC for govt. spend and capital return.
Our house view – a Red Hot Capex Cycle. We see a strong consumption outlook continuing to drive demand, and as is typical in a transition to mid-cycle, we expect companies to invest to meet future demand. In the US, we expect investment will rise to 116% of pre-recession levels after just 12 quarters.
Historically sales in Commercial Aero have been strongly correlated with capex on a lag; this cycle might take some extra time. As recoveries progress and businesses invest, the expense and lead time associated with purchases in Commercial Aero tends to make the timing of dollar flows lag the broader investment recovery. However, on a one year lag, Commercial Aero’s growth vs the market has the highest correlation to the growth of private investment vs GDP. Growth in capex, and in particular strong growth in structures investment into next year, suggests upside for Commercial Aero sales ahead, but an inventory overhang from BA’s 737 MAX and a lagged return of international travel may make this cycle a bit different.
Within A&D, Aero has historically been the link to private capex, but we like Defense as a value option on govt. defense spending. Defense is still cheap on a relative P/E basis, trading at a 20% discount to the S&P 500. This discount looks particularly attractive as fears that a Democratic sweep would spell deep cuts to Defense have not materialized. Instead, we believe bipartisan recognition that the Great Power Competition is back and here to stay provides a strong floor for Defense. While our call for capex is focused on private spend, we see potential upside in public spend relative to investor expectations.
Stocks to play it. In A&D we like Textron (TXT) as a capex play given (1) the historical relationship between economy-wide capex and medium-size jet demand and (2) the flexibility these jets offer in replacing intra-city route reduction in the US post-COVID. In Defense, we think Northrop Grumman (NOC) offers attractive exposure to govt. defense spending (where we have an above consensus view) and capital return optionality.
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