Morgan Stanley Research / Aerospace: 3Q 2021 A&D Earnings Preview

AF-4 Flight 109, 1st KC-10 in flight refueling qualifications with external stores, Pilot LtCol George “Boxer” Schwartz, Edwards AFB, Ca. April, 21, 2012

11 Oct 2021 | Kristine T Liwag | Matthew Sharpe | Jason T Holcomb
Aerospace: 3Q 2021 A&D Earnings Preview
Our top stock picks are Transdigm (ticker: TDG) for aerospace and Textron (ticker: TXT) for business jets. Our preferred stock in Defense is Northrop Grumman (ticker: NOC), while we view Lockheed Martin’s (ticker: LMT) earnings call as a potential catalyst event.

Top Stock Picks: TDG and TXT; Other Stocks to Watch: LMT and NOC

Our top stock picks going into 3Q21 are Overweight-rated TransDigm (ticker: TDG) for the aftermarket and strong book to bill in medium sized business jets for Textron (ticker: TXT). Overweight-rated Lockheed Martin (ticker: LMT) will be an undervalued stock to watch as 3Q earnings has the potential to be a material catalyst for the stock. Steady performance plus upside from buybacks from Northrop Grumman (ticker: NOC) continues to keep the stock attractive at current levels.

How Will a Decline in Air Traffic Impact Aftermarket?

We’re overall positive about long-term trends in aftermarket, but recognize that 3Q21 and 4Q21 could be lumpy. After strong growth in air traffic through the spring and beginning of summer, we saw a recent pullback in August due to concerns with the Delta variant. We note that RTX highlighted at our Laguna conference in September that positive trends seen in 1H21 in Commercial Aero have continued into 3Q21. This bodes well for the company’s aftermarket business.

Some potential tailwinds that could offset the slowdown in August air traffic are 1) airlines taking the opportunity to take aircraft for shop visits in preparation for 2022, 2) catching-up on deferred maintenance during 2020 and 2021, and 3) maintenance as aircraft in long storage re-enter the fleet. Our view is August’s air traffic slowdown may find its way into 3Q earnings, but we see any potential weakness as a buying opportunity as 2022 is set to be a strong year for aftermarket. Anecdotally, we’re seeing the return of business travel, which could provide unexpected upside in 2022.

Looking for Clarity on the 737 MAX and 787

This quarter we are looking for signs of clarity on the 787 and the 737 MAX. We expect the 787 to be certified for deliveries to begin again in October by the FAA. If this happens before earnings, we expect management to provide more clarity. If not, we expect earnings to be a potential non-event for Boeing.

There has recently been positive news flow on the 737 MAX as the test flight in China was a success. Management has reiterated confidence in a recertification of the MAX by year end, but they have not provided many details. We don’t expect to gain clarity on future 737 MAX production rates until China recertifies the MAX.

Biz Jets: Watching for Strong Bookings

Last quarter, Textron had strong book to bill for Cessna and Beechcraft aircraft at ~2x, while Textron Aviation had an overall book to bill of 1.52. One pushback we heard from investors is the strong book to bill came on the back of a low bill number. This quarter we will be following book to bill and closely watching growth in bookings on an absolute basis. In 2Q, absolute bookings were ~$1.8bn at Textron Aviation and ~$3.3bn at GD’s Aerospace segment.

Defense

With the announcement of the F-35 production rebaseline, we will be watching out for any updates to larger DoD programs. We are looking to understand if the F-35 rebaseline is a one-off event or the beginning of further developments in the DoD’s agenda.

Also, we will be interested to hear any guidance on pricing for the F-35. Will there be lower volume, but better pricing or lower volume and consistent pricing?

Below 3Q Consensus for TDG and TXT

Our 3Q estimates are below the street for both Transdigm and Textron. Our 3Q estimates for TDG reflect caution given the pullback in air traffic in August. We expect some aircraft requiring further green time will help offset some of the air traffic slowdown, but we will be interested to see the strength of aftermarket as results come in. We would be buyers on any potential weakness as we expect 2022 to be a strong year for aftermarket.

Our estimates are also below 3Q street estimates for Textron as we are cautious heading into the quarter given the strong seasonality typically seen in 4Q. We see the potential for the market to be factoring in a strong recovery in orders too early. We would be buyers of any pullback as we expect overall bizjet strength to continue.

Disparity in Boeing Consensus Earnings

We are seeing wide dispersion among consensus 3Q earnings for Boeing. Given this dispersion, we are focusing on free cash flow for the quarter. We estimate free cash flow will be ~(-$2.1bn) given headwinds from working capital. We are more positive free cash flow in 4Q as we expect cash tax benefits to be recognized in the quarter.

LMT: Catalyst Event for a Value Stock

From our meeting with acting Chief Financial Officer (CFO) John Mollard, we get the sense that management recognizes that investors would like a more detailed growth outlook over the next five years. If the company moves away from this mid-single digit growth, but provides a detailed floor in revenue growth, a bridge to margin upside, and reiterates a capital deployment strategy focused on share buybacks, we could see shares outperform.

YTD, LMT’s stock has underperformed the market and peers, up 3.8% vs. S&P 500 of up 18.7%. Pureplay defense peer Northrop Grumman (ticker: NOC) is up 29.8% and L3Harris (ticker: LHX) is up 27.6%. Lockheed’s underperformance is overdone, in our view, and we see discount valuation in particular creating attractive entry points. We see Lockheed Martin as the preferred value stock pick in our coverage universe. We maintain our Overweight and our PT of $458.

TXT: Sweet Spot for TXT Aviation

Textron is our top bizjet stock pick. We believe the company is in a sweet spot to flex pricing power and production rates as we are seeing strong book to bill, revenue growth, and margin expansion at the same time. We view it positively that management has a balanced approach to pricing increases vs. production rate increases, but recognizes that customers don’t want to wait more than 6-9 months for an asset. We maintain our Overweight rating and $88 price target.

Transdigm Is Our Top Stock in Aerospace

Transdigm is our top stock pick in Aerospace as it should continue to benefit from tailwinds in aftermarket. The company’s leverage as a sole sourced provider, paired with increased demand, puts it in a strong position to control pricing and expand margins. We highlight the near and medium-term catalysts we continue to see for aftermarket below.

1) During the pandemic, airlines prioritized use of aircraft with the greatest amount of green time available. These airplanes are now running out of green time and will need to come in for maintenance.

2) Aircraft that are still in storage have less remaining green time than the aircraft that already entered into service. These stored aircraft will also require maintenance before entering into service.

3) As the air traffic picks up, airlines are proactively performing maintenance to prevent removing aircraft from service once utilization increases.

NOC: Valuation Attractive, Growth Prospects Remain

We like NOC for its attractive risk-adjusted growth profile, driven by strong alignment to Great Power Competition priority areas. The company’s marquee programs are well-supported in the FY22 budget request. B-21 and GBSD, two legs of the nuclear triad, saw sizeable funding growth in the President’s budget request. NOC is also primed to benefit from increased national security spending on Space systems (up $1.2bn / 8% in FY22); Space is NOC’s fastest growing segment.

Valuation is also attractive, in our view. NOC trades at a 14% discount relative to peers and a 28% discount relative to the S&P 500 based on NTM P/E valuations (as of 10/5). We reiterate our Overweight rating and price target of $478, implying ~29% upside. This discount looks particularly attractive as fears that a Democratic sweep would spell deep cuts to Defense have not materialized. We like NOC’s strong path for revenue growth and continue to see more upside potential for capital allocation.