Independence Day 2009

(A reason why I think the best is yet to come for an Aerospace Super Cycle. 2300 words) 

 The approach of the Independence Day (a.k.a. 4th of July Weekend) always gets me thinking about the state of our Founders’ experiment in ordered liberty. Over the half century or so that I have observed this national holiday, the very meaning of what it means to be an American seems to have undergone a bit of evolution. 2009 seems to be shaping up to be a year of not just gradual evolution but wrenching discontinuity. To the proverbial visitor from outer space, it would seem that America is all of a sudden just another unexceptional State, if exceptional in any way, by virtue of the hurt it has inflicted on other people groups, most notably during the Reign of the Manifestly Evil One (2000-2008). As of a few weeks ago (when the “what should I write for the end of June?” question was starting to percolate), I was seeing a stream of articles suggesting that U.S. defense spending was heading for a precipitous decline. Apparently, the ongoing Apology Tour was going to so bedazzle the various Supreme Leaders and Omar Bongo emulators that surely, the mother of all peace dividends was about to land in our collective lap. Or so it seemed all of three weeks ago. This week’s Musings begs to differ, and not just because the hunger for basic human dignity just boiled up in (among other places) Greater Persia in a way no one (at least in the flaccid West) was thinking less than a month ago. I see very bright prospects for many defense related aerospace suppliers, certainly much more promising than their current valuations suggest. 

I have been following the Aerospace industry for a very long time now and am frankly amused by what investors and the commentators they look to fret about over the course of a cycle. In my view, aviation will grow as long as the global economy is growing and the industry is holding its own with respect to its value proposition (i.e., bringing down the all-in cost of air transport as perceived by the end user). It will also grow to the extent there continues to be conflict in the world and strategic and tactical advantage to be had from “securing the high ground"). A very good case can be made as to why the latest forecasts for air travel growth over the next twenty years are probably overly optimistic, but I will not do so at this time because it does not concern me. What concerns me is current valuation relative to prospects over the course of the next five to ten years. Bottom line: while there are all kinds of reasons why demand over the next decade or two might not live up to expectations, many of the suppliers who have survived the perturbations of the past two decades are positioned to be surprisingly prosperous with even modest and gradual improvement in demand. It is the result of a two decade consolidation undoing the inefficiencies rendered by a five decade buildup of capacity that was driven by geopolitical rather than economic considerations. In my estimation, the point at which diminished long term growth prospects might permanently outweigh positive cyclical factors (improving demand, the onset of significant new programs) is still at least a half decade away. As such, my portfolio reflects the expectation of at least one more cycle of rising earnings and concomitant investor enthusiasm. 

At present, the Bear case seems to be that the global economy is stuck in the mud for the foreseeable future (weighing on demand of aviation capacity) and that a new “realism” entailing a diminished role on the global stage for the  US (i.e., be more like France or Canada) has taken root. It also matters that the really big, game-changing programs like 787 and A-380 have been fraught with delays, prompting doubts about our collective ability to render technological advance. We forget that every past program had its moments of doubt, if not white knuckle terror in the midst of a flight test that only a very few engineers and managers ever heard about. I would suggest that what stands between the 787 today and its place a few years from now driving a protracted retrofit of much of the world’s fleet is an engineering problem. The thing about engineering problems is that as long as the objective is not somehow at odds with the laws of nature, they can and will be solved. It might take longer than you hoped and cost more than you expected, but as long as there are at least reasonable incentives in place (as opposed to the lash of despotic fiat), the left-brain, problem solving crowd always delivers. This is woven into the history of humanity. The ongoing delays are a problem right now for owners of prime contractors who took on more step-change complexity than they could handle. They might not be a problem if they are buying in at today’s prices, and they are certainly not a problem for suppliers who are qualified into specific parts of the programs that will define aviation progress over the next decade. 

As important as the 787 is going to be by 2012 (which after nearly 30 years of looking to the future I can assure you will be here sooner than you think), it is the defense side of the business that really intrigues me right now, especially as it pertains to a mastodon of an aircraft program that is no longer way out there in time. I actually view the Apology Tour as something of a positive, insofar and defense spending remains in large part a hedge against future and so unknown trouble, and nothing stirs up troublemakers like abject groveling. To the extent that a case for peace breaking out, or at least less conflict than there might have been, can be made, I am reminded of a prediction that appeared in Musings shortly after 9/11/01. I predicted that the US would undertake to use Iraq and Afghanistan like giant roach motels. Martyr wannabees would flock by the thousands to those dusty arenas, where US Marines and Special Forces would accommodate their fatal misguidedness. They would check in, but would not check out. I knew we were in for a protracted, if not never ending, struggle. I anticipated, as in all wars, what business calls “execution issues”, but not to the degree that ended up defining 2006. The end result, though, is that untold thousands of would-be terrorists, that distinct minority of the so-called “seething masses” who are actually willing to get off their miserable butts and go stand in harm’s way, now lie in peaceful repose. The problem of people in various places who hate us enough to want to kill us has not gone away, but for the next few years at least it is quite a bit smaller than it might have been. This might be thought of as a peace dividend (i.e., increased likelihood of avoiding blowback from Jimmy-Carter-stupid foreign policy), but not of the sort that is going to move the needle in a defense budget that at least tries to be years ahead of the next threat.

Debates will continue to rage as to which programs should go forward and which branch gets what and how many ships or aircraft, and there will be a few that fall by the wayside. These are inscrutable issues. (e.g., How many F-22s is the right number? I would suggest that as long as we have lots of something that China or Russia cannot dream of equalling in our lifetimes, we will not arrive at the day where we are thankful to whoever had the foresight to see to it that we had them, but if we go with “just enough” that day when we wished we had more just might arrive.) There are some programs, however, which the Administration has clearly signaled will be high priority. Right now, the one program that I do not understand why it is not generating a lot more enthusiasm is the F-35 Joint Strike Fighter (JSF). Perhaps it is because this program was launched a very long (as investors reckon it) time ago, which means it stays in a mental bin called “out there” until it starts showing up in year ahead earnings models. I know this because it was in my “out there” bin until very recently. As is my practice, items in that bin get dusted off from time to time and usually dropped back in. This time, it’s not so out there any more. The volumes this year (14 aircraft) and next (30) are nothing to get excited about. But start pushing a few other numbers around and it gets really interesting.

The JSF is expected to replace the F-16, A-10, AV-8B and all but the most recent (E/F) versions of the F/A-18. An estimated 800 such aircraft are scheduled for retirement by 2024. As impressive as these aircraft have been, the JFS will provide a step-change improvement in “stealthiness”, a several fold improvement in tactical efficiency and many of the ease-of-maintenance features that have found their way into recent aircraft and engine programs. Three variants will include a conventional version for the Air Force, a carrier based version for the Navy and a VSTOL version. It is intended to be the world’s premier strike aircraft, excluding the F-22, through 2040. As of April 2009, the DoD was on record intending to purchase 2443 aircraft. Other nations who have contributed to the development effort have made orders which push the total upwards of 3100. Estimates of potential sales beyond that indicate a market of roughly double that. So what we are looking at is 3000 to 6000 aircraft, the bulk of which will be delivered over fifteen to twenty years commencing in 2015. The plan which prime contractor Lockheed Martin is undertaking is to ramp to an annual production rate of about 240 in 2015. 

These simple numbers, 200+ units per year over a 15-20 years, are presumably a very large slug of earnings and cash flow that has not yet figured into analysts’ models (still in the “out there” bin). However, it’s not so out there anymore. The production ramp between 2010 and 2015 will be a source of “execution” risk and get “lost in the rounding” for Lockheed Martin (389MM shares) and the sole engine producer (UTX subsidiary Pratt & Whitney; 942MM shares. P&W’s F-135 will probably be the sole engine, although a second engine proposed by GE & Rolls Royce seems to have friends in Congress who just won’t quit trying.) Neither of these estimable entities pass my scrutability screen anyway. Better opportunity resides with suppliers who are qualified to provide content into the program in quantities that are meaningful relative to their capital base. At the the top of the list, to the best of my knowledge, would be Esterline Technology. ESL recently noted on a conference call that its content per aircraft in this program had grown past $1MM. (I suspect this reflects the amount of “stealth” being designed into the aircraft.) For the almost twenty years I have been watching, ESL has assiduously avoided over-reliance on “any one program”, to a degree that the success or failure of any one customer program hardly moved the needle on earnings. With JSF, at $1MM+ and 200+ units/year, the leverage across 29.4MM shares stands to be impressive. Other companies I own which are well positioned to see strong growth from the JSF program include Ladish and Precision Castparts, both primarily engine part suppliers. And it really doesn’t matter, in light of today’s valuations, if the stated objective of “one per workday by 2015” (i.e., five workdays per week, less holidays = 240/year) is realized on time or a year or two late. The Market’s valuation of these stocks will in the next few years be based on a decidedly more robust stream of future cash flow than it is today. 

As we approach Independence Day, we should reflect on what was being wrought some 233 years ago, the willingness of our forebears to risk and to sacrifice so much on behalf of the generations which have followed. It is entirely possible that we are in the midst of seeing all of that being irretrievably squandered. Damage is being done, and will likely get worse as long as all the trouble in the world stays at a simmer. However, as the good people of Persia have just reminded us, we are never more than a heartbeat or so away from some kind of hell breaking loose. (Postscript: late breaking developments out of Honduras and Argentina are confirming that the willingness push back against Anointed Ones seeking to subvert accountability and render their hold on power permanent is alive and well.) A status quo amenable to beating swords into plowshares continues to be a really dumb bet. Like it or not, as demographic trends lock the major powers into what is shaping up to be a struggle to avoid coming in first in a race to the bottom, the U.S. has no choice but to act like the superpower it still is. This reality, coupled with the porcine reality of employment in hundreds of Congressional districts, will keep defense appropriations aloft for a very long time. We must not despair of an inscrutable  future, but do the best we can with what remains of the small slice of time we have been allotted. If that means owning shares of businesses, I want to own the ones who hold the increasingly scarce keys to air superiority.