TEAL GROUP: THE JETLINER INDUSTRY NEVER HAD IT SO GOOD.

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The Jetliner Industry Never Had it so Good
BAE Systems plc – Teal Group Analysis
Space Module Zvezda

 
The Jetliner Industry Never Had it so Good
Posted: 26 Sep 2014 01:39 PM PDT
Deliveries from just Airbus and Boeing last year reached $92 billion in value, another record after two other record years. In 2012, they rose 29.4% in value over 2011, capping a remarkable 55.5% growth spurt in 2008-2012.

The jetliner industry never had it so good. Deliveries from just Airbus and Boeing last year reached $92 billion in value, another record after two other record years. In 2012, they rose 29.4% in value over 2011, capping a remarkable 55.5% growth spurt in 2008-2012.

The problem is that these fantastic numbers are disconnected from all the usual jetliner demand drivers. While jetliners grew at a record pace, the world economy had its worst years since World War Two. The macroeconomic recovery has since been anemic, and air travel demand only marginally better. While airline revenue passenger kilometers recovered at a respectable 6.9% pace in 2011, growth fell to just 5.3% in 2012, and has stayed at about that level in 2013 and this year.

The primary driver behind jetliner deliveries, instead of the usual economic and travel demand factors, is a very unusual divergence between the cost of capital and the cost of oil, coupled with a lack of other investment opportunities. Historically, oil prices and interest rates have followed a similar line. When oil was cheap and airlines didn’t need to re-fleet with more efficient jets, interest rates were low. When fuel was expensive and new jets were essential, interest rates were high enough to make airlines baulk at new orders.

But for the first time in decades, the past four years have seen an astonishing divergence between fuel and cash costs (as indicated in our chart on the next page). Fuel prices, which normally fall during economic down¬turns, have remained stuck near all-time highs. Meanwhile, central banks around the globe have at¬tempted to promote growth by providing very cheap cash. The US Federal Reserve interest rate is now around 0.1%. Even if the retail price of money is a few points higher, that rate is a good indicator of the low cost of financing, particularly with ongoing high levels of backstop financing from government export credit agencies.

Jets, of course, have become a very attractive asset to finance. It isn’t just that they are mobile, revenue producing tools with a high degree of durability and safety; it’s also the absence of competing demands for investment money. That is the third variable that’s in record territory. Returns on investment in almost any other segment (whether stocks, bonds, or housing), spent 2008-2011 at close to record low levels.

In short, three unusual drivers have catalyzed a sudden and unprecedented jetliner output surge. This isn’t mere speculation; many airlines really do want new jets, and, for now at least, they can get financing at good rates. This is a one-off event, but probably not a bubble. Unfortunately, Airbus and Boeing production plans seem to indicate a desire to engineer one. Current output expectations call for an additional year of strong growth, followed by modest, incremental increases, culminating in a $104 billion market in 2014.

The industry seems to be thinking, “we deserve a recovery from that downturn.” Of course, there was no downturn. The years 2004-2013 saw ten remarkable years of growth at a 9.9% annual rate.

It’s important to remember that each of the three factors that created this output surge can only get worse. It’s difficult to imagine interest rates lower than 0.1%. At 80-100/bbl, oil is in a sweet spot—if it gets more expensive that starts to hobble airline profitability and/or travel demand. If it gets less expensive, that makes older jets more competitive relative to new build ones. Meanwhile, the economic recovery, particularly in the US, will likely start to accelerate. This will create new investment opportunities, attracting money that otherwise might be put into jets. Recoveries in US equities and the housing market already imply more attractive investments elsewhere, particularly since the jet-leasing returns on investment have been falling due to a high level of jet supply.

The only jet demand driver that can be improved, in short, is air traffic growth. There are few short and mid-term hopes of faster air travel demand.

Therefore, when it comes to predicting future demand, this is a dangerous starting point. After all, every year Airbus and Boeing release a 20-year market projection anticipating a roughly 5% annual growth rate in deliveries. Six years ago, the base year for projecting this market would have been about one third smaller in size. Yet the long term growth expectations haven’t changed. Every year, the two primes re-set long-term demand by starting at a new high level reached because of an extremely unusual combination of factors. If the two primes execute on their current output plans, we’ll see a 2015 starting point that is an even less reliable indicator of the times ahead.

Author

Richard L. Aboulafia

BAE Systems plc – Teal Group Analysis
Posted: 26 Sep 2014 01:13 PM PDT
BAE Systems plc (BAE), the United Kingdom’s largest defense and aerospace contractor and the world’s third largest defense contractor, is working to manage pressures on its business from budgetary cut¬backs in the United States and the United Kingdom.

Strategy: BAE Systems plc (BAE), the United Kingdom’s largest defense and aerospace contractor and the world’s third largest defense contractor, is working to manage pressures on its business from budgetary cut-backs in the United States and the United Kingdom. BAE is now focusing on migrating capabilities across home markets and broadening its international business. It is also working to mollify shareholders with a stock buyback and a management shift intended to satisfy frustrations with the failed merger with EADS (now Airbus).

Strengths: BAE Systems’ strategy of expansion into the United States proved to be an astute move. Despite its recent decline, the US defense budget is the world’s largest, presenting the company with a number of opportunities. Moreover, the US electronic warfare business, much of it purchased from Lockheed Martin Corp., is an extremely desirable property with strong technological leadership in its field.

BAE Systems also has used this strategy of building up its position as a domestic manufacturer in other countries, including Australia and Saudi Arabia. Saudi Arabia in particular has proved to be an extremely valuable customer, representing one-fifth of the company’s total sales.

BAE Systems remains committed to improving its profitability rather than gaining market share. With this focus, it has been willing to get out of the unprofitable regional aircraft market and sell off stakes in unprofitable joint ventures. In addition to the potential for growth in defense sales to key markets such as Saudi Arabia and the United States, BAE Systems sees the potential for growth in the homeland security market, integrated services and unmanned aerial vehicles.

Weaknesses: BAE has built up a very strong position as the world’s leading ground systems company through its acquisitions of United Defense and Armored Holdings in the United States. With the wind-down of operations in Iraq and Afghanistan, US purchases of equipment have plummeted.

The US Army’s serious budgetary crunch means that major programs are being postponed or cancelled
As a result, BAE is being forced to close facilities and lay off personnel in its US ground systems businesses.

More broadly across the corporation, BAE Systems also is unable to achieve the synergies that one might expect of a company of its size. US technology transfer restrictions hamper its ability to share technologies and even information within the company between its US and UK business units.

BAE Systems’ position on the network centric systems of the future is relatively weak in its UK operations, particularly compared to the strength of its US operations.

Like other European defense companies, BAE Systems is handicapped by low British spending on research and development and funds wasted on duplicative national programs in Europe.

Opportunities: BAE Systems has aggressively worked to build up its cyber security, intelligence and security business both in the United Kingdom and the United States. Despite disappointments, it remains committed to increasing the business. Commercial cyber security is seen a particularly promising portion of the market.

Electronic Systems is also seen as a potential growth area.

International sales outside the United States also offer opportunities. Saudi Arabia in particular offers promise following formal agreement on pricing for the Typhoons and a series of large value support contracts.

Management is focusing increasingly on improving its profit and cash generation.

Threats: Further cuts in the US defense budget, particularly in the Army, would hurt badly. There could be a direct impact in new prime contracts and a secondary impact by driving other prime contractors to keep more business in-house. That could hurt the Electronics business.

For BAE, the lack of new work to keep ground facilities open is a very serious threat. If programs such as the Joint Light Tactical Combat Vehicle are further postponed, the company’s position will further worsen with inadequate work to keep key facilities like York, Pennsylvania open.

The armored systems business faces increasing competition both in the United States and in the United Kingdom. It also faces a steeply declining worldwide market.

Affordability of UK programs also is a serious problem for the company. The UK Ministry of Defence has cut its procurement plans and programs.

Instability in Saudi Arabia would represent a serious threat to the company’s very profitable Al Yamamah arms for oil program since the Kingdom represents 20% of the company’s sales. It has represented a significantly greater share of profits in recent years.
Space Module Zvezda
Posted: 26 Sep 2014 12:47 PM PDT
Z-vez-da! Remember that word, because you’ll be hearing it a lot over the next few months, and probably years. Zvezda is a space module that weighs about 42,000 pounds. It was launched aboard a Russian Proton K rocket to low earth orbit (LEO) on July 12, 2000.

Z-vez-da! Remember that word, because you’ll be hearing it a lot over the next few months, and probably years. Zvezda is a space module that weighs about 42,000 pounds. It was launched aboard a Russian Proton K rocket to low earth orbit (LEO) on July 12, 2000. About a year later, it became the cornerstone of the International Space Station (ISS), providing all of the station’s life support systems, electrical power, and attitude control functions. The module also serves as the living quarters for the ISS crew.

In short, the Zvezda “service module” is critical to the operation of the station. It was Russia’s goodwill contribution to this international space project. But the facility still technically belongs to the Russian space agency, Rosaviaskosmos, and is controlled by it. Unfortunately for the United States, that goodwill has eroded considerably during the past few months as a result of escalating tensions between Russia and the West over the political situation in Ukraine, particularly following the former’s annexation of Crimea and threats of further incursions into eastern Ukraine.

It’s unfortunate because absent a friendly and cooperative working relationship with the Russians on ISS, the Obama administration faces the hugely embarrassing dilemma of what to do if Mr. Putin wakes up one morning and simply decides to shut the station down. Okay okay, it wouldn’t happen quite that way. There would be plenty of lead time to allow crew members to pack their belongings and exit in an orderly fashion. You would need months of advance planning to responsibly shut down systems and thoroughly figure out the consequences of leaving such a massive collection of hardware orbiting just 230 miles above our planet.

Do you make preparations for some sort of controlled gradual de-orbit of the station as a whole? All 1 million pounds of it? Do you disassemble the station and de-orbit it in pieces? Or do you simply let the $100 billion-plus structure sit up there in orbit, gradually losing altitude over many years, slowly burning up on its own as it re-enters the atmosphere? (Hopefully over one of the bigger oceans.)

Given that they hold the power (literally) with regard to the station, the Russians could be real jerks and decide to pull the plug without much warning. Fortunately, they’ve opted against this. Instead, Russian Deputy Prime Minister Dmitry Rogozin informed the US that his country plans to end its role in ISS in 2020. In other words, Zvezda will be unplugged and boarded up, and — by logical extension — so will the entire space station.

That is a problem. The U.S. has been planning to keep the place going until at least 2024. Fortunately, NASA has something called the “Interim Control Module” (ICM), which the US Naval Research Lab (NRL) built many years ago as a temporary backup for Zvezda. It could launch the ICM and mate it with ISS, thereby extending the station’s life through perhaps 2023.

However, the ICM was originally to be launched by one of the Space Shuttles. The Shuttle program ended in 2011, and we currently do not have a rocket capable of launching the ICM or another replacement for Zvezda.

I think I may have found a mission for NASA’s SLS (Space Launch System). You know, that mammoth rocket the agency aims to have ready by 2017-2018, but which thus far has no viable mission.

Still, it all seems like an awful lot of trouble and expense for keeping ISS open only a few additional years — especially since up until 3-4 years ago the Obama administration had planned to retire ISS in 2016 and up until January of this year retirement was set for 2020. Reason might dictate, “What the heck, let’s just go back to what we had in mind a few months ago.” Two thousand twenty sounds like a nice round number, right?

Don’t count on it. The Russians have dropped the gauntlet. Race is on. Suddenly, space has gotten interesting again.

Author

Marco A. Caceres

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