Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Joachim Kotze. He is an analyst at Morningstar. Hello.
Joachim Kotze: Hi, good morning.
Black: So, you are looking at the defense and aerospace sector and I think aerospace in particular is getting a lot of attention at the moment because travel has just fallen off a cliff in the last few months. So, what are the short-term implications from the coronavirus outbreak that you're seeing?
Kotze: Holly, as you correctly pointed out, demand is down aggressively due to travel restrictions by the governments. The trade body IATA, their latest forecast predicts revenue passenger kilometers which is a measure of demand to be down about 33% in 2020 for the full year. And with more than 60% of the global fleets currently grounded airlines are deferring or cancelling orders to maintain liquidity which will impact the revenue and profit for aerospace suppliers. However, more importantly, with the grounded fleet and the low current flying hours, you are seeing valuable and highly profitable after-market service and spare parts sales drop off sharply. And these types of revenues generally are cash card for many of the engine manufacturers in our coverage such as Safran, Rolls-Royce and MTU Aero. In addition, many of the older aircrafts in the fleet will be permanently – like permanently retired and that will impact the size of the fleet.
Black: What are the long-term implications for the sector? I know a lot of people are itching to get away on their summer holidays. So, can we expect a recovery?
Kotze: Look, the recovery is going to be two-pronged. It's going to be a split between the willingness and the ability of consumers to travel. The ability of consumers to travel that will be impacted by the economic fallout of the crisis such as share of wallet and ability to spend over or go on holidays. And also, the travel restrictions that remain in place while we wait for the development and the distribution of the vaccine. And that could take some time; some estimates say up to 18 months. The second factor is willingness which is a lot more fear driven and that will depend on when consumers are comfortable to fly. There will be a marginal part, especially in the older part of the population which will be hesitant to travel and that could continue to weigh on that marginal part more. If you split between domestic and long haul, domestic and short haul travel should recover first while long haul travel could face a more prolonged recovery as international travel restrictions remain in place for longer. The IATA predicts domestic flight demand to recover to 2019 levels by 2022 whereas with the long haul and international flights only recovering by 2024.
Black: So, one of the better known names in the sector I think is Rolls-Royce and it's also undergoing a restructuring at the moment. So, what's the outlook for that stock?
Kotze: Yeah. Last week the group announced sharp cuts to its civil aerospace labor force in excess of 30% in an effort to save costs amidst their prediction of a muted recovery and lower demand. Before going into this crisis Rolls-Royce's aerospace segment was already loss making and it was facing in-service engine related issues with their Trent 1000 engine which is quite a costly recovery for them. Whilst optically the valuation appears attractive and the share price is currently way below our fair value estimate, it requires perfect execution from management and we believe the uncertainty and the execution risks are very, very high.
Black: Okay. So, a lot of issues with that stock. Is there a company in the sector that you are particularly positive on?
Kotze: Yeah. Look, I mean, our top pick remains our best idea Safran. The group is extremely well positioned as they focus on supplying narrow-body engines to both Boeing and Airbus. They are one of the biggest – or they are the biggest narrow-body engine manufacturer. And we believe that both narrow bodies and Safran have robust long-term drivers. And the group is highly profitable with generating a lot of free cash flow. It has adequate liquidity on its balance sheet to see it through the crisis that lies ahead. And the share price currently leaves plenty of upside and we believe many of the risks are priced in. However, it will be a matter of sentiment change towards travel-exposed companies before we see a recovery in price though.
Black: Okay. Joachim, thank you so much for your time. For Morningstar, I'm Holly Black.
