Executive summary

  • The airline industry has been floored by Covid-19.
  • Smaller aircraft to dominate the skies going forward.
  • Of the two aircraft manufacturers, we favour Airbus.

Bloody Mary’s taste better at altitude. The change in air pressure numbs a third of our taste buds, reducing the acidity of the tomato-based cocktail. It’s an experience that not many have had of late. But with the respect due to All Gold, there are bigger problems that come with grounded aircraft fleets.

Rolls Royce, who manufacture jet engines, are laying off 9,000 people, a fifth of their workforce. Boeing are looking at cutting 10% of their staff, about 16,000 jobs. Multiple carriers have entered business rescue or bankruptcy procedures. The airline industry, and ecosystem that feeds off it, is starving.

But commercial flight has shown itself to be remarkably resilient through time. The simple analysis shows that as GDP per capita rises, more people fly. The human desire to see the world and connect with others (sans screen) is a powerful and ancient force. We see no reason why wanderlust will not return. The next chart suggests that the worst is already behind us.

As the global economy tries to break the shackles of Covid-19, we look at how commercial flight will change, and which aircraft manufacturer, Boeing, or Airbus, is best positioned to break through the prevailing dark clouds.

Domestic over international

There are major headwinds to international air travel. Quarantine-on-arrival protocols, fear of having to enter a foreign healthcare system, and the potential for borders to close at a moment’s notice are strong deterrents to dusting off your passport. Domestic travel doesn’t face the same problems and will therefore rebound faster. There is already evidence of this in the countries hit early by the virus.

This trend of domestic over international flight has consequences for the types of aircraft airlines will need. Commercial jets fall into one of two categories: wide- (>300 passengers) and narrow-body (<300). The former generally has two aisles, the latter one. Wide-body aircraft are mostly used for long-haul flights between major international hubs, with narrow-bodies catering for the shorter routes, i.e. domestic air travel.

If domestic travel dominates, carriers around the world will need more narrow-body aircraft post pandemic. The next chart shows how the length of flights taken (measured in kilometres) are expected to shorten and then rise only gradually. This would support the thesis we’re putting forward.

More airports = smaller aircraft

Many an emerging market is characterised by thriving hubs with little in between. But as they advance, their smaller cities become economically meaningful, with access via air travel becoming mandatory. That means more airports and runways. Low cost carriers (LCC’s) are likely to flourish in such instances given their newly middle-class clientele. Using South-East Asia as an example, you can see how LCC’s in the region plan to add many more narrow-body aircraft to their fleets as opposed to the wide-body models.

Narrow-body aircraft are greener

Many of the world’s airlines will need financial assistance from their respective governments if they are to survive the current crisis. This gives government an opportunity to potentially influence the future of the airline industry. And high up on most government agenda is the need to slow global warming. You can see how governments have provided support to their respective airlines in the next graphic.

Governments are likely to favour the use of narrow-body aircraft. They have lower emission profiles. And with more efficient engines and increased range, these smaller jets are now genuine contenders for broad adoption. This includes transatlantic flight historically reserved for their double-aisled peers. A positive spin-off for passengers (and the environment) is that long-range, narrow-body aircraft will reduce the need for indirect flights – because they’re more likely to be full – and the concomitant inefficiencies they produce.

Who’s the better duopolist?

99% of all commercial aircraft in the 150-seater and above range are manufactured by either Boeing or Airbus. If you’ve flown before, you’ve flown on one of their planes. If you want to know who you’re flying with next time around, here are three clues:

  1. Boeing aircraft have sharper nose cones. Airbus’s sport a more bulbous equivalent.
  2. Airbus engines have a circular opening. Boeing engines flatten out on the bottom.
  3. The wing tip lights on a Boeing use a single pulse at night. Airbus’s flash twice.

For all their subtle design differences, their share prices have stepped together during the crisis. Both manufacturers have seen their shares lose more than 50% of their value (at the time of writing) since the beginning of 2020. Each faces a different set of challenges in the coming months and years.

Crashes and bribery

If the trend is indeed toward narrow-body planes, Airbus can sate that demand with its A320 range, while Boeing has the 737 MAX aircraft. You can see how tight the race is between these two in the next graphic. ASK stands for Available Seat Kilometres, a measure of the carrying capacity an airline has to generate revenue.

The proposed preference for narrow-body aircraft suits both Boeing and Airbus. These planes are manufactured on the mature platforms within their businesses, where falling R&D and capex expenditure allows for higher profitability. Morgan Stanley estimate that both manufacturers make 20% plus margins on their narrow-body lines, roughly double their company-wide margins. The increased profitability that comes with this trend toward narrow-body aircraft stands large as an attraction to investing in this duopoly.

However, there’s a temporary but glaring difference between these dog-fighting commercial aircraft. It has to do with disaster.

Boeing’s 737 MAX range was launched in January 2016 to much acclaim. But then two of its aircraft crashed, killing a total of 346 passengers, as software meant to correct flight pitch malfunctioned. The pilots were unable to override its influence due to a lack of training. The fallout has seen the 737 MAX aircraft grounded since March 2019. These disasters put Boeing’s future pipeline at risk, while many customers with outstanding orders are unsurprisingly trying to renege on their contracts as flight demand plummets.

Airbus, too, have reputational challenges. They have recently agreed to pay a $4 billion fine in a plea bargain over alleged bribery and corruption stretching back almost 15-years. This could negatively impact their relationships with their airline customers.

But the beauty of a duopoly is that you just need to keep your nose in front of your competitor to succeed. To be sure, Russia and China are trying to eat their lunch. But analysts reckon they’re a decade away from producing competitive commercial aircraft.

Source: Airbus Covid-19 Update Presentation

Order book superiority

At the end of February 2020, Airbus had a total order backlog of 7,670 commercial aircraft. 81% of that pipeline is for their highly sought-after A320 narrow-body models.

To give you an idea of the timeline involved here, Airbus produced 53 aircraft per month in 2019 in the A320 family; they have reduced that number to 40 to align production with estimated demand. With a backlog of 6,209 A320’s, that equates to roughly a decade worth of production for their highest margin aircraft. The graphic below comes from Airbus’s recent Covid-19 update, breaking down their order pipeline by region and aircraft type.

In Boeing’s defense

Both manufacturers in question have government defence contracts. Boeing makes as much as a third of their revenue from its defence business. It was recently awarded the contracts to build the US Air Force’s trainer jet ($9,2bn), replace the UH-1N Huey Helicopter ($2bn), and to design a new US Navy refuelling drone ($802m), to mention a few. Airbus is not as prodigious in the defence space, generating between 15-20% of their revenue arming government forces.

While the orders and deliveries of commercial aircraft dominate the headlines for Airbus and Boeing, their defence businesses provide resilience in times of stress – governments are reticent to cut back on their defence spending during such intervals. Boeing has a clear advantage on this front.

We choose Airbus

One of the key factors in our equity selection process is debt. Too much of it cripples businesses in times of turmoil. Boeing’s balance sheet has taken a material hit in this crisis, and the $25bn bond issuance they’ve just concluded only adds to that problem. There is also uncertainty around their future profitability given the vulnerability of their order book and uncertainty about when the 737 MAX will again take to the skies. All-in Boeing looks like the riskier investment.

Airbus, too, is suffering. But the health and mix of their order book looks more defensive. Our analysis of its financials also suggests it’s a well-run business. Let’s start with their profitability growth, the most important factor we consider when investing in any business. The first chart illustrates their earnings growth from 2003 to 2019 (pre-Covid).

Source: Airbus AFS, Obsidian Capital, June 2020

The relative strength of their earnings growth (and its impact) can be seen in the next chart. In white we have Airbus earnings relative to the average earnings of companies listed on the DAX. In yellow is the relative share price performance. When the white line trends upwards Airbus is producing better earnings than the index; a rising yellow line means the Airbus share price is outperforming the DAX index of which it is a constituent.

Source: Bloomberg, Obsidian Capital, June 2020

This is how active equity management works; pick a stock that outperforms on earnings and the share price will outperform the index that houses it. What’s also obvious from this chart is how dramatically Covid-19 has impacted Airbus.

But the material reset to their profitability gives investors an opportunity to capture the potential reversion to previous margins. To gauge the strength of the underlying business operations, a steer on the likelihood of a return to margins of old, have a look at the return on capital employed (ROCE) in the next chart.

Source: Airbus AFS, Obsidian Capital, June 2020

What we’re seeing in the above chart (par the recent leg down) is evidence that the management team deploys resources in an effective and profitable manner over time. The growth in their EBITDA margins has been similarly impressive in recent years. We think there’s a good chance that Airbus’s management will be able to drive up profitability in the years ahead – delivering good earnings growth as a result – especially as demand shifts toward the margin-rich narrow-body aircraft.

Finally, Airbus entered this crisis with a strong balance sheet. This reduces the risk of any dilutive events for equity holders and positions them nicely to ramp up production when the time comes. There’s also more chance they reinstate a dividend before Boeing. Negative net debt/EBITDA ratios mean they have more cash than they do debt on their balance sheet.

Source: Airbus AFS, Obsidian Capital, June 2020

The big picture

The airline industry is in a dark place. Casualties are inevitable. The manufacturers who supply aircraft have not been spared, suffering a significant reset to both their profitability and valuations. But history and human nature suggest people will return to the skies; they can only do in planes.

This gives us and other investors an opportunity to invest in strong businesses that have shown admirable profitability growth over the last decade. An investment in either manufacturer will, however, require patience. Of the two, Airbus looks to have its nose in front on the runway, Bloody Mary’s at the ready.