RBC Capital: 'War in Iran and the aerospace aftermarket'

RBC Capital analyst Ken Herbert weighs in on aerospace stocks amid the Iran war.

The analyst commented: "Minimal aircraft retirement risk, but travel, stock sentiment the focus; The commercial aerospace aftermarket risks have increased with the launch of the Iran war. Since the start of the conflict, AM stocks are down an average of (11%), compared to a decline of (8%) for the aerospace OE stocks and a (4%) decline for the A&D sector. We see three broad risks for the AM as a result of the Iran war. First, we expect some impact on short cycle AM parts sales. While the Middle East accounts for only ~6% of the global fleet, we believe ME airlines have begun to selectively reduce spare parts purchases. Second, the surge in crude prices will add financial strain to all airlines globally, and could eventually result in broader travel demand destruction. Based on our analysis, we do not expect a significant uptick in retirements in the near-term as a result of higher crude prices, and we believe airlines will be reluctant to over-react and reduce capacity. Finally, while the fundamental impact, in our view, will be limited, with many AM stocks trading at peak multiples, any shift in sentiment could be material. The stocks we see most at risk include AAR, HEI, LOAR, TDG and VSEC.

Short cycle AM most at risk, but as of now we see limited fundamental risk. While the Middle East accounts for just 6% of the total commercial fleet (but ~14% of the total widebody fleet) and ~7% of commercial flight activity--and the fleet is relatively young compared to the global fleet--based on our channel checks we believe some regional airlines (as well as others with significant exposure, such as in India) have lowered spare parts purchases. In our view, non-engine OEMs and parts distributors are more exposed to short cycle impacts, and we would call out AAR, LOAR, HEI, TDG, and VSEC as companies with greater exposure to commercial parts aftermarket sales, or component MRO activity. However, we would put the direct impact on AM growth now as a result of the war at likely under ~1%, and we believe that if the conflict is over in the next 2-3 weeks, there will be very little fundamental market impact. Considering the state of engine shop visit TATs, and ongoing asset scarcity, we see very little risk to the engine and heavy MRO outlook, and we believe risk to OE backlogs are also very limited. See below for a detailed breakout of AM revenues for our universe. Discretionary spending could also be a risk (WB interior, for example), which we think is most impactful for RTX and SAF.

However, the higher fuel prices are a concern. Since the start of the conflict, jet fuel is up ~63%, with crude up ~45%. Airlines will look to pass on as much of the higher fuel prices as possible. Considering how resilient air travel has been over the past several years, we believe the risks associated with a broader slowdown in air travel are limited. Based on our analysis, we do not believe we will see a meaningful uptick in aircraft retirements as a result of higher crude prices, and we believe airlines will be reluctant to over-react and reduce capacity, considering the recovery from the pandemic was stronger than expected. While we have seen a meaningful increase in retirements from prior crude oil price surges, more recent data (post-2008) suggests a more meaningful lag of 6+ months. Further, we note the PLF and average fleet age are the highest it has been relative to prior surges of oil prices, reflecting the significant under-supply of new aircraft today, and we believe airlines will be more reluctant to accelerate retirements in the short-term.

We believe the biggest near-term risk is the impact on investor aftermarket sentiment. Will the Iran war be the issue that accelerates the normalization of AM multiples? We do not think so, but we believe multiples today are on average ~30% higher than the pre-pandemic average (note many AM stocks, such as GE Aero, LOAR, SARO, VSEC do not have a long-trading track record). In our view, the sell-off in particular in FTAI and SARO (legacy engine exposure) is overdone. We believe investors will continue to favor defense stocks in the near term, and we see very limited risk to the aerospace OE cycle (aside from incremental supply chain disruptions)."

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