With Libya and Bahrain joining Tunisia and Egypt in the tally of revolting Middle Eastern states, RBC Capital Markets has considered what the fundamental and stock price impact could be on the Aerospace & Defense sector.
RBC Capital said the major concern in defense is the impact on exports to the region. Although some delays cannot be ruled out, the key U.S. customers in the region are relatively stable, and still have strategic, Iran driven defense requirements. For aerospace, the oil price spike is creating concern over the scale of the impact on airline profits.
However, the demand environment should not be overlooked, and we see airlines largely passing the costs on to passengers, and stepping up fleet renewal efforts. If the unrest is contained, we see an oil driven aerospace sell off as a potential buying opportunity, as we do not foresee a material impact on aftermarket or original equipment manufacturer (OEM)demand. Our top picks remain Precision Castparts Corp. (PCP) and BE Aerospace Inc. (BEAV), said Robert Stallard, an analyst at RBC Capital Markets.
In 2009/10, 88 percent of U.S. defense exports to the Middle East (45 percent of total exports) went to the following countries - Saudi, Kuwait, Israel, Oman, Qatar, UAE, Turkey and Egypt. Excepting Egypt, the rest of these countries are arguably the more secure in the region.
Stallard also noted that the strategic rationale driving defense export demand in these countries, principally concern about Iran, remains -- and has arguably increased given the Iranian decision to send naval ships through the Suez canal.
Stallard said that with an average of 30 percent of their costs coming from fuel, an oil price spike is clearly bad for airline profitability, though hedging mitigates the effect for many carriers.
However, with good demand coupled with capacity management, load factors of 79 percent should allow airlines to pass much of this cost on to customers. Stallard also sees airlines stepping up fleet replacement efforts.
We think the sell off in the aerospace sector could prove to be a good buying opportunity. As we saw in the last upturn, rising oil prices can occur in tandem with rising airline traffic, capacity and new orders, and we expect that to again be the case here. In defense, we may see some short term outperformance given the 'defensive' stereotype of the sector. We see concerns over defense exports as overdone, making Raytheon particularly attractive, said Stallard.
The biggest risk to this scenario is that the unrest spreads, and Stallard sees a regime change in Saudi Arabia. Although Stallard thinks this is highly unlikely, unrest in the major oil producing country and a change in Government could be akin to Iran in 1979, and also a major oil producer.
If Saudi goes, then all bets are off, with major implications for oil, the global economy and the United States' strategic position in the region. Such a scenario has a low possibility, but Stallard continues to monitor developments in the region.