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Morningstar | What Investors Learned During the Farnborough Air Show

We came away from Farnborough thinking that signs of life exist in regional jets, the Boeing 797 aircraft might not be launched after all, and demand is still very weak for large wide-bodies like the 777X and A350-1000. Per the Flight Global order tracker, aircraft manufacturers landed 1,464 orders and options (excluding conversions), which represents a 238 aircraft increase over the 2017 Paris Air Show. Additionally, a tentative deal between the Department of Defense and Lockheed Martin on the F-35 lot 11 contract was announced at the show.

As per usual, narrow bodies (the 737 MAX and A320neo) racked up the most sales but regional jets were the real stars, capturing nearly a fourth of all sales. Although we anticipated interest in regional jets, the high level of demand was surprising. A few days before the show, the Airbus A220 (previously the C Series) was off to a strong start as it beat the Embraer E-195-E2 on a 60-aircraft order for JetBlue. In the end, however, the A220 only landed 60 additional orders from a startup airline.

The E1/E2 jets racked up 300 orders, commitments, and options versus a backlog of 360 going into the event. We’d note that 200 of the E1/E2 aircraft sold were linked to a Republic Airways deal (100 via a letter of intent plus 100 purchases options). We think Embraer might have gotten a modest boost from its recently announced joint venture with Boeing, which if approved would close by year-end 2019. We’re looking ahead to Embraer’s second-quarter earnings on July 31 and may rework our E1/E2 transition, while concomitantly increasing deliveries in the later years of our forecast.

Several months ago, we gave a next-generation midsize aircraft, dubbed the Boeing 797, a 70% chance of being launched, but coming out of Farnborough we think it’s more like 50/50. The engine manufacturers (GE in particular) continued to voice concerns over the market size for the 797, and the design of the aircraft seems to still be in flux.

Rumors circulated earlier in the show that Boeing was moving away from a composite fuselage on the aircraft, and although Boeing’s management team sought to tamp down this speculation, the fact that it surfaced indicates the uncertainty of the design configuration for the 797, owing to competing customer requirements. We think Boeing now has an even higher bar to meet to convince shareholders that the $16 billion-$18 billion it will most likely spend on developing this clean sheet aircraft is a good use of funds. If Boeing doesn’t launch the program, then we think the question on investors' minds will be what Boeing plans to do with all the cash it's throwing off. We outlined why the 797 business case is so difficult to nail down in our December 2017 Observer titled “Over my Dead Wide-Body”.

We thought that China might use the show to send a message to the Trump administration on trade by putting in a large wide-body order with Airbus, but this didn’t materialize, and the only disclosed activity from a China carrier or lessor was for 10 A350-900s, which were previously announced earlier in 2018. Large wide-body orders were conspicuously absent from the show, but we weren’t surprised. The A350-1000 landed 12 orders from Starlux Airlines, but in a repeat of the 2017 Paris Air Show, the 777X program once again walked away with zero orders. We continue to forecast fewer large wide-body deliveries than either Boeing or Airbus over the next two decades.

However, we maintain our more bullish stance on smaller wide-bodies like the 787 and A330neo. That said, the A330neo has been under significant pressure in the market, and we think Boeing continues to attack the program with a highly competitive 787 offering to pave the way for a 797 aircraft. Thankfully for Airbus, AirAsia expanded its order from 66 A330neos to 100 of this aircraft type. Although this is indeed positive, the carrier now represents nearly 40% of Airbus’ A330neo orders, creating a significant customer concentration risk.

We’d be remiss not to mention some defense activity at the show. Lockheed announced a “handshake” agreement on lot 11 of the F-35 program’s low-rate initial production with the Department of Defense, covering 141 aircraft. Lockheed didn't mention the unit cost for the Air Force variant of the F-35 under the lot 11 contract, but reports surfaced that this figure could come in below $90 million per aircraft, which would be a 6% drop versus lot 10. The company also discussed the possibility of a future multi-lot buy with the Department of Defense, which sounds a lot like a multiyear procurement, but the company stopped short of calling it this. We think this agreement will cover lots 12 through 14 and could be for up to 450 aircraft.

Turning to international defense sales, the U.S. government’s Defense Security Cooperation Agency, which assists in the transfer of defense weapons and systems to international militaries, reported at Farnborough that the U.S. State Department had approved deals worth $47 billion of international weapon sales through the first half of 2018, which is about $5 billion above all of 2017. We think strong demand from Asia and the Middle East are driving sales, but we still believe that lower oil prices (the Morningstar energy team forecasts a normalized Brent price of $60), combined with elevated levels of military spending as a percentage of GDP across the Middle East, means that over the medium term, Middle Eastern defense budgets will moderate. Raytheon remains the most exposed to the Middle East, with about half of its international business driven by customers from the region.