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Are Aerospace's fallen angels the next market stars?

Aerospace and defence shares were a stellar performer in 2017, led by the spectacular rise in Boeing shares from $156 to $335. Geopolitical crises in the Middle East/North Korea, the Indian-Pakistan subcontinent, Crimea/Ukraine, South China Sea etc have convinced the US, its Nato allies and countries as diverse as India to Saudi Arabia, Indonesia to Egypt to increase their military budgets. The reduction in tax rates and expansion of the capital expense depreciation allowance to 100 per cent will hugely boost the sector's free cash flow. Synchronised global economic growth will increase passenger traffic and global aviation. The multi-billion dollar research and development (R&D) under Trumps tax plan will also reduce effective tax plan.
Raytheon was my top pick in this sector, profiled in this column as a hedge against geopolitical risk in the Korean DMZ due to its role as the world's preeminent vendor of anti-ballistic missiles and defense microelectronics. However, other than Raytheon, I am mostly interested in the Cinderellas/fallen angels of global aerospace. This leads me to United Technologies (UTX) and General Electric (GE), two classic canines of the Dow.
United Technologies is one of the world's best known conglomerates, thanks to its global franchise in Otis elevators and Pratt and Whitney aircraft engines, though it has divested its Sikorsky helicopter business. The shares had grossly lagged Boeing due to the stock markets concern about the takeover premium the company paid to acquire Rockwell Collins, operating margins for Otis elevators and the scale of the tax payable on its $31 billion in undistributed repatriated earnings.
Yet Trump's tax plan will see the company's effective tax rate fall by at least 4 to 6 points as it takes advantage of R&D credits and 100 per cent capex depreciation allowances. Now that it can access its global cash hoard, United Technologies can reduce its balance sheet leverage, which will unquestionably boost 2018 earnings and cash flow. Aerospace analysts on Wall Street it is not unrealistic to expect $8.20 in 2019 pro forma EPS. Given the post Rockwell deal will be a unique aerospace beast, I expect United Technologies can trade at a valuation multiple of 20 times earnings or $164 a share. This is a classic high delta put sale candidate on any slip to 124.
General Electric was the ultimate bow wow stocks in the Dow Jones index in 2017 and in fact the entire past decade. Jeff Immelt gutted shareholder value for 15 years, with an imperial CEO's unique talent for selling great assets at market bottoms and buying garbage assets at market tops. The 50 per cent plunge in the stock price, dividend cut and new CEO John Flannery's still incoherent vision for the epic restructuring that lies ahead has created a classic "blood on the street" argument that Nathan Mayer Rothschild would have loved.
General Electric was leprosy in 2017 and white-hot in the first week of January, rising from its 17.40 bottom to 18.78 now. Has this mismanaged, unloved conglomerate finally made a capitulation bottom? My instincts and corporate math tell me yes I expect Flannery to reinvent General Electric as a global aerospace company and for normalized EPS to be as high as $1.70. General Electric is also one of the Goldman Sachs high growth capex/R&D relative to corporate cash flow from operations basket. Of course, trying to bottom fish a broken stock like GE is like trying to ballet dance on a minefield - never a good idea. I realise that no one on earth, not even the CEO himself, knows what General Electric will look like in 2019. Yet Flannery has invited a Trian partner on his board and got rid of most of the deadbeats. This is a good omen. The GE of the future is an aerospace firm, not a healthcare/wind/energy conglomerate.
GE is not for widows and orphans. GE's financial leverage is dangerously high at 3.5X earnings. Cash flow and EPS has been slashed by 50%. Flannery has not articulated a credible turnaround vision to Wall Street. GE is leprosy in the industrial sector in its balance sheet and commercial paper borrowings. Caveat emptor!
Textron, the maker of Bell Helicopter and the US Air Force's scorpion jet, could well be aerospace takeover bait in 2018. The die is cast, the game's a foot! Note the shares surge from 46 to 58. This spells merger arbs/accumulation to me. My Fox trade déjà vu!