PPA: Boeing Cash Problem, Lockheed F-35 Delays (Rating Downgrade)

Investment Thesis

Invesco Aerospace & Defense ETF (NYSEARCA:PPA) warrants a rating downgrade to a hold due to the continued safety-related problems facing the Boeing Company (BA) as well as Lockheed Martin’s (LMT) F-35 program delays and costs. Additionally, while short-term government spending is expected to remain high due to the many geopolitical tensions and conflicts, debt as a percentage of GDP has risen to concerning levels. Therefore, the long-term risk of reduced defense spending may directly impact PPA’s top holdings.

Fund Overview and Previous Coverage

PPA is a passively managed ETF that seeks to track the SPADE Defense Index. I wrote previously on the fund this past February and rated the fund a buy. For comparison purposes, other funds examined are SPDR S&P Aerospace & Defense ETF (XAR) and iShares U.S. Aerospace & Defense ETF (ITA). Since February, PPA has slightly underperformed the S&P 500 Index, with a 12.3% return compared to the market’s 13.3% return. However, the fund has continued to outperform peer defense ETFs.

PPA has seen a solid 10-year price return CAGR of 13.38%, higher than both peer funds. However, PPA has an expense ratio of 0.58%, higher than competitors with a dividend yield of 0.61%. PPA is more diversified than XAR and ITA, with 56 holdings. The fund was created in 2005 and has $3.37B in AUM, currently. I believe the fund deserves a downgrade to hold due to the reasons discussed in this article.

Fund Holdings and Key Outlook Updates

Since February, several key holdings changes have taken place. The first is that Boeing now takes the top spot for PPA at 6.80% weight. Secondly, RTX Corporation (RTX) has a lower weight at the #4 holding. Finally, Howmet Aerospace (HWM) joined PPA’s top 10 holdings earlier this year.

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Source: Compiled by Author from Multiple Sources, 13 Jul 24

Looking forward, there are multiple reasons PPA deserves a hold. The first is that while Boeing, PPA’s new #1 holding, has several robust strengths, the company continues to face safety issues resulting in negative cashflow. Second, while PPA’s #2 and #3 holdings both have seen strong growth, GE is now unfavorably valued while Lockheed Martin faces further delays in its largest program, the F-35. Finally, while defense spending is expected to remain strong for the remainder of this decade, spending has now reached high levels in relation to GDP, causing long-term sustainability issues.

Outlook Factor #1: Boeing is Bleeding Cash, But Positive Factors Remain

The first consideration factor is PPA’s increased weight on Boeing from 5.1% to 6.8%. Boeing’s commercial aircraft problems are widespread, going back to the 737 Max crashes in 2018 and 2019. Just this past week, Boeing pleaded guilty and agreed to pay a $487M fine. Boeing’s Q1 report listed total cash and short-term investments at $7.53B. However, the company saw a net change in cash in Q1 of -$5.78B. Such a cash outflow is unsustainable for the company. However, there are reasons to remain optimistic for the airplane manufacturer. First, Boeing has 5,600 commercial planes in backlog. This backlog quantity has slowly increased since the COVID pandemic.

Additionally, airlines cannot easily switch from Boeing to a competitor manufacturer due to airplane backlogs and pilot certification costs. Specifically, Airbus (XPAR:AIR) has a backlog of over 8,000 planes, meaning that a widespread change from Boeing to Airbus would not be quick or easy. Additionally, retraining pilots that currently have certifications in Boeing aircraft is costly in money and time. It is estimated to cost between $17,000 and $37,000 for a Boeing 737 type rating, while it could take over a month for each pilot to retrain in an Airbus certification. With 15,000 pilots at Delta Air Lines alone, a rapid switch from Boeing to a competitor is infeasible, at least in the short term.

At 6.82% weight, BA’s #1 weight on PPA potentially represents a liability for the fund. However, Boeing has proven its resiliency in the past. Its 1.45 price-to-sales ratio may present an opportunity if the company can implement proper safety measures and regain profitability. However, given the cultural problems that have surfaced over the past few years, there are clear risk factors.

Outlook Factor #2: GE’s High Valuation and Lockheed’s F-35 Delays

The second key outlook factor can be found in PPA’s #2 and #3 holdings, Lockheed Martin (LMT) and General Electric (GE). Like Boeing, both GE and LMT have positive outlook factors as well as risk factors. Looking at GE’s latest 10-Q for Q1, we see a revenue increase of 10.8% YoY. Additionally, the company is making advances in hybrid engines, crucial for the future of commercial aviation. These hybrid engines for commercial airlines will potentially be bought by big-name manufacturers like Boeing and Airbus as fossil fuels are exhausted in the coming decades. While BA has seen a -16% price return over the past six months, GE has seen a sharp rise at 53%. However, GE’s growth appears to be priced in with GE’s P/E at a high 41.7, 74% higher than its market sector median.

Lockheed Martin also saw a strong Q1 with a revenue increase of 13.7% YoY according to its latest 10-Q. Contributing to its positive outlook, LMT has a backlog of 373 F-35 aircraft internationally. However, Lockheed is more than $183 billion over the original cost estimates and years behind schedule. While LMT, like BA, is diversified into many different business segments, the F-35 program is LMT’s largest program. Therefore, delays and setbacks with the F-35 will have an outsized impact on the defense contractor.

Outlook Factor #3: Short-Term Defense Spending Outlook

The final outlook factor is the defense budget. Because PPA’s top holdings are heavily reliant on defense contracts, an increase or decrease of the defense budget directly impacts company earnings. However, a multitude of geopolitical concerns exist including the continued conflict in Ukraine, tensions between China and Taiwan, and the Israel-Palestinian conflict. Therefore, it appears unlikely that a sharp decline in defense spending is on the horizon.

Additionally, the upcoming presidential election may play a factor. Both leading candidates in the next U.S. election have raised defense spending during their presidency. The defense budget in 2016 was $534B compared to 2020 $778B, a 45% total increase during the Trump Administration. The 2020 defense budget compared to 2024’s $842B budget resulted in an 8% total increase during the Biden Administration. Therefore, it is a solid assumption that there will not be any drastic cuts, at least in the short term.

Current Valuation

Despite, LMT’s relatively attractive P/E of 16.95, PPA is weighed by RTX’s P/E over the past year of 40.9 and GE’s 41.7 P/E. As a result, PPA’s P/E ratio has gone up about 6.5% since February, higher than two compared funds.

Valuation Changes for PPA, Peer Competitors, and S&P 500 Index

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Source: Compiled by Author from Multiple Sources, 13 Jul 24

By comparison, S&P 500 P/E ratio from 27.02 in February to 29.34 today, up over 9%. Given PPA’s less attractive valuation since February and several concerning factors of its top holdings, I do not rate the fund a buy. Looking further forward, there are also risk factors for long-term government spending.

Risks to Investors

A key risk factor, particularly for long-term investors, is the sharp increase in government spending as a percentage of GDP. While I already mentioned that spending will likely remain strong in the short term, there may be issues over the long term. Government spending compared to GDP is now at over 120%. This percentage is forecast to potentially hit 150% within the next decade. Such levels would likely result in stunted economic growth, a higher portion of the budget towards servicing this debt, and potentially a debt default.

Because defense spending ultimately impacts defense contracts for PPA’s top holdings, what is more relevant is defense spending as a percentage of this overall budget. A $7T national budget was submitted to congress for FY24. Of that total amount, 13% was for national defense. Other spending areas such as Medicaid, Medicare, and social security also take up large portions of the budget. However, because these programs provide a safety net for so many people, the defense budget could come under scrutiny.

Concluding Summary

Despite a solid price return for PPA since my last article in February, there are concerning factors for PPA’s top holdings, including Boeing and Lockheed Martin. The fund does not necessitate a sell, as both Boeing and Lockheed Martin still demonstrate multiple indicators of resiliency and backlog orders. However, Boeing’s cash position and F-35 delays for Lockheed present risk factors. While short-term defense spending will likely remain high regardless of the next presidential election, long-term concerns exist due to the increasing level of government debt as a percentage of GDP.