|Shares Out. (in M):||614||P/E||16.5||14.7|
|Market Cap (in M):||87,848||P/FCF||12.6||11|
|Net Debt (in M):||-1,600||EBIT||8,365||8,750|
Boeing (BA) is significantly mispriced and offers a highly compelling risk/reward profile. Boeing is one of two key OEMs in the global aerospace industry, which features long-term growth well in excess of GDP, primarily due to increased affordability of air travel. With a powerful moat, BA has excellent and growing returns on capital. Boeing generates a 29% ROIC on just 9.5% margins, which management believe can rise to mid-teens over time. At the low end of our estimates, Boeing will generate $13 of FCF/share in 2017, $15.31 in 2018 and $18.49 in 2019. Boeing has historically traded at 15-17x; using a low forward multiple of 12x to account for the current position in the book/bill cycle, BA would be worth $184 by YE17 and $222 by YE18.
In December, Boeing will raise its dividend to $5-5.50/share for a yield at the low end of 3.5%. On the 4Q release, Boeing will guide to at least $13/share in 2017 with potential for upside.
Since BA is a highly liquid, blue chip company which should be efficiently priced, why does this opportunity exist?
- First, sentiment on the stock is muted. Short interest is 8 days to cover. Another example is BA hasn’t been written up on VIC since 2004 and that write up had no messages.
- Second, the market is overly concerned with book/bill cycle. Sell-side bears are overly focused on a lack of widebody orders this year and the industry book/bill of likely less than 1x this year.
o This cycle is different, since it has been driven more by new product introductions than underlying air traffic fundamentals, which led to significant pull forward of orders in 2013 and 2014 as several new models were launched.
§ Nevertheless, this bear case does have some merit, but was much more compelling in 2013, when book/bill (and, in turn, BA’s multiple) peaked. By 2016, book/bill will likely be under 1 (again primarily due to a pull forward of demand) and resulting long order books.
§ Valuation more than takes into account a bear case. In a severe recessionary scenario, it is difficult to get to trough FCF of anywhere less than $10/share outside of a one-time working capital hit.
- Third, BA uses unique program accounting which attempts to average out prices/margins over the course of its programs. While not diving deep into the details of program accounting here, BA’s adjusted EPS over the past several years was significantly higher than its cash EPS, as BA booked profits on 787 while the 787 actually burned $28bn of cash. 3Q16 results marked the inflection in that trend with the 787 cash flow now significantly outpacing booked profits. While 3Q16 results marked an inflection, the bears continue to say the program has a long way to go to live up to its promised 25-30% cash gross margin profile. The 787 will be at least a 20% gross margin business as a result of initial price penalties on the heavily delayed initial deliveries phase out, mix benefit with the -9 and -10s significantly more profitable than the -8s, supplier step downs as the program matures and Boeing’s own productivity curves (i.e., assembling unit 600 will be cheaper than unit 500).
- Fourth, BA suffers from management credibility issues. While management is in fact credible, Boeing management speaks to a number of different constituencies and balances their rhetoric when speaking to shareholders as it impacts relationships with their unions, governmental entities, its customers and so on. Boeing’s slow motion cut to the 777 program is a case in point, as the company seems to be desperate for orders and not willing to manage supply with demand. In actuality, BA has cunningly used the threat of production cut and impact to its employees to help push the government to finalize the Iran order in a timely manner. While we model the 777 on a worst case basis, we think it’s likely BA can keep rate at 7/month throughout 2017 (which would be a hike to street 2017 numbers) and manage delivered rate from a currently expected 5.5 in 2018 to 4-4.5 (above the worst case 3.5 most sell side analysts assume).
- Finally, the bears model much worse FCF/share estimates due to a misunderstanding of how advanced payments work. Bears also assume management has significant excess costs on the 777X program without crediting them for tailwinds on other key programs.
o BA will face the bulk of the advance payment cash headwind in 2017 as a result of lowered 777 deliveries, so we believe that by the end of ’17, this issue will be moot.
o The 777X program, while unknown, is unlikely to generate significant upfront cash outs aside from the actual physical inventory and minor upfront losses as BA climbs the learning curve in incorporating a composite wing. At the same time, BA will get a tailwind from inventory on both the 737MAX and 787 program that the bears do not incorporate.
In a sluggish global environment, air traffic grew a whopping 7.0% in September and 5.9% YTD, as air traffic continues to exceed GDP growth primarily due to increased affordability (including more middle class in APAC, more Low Cost Carriers like Ryanair aggressively expanding capacity, etc.). In the last recession during the global financial crisis, air traffic was down just 5.5% using the peak to trough on a seasonally adjusted basis; compared to other cyclical industries, that is simply a blip. While the airline industry itself is brutally competitive, BA and Airbus as well as its consolidated supply base, are the key beneficiaries of this long-term secular growth.
IATA publishes monthly air traffic statistics at the following link
The positive outlook for Aerospace is further highlighted by a slew of M&A transactions including Rockwell Collins purchase of B/E Aerospace (despite its heavy exposure to the widebody market), Berkshire Hathaway’s purchase of Precision Castparts, the take-outs of CIT’s aircraft leasing business and Avolon, Solvay’s purchase of CYT (maker of carbon fiber), Alcoa’s purchase of RTI (Titanium), UTX/GR and numerous smaller acquisitions best highlighted by the successful roll up of parts suppliers by Transdigm.
Boeing Investment Case
While Boeing is a long-term growth investment on the long-term secular drivers of Aerospace, it is currently a value stock at just ~11x 2017 FCF on the low end case with no net debt.
Boeing is a relatively simple business delivering just 750 units in its Commercial Aerospace division across 3 main models, the 737, 777 and 787, which comprise 96% of Commercial manufacturing revenues. The 737 (38% of revenues) is a near 30% cash gross margin business that will have increased production in 2017 and 2018 and is undergoing an upgrade cycle with the 737MAX scheduled to be delivered in 2017. Boeing may add another stretched variant to this product to further support orders into the early and mid 2020s. The 777 (26% of revenues) is also undergoing a transformation, though larger in scale, to the 777X. Bridging from the 777 to the 777x will require a significant decline in deliveries with an upturn expected with the launch of the 777X in 2019-2020. The 777X has already secured 4.5 years of backlog at our expected 6 per month normalized delivery rate. The 777 is currently mid-20s cash gross margin business, which will suffer from negative operating leverage as rate comes down. The 787 (32% of revenues) will produce a 4.1% cash gross margin in 2016. The 787 surprised the market by producing a 6% cash gross margin in the third quarter. By 2018, 787 will produce a 17% cash gross margin.
The 787 therefore is the biggest driver of FCF with a 13% cash gross margin improvement expected from 2016 to 2018. On $20bn of revenues, that’s $2.6bn of incremental FCF not including impact from higher ASP. This is driven by a few key factors. 3Q was already at 6% cash gross margin, so that bridges 2 of the 13 points. 3Q had 9 787-8 deliveries that were all low cash gross margin. As the -9s (price 20% higher than -8) and -10s (priced 40% higher than -8s) enter production lines and the -8s decline, BA will benefit from significant mix improvement with minimal added cost with -9 and -10 having very high commonality with the -8. BA itself has publicly stated that 70% of the way to normalized cash margins on the 787 is mix and price. Price/mix will add 7.1% to cash margins from 3Q2016 to 2018. The incremental 390bps of improvement will come from standard aerospace learning curve improvements and supplier step downs. In our diligence, we have uncovered numerous pricing arrangements were BA’s procurement prices drop as its own suppliers go up their own learning curves. Often these occur on 100-unit block changes (we just entered unit 500 in 3Q), or they can simply be driven by time (i.e., on Jan 1 of every year, price drops 2% for example). BA is currently in negotiations with Spirit Aerosystems (SPR), one of its large suppliers on the pricing of the 787 fuselage and cockpit and the question is the magnitude of the decline, not whether SPR will be able to push through an increase.
We have mostly kept our discussion to Commerical Aerospace. Defense, Space & Security will be relatively stable at slightly north of $3bn of EBIT per year.
Below is a summary output of the key drivers of FCF/share for the next several years. The key assumptions here are 737 rate of 52/month (vs. 57 planned), 777 rate of 4, 787 rate of 12 (with an annual rate of 25 on 787-10), and 787 cash gross margin of 18.6%.
Free Cash Flow Per Share YoY Bridge
2014 2015 2016E 2017E 2018E 2019E
Beginning FCF per Share $7.90 $8.98 $9.93 $11.32 $13.04 $15.31
737 0.77 0.25 (0.13) 0.54 1.31 0.87
777 0.11 0.04 (0.34) (0.89) (1.84) 0.03
787 0.63 1.67 2.77 1.93 1.54 0.73
Working Capital (1.50) (0.22) (3.32) (1.13) 1.44 0.61
Capex (0.18) (0.29) (0.50) 0.31 0.33 -
Share Repurchases 0.34 0.54 0.83 0.78 0.61 0.73
Other 0.90 (1.02) 2.08 0.17 (1.11) 0.21
Ending FCF per Share $8.98 $9.93 $11.32 $13.04 $15.31 $18.49
YoY Growth 13.6% 10.7% 13.9% 15.2% 17.5% 20.7%
To address the numerous bears on Boeing, we look at a highly unlikely bear case scenario in 2019. If we assume a monthly rate of just 42 737s (this would compare to BA’s plan of 57 and a backlog of 4,300), 3 777s (despite a backlog of over 300 777X orders to date and a 2017 rate of 7/month), and 10 787s (vs. a plan of 12-14 and despite a backlog of 715 currently). If all those decreases happened at the same time (which would be highly unlikely), then BA will face a significant one-time WC headwind of $4.72/share. Adjusted for that one-time headwind, FCF/Share, would be $11.09/share in 2019.
Free Cash Flow Per Share YoY Bridge
2014 2015 2016E 2017E 2018E 2019E
Beginning FCF per Share $7.90 $8.98 $9.93 $11.32 $13.04 $15.31
737 0.77 0.25 (0.13) 0.54 1.31 (2.57)
777 0.11 0.04 (0.34) (0.89) (1.84) (0.73)
787 0.63 1.67 2.77 1.93 1.54 (1.01)
Working Capital (1.50) (0.22) (3.32) (1.13) 1.44 (4.72)
Capex (0.18) (0.29) (0.50) 0.31 0.33 -
Share Repurchases 0.34 0.54 0.83 0.78 0.61 0.30
Other 0.90 (1.02) 2.08 0.17 (1.11) (0.22)
Ending FCF per Share $8.98 $9.93 $11.32 $13.04 $15.31 $6.37
YoY Growth 13.6% 10.7% 13.9% 15.2% 17.5% -58.4%
With the 787 performance now exceeding expectations, the path for BA’s FCF/share to continue to improve through the end of the decade is apparent. At just 9.3x 2018 FCF and 7.7x 2019 FCF, there exists significant long-term upside in BA. Near term, there is total return of 33.3% to YE16 based on 12x 2018 FCF and a $5 dividend. Downside is protected by strong FCF, a sustainable and growing dividend, (modeling in $5.23 in 2017 or a 3.7% yield and $6 in 2018 (4.2% yield), a fortress balance sheet, an extended backlog, the resiliency of air traffic as shown in the GFC, and significant capital returns (estimate BA will return over 30% of its market cap via dividends and share buyback over the next 3 years).
Significant global recession; Declines in air traffic from terrorism or oil price shock; Longer-term growth rate hit by viable Chinese competitor; Program risks on the 777X or a launch of a new 757.
There are strong catalysts that will highlight the value in the near term. Dividend increase in December, 4Q results demonstrating further 787 cash improvement, and 2017 guidance. Given where sentiment is around aerospace and the “cycle”, orders will be viewed positively, particularly an executed Iran order would fill the 2017 production line for the 777 and give some further visibility to 2018.
|Subject||Your idea is not as novel as you think...|
|Entry||11/09/2016 09:55 AM|
"Another example is BA hasn’t been written up on VIC since 2004 and that write up had no messages."
Below is the link to Novana's excellent write up from July 2015 which has 18 follow up messages
|Subject||Re: Your idea is not as novel as you think...|
|Entry||11/10/2016 07:27 AM|
Avahaz, good point that the idea has been written up a year and a half ago with a similar thesis. I had searched for ticker BA, not BA US, my miskate. Neverheless, the stock and sector has had significant negative sentiment and short interest remains very high for a large cap company at 23mm shares and now 5 days to cover. Also note the stock has been flat since that write-up despite a significant decline in market cap and an increase in FCF, making the idea much more compelling today than it was then. Finally, the write by Novana, while solid, underestimates the impact of the 777 with a $10mm contribution margin and therefore partially explains the underperformance since that write-up. At a rate of 8.3/month, the 777 has low 20s cash gross margins and ~$160mm price tag, so the contribution margin per plane is in fact $37mm. This point is noteworthy, because the numbers in the write up use a significant collapse in the cash profitability of the 777 from producing $3.6bn in cash gross margin in 2016 to $1.2bn in 2018 as a result of the production declines. Even with this headwind (and a nod to the bears who got that right from July 2015 to now), we see cash flow per share growing to $15.30 in 2018.
|Subject||Re: the current financials|
|Entry||11/10/2016 07:47 AM|
Let's use 3Q16 as an example. We estimate BA is carrying the 787 at a 3% reported PNL margin not 0. If you look back at 3Q13, BA had a significant beat as they increased margins on the program. They also slight increased in booked margins as a result of an R&D cost classification in 2Q16. So our starting point is 3%. Deferred production declined by about $150mm and with average price of $137mm and 36 deliveries, we get to another 3%, thereby solving to a 6% cash gross margin in 3Q.
First, i'm not giving full credit to BA's program accounting assumptions and what that means for FCF. Honestly, I think it'll be very difficult for BA to bring deferred balance from $27.5bn to 0 with 778 units left in the block (which would mean the $35mm cash flow on top of the 3% reported PNL margin for a total average gross margin of 26% (assuming average price of about $155mm remaining for the block). The way BA's accounting work is as they go into the block, up the curve on number of deliveries and receive more orders, they will extend the block (the last time they did this was in 3Q13, which led them to increase margins). An easy way for BA to manage the accounting would be to not raise the PNL margin as much as one would think, which would then reduce the needed cash gross margin to make the accounting work on the deferred. That is our assumption in order to be conservative. So here I discuss an 17% cash gross margin vs. the 26%. Bears get too caught up on this; if BA can get to 26% that's great, you just don't need it though to have a compelling view on the stock. If BA can execute on cost, increase rate to 14/month, then the 26% is indeed acheivable; we do see the program settling into the low 20s at a rate of 12/month.
So if our initial bogey is an 17% cash gross margin in 2018 and we are starting at 6% in 3Q16, the bridge of 11 points is pretty straightforward. We see average price moving from $137mm/plane to $151mm/plane, that's $15mm more a plane with very minimal added cost (i.e., BA has repeatedly said it doesn't cost much more to build a -9 vs. -8). We use a 75% incremental margin on price/mix. So that's, $11mm a plane or 7.2 points of margin, so we're at 13.2%. The remaining sub 400bps comes from learning curve (we still only got to unit 500 in a program that will likely be in the 2500-3000 range), efficiencies at running production line at 12/month (3Q was the first full quarter at this rate) and supplier step downs. I think $6mm a plane is a reasonable cost takeout number from 3Q16 to 2018 given that combination.
Thanks for your question.
|Subject||Re: Re: Re: the current financials|
|Entry||11/14/2016 10:18 AM|
thanks for the follow up.
yes, you are correct on understanding the 787 numbers on a per unit basis and correct on the bridge I am not giving them the benefit of lapping through potentially heavily discounted -8s.
overall i am being conservative on my numbers and as you correctly state, there is a large gap between where I am and where accountants/auditors/mgmt are. Those insiders all have the benefit of looking into the full backlog specifics in terms of pricing and mix bnenefit. They also have the benefit of understanding the cost profile (supplier contracts and assembly efficiencies) that I don't have. They also know exaclty what the price penalties on the 787-8 deliveries are and how much that impacted them in the 3Q16 for example. Those are all the key areas of where i am being conservative relative to management. My conversations with suppliers indicate the cost potential there is significant. BA has embedded price increases to their customers while they have embedded price decreases on supply contracts as they flex their OEM muscle.
Why am i being conservative? the bridge is huge as the bears correctly note. Also, i have the experience in owning the stock in 2013 where I had expected a huge "gaap earnings" beat on the 787 booked profits. While the company beat the quarter, they should have beaten the quarter by more as a result of extending the 787 block by 200 units. In a way, they just threw some of the deferred production accounting under the rug (i.e, they should've theoretically brough booked margins to 5=6% instead of low single digits; the delta is allowing for more units to amortize the deferred). I fully expect BA to do this again to help with the bridge. Eventually BA will get deferred to 0, but my guesstimate is it will take longer than the current 1300 block. If I am wrong there is more upside. In any situation, there is huge upside and more upside if i am being too conservative
On the tooling, same reason I don't give them the cash benefit there on the unwind. I am buidling my model on cash basis using assumptions for price, mix and cost. The accounting doesn't drive my numbers, but as I said I still see a path of the accounting being either or manageable as a result of block extensions.
Finally, no write up is now fully complete without some thoughts on the election, so let me just to use post to quickly address that. I have no idea if the new government will or will not label China a currency manipulator (seems unlikely given recent commentary). If that does happen, you'd have to imagine a response by China. This will not affect the current backlog but could affect future orders for BA as the Chinese airlines are a significant source of incremental demand. That's a clear risk, but again there is signfiicant margin of safety given current valuation, cash flow from delivering current backlog as well as its defense business. It's interesting to note that LMT and NOC both trade at 16x EBIT. If one were to give that muliple to BA's defense business, then BA's defense business is worth $50bn of the current $87bn market cap; this is the clear mitigant to the trade risk. When including the FCF generation over the next 4 years on backlog execution, hard to find real fundamental downside to BA on both a trough FCF analysis and a SoP analysis.