|Shares Out. (in M):||1,737||P/E||7.3x||7.3x|
|Market Cap (in $M):||6,069||P/FCF||NM||NM|
|Net Debt (in $M):||2,021||EBIT||1,250||1,270|
At $3.49 Bombardier is trading at 7-8x 2012 earnings of $0.43-0.53 (all currencies in this writeup including the stock quote are in USD; though traded in Canada BBD reports in USD). Including net debt, it trades at 8.7x unlevered after-tax calendar 2012 earnings. Including pension and net debt, it trades at 11.7x unlevered after-tax calendar 2012 earnings.
The market’s chief concerns about Bombardier are (a) exposure of the Transportation segment to declining infrastructure spending by deficit-plagued European governments; and (b) evaporating demand for its commercial aircraft.
These risks are real, but unlikely to reduce long-term earnings more than 10% from 2012 levels. The most significant pieces of the business (Business Jet and Transportation segments, which together constitute roughly 90% of profits) are growing profits, have unlevered after-tax ROICs greater than 20% and enjoy strong franchises within stable oligopolies. Bombardier’s commercial aircraft business has stumbled badly over the last several quarters, though it is now developing a plane that could reverse this unit’s weak performance. The impact of profit declines in commercial aircraft is not likely to reduce 2012 earnings levels more than 3-5 cents a share; the new plane could in a few years add 10-20 cents per share to earnings.
The more significant risk, as with most good businesses trading cheaply, is capital allocation. I discuss that separately below.
The Transportation segment is about 60% of BBD’s profits. Together with Alstom and Siemens, it dominates the market for sophisticated mass transit systems. The segment has a 3 year backlog. Cancellations in this business are rare, though contract delays are not. Roughly 60% of the backlog is to Europe. Though the backlog protects the earnings power of this segment through 2014, the stock’s current low multiple reflects the concern that Europe’s troubles will last beyond the duration of the current backlog and ultimately reduce earnings levels. This is a hard risk to quantify, but should be measured in light of the following:
(a) The rest of the world, particularly emerging markets, should be spending more on transit systems in 2015 than in 2012;
(b) Most of the current backlog is to Germany, Switzerland and Scandinavia, though it includes significant exposure to France, Spain and Italy. Spending on mass transit by governments of Southern Europe may decline as part of austerity measures. However, in both Northern and Southern Europe, mass transit enjoys a status analogous to defense spending in the U.S. budget – the funding provides local jobs and the product meets a widely shared social priority. Apart from severe cuts by fiscally stable Northern European governments, Europe-wide annual spending on mass transit in 2015-2020 is not likely to fall more than 10% from current levels.
(c) Management has committed to take margins to 8% by 2014 from the roughly 7.5% expected in 2012. They have a steady track record of margin improvement over the last 5 years in this segment. Such an improvement would roughly offset the impact on profits of a 10% decline in European spending, which I view as a highly conservative assumption.
This year free cash flow has significantly trailed Transportation earnings, due to execution problems and resulting payment delays. The company will ultimately receive cash for this year’s accrued earnings and this should not be a recurring problem. The Transportation segment generated free cash flow equal to earnings over the last five years.
Business jets (and related services) constitute about 30% of total profits. These profits should grow robustly over the next several years as the global business jet market continues to recover from the blow dealt to it by the financial crisis. The “Global” family of planes (large jets) is about 50-55% by dollar volume of Bombardier’s overall business jets revenue. The large business jet market is recovering steadily from the 08-09 downturn in orders. Global has slightly more than a third of the global large jet market and enjoys a 3 year backlog. Dassault and Gulfstream are its competitors. Its newest models will share a duopoly with Gulfstream’s 650 at the largest end of the global business jet segment.
The Learjet and Challenger families (small and medium, respectively) suffer from the fact that global market inventories of used planes remain high relative to the small and medium fleet. As a result, demand for new planes is recovering more slowly than for large jets. Bombardier’s Learjet and Challenger families have maintained and modestly extended their backlogs over the course of the last year (to 6 months and 12 months respectively). A new Learjet 85 model scheduled for 2013 entry into service may lift orders at some point.
Apart from a significant slowdown in China or recession in the U.S., growing Asian demand is likely to drive decent profit growth from business jets. This assumes Global grows briskly, while Learjet and Challenger remain flat or grow slowly. My 2012 projections assume 2012 margins remain flat with 2011, slightly above 5%. The company has targeted a doubling of its margins to 10%; this seems implausible but some expansion of the margin above 5% should be achievable. Embraer, Boeing, Gulfstream all have margins in high single digits or double digits and any progress in this respect would provide upside on top of what should be at least high single digit revenue growth for business jets.
Commercial (including related services) represents 5- 10% of total company 2012 profits. New orders for existing plane families (Q Series for turboprop and CRJ Series for jet) ground to a halt over the last 12 months. Competitors designed low price-point planes more suitable for demand from emerging markets (ATR in turboprob and Embraer for 50-100 passenger jets), which is where the orders are now coming from. Bombardier has been caught flat-footed with highly functional but expensive models unsuited to emerging markets. Its most recent commercial models, orders for the Q400NextGen and CRJ 1000 planes may pick up if North American and European demand revives, but right now they are not selling.
While the earnings impact from Commercial’s poor performance is modest, the capital the company is spending to address the problem is not. Bombardier will spend at least $2.4 billion over the next 2 years to develop their C Series plane, by which they will seek to enter the market for 100-150 passenger jets, currently dominated by Airbus and Boeing. Entry into service is projected for late 2013. So far demand for the C Series has been tepid (133 firm orders to date, which is the first 2 years of production). Since Bombardier committed to the C Series 2013 launch date, demand for the Airbus and Boeing models of comparable size but inferior cost efficiency (A319NEO and Boeing 737-MAX 7) has been even weaker. The market-wide weakness in demand is puzzling, since there is a significant installed base of aging 100-150 passenger planes and demand for Boeing and Airbus planes in this size was relatively strong until 2-3 years ago. Moreover, new orders for 150-225 passenger planes have been robust. The weakness for the 100-150 passenger planes may reflect a shift in demand to larger planes. If so, Bombardier may be wasting its development money, which will be an incremental $1.00 per share after-tax over the next 2 years (assuming no cost overruns).
Current order weakness may, however, reflect a decision by carriers to withhold orders until Bombardier proves it can deliver the plane on schedule. If the C Series does come in roughly on budget and on schedule and sells, it could expand the company’s earnings power materially. List prices for the 110-seater and 130-seater are $58mm and $78mm respectively. 100 planes per year (the company claims it will sell 175 per year) at average price of $55mm (assume 20% discount to list) would deliver about $5.5 billion of revenue versus current total 2012 commercial manufacturing revenue of about $2 billion.
The business risks to this investment are relatively low. The ROIC and competitive position of about 90% of the earnings are excellent. Apart from sustained global recession, the likelihood of long-term material declines from expected 2012 earnings level of $0.43-0.53 is low and more than compensated for by the 7-8x earnings multiple.
Capital allocation poses a greater risk. The Beaudoin family uses dual-class voting stock to control the company. They excessively levered the balance sheet just prior to 9/11, forcing them to sell the recreation division (to themselves) and sell Bombardier equity at depressed prices into a recession. Laurent Beaudoin, then Chairman, shifted responsibility squarely onto the existing CEO, whom he fired, and installed the well-respected Paul Tellier as CEO. Beaudoin proceeded to inexplicably fire Tellier 2 years later in the wake of good performance. The current CEO, none other than Laurent Beaudoin’s son Pierre, ran the Aerospace division from 2001-2008. This record, more than business risk, may explain the company’s current low valuation. The stock has done nothing but lose money for investors for a decade.
That may also be the opportunity. Even including the 2001 wipeout, the stock has returned nearly 14% (including dividends) for 30 years. The Transportation segment margin has improved steadily over the last decade and the business jets unit has grown profits in line with GD’s Gulfstream. There is opportunity to increase margins in business jets (which are much lower than Gulfstream) and the Beaudoins have committed the company to do so. I would classify their 2001 balance sheet mistake as an error in judgment rather than demonstrating indifference to shareholder value. The 2001 acquisition that destabilized the company’s capital structure would have been an excellent use of capital had it been equity financed; they paid about 2x 2012 EBIT. Since then, the company has paid down debt and, apart from the C Series, not made major capital allocation errors. If 90-150 C Series planes can be sold per year at high single digit margins, the $3.4 billion investment in the plane will have been a good use of capital. If the C Series turns into a bust, I would not expect another large mistake from them for a long time.