Boeing BA US
July 07, 2015 - 5:19am EST by
Novana
2015 2016
Price: 140.00 EPS 0 0
Shares Out. (in M): 700 P/E 0 0
Market Cap (in M): 98,000 P/FCF 0 0
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT 0 0

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  • Aerospace
  • Share Repurchase
  • Dividend
 

Description

Introduction

We’d like to try to make up to VIC readers after the Bombardier debacle with another Aerospace company that will hopefully fare a lot better: Boeing.

We will not spend many lines describing the business of this $100bn market cap, Dow member, as pretty obvious to everybody. Very briefly though, Boeing operates under 3 divisions: Boeing Commercial Airplanes (“BCA”), Boeing Defense Space and Security (“BDS”) and Boeing Capital (“BC”):

·         BCA – c. 70% of sales, ¾ of contribution profits (before central costs)

·         BDS – c. 30% of sales, ¼  of contribution profits

·         BC – negligible

Summary Investment thesis

Boeing represents a compelling risk-adjusted investment proposition at current levels. In our estimates, the company will generate over 50% current market cap in free cash flow over the next 5 years and will use 100% of this free cash flow in dividends and share buybacks. Whilst Boeing has been around for about a century, we’d argue it has never been in such a sweet spot as it is today. We believe that cash flow is about to accelerate dramatically, well above consensus estimates. Furthermore, Boeing has incredible visibility over the next 5-6 years with virtually no development program in the pipeline to spoil the party. We think investors can double their money on a 3-4 year time frame with virtually no downside in a more pessimistic bear case scenario.

Brief business description

 Boeing is the largest Aerospace and Defense Company worldwide with nearly $100bn in sales and 165,000 employees worldwide. Whilst the US represents only c. 25% of the civil business and c. 2/3 of the defense business, the company has very little FX exposure as the vast majority of costs are denominated in USD and virtually 100% of sales are in USD. Over 95% of its properties are based in the US. It has about $500bn in backlog, representing over 5 years in sales.

A word on management

It is crucial when investing in aerospace to get comfortable with management. When dealing with multi-year, multi-billion dollar very complex projects, execution is paramount. The biggest risks in investing in aerospace are associated with program delays and cost overruns. Boeing is not immune from this but we’d argue that current management does instill some degree of confidence that such blunders (see the 787) are a thing of the past. Jim McNerney came on board in 2005 when the 787 was already in the pipeline and his contribution in this regard was actually positive. He successfully reduced costs across all other platforms as well as in the defense business and executed his plan to perfection. Over the last 6 years, Boeing has consistently under promised and over delivered. McNerney recently retired as Chairman of the company and is succeeded by Dennis Muilenburg, a true veteran at Boeing with strong operational experience. The choice of McNerney by the Board is telling: Boeing chose a true operational person, someone that will continue to execute and improve operationally to bring further cost efficiency, cash generation and margin expansion. From this point of view we are relieved Boeing didn’t choose an external person that may have been more focused on growth.

BDS

Boeing Defense Space and Security has the DoD as its major customer representing c. 65% of sales. The second largest customer it NASA. BDS operates under 3 segments:

1.       Boeing Military Aircraft

As the name suggests, this division is responsible for the production of a number of aircrafts for combat (e.g. F/A-18E/F Super Hornet, F-15 Strike Eagle), helicopters (e.g. Chinook, Apache), surveillance and engagement (e.g. C-17) and drones

2.       Network Space & Systems

This segment is involved in military applications, such as missile launches, electronic and communication solutions, as well as commercial applications such as regular satellite launches

3.       Global Service and Support

This segment is focused primarily on military applications, offering training, logistics and overall maintenance services to Defense operations worldwide

Whilst BDS contributes to c. 1/3 of overall earnings from operations before central costs and pensions, we will not spend time on this section for a number of reasons. First and foremost, there is very little debate out there on the prospects of this segment. The effects of recent DoD cuts are clearly visible in results with top line declining from a peak of c. $33bn in 2013 to c. $30bn. The outlook doesn’t look much brighter. However – Boeing is well equipped to deal with this and used current market weakness as an opportunity to take billions of dollars in cost out of the system in the last 2-3 years with plans for further cost cuts. For this reason, notwithstanding some notable program headwinds (for example the  C-17, with 10 deliveries in 2013, 7 in 2014 and the program ending this year) margins actually expanded in the last 2 years, from 9.4% in 2012 to expected 10% this year. The company’s focus on lean manufacturing and cost cutting will lead to further margin expansion even in a depressed macro environment. We actually think that risk is on the upside if DoD budget recovers from the trough in 2015. Our assumptions are very much in line with street consensus: zero top line growth and marginal (20bps) annual margin expansion.

 

BCA

Boeing Commercial Airplanes includes the production of the 737, 747, 767, 777 and 787. In order of importance from a current year delivery standpoint:

·         737 - The 737 is the longest serving, world’s best-selling family of commercial jetliners. During 2014, its 5,000th Next-Generation 737 was delivered. In August 2011, Boeing launched the 737MAX, which is a family of aircrafts build on the 737NG model with new CFM engines and other technological improvements. Since its launch, the 737MAX achieved 2,725 orders. Its first flight is planned for 2016 with first delivery in 2017. This year, we expect c. 500 deliveries of the 737

·         787 – The Dreamliner entered into service for the first time in 2011 after years of delay (and c. $50bn in costs to date). The troubled Dreamliner, whilst a disaster from a financial standpoint, it actually gained quite some traction commercially with over 1,100 orders to date (and 282 deliveries to date). This program has been the biggest cash drainer for Boeing. It is expected to deliver c. 130 planes this year

·         777 – The Boeing 777 was introduced first in 1995 for very long distances and able to carry up to 400 passengers. Before the introduction of the A350, the 777 had basically no competition and enjoyed strong pricing power. Whilst not disclosed, it is widely assumed that Boeing earns up to 30% contribution margin on the 777, the highest margin of all planes. In 2020, Boeing will introduce the next generation of 777, the 777x. Being will deliver c. 96 777s this year

·         747 – The famous “Jumbo jet” is at the end of its glorious career, having been in production is some shape or another for c. 40 years. Demand for the 747 is falling and we expect production to fall to just 1 plane per month in the last years of the program

·         767 – As the 747, the 767 is also destined to be retired soon. Commercially, it fits between the 737 and the 787 and the current economics of the plane make it unattractive. Last year only 6 767s were delivered. We don’t expect a new 767 to enter into service before the middle of the next decade

Acceleration in cash generation

The reason Boeing is attractive today is because of its free cash generation acceleration expected over the next 5 years. There are a number of factors contributing to it:

1.       Unwinding of deferred costs on 787

As mentioned, the 787 has been a total disaster with c. $50bn in sunk costs to date. Of these, c. $30bn are capitalized and will be amortized over the remaining duration of the program accounting. For those that are not familiar with program accounting, Boeing sets a reasonable “block” on a program and calculates an average margin over the life of the program. In the case of the 787, the block consists of 1,300 and the company assumes “low single digit” margins on this program. When cash costs are above average program margins, Boeing capitalizes deferred costs. Vice versa, as we go down the learning curve and costs go down and cash margins improve, Boeing still reports the same margin in P&L but is actually generating cash. The difference is to be found in deferred costs which are being amortized. As of Q1-15, Boeing had over $30bn in deferred costs to be recovered in the program. “At March 31 2015, $22,357 of 787 deferred production costs, unamortized tooling and other non-recurring costs are expected to be recovered from units included in the program accounting quantity that have firm orders and $8,498 is expected to be recovered from units included in the program accounting quantity that represent expected future orders”. Under our assumptions, the program will be completed by 2021. This means that between the time deferred costs will start declining (we think Q1-16) and 2021, the company will generate c. $30bn in cash above accounting P&L. Effectively, this is, on average, c. $5bn in annual free cash flow tailwind pre-tax. Because Boeing pays taxes on cash margin and not accounting margins, net of taxes this represent c. $3.5bn of annual free cash flow tailwind over the next 6 years. Much controversy is going about the exact timing of deferred costs: will they peak in Q4-15? Q1-16? Q4-16? The bear case on Boeing is predicated on the fact that the learning curve on the 787 apparently flattened and deferred costs are not coming down fast enough. After a big deceleration in deferred costs build up in Q1-14, the learning curve seems to have flattened over the last 3 quarters which would imply that further margin expansion on a cash basis will be hard to come by for Boeing.

In reality, the program seems to be progressing as per management expectations. The sell side seems to be missing the fact that Boeing is transitioning from the 787-8 to the 787-9 which has similar (but higher) costs but much higher selling price, so as the proportion of 787-9s increases, deferred costs will rapidly peak and then decline to zero over the next 6 years. For those interested, DB is probably the clearest on the sell side on this point

2.       737 production increase

The second big reason for FCF acceleration is due to increased production of the 737. Whilst undisclosed, we believe the 737 is currently earning margins in the vicinity of 20%. It is effectively sold out to 2020 and production is set to increase markedly over the next couple of years. We believe Boeing will deliver c. 620 737 in 2019 which is c. 130 more than in 2015. Very simplistically, assuming c. $10m of margin per plane, that’s c. $1.3bn in incremental EBIT a year on average

3.       Pension costs

The third reason for the acceleration in free cash flow is linked to pension costs. Historically, Boeing had a sizeable defined benefit pension scheme that had to be funded annually. Beginning in 2016, following a renegotiation with the unions, around 90% of the workforce will be covered by defined contribution plan. At 2014 year end, Boeing’s plan was $17.3 billion underfunded on a GAAP basis, but due to the extension of MAP-21 (the HATFA legislation) for ERISA funding calculations, necessary funding should be very small over the next couple of years (the company assumes zero funding in the foreseeable future). With the recent sun setting of the main defined benefit plan (and with a potential rise in rates…not banking on this), BA significantly reduced its potential liabilities which were once a big drag on cash flow. This is not in consensus and bears like UBS assume c. $1.5bn in annual voluntary pension contributions going forward

4.       Absence of large development programs

This is not a positive factor in cash generation but it does significantly reduce the risk of cash burn due to cost overruns on large programs. The issue with large OEMs has always been the large amount of capital that went into new programs that didn’t earn the required returns because of delays and cost overruns (see A380, B787, and Bombardier C-Series). For the first time in its history, Boeing has probably a decade of visibility on existing programs with no obvious need to invest in new ones. The duopoly is well consolidated and neither Airbus nor Boeing has much interest in diluting returns venturing into unnecessary developments. Boeing will be focused on its 3 core programs to generated shareholders return: 737, 777 and the 787. Each one will be a material cash generator. Looking at the 4 programs under development:

·         787-9 will turn cash flow positive in 2016 as discussed above

·         The 737MAX has full deck commonality with the 737NG, substantially reducing development risks

·         The 787-10 has 95% commonality with the 787-9, hence very low risk

·         The 777x is probably the only program that will absorb some cash in its development over the next couple of years but the magnitude is such not to cause us major worries

5.       Margin upside

We don’t factor much margin upside going forward. However, as program blocks get extended, so will reported margins. Furthermore, Boeing’s R&D spending will provide some operating leverage having now spent most of what was needed on the 787. The next program (767?) will only materialize in the next decade, we think.

 

The bear case

We wouldn’t be able to buy Boeing at such attractive valuation (see below, forward 10% FCF yield) if not for some bear cases clouding the story. Very briefly, we list some of the commonly cited ones:

·         End of cycle. Conventional wisdom say “buy when book to bill is low and sell when it’s high”. Boeing has had book to bill above 1.0x for years now and at some point it will naturally drop. In fact, book-to-bill was below 1x in Q1 and Q2 2015. Last time it happened it was in 2009. See yesterday’s GS bear note on this. When this will intensify, Boeing will need to adjust its production line, so the bears say. We think we are in the midst of a super-cycle in commercial aviation and a year of lower than 1x book-to-bill is only natural and won’t change things. In the past, lower orders and cancellations had huge impact on Boeing but backlog stood at only 2-3 years. Today backlogs covers c. 8 years of production for most programs so a weak year from a commercial perspective won’t affect planned delivery. Furthermore, airlines have never been so profitable over the last 20 years which diminish the risk of cancellations. Load factors increased c. 15% from 65% 20 years ago to almost 80% today, effectively “eating” some of demand through better aircraft mutilation. We think the industry reached a likely maximum in terms of load factor. Finally, Boeing order book has never been so geographically diversified making it less prone to regional macroeconomic shocks

·         787 deferred costs to disappoint. We touched on this point above. Bears believe that Boeing is a few quarters away from peak deferred costs. In some ways, we don’t really care because the $30bn in deferred costs will eventually be recovered over the next 6 years and trying to model it on a quarterly basis seems useless. It may happen in Q1-16 or in Q3-16, we don’t really mind because it will happen

·         Bridge to 777x. There is a short term gap to bridge in terms of orders to match the expected deliveries of the 777. The 777x will be delivered in 2020 so there are c. 4.5 years of production to fill on the older 777. To date, there are 262 unfilled orders. We estimate that there are currently c. 400-425 incremental 777 to be delivered in the supply chain assumption before the 777x comes into service. This implies c. 150 of orders needed to fill this gap or c. 50 per year over the next 3 years. The risk of production shortfall is material. Assuming $10m in contribution margin per plane, that’s c. $500m downside to cash flow on an annual basis, or c. 7-8% of base free cash flow. This would be a worst case scenario. We are not too worried: a) even a $1.5bn cumulative impact to FCF would correspond to less than 2% of market cap, not material enough to move the needle fundamentally, and b) Boeing has ample time to get these orders given the fact 2015 and 2016 are fully booked already

·         Lack of earnings momentum. Boeing historically guided very conservatively and almost inevitably beat both on EPS and on Free Cash Flow. Over the last 3 quarters, EPS surprise turned negative, partially due to the fact that the Street moved at the high end of guidance given the company previous track record of beating estimates. Furthermore, for the first time in years Boeing had in Q1-15 a quarter of negative free cash flow. We are not particularly bothered by these short term noises to the overall long term thesis

·         Pre delivery payments. Boeing generated significant amount of cash in the past from advances and progress billings from customers. In 2014, advances and progress billings increased from $25.5bn to $29.2bn, generating c. $3.7bn in cash. The bear case is that as the order book will go below 1x, there will be fewer advances (i.e. down payments) and from being a source of cash, advances and process billings will decline, becoming a drag on cash. In reality though, the vast majority of cash comes from progress payments which starts c. 24 to 12 months before deliveries. The down payment part is very small. For this reason, cash from progress billings is much more tied to deliveries than to orders. As Boeing deliveries are set to increase, we expect this to remain a source of cash. Over the last 10 years, pre delivery payments have been a drag on cash flow only in 2009, a year when deliveries actually declined. As long as deliveries increase, it will remain a source of cash for Boeing

 

Putting the above together

We believe Boeing will be able to generate c. $55bn in free cash flow over the next 5 years, equal to over half of its market cap. Given its net cash position, we believe Boeing will use 100% of free cash flow in dividends and share buybacks. Simplistically:

Cumulative 2016-2020 (5 years)

 

Normalized 2015 free cash flow

7,500

5 years of normalized cash flow

37,500

Plus: $25bn in deferred cost taxed @ 30%

17,500

Plus: after tax increase in 737 production

4,200

Less: after tax $5bn deferred costs on 777x

(3,500)

Total Cash flow next 5 years

55,700

 

The above is a very summary view of cash flow generation over the next 5 years. The output of our more detailed model is the following:

Cash Flow

2014

2015

2016

2017

2018

2019

2020

Net earnings

5,446

5,904

5,983

6,616

7,207

7,647

8,159

Stock comp

195

201

207

213

220

226

233

Depreciation and amortisation

1,906

1,982

1,988

2,108

2,202

2,304

2,368

Other

414

(360)

(103)

(107)

(110)

(113)

(116)

Total changes in working capital:

897

2,376

3,350

4,050

3,700

4,260

4,190

Receivables

(1,328)

(202)

(200)

(200)

(200)

(200)

(200)

Inventory

(4,330)

(1,687)

1,750

3,500

3,000

3,800

3,700

Payables

1,339

578

300

300

300

300

300

Customer advances

3,145

920

500

500

500

500

500

Deferred Income tax

1,325

830

-

(1,050)

(900)

(1,140)

(1,110)

Pension and post retirement plans

1,186

1,988

1,000

1,000

1,000

1,000

1,000

Other  

(440)

(50)

-

-

-

-

-

Total cash from operating activities

8,858

10,103

11,424

12,880

13,219

14,324

14,833

               

CAPEX

(2,202)

(2,655)

(2,500)

(2,500)

(2,500)

(2,500)

(2,500)

Free Cash Flow

6,656

7,448

8,924

10,380

10,719

11,824

12,333

Per share

$9.02

$10.62

$13.31

$16.25

$17.65

$20.52

$22.42

Growth (%)

13%

18%

25%

22%

9%

16%

9%

 

Applying a 12.5 forward FCF multiple, we see almost 100% upside on a 3 year basis:

 

Base Case Scenario

FCF yield

3yrs

Forward FCF per share

 

$20.52

FCF multiple at exit

8.0%

12.5x

Exit price

 

 

$256

Dividends (cumulative)

$12.83

Exit price including dividends

$269

Gross Return

 

92%

IRR  

 

 

24%

Forward EPS

 

$13.61

Forward P/E at exit

 

18.8x

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • 787 Deferred cost coming down
  • FCF generation coming above expectations
  • Continued buybacks
    sort by   Expand   New

    Description

    Introduction

    We’d like to try to make up to VIC readers after the Bombardier debacle with another Aerospace company that will hopefully fare a lot better: Boeing.

    We will not spend many lines describing the business of this $100bn market cap, Dow member, as pretty obvious to everybody. Very briefly though, Boeing operates under 3 divisions: Boeing Commercial Airplanes (“BCA”), Boeing Defense Space and Security (“BDS”) and Boeing Capital (“BC”):

    ·         BCA – c. 70% of sales, ¾ of contribution profits (before central costs)

    ·         BDS – c. 30% of sales, ¼  of contribution profits

    ·         BC – negligible

    Summary Investment thesis

    Boeing represents a compelling risk-adjusted investment proposition at current levels. In our estimates, the company will generate over 50% current market cap in free cash flow over the next 5 years and will use 100% of this free cash flow in dividends and share buybacks. Whilst Boeing has been around for about a century, we’d argue it has never been in such a sweet spot as it is today. We believe that cash flow is about to accelerate dramatically, well above consensus estimates. Furthermore, Boeing has incredible visibility over the next 5-6 years with virtually no development program in the pipeline to spoil the party. We think investors can double their money on a 3-4 year time frame with virtually no downside in a more pessimistic bear case scenario.

    Brief business description

     Boeing is the largest Aerospace and Defense Company worldwide with nearly $100bn in sales and 165,000 employees worldwide. Whilst the US represents only c. 25% of the civil business and c. 2/3 of the defense business, the company has very little FX exposure as the vast majority of costs are denominated in USD and virtually 100% of sales are in USD. Over 95% of its properties are based in the US. It has about $500bn in backlog, representing over 5 years in sales.

    A word on management

    It is crucial when investing in aerospace to get comfortable with management. When dealing with multi-year, multi-billion dollar very complex projects, execution is paramount. The biggest risks in investing in aerospace are associated with program delays and cost overruns. Boeing is not immune from this but we’d argue that current management does instill some degree of confidence that such blunders (see the 787) are a thing of the past. Jim McNerney came on board in 2005 when the 787 was already in the pipeline and his contribution in this regard was actually positive. He successfully reduced costs across all other platforms as well as in the defense business and executed his plan to perfection. Over the last 6 years, Boeing has consistently under promised and over delivered. McNerney recently retired as Chairman of the company and is succeeded by Dennis Muilenburg, a true veteran at Boeing with strong operational experience. The choice of McNerney by the Board is telling: Boeing chose a true operational person, someone that will continue to execute and improve operationally to bring further cost efficiency, cash generation and margin expansion. From this point of view we are relieved Boeing didn’t choose an external person that may have been more focused on growth.

    BDS

    Boeing Defense Space and Security has the DoD as its major customer representing c. 65% of sales. The second largest customer it NASA. BDS operates under 3 segments:

    1.       Boeing Military Aircraft

    As the name suggests, this division is responsible for the production of a number of aircrafts for combat (e.g. F/A-18E/F Super Hornet, F-15 Strike Eagle), helicopters (e.g. Chinook, Apache), surveillance and engagement (e.g. C-17) and drones

    2.       Network Space & Systems

    This segment is involved in military applications, such as missile launches, electronic and communication solutions, as well as commercial applications such as regular satellite launches

    3.       Global Service and Support

    This segment is focused primarily on military applications, offering training, logistics and overall maintenance services to Defense operations worldwide

    Whilst BDS contributes to c. 1/3 of overall earnings from operations before central costs and pensions, we will not spend time on this section for a number of reasons. First and foremost, there is very little debate out there on the prospects of this segment. The effects of recent DoD cuts are clearly visible in results with top line declining from a peak of c. $33bn in 2013 to c. $30bn. The outlook doesn’t look much brighter. However – Boeing is well equipped to deal with this and used current market weakness as an opportunity to take billions of dollars in cost out of the system in the last 2-3 years with plans for further cost cuts. For this reason, notwithstanding some notable program headwinds (for example the  C-17, with 10 deliveries in 2013, 7 in 2014 and the program ending this year) margins actually expanded in the last 2 years, from 9.4% in 2012 to expected 10% this year. The company’s focus on lean manufacturing and cost cutting will lead to further margin expansion even in a depressed macro environment. We actually think that risk is on the upside if DoD budget recovers from the trough in 2015. Our assumptions are very much in line with street consensus: zero top line growth and marginal (20bps) annual margin expansion.

     

    BCA

    Boeing Commercial Airplanes includes the production of the 737, 747, 767, 777 and 787. In order of importance from a current year delivery standpoint:

    ·         737 - The 737 is the longest serving, world’s best-selling family of commercial jetliners. During 2014, its 5,000th Next-Generation 737 was delivered. In August 2011, Boeing launched the 737MAX, which is a family of aircrafts build on the 737NG model with new CFM engines and other technological improvements. Since its launch, the 737MAX achieved 2,725 orders. Its first flight is planned for 2016 with first delivery in 2017. This year, we expect c. 500 deliveries of the 737

    ·         787 – The Dreamliner entered into service for the first time in 2011 after years of delay (and c. $50bn in costs to date). The troubled Dreamliner, whilst a disaster from a financial standpoint, it actually gained quite some traction commercially with over 1,100 orders to date (and 282 deliveries to date). This program has been the biggest cash drainer for Boeing. It is expected to deliver c. 130 planes this year

    ·         777 – The Boeing 777 was introduced first in 1995 for very long distances and able to carry up to 400 passengers. Before the introduction of the A350, the 777 had basically no competition and enjoyed strong pricing power. Whilst not disclosed, it is widely assumed that Boeing earns up to 30% contribution margin on the 777, the highest margin of all planes. In 2020, Boeing will introduce the next generation of 777, the 777x. Being will deliver c. 96 777s this year

    ·         747 – The famous “Jumbo jet” is at the end of its glorious career, having been in production is some shape or another for c. 40 years. Demand for the 747 is falling and we expect production to fall to just 1 plane per month in the last years of the program

    ·         767 – As the 747, the 767 is also destined to be retired soon. Commercially, it fits between the 737 and the 787 and the current economics of the plane make it unattractive. Last year only 6 767s were delivered. We don’t expect a new 767 to enter into service before the middle of the next decade

    Acceleration in cash generation

    The reason Boeing is attractive today is because of its free cash generation acceleration expected over the next 5 years. There are a number of factors contributing to it:

    1.       Unwinding of deferred costs on 787

    As mentioned, the 787 has been a total disaster with c. $50bn in sunk costs to date. Of these, c. $30bn are capitalized and will be amortized over the remaining duration of the program accounting. For those that are not familiar with program accounting, Boeing sets a reasonable “block” on a program and calculates an average margin over the life of the program. In the case of the 787, the block consists of 1,300 and the company assumes “low single digit” margins on this program. When cash costs are above average program margins, Boeing capitalizes deferred costs. Vice versa, as we go down the learning curve and costs go down and cash margins improve, Boeing still reports the same margin in P&L but is actually generating cash. The difference is to be found in deferred costs which are being amortized. As of Q1-15, Boeing had over $30bn in deferred costs to be recovered in the program. “At March 31 2015, $22,357 of 787 deferred production costs, unamortized tooling and other non-recurring costs are expected to be recovered from units included in the program accounting quantity that have firm orders and $8,498 is expected to be recovered from units included in the program accounting quantity that represent expected future orders”. Under our assumptions, the program will be completed by 2021. This means that between the time deferred costs will start declining (we think Q1-16) and 2021, the company will generate c. $30bn in cash above accounting P&L. Effectively, this is, on average, c. $5bn in annual free cash flow tailwind pre-tax. Because Boeing pays taxes on cash margin and not accounting margins, net of taxes this represent c. $3.5bn of annual free cash flow tailwind over the next 6 years. Much controversy is going about the exact timing of deferred costs: will they peak in Q4-15? Q1-16? Q4-16? The bear case on Boeing is predicated on the fact that the learning curve on the 787 apparently flattened and deferred costs are not coming down fast enough. After a big deceleration in deferred costs build up in Q1-14, the learning curve seems to have flattened over the last 3 quarters which would imply that further margin expansion on a cash basis will be hard to come by for Boeing.

    In reality, the program seems to be progressing as per management expectations. The sell side seems to be missing the fact that Boeing is transitioning from the 787-8 to the 787-9 which has similar (but higher) costs but much higher selling price, so as the proportion of 787-9s increases, deferred costs will rapidly peak and then decline to zero over the next 6 years. For those interested, DB is probably the clearest on the sell side on this point

    2.       737 production increase

    The second big reason for FCF acceleration is due to increased production of the 737. Whilst undisclosed, we believe the 737 is currently earning margins in the vicinity of 20%. It is effectively sold out to 2020 and production is set to increase markedly over the next couple of years. We believe Boeing will deliver c. 620 737 in 2019 which is c. 130 more than in 2015. Very simplistically, assuming c. $10m of margin per plane, that’s c. $1.3bn in incremental EBIT a year on average

    3.       Pension costs

    The third reason for the acceleration in free cash flow is linked to pension costs. Historically, Boeing had a sizeable defined benefit pension scheme that had to be funded annually. Beginning in 2016, following a renegotiation with the unions, around 90% of the workforce will be covered by defined contribution plan. At 2014 year end, Boeing’s plan was $17.3 billion underfunded on a GAAP basis, but due to the extension of MAP-21 (the HATFA legislation) for ERISA funding calculations, necessary funding should be very small over the next couple of years (the company assumes zero funding in the foreseeable future). With the recent sun setting of the main defined benefit plan (and with a potential rise in rates…not banking on this), BA significantly reduced its potential liabilities which were once a big drag on cash flow. This is not in consensus and bears like UBS assume c. $1.5bn in annual voluntary pension contributions going forward

    4.       Absence of large development programs

    This is not a positive factor in cash generation but it does significantly reduce the risk of cash burn due to cost overruns on large programs. The issue with large OEMs has always been the large amount of capital that went into new programs that didn’t earn the required returns because of delays and cost overruns (see A380, B787, and Bombardier C-Series). For the first time in its history, Boeing has probably a decade of visibility on existing programs with no obvious need to invest in new ones. The duopoly is well consolidated and neither Airbus nor Boeing has much interest in diluting returns venturing into unnecessary developments. Boeing will be focused on its 3 core programs to generated shareholders return: 737, 777 and the 787. Each one will be a material cash generator. Looking at the 4 programs under development:

    ·         787-9 will turn cash flow positive in 2016 as discussed above

    ·         The 737MAX has full deck commonality with the 737NG, substantially reducing development risks

    ·         The 787-10 has 95% commonality with the 787-9, hence very low risk

    ·         The 777x is probably the only program that will absorb some cash in its development over the next couple of years but the magnitude is such not to cause us major worries

    5.       Margin upside

    We don’t factor much margin upside going forward. However, as program blocks get extended, so will reported margins. Furthermore, Boeing’s R&D spending will provide some operating leverage having now spent most of what was needed on the 787. The next program (767?) will only materialize in the next decade, we think.

     

    The bear case

    We wouldn’t be able to buy Boeing at such attractive valuation (see below, forward 10% FCF yield) if not for some bear cases clouding the story. Very briefly, we list some of the commonly cited ones:

    ·         End of cycle. Conventional wisdom say “buy when book to bill is low and sell when it’s high”. Boeing has had book to bill above 1.0x for years now and at some point it will naturally drop. In fact, book-to-bill was below 1x in Q1 and Q2 2015. Last time it happened it was in 2009. See yesterday’s GS bear note on this. When this will intensify, Boeing will need to adjust its production line, so the bears say. We think we are in the midst of a super-cycle in commercial aviation and a year of lower than 1x book-to-bill is only natural and won’t change things. In the past, lower orders and cancellations had huge impact on Boeing but backlog stood at only 2-3 years. Today backlogs covers c. 8 years of production for most programs so a weak year from a commercial perspective won’t affect planned delivery. Furthermore, airlines have never been so profitable over the last 20 years which diminish the risk of cancellations. Load factors increased c. 15% from 65% 20 years ago to almost 80% today, effectively “eating” some of demand through better aircraft mutilation. We think the industry reached a likely maximum in terms of load factor. Finally, Boeing order book has never been so geographically diversified making it less prone to regional macroeconomic shocks

    ·         787 deferred costs to disappoint. We touched on this point above. Bears believe that Boeing is a few quarters away from peak deferred costs. In some ways, we don’t really care because the $30bn in deferred costs will eventually be recovered over the next 6 years and trying to model it on a quarterly basis seems useless. It may happen in Q1-16 or in Q3-16, we don’t really mind because it will happen

    ·         Bridge to 777x. There is a short term gap to bridge in terms of orders to match the expected deliveries of the 777. The 777x will be delivered in 2020 so there are c. 4.5 years of production to fill on the older 777. To date, there are 262 unfilled orders. We estimate that there are currently c. 400-425 incremental 777 to be delivered in the supply chain assumption before the 777x comes into service. This implies c. 150 of orders needed to fill this gap or c. 50 per year over the next 3 years. The risk of production shortfall is material. Assuming $10m in contribution margin per plane, that’s c. $500m downside to cash flow on an annual basis, or c. 7-8% of base free cash flow. This would be a worst case scenario. We are not too worried: a) even a $1.5bn cumulative impact to FCF would correspond to less than 2% of market cap, not material enough to move the needle fundamentally, and b) Boeing has ample time to get these orders given the fact 2015 and 2016 are fully booked already

    ·         Lack of earnings momentum. Boeing historically guided very conservatively and almost inevitably beat both on EPS and on Free Cash Flow. Over the last 3 quarters, EPS surprise turned negative, partially due to the fact that the Street moved at the high end of guidance given the company previous track record of beating estimates. Furthermore, for the first time in years Boeing had in Q1-15 a quarter of negative free cash flow. We are not particularly bothered by these short term noises to the overall long term thesis

    ·         Pre delivery payments. Boeing generated significant amount of cash in the past from advances and progress billings from customers. In 2014, advances and progress billings increased from $25.5bn to $29.2bn, generating c. $3.7bn in cash. The bear case is that as the order book will go below 1x, there will be fewer advances (i.e. down payments) and from being a source of cash, advances and process billings will decline, becoming a drag on cash. In reality though, the vast majority of cash comes from progress payments which starts c. 24 to 12 months before deliveries. The down payment part is very small. For this reason, cash from progress billings is much more tied to deliveries than to orders. As Boeing deliveries are set to increase, we expect this to remain a source of cash. Over the last 10 years, pre delivery payments have been a drag on cash flow only in 2009, a year when deliveries actually declined. As long as deliveries increase, it will remain a source of cash for Boeing

     

    Putting the above together

    We believe Boeing will be able to generate c. $55bn in free cash flow over the next 5 years, equal to over half of its market cap. Given its net cash position, we believe Boeing will use 100% of free cash flow in dividends and share buybacks. Simplistically:

    Cumulative 2016-2020 (5 years)

     

    Normalized 2015 free cash flow

    7,500

    5 years of normalized cash flow

    37,500

    Plus: $25bn in deferred cost taxed @ 30%

    17,500

    Plus: after tax increase in 737 production

    4,200

    Less: after tax $5bn deferred costs on 777x

    (3,500)

    Total Cash flow next 5 years

    55,700

     

    The above is a very summary view of cash flow generation over the next 5 years. The output of our more detailed model is the following:

    Cash Flow

    2014

    2015

    2016

    2017

    2018

    2019

    2020

    Net earnings

    5,446

    5,904

    5,983

    6,616

    7,207

    7,647

    8,159

    Stock comp

    195

    201

    207

    213

    220

    226

    233

    Depreciation and amortisation

    1,906

    1,982

    1,988

    2,108

    2,202

    2,304

    2,368

    Other

    414

    (360)

    (103)

    (107)

    (110)

    (113)

    (116)

    Total changes in working capital:

    897

    2,376

    3,350

    4,050

    3,700

    4,260

    4,190

    Receivables

    (1,328)

    (202)

    (200)

    (200)

    (200)

    (200)

    (200)

    Inventory

    (4,330)

    (1,687)

    1,750

    3,500

    3,000

    3,800

    3,700

    Payables

    1,339

    578

    300

    300

    300

    300

    300

    Customer advances

    3,145

    920

    500

    500

    500

    500

    500

    Deferred Income tax

    1,325

    830

    -

    (1,050)

    (900)

    (1,140)

    (1,110)

    Pension and post retirement plans

    1,186

    1,988

    1,000

    1,000

    1,000

    1,000

    1,000

    Other  

    (440)

    (50)

    -

    -

    -

    -

    -

    Total cash from operating activities

    8,858

    10,103

    11,424

    12,880

    13,219

    14,324

    14,833

                   

    CAPEX

    (2,202)

    (2,655)

    (2,500)

    (2,500)

    (2,500)

    (2,500)

    (2,500)

    Free Cash Flow

    6,656

    7,448

    8,924

    10,380

    10,719

    11,824

    12,333

    Per share

    $9.02

    $10.62

    $13.31

    $16.25

    $17.65

    $20.52

    $22.42

    Growth (%)

    13%

    18%

    25%

    22%

    9%

    16%

    9%

     

    Applying a 12.5 forward FCF multiple, we see almost 100% upside on a 3 year basis:

     

    Base Case Scenario

    FCF yield

    3yrs

    Forward FCF per share

     

    $20.52

    FCF multiple at exit

    8.0%

    12.5x

    Exit price

     

     

    $256

    Dividends (cumulative)

    $12.83

    Exit price including dividends

    $269

    Gross Return

     

    92%

    IRR  

     

     

    24%

    Forward EPS

     

    $13.61

    Forward P/E at exit

     

    18.8x

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Messages


    SubjectRe: Multiple on Cash Flow Generation from Working Capital
    Entry07/07/2015 03:03 PM
    MemberNovana

    The whole point is that fcf reflects true underlying cash generation of the business. You see it in WC just because of program accounting, if the company were to report under cost accounting it'd be in the P&L, not in WC


    Subjectcurrency issues
    Entry07/08/2015 10:30 AM
    Membermiser861

    How big of a deal is the strong dollar/weak euro phenomenon for BA?


    SubjectRe: currency issues
    Entry07/08/2015 11:01 AM
    MemberNovana

    Good question, it was my first worry when I looked at it because I know how big of a deal it is for Airbus. Boeing has virtually 100% of revenues and nearly 100% of costs in USD. The transaction effect is therefore minimal. 

    The medium term issue is one of competiveness with Airbus. It's clear that Airbus has an advantage if the Euro were to stay here forever. However, Airbus has long term hedges in place and will benefit materially only in 2018-2020. Furthermore, and more importantly, the commercial aerospace market is a USD denominated market and given Boeing (and Airbus) backlogs, the top line is already secured over the next 5 years or so in USD. The risk is therefore very small.

    The longer term (i.e. into next decade) issue is that Airbus could use some of its fx advantage to cut prices and capture market share instead of internalising margins. I am pretty comfortable about this risk: 1) Airbus management is clever enough to capitalise on fx advantage to drive margins / free cash flow and not spoil the equilibrium in a perfect duopoly, 2) we are talking about a risk materialising 5-6 years down the line

     


    Subjectbook to bill and 8 year backlog
    Entry07/08/2015 01:08 PM
    Memberjessie993

    hi

    thanks for the writeup. i differ on a few points which i'd like to discuss. i will put them in different heading for clarity.

    on book to bill and the 8 year backlog...the 8 year backlog stretches over many more than 8 years so unclear to me why this is a fair characteriziation.  the operating leverage in the business is very large so if there is a cut on the 777 program doesnt that impair the next couple of years?

    and on book to bill...hers is why i think it matters. when book to bill is above 1, cash flow is very strong because you get advanced payments and it is an indicator that production can increase. as long as production increases, cash flow should be very strong. unlike many book to bill businesses, cash flow actually come early than accounting income here. so that is sort a good quality of the business in that your customers fund your production. but that also means cash flow peaks as production growth rate peaks or slighlty after.  in other words, accounting income is generated when the plane is delivered. and cash flow is generated earlier and sometimes much earlier.

    so you sort of have to care about orders and book to bill because that drives cash flow, no? i mean you cant really argue that you own this for cash flow and also for backlog visiblity.  that is because today's backlog is actually generating teh cash flow. it's not really on the come so to speak. 

    maybe im oversimplifying....or maybe i have it wrong but im pretty sure this is how their accounting works. otherwise wouldnt cash flow always be higher than net income? which isnt really possible...

     

     

     


    SubjectRe: book to bill and 8 year backlog
    Entry07/08/2015 01:27 PM
    Memberjso1123

    My understanding (and please correct me if wrong here) is that the customer pre-payment cycle begins with a non-refundable deposit at order that is small (2-5% of the value of the plane) and that the serious pre-payments kick in ~18-24 months before the plane is delivered to align with the inventory/working capital build at Boeing as they begin production.  If I recall from meeting with Airbus, it's something like 2-5% up front then 15-20% type payments in intervals at different milestones.  

    Bottom line is if you look at "prepayments" in the cash flow statement, the vast majority of that # isn't deposits on new orders but pre-production payments within 18-24 months of delivery.  

    Therefore cash flow will not be that sensitive to order rates.

    Let me know if anyone disagrees.

     


    SubjectRe: book to bill and 8 year backlog
    Entry07/08/2015 01:31 PM
    MemberNovana

    Jessie993,

    not sure if you missed this in the write up. You are asking about the 777 and pre delivery payments. Let me copy and paste on these specific 2 points from the write up that highlight the bear case:

       Bridge to 777x. There is a short term gap to bridge in terms of orders to match the expected deliveries of the 777. The 777x will be delivered in 2020 so there are c. 4.5 years of production to fill on the older 777. To date, there are 262 unfilled orders. We estimate that there are currently c. 400-425 incremental 777 to be delivered in the supply chain assumption before the 777x comes into service. This implies c. 150 of orders needed to fill this gap or c. 50 per year over the next 3 years. The risk of production shortfall is material. Assuming $10m in contribution margin per plane, that’s c. $500m downside to cash flow on an annual basis, or c. 7-8% of base free cash flow. This would be a worst case scenario. We are not too worried: a) even a $1.5bn cumulative impact to FCF would correspond to less than 2% of market cap, not material enough to move the needle fundamentally, and b) Boeing has ample time to get these orders given the fact 2015 and 2016 are fully booked already

     

    ·         Pre delivery payments. Boeing generated significant amount of cash in the past from advances and progress billings from customers. In 2014, advances and progress billings increased from $25.5bn to $29.2bn, generating c. $3.7bn in cash. The bear case is that as the order book will go below 1x, there will be fewer advances (i.e. down payments) and from being a source of cash, advances and process billings will decline, becoming a drag on cash. In reality though, the vast majority of cash comes from progress payments which starts c. 24 to 12 months before deliveries. The down payment part is very small. For this reason, cash from progress billings is much more tied to deliveries than to orders. As Boeing deliveries are set to increase, we expect this to remain a source of cash. Over the last 10 years, pre delivery payments have been a drag on cash flow only in 2009, a year when deliveries actually declined. As long as deliveries increase, it will remain a source of cash for Boeing


    SubjectRe: Re: book to bill and 8 year backlog
    Entry07/08/2015 01:32 PM
    MemberNovana

    tx jso1123, you just beat me to it


    SubjectRe: Re: Re: book to bill and 8 year backlog
    Entry07/08/2015 03:56 PM
    Memberjessie993

    right so my point isnt the correlation precisely wiht orders. but my point/question is that as i understand it, you book the accounting p/l upon delivery. but you collect cash for 18-24 months leading up to delivery. so cash flow actually leads deliveries and P&L. no? no about prepayments. but rather that orders lead production which leads cash flow which leads accounting p&L.


    SubjectRe: Re: Re: Re: book to bill and 8 year backlog
    Entry07/08/2015 04:04 PM
    Memberjessie993

    in other words, when a single plane is actually delivered, you are booking much more net income than cash. and so if production rates plateau or the growth of produciton slows, your cash flow to net income conversion comes down. and then so if book to bill comes down to sub 1x, then produciton will eventually come down and so cash flow will have peaked and so then why pay a multiple...

     


    Subject787 and deferred production costs
    Entry07/08/2015 04:43 PM
    Memberjessie993

    so if the deferred is the cash cost incurred in excess of assumed margins in the block and if assumed margins are low singlge digit then cant we estimate the cash flow estimates per plane?

    in other words, if we have the deferred production costs according to firm and expected future orders, then cant we figure out what the implied recovery per plane is and whether that makes sense.  so divided the numbers you provided by the orders and see what management is implying. 

    so roughly have delivered 300 787s already for a build of $30bln of deferred production. i think this means htey ahve lost $100mm/plane. now they have ~800 planes ordered and so ~200 planes needed to complete the current 1300. that implies they think the last 200 planes will generate $40mm/plane in cash which is double the next 800 which is a massive, unbelievable improvement.

    so i agree...if this happens then its a monster long. but i dont see how that is remotely happeneing. and i dont think this has ever remotely happened in any airplane or other manfacturing process of similar magnitude. i believe they call this the learning curve.

    i think the 777 was the best selling widebody plane ever and in a decade sold ~1300 planes and with less competition and so this 787 better be much much more successful that.

    what is much more likely is that they keep extending the block and amortizing this over more nad more planes...which means you need orders to justify that which means book to bill matters. and not just book to bill. but widebody book to bill which i think has been way below 1.0 before fx moved and oil moved even.

    which also speaks ot margins. how do we get upside to accounting margins if we are already implying 25%+ cash margins on the next 200+ orders?

    all this said, i do agree cash flow appears to be strong and they are returning a whole lot of it so near term especially setup is good...agree there. i just think free cash is nowhere near $20/share and probably closer to $10/share.

     


    SubjectRe: 787 and deferred production costs
    Entry07/09/2015 05:16 AM
    MemberNovana

    Jessie993,

    Yes - we can estimate free cash flow per plane.

    your math is not too far off - they won't be making $40m put I get around $33m per plane. Very simplistically - you have c. 1,000 planes to go in the block, you have c. $30bn in deferred costs, that's $30m per plane. Add to it the accounting profit which Boeing said it is "low single margin", or, say, $3m per plane, you get to $33m cash margin per plane over the rest of the block. Very hard to know what is the realised average price on 787. The 787-8 list price is $224.6m, the 787-9 $264.6m and the 787-10 $306.1m. Over the rest of the block the 787-9 will be the biggest contributor. Nobody knows average discount, let's say c. 45% and you get something like $145m per plane on average. $33m/$145m is c. 23%

    You say: "I dont see how that is remotely happeneing. and i dont think this has ever remotely happened in any airplane".  You just need a calculator to see that it happens every year at Boeing. In fact, it is widely recognised that the 777 makes close to 30% margin, well above the 23% assumed for the rest of the 787. Just take the following numbers for 2014:

     

    BCA sales   59,990
    Less: 787 sales (12,130)
    BCA sales ex 787 47,860
         
    BCA earnings: 6,411
    Less: 787 P&L margin (243)
    Plus: 787 deferred costs 4,953
    BCA margin ex 787 11,121
    Margin (%) 23%

    As you can see, Boeing is basically assuming that the 787 will earn "average" margins for the rest of the program - 23%, just as they do on average all other programs. Not a big stretch. You could argue on the margin that it should be lower given the many problems the 787 had but you could just as well argue it should be higher as the 787 is a widebody plane (like the 777) which is a higher margin market. You say the 787 better be much more successful than the 777. We are not saying this at all! The 777 makes higher margin (closer to 30%) than the 787 will ever make and this is baked into the numbers.

    As per your question as to how do we get upside to accounting margins, there are 3 levers:

    1. program extension - as you get more orders the block will be extended beyond 1,300. Nothing changes on cash margin but your accounting margins need to increase
    2. As the program gets derisked and efficiency measures improve margins compared to original estimated (positive catch up adjustments), the average margin on the program gets revised upwards
    3. You get natural operating leverage on SG&A and R&D irrespective of program accounting

    Finally, as per your comment "I just think free cash is nowhere near $20 and probably closer to $10" once again I wonder whether you actually read the write up. I also have $10....we don't get $20 in fcf/share before 2019-2020 and a decent portion of the increase is due to assumed decline in number of shares due to buybacks.


    SubjectRe: A350 threat to 777?
    Entry07/09/2015 05:31 AM
    MemberNovana

    Hi Katana,

    the 777 is the most talked about risk for Boeing and for good reasons - the 777 is its most profitable program. The A350 is posing some challenges to the 777 but I'd note that the A350 is pretty much full over the next few years so Boeing has the advantage of timing. If an airline needs a widebody in 2017-2019, they basically can only go to Boeing as Airbus is fully booked (to give you a sense, the A350 has c. 780 aircrafts in order and production is ramping up very slowly, it is assumed they'll cross the 100 planes / year mark only in 2018, so there are not slots available this decade).

    Now, the risk is that no airlines will put any orders for those 3 years. This is a much bigger risk than airlines needing one but deciding to go to Airbus. It is hard to imagine that Boeing will not be able to find any customer for the remaining 150 777 they need to sell. However, assuming this does happen and assuming they make 30% margin on the 777 or simplistically $40m per plane, that would be a cumulative $6bn hit between now and 2020. It is certainly material and source of concern but it does represent, after tax (which is the way to look at it) c. 4% of market cap or c. 8% of FCF generation over the next 5 years. Material but not a thesis killer.


    SubjectRe: Re: 787 and deferred production costs
    Entry07/09/2015 09:39 AM
    Memberjessie993

     

    here are the exact numbers for 787 from 10Q. please let me know where i am mistaken:

     

    Block size: 1300

     

    Cumulative orders: 1105

     

    Undelivered but w/firm orders: 847

     

    Undelivered without firm orders: 195

     

    Delivered planes: 258

     

    Total Deferred to be recovered: $30,855

     

    Deferred to be recovered from current backlog: 22,357

     

    Deferred to be recovered from future orders in current block: 8,498

     

    So 30,357 / 258 delivered planes = -$120mm cash margin per plane delivered

     

    22357 / 847 = $26.4 implied cash margin per plane ordered but not delivered

     

    8498 / 195 = $43.6mm in profits per plane unordered

     

    So we ramp from losing $120mm per plane on the first 258 planes to making $43.6mm on the last 195 planes. What I'm saying is that is a learning curve that is way too aggressive.  This implies not only a very rapid increase in unit economics that is contrary to any learning curve ever (I think) and it implies the 787 will exit the 1300 block as the most profitable airplane ever with ~30% margins despite having 10x the deferred build that the greatest selling widebody ever had (777).  Per your analysis, which is very helpful, this implies that the 787 will be more profitable than all the legacy programs together at 23%.

     

    Look at page 9 here for a graph of 777 deferred history vs 787 life to date. http://www.speea.org/publications/files/Archive_Spotlite/Spotlite_2014/Spotlite_2014_November.pdf

     

    I think the 787 will get to very good margins per plane. Just not in the current block and certainly not in the next 2-3 years which your cash flow ramp implies. 

     

    Agree that if they hit this and extend block, accounting margins going higher and then yes, maybe a huge cash flow number by 2020 but that assumes no new program and not nearly punitive enough on cash taxes.  Either their cash tax rate goes much higher or they announce a new plane. I bet on the latter and therefore a new deferred bucket in the next couple of years.

     

    To be clear, I don’t think this is a terrible idea. I just don’t think the cash flow argument is obvious at all.

     

    2 more comments for perspective: the history of deferred production is pretty amazing here. I mean this company has revised it higher from a few billion off the bat to $30bln+ but has kept the block margin the same implying that their perspective on what a plane will make in cash/copy is much, much higher than what it was when deferred was $20bln+ lower.

     

    Second, book to bill for the program was way below 1 last year and is below 1 this year. So if you cant extend the block, then I think a writedown is more likely than making $40mm+ on the last 200 or so slots in the book. 

     

    There is no question that the deferred balance will unwind and release cash flow. I’m arguing it will take longer and will be less than your trajectory implies.

     


    SubjectRe: Re: Re: 787 and deferred production costs
    Entry07/09/2015 11:07 AM
    MemberNovana

    The reason, I think, many analysts don't believe Boeing is because the learning curve has not been linear, fitting a nice logarithmic curve, and the curve flattened dramatically in the last 3 quarters. I believe most of the confusion / skepticism is explained by the fact there is a big shift in 787 from 787-8 to 787-9 and 787-10. there are 199 unfulfilled 787-8, 464 unfulfilled 787-9 and 140 787-10. Out of the 292 delivered to date, c. 90% (258) were the 787-8. This is very important. The cost difference between the -8 and the -9 is actually very small and between the -9 and the -10 will be even smaller given 95% commonality. The production line is producing 787-8 but also preparing itself for the 787-9 via process efficiencies, automatisation etc. The 787-9 has a list price 18% higher than the 787-8 and the 787-10 36% higher. When costs go up only 5-10% but prices go up disproportionally more, you get very material margin expansion. The mix shift is very important here and you can't really see it in the numbers. From 2016 onwards, the 787-8 will drop as proportion of 787 deliveries. This is how you are going to see the next leg down in learning curve. It is virtually impossible to model it properly and that's why analysts throw in the towel and say "well, it seems a bit aggressive as it doesn't fit the chart, we don't believe them".

    Note that it's not a stretch to assume that at the end of the bloc, when margin are the highest, the 787 will earn above-average margins since wide-body planes have better margin than narrowbody.

    "not nearly punitive enough in cash taxes" - I am not sure what you mean here. I assumed 30% cash tax rate on deferred costs

    " Either their cash tax rate goes much higher or they announce a new plane" - what is the connection between taxes and announcing a new plane?!


    SubjectRe: Update?
    Entry02/26/2016 08:56 AM
    MemberNovana

    Nails,

    sorry for late reply.

    I think Boeing is as interesting as it was 6 months ago. FCF share per estimate ended up being $10 in 2015 against my earlier estimate of $10.62 (-6%) and I currently have $11.30 for 2016 against earlier estimate of $13.31 (-15%). The stock is down c. 15% since I posted it so the multiple hasn't really changed. It's currently trading on c. 10% fcf yield for this current year.

    Ironically, the stock is down for other reasons than the biggest risks idenified in the write up - 787 deferred costs and 777 decline. On the 787 deferred costs, Boeing is executing as per expectations. Q4-15 was probably the last quarter of negative cash generation on the 787 and from 2016 it will be major cash contributor to the group. On the 777, the well telegraphed reduction in 777 delivery schedule was finally announced to 6 per month from 2017 onwards - in line or better than feared.

    The issue with the recent results was 2016 delivery guidance. I think it was very badly communicated to the market. A company with 8 years worth of backlog should not surprise on annual deliveries. It wasn't a question of lack of demand - it was a supply chain issue in  the transition from 737NG to 737 MAX. The should have communicated it better in previous quarters as the decline in deliveries came as a big surprise to everyone. This ultimately is the cause of lower than expected revenues, hence margins and cash generation.

    Having said that, from 2017 onwards we see continued growth in deliveries and growth in cash generation - some of the headwinds in 2016 will become tailwinds in 2017. The company seems set to continue returning 100% of fcf to shareholders via dividends and buyback.

    Over the last decade, Boeing traded below 10x FCF only in Q4-08/Q1-09 when the world was imploding. Unless we are going into a global recession, FCF will continue to grow and from a valuation standpoint it's hard to see much downside from here

     

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