Description

Airbus SE (AIR FP)

Business Overview

Airbus has been written up twice on VIC already, adding to the heaps of information that is already out there about the company and what the fundamental bull case looks like. We assume, therefore, that readers are generally familiar with the company and focus instead on a situational overview, breaking down why we think the company’s 64% share price decline since the recent peak (02/11) is unjustified.

But just as a reminder, Airbus was formed in 1970 out of the consolidation of the European aerospace industry into Airbus Industrie – a European aircraft manufacturing consortium – to compete with American aircraft manufacturers such as Boeing, Douglas and Lockheed. In 2000, some of Airbus’ early shareholders merged to become EADS (European Aeronautic Defence and Space Company), which owned 80% of the new Airbus company until its acquisition of BAE System’s 20% remaining stake in 2006. This was followed by years of integration and a reorganization of the corporate governance and shareholder structures of the company creating the modern Airbus company. Today, ~26% of the company is owned by the French, German and Spanish governments which regard Airbus as an asset of immense strategic importance.

Airbus operates in 3 divisions – Airbus (Commercial Aircraft), Helicopters and Defence and Space:

-        Airbus (Commercial Aircraft; 77% of FY19 revenues) manufactures large commercial aircraft with planes ranging in capacity from 100-600 seats that operate on routes from up to 3,000 to up to 10,000 nautical miles. The vast majority of revenues come from the sale of aircraft to airlines and lessors, with after-market services accounting for only ~5% of revenues. Some of the segment’s largest customers include IndiGo, AirAsia, Wizz Air, Delta, Frontier Airlines

-        Helicopters (8% of FY19 revenues) is the global leader in civil/parapublic and military helicopters. In FY19 platform sales accounted for 57% of segmental revenues with the remaining 43% coming from services.

-        Defence and Space (15% of FY19 revenues) segmental business lines include (1) Military Aircraft, (2) Space Systems, (3) Communications, Intelligence & Security, and (4) Unmanned Aerial Systems. 68% of FY19 revenues came from platform sales, with the remaining 32% coming from the provision of services.

Situation Overview

Airbus’ share price is down 64% since its peak (02/11) largely because it has been sold down with airline stocks which are being affected disproportionately by the current events and which are down 61% over the same time period (US Global Jets Index).

We argue below that the market is overestimating the risks from the current economic environment for Airbus and that this presents a rare opportunity to buy a company with a strong competitive position in a structurally attractive sector. Airbus’ stock is also a unique opportunity to get exposure to secular emerging markets growth driven by a growing middle-class population and the accompanying growth in air travel, through a company the history and corporate governance of which is firmly grounded in Europe and its traditions.

We think Airbus’ share price has declined for the following reasons:

1.     Concerns about deferrals or cancellations of deliveries

2.     Concerns about potential airline (customer) bankruptcies negatively affecting demand

3.     General market decline due to concerns about economic environment and its implications for cash flows and balance sheet positions of industries most affected (including airlines and the supply chain feeding this end market)

Below we address each of these concerns and show why they are overdone and don’t justify a share price decline to the current level of €49.51.

1.     Concerns about deferrals or cancellations of deliveries

The sharp drop in traffic that is already being seen in months of lockdown (~70% drop in traffic experienced in China in February) will put immense pressure on airlines as cash inflows practically dry up. A number of airlines have already announced a number of measures like the parking of a large part of their fleets, postponement of capex plans in the form of delays to deliveries of aircraft from the likes of Airbus and Boeing, and consideration of sale and leaseback transactions, all aimed at shoring up liquidity at a time when cash is scarce. Unsurprisingly this reality has led to significant concern on the part of investors about the willingness of Airbus’ customers to accept deliveries over the near-to-medium future.

Mitigating factors

Below we set out the reasons why we think the extent of deferrals and cancellations aren’t likely to amount to that priced in:

a.     Contractual protections

There are practically no ways for Airbus’ customers to unilaterally step out of their contracts and cancel deliveries, as even such protections as MAC clauses have been indicated by Airbus to generally be excluded from their contracts (even though practically these would be very hard to trigger). In addition, the structure of aircraft order and delivery contracts means that scheduled non-refundable payments of 25-30% of the value of the aircraft take place as long as 12-18 months prior to delivery (pre-delivery deposits), meaning that delays or cancellations of deliveries that are to take place within the next 12 months are rarely feasible and incur significant penalties.

Thus, rather than finding itself in a situation where its customers simultaneously and unilaterally cancel and delay deliveries in a desperate attempt to conserve cash, this process will instead take the form of negotiated agreements with each, where Airbus is likely to allow some customers to delay their delivery schedules or alternatively to alter the schedule of payment of pre-delivery deposits so as to avoid cancellations as much as possible. However, once again, this is most likely to be the case with aircraft the delivery date for which is at least 12 months away, as delays to delivery of aircraft that is already in the customisation process (typically 9-12 months before delivery) is much more costly.

This means that while 2020 is bound to see the delivery schedule being affected by a combination of Airbus’ accommodation of the needs of some its customers to allow them to overcome the acute pain created by this environment as well as by the general logistical issues created by travel bans and restrictions, the larger impact is likely to be felt in 2021.

However, the sheer size of Airbus’ backlog of orders featuring significant overbooking will mean that delivery deferrals for late 2020 and 2021 can be managed fairly smoothly by Airbus – something that stood out in the previous economic downturn (as addressed in the next point).

b.     Size and nature of orderbook provides flexibility of smoothing the delivery schedule, as evidenced by performance in previous downturns

Airbus’ Commercial Aircraft backlog amounts to 7,670 units (~8 years’ worth of production), which is ~35% larger than Boeing’s as well as being larger than the backlog Airbus held going into the previous economic downturn in 2008, giving it greater flexibility in reshuffling its delivery schedule. The A320 family which is sold out until 2026, represents the vast majority (~81%) of this backlog and stands as high as ~10 years’ worth of production – a much stronger position vs 2009 when the A320 backlog amounted to 6 years’ worth of production and vs 2001 when the backlog was equal to 4 years’ worth of production. A large orderbook of this sort allows Airbus more flexibility to shift around deliveries by allowing certain customers with nearer-term delivery slots to swap them with customers who are willing to opportunistically pull forward their own deliveries and perhaps attain better pricing terms.

This large backlog of orders is also characterized by overbooking, and while the exact extent of overbooking isn’t revealed by the company there are estimates that of the backlog for deliveries up to 3 years out, as much as 30% of orders could be overbookings. These overbookings will also be a key shock absorber over the next 2 years.

The success of this strategy was visible in the years following 2008 as Airbus managed to pull forward 300 deliveries so as to allow for 300 deferrals over an 18-month period, which resulted in flat deliveries over the subsequent years. This pattern is also likely to be helped by Airbus’ much heavier weighting towards narrowbody aircraft as following both 2001 and 2008 narrowbody aircraft proved to be more resilient in the face of deferrals and cancellations vs widebody aircraft, which is now also helped by the structurally stronger demand for narrowbody aircraft from low-cost carriers.

c.      Competitive position vs Boeing

Airbus’ strong narrowbody aircraft portfolio and the resilience of it to economic shocks is particularly notable this time around as Boeing’s own troubles with the 737 MAX have left Airbus with the narrowbody market to itself as Boeing remains unable to manufacture or deliver MAXs, creating the perfect set-up for Airbus to be able to take advantage of given its strong product offering in this market segment.

As mentioned above, Asia and particularly China form a significant portion of Airbus’ backlog as well as having accounted for ~45% of A320 deliveries in the period 2015-19, reflecting the degree of demand for narrowbody aircraft from the region’s low-cost carriers which is going to continue being a significant demand driver for the industry, making Boeing’s temporary absence from this market of even greater significance. This is also the case in the short-term, as domestic flights which use narrowbody aircraft have been the main source of air travel recovery since the end of lockdown in China, something which is likely to remain the case in the near-term as China tries to reduce chances of reimportation of the virus.

In addition to this being an opportunity for Airbus to strengthen its standing in the narrowbody aircraft market, the grounding of the 737 MAX is likely to be an additional and substantial absorber of any deferrals or cancellations as airlines which operate mixed fleets will now turn to Airbus for their narrowbody needs that would otherwise have been served by Boeing.

Conclusion: We believe that the combination of the aforementioned factors means that the consequences for deliveries of the current reality aren’t likely to be as catastrophic as implied by the current share price decline, with a number of circumstances acting as mitigating factors and absorbers for any potential near-to-medium shifts in demand.

2.     Concerns about potential airline (customer) bankruptcies negatively affecting demand

The airline industry will inevitably see bankruptcies - particularly among its smaller players - through this and next year. However, we believe that the below-listed factors will significantly cushion the blow to Airbus’ demand environment.

Mitigating factors:

a.     Strong customer and geographical composition of Airbus’ backlog of demand

Airbus’ exposure is much more heavily weighted towards the stronger low-cost carrier airlines which have strong balance sheet positions and are most likely to weather this period of disruption, with a less notable exposure to the weaker airlines (such as flag carriers) which are more likely to go bust. Moreover, this period of disruption is likely to result in the stronger airlines gaining market share at the expense of competitors that go bust, meaning that the net effect on Airbus will be neutral at the worst. On the other hand, with financing particularly cheap in the current environment, lessors are likely to be opportunistic and offset the reduction in demand from struggling or bust airlines especially since the medium to long-term outlook for the industry remains favourable.

Of equal importance is the geographic composition of Airbus’ backlog of demand, with emerging markets/Asia as well as China more specifically featuring more prominently in its demand profile than is the case with Boeing. Asia forms 27% of Airbus’ backlog vs 19% for Boeing and while China only forms 4% of Airbus’ backlog it represents as much as ~20% of its annual deliveries. This means that Airbus is likely to benefit from the more successful Asian and Chinese experience of curbing the spread of coronavirus, with the concomitant ongoing recovery in domestic travel in China for example, as well as the greater willingness and ability of the Chinese government to support its national airlines, forming a more robust source of demand (barring a re-emergence of coronavirus in the country and wider region) in the context of a worsening situation in the rest of the world.

Airbus’ production line in Tianjin (China) which services ~35% of Airbus’ Chinese demand should further help with benefiting from this area of demand.

b.     State support

Flag carriers are of strategic importance to individual countries and are therefore likely to garner significant support from national governments. To date states across the world have shown a strong willingness to stand behind the airline industry with the US allocating $50bn from the $2.2tn stimulus bill to the airline industry, European governments voicing their support for their flagship carriers with the UK government going so far as to suggest taking equity stakes in struggling airlines, France pledging to nationalize big companies that are struggling in the current environment, as well as the Chinese government’s strong and aggressive support of its own airlines. All of this promises to ease the pain which Airbus and the industry may have otherwise faced.

In the event of significant financial detriment from a weakened end market, Airbus is also a strong candidate for state support. As mentioned above, the strategically important nature of a European aircraft manufacturer and competitor to Boeing is such as to make Airbus “too important to fail”. What makes it even more important, particularly in today’s environment where joblessness is on the rise, is its role as a large European employer, with ~90% of its 121,000 workforce located in Europe.

Thus, states are likely to shoulder a large share of the burden that the industry faces from the effects of lockdown measures.

3.     General market decline due to concerns about economic environment and its implications for cash flows and balance sheet positions of industries most affected (including airlines and the supply chain feeding this end market)

Mitigating factor:

a.     Strong balance sheet position

As of the end of FY19 Airbus had a net cash position of €12.5bn, which after its YTD funding of operations combined with certain other payments (€3.6bn payment related to penalties for agreements with authorities and $0.5bn payment related to the acquisition of Bombardier’s remaining stake in the Airbus Canada Limited Partnership) and the securing of a new €15bn credit line, brings it to an available liquidity position of ~€30bn. Combined with Airbus’ withdrawal of its 2019 dividend proposal and suspension of the pension funding top up, this puts Airbus in a strong position going into this crisis.

Given the fact that the defining characteristic of this crisis/downturn is the drying-up of cash, strong liquidity is of paramount importance with Airbus’ liquidity of €30bn putting it in a strong position to endure delays in pre-payments for deliveries that take place on schedule, deferrals or delays in deliveries themselves and the corresponding working capital outflows from greater inventories and lower pre-payments.

As much as ~70-75% of Airbus’ costs are variable and primarily linked to payments to suppliers for components. This is a potentially large lever for profitability and cash conservation in an environment when production will inevitably slow. However, we wouldn’t assume that variable costs are fully flexible as by significantly reducing its purchase of parts from suppliers Airbus would be putting them at significant bankruptcy risk – something clearly not in Airbus’ own interests. Therefore, while variable costs are a potential lever for conserving profitability and FCF, this shouldn’t be relied on as a driving assumption as Airbus is more likely to try reducing the impact to volumes by reshuffling delivery schedules, in which case production would need to continue, and because the risk of supplier bankruptcy is too big for Airbus to completely cut off demand or in so doing to not replace it with financing.

Finally, with both share buybacks and dividends featuring prominently in Airbus’ capital allocation programme, these provide additional levers for cash conservation with the 2019 dividend proposal already withdrawn.

Valuation

At its current price of €49.51 Airbus’ shares are trading on trailing cash-adjusted P/E of 5.5x and a trailing cash- adjusted FCF yield of 13.4% - close to trough multiples achieved in 2008.

Estimating the degree of deferrals, cancellations and the corresponding declines in profitability and cash flows are very difficult in the current highly fluid environment. While we don’t attempt to estimate the timing of a full recovery in traffic, we note that it took ~3 years for traffic to recover after 9/11 which we believe sets out the worst-case scenario timeline for a post-coronavirus recovery.

We look at Airbus’ current trading multiples in scenarios where we apply haircuts to its trailing metrics:

-        10% haircut to FY19 figures

Airbus would be trading on a trailing cash-adjusted P/E (adjusted) of 6.1x and a trailing cash-adjusted FCF yield of 12%

-        20% haircut to FY19 figures

Airbus would be trading on a trailing cash-adjusted P/E (adjusted) of 6.9x and a trailing cash-adjusted FCF yield of 10.7%

This is against Airbus’ historical average trailing cash-adjusted P/E of 22x and a trailing cash-adjusted FCF yield of ~4%.

Risks

-        Continuation of coronavirus crisis into 2021 and beyond

-        Non-materialization or belated nature of government support for Airbus or wider industry, or linking of government support to strenuous and unattractive terms

-        High rates of bankruptcies among Airbus’ customer airlines

-        Higher than expected customer cancellation rates

-        Significant supplier weakness requiring Airbus to participate in financing of key part manufacturers

-        Supply chain disruption due to lockdown measures or air traffic restrictions

-        Execution risk

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purposes only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

- normalisation of airline industry dynamics

- visibility on orders

- company guidance

- share buybacks