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Apr 1, 2021 - Airbus is an exceptionally high quality mega cap franchise trading at an undemanding price.  Sell side consensus is for €7B of EBIT, or back to 2019 levels, by 2024, putting Airbus at an undemanding multiple of 11x normal EV/EBIT and 1.1x sales (~10% consensus margins).

In addition, I think sell side margin estimates are way too low – margins will be up on 1) a massive mix shift toward high margin A320s and away from lower margin wide bodies, 2) the chance to fix the supply chain, rushed and out of sequence work and 3) cost cuts, operating leverage and increased automation.  My rough intuition is that 15% margins are more appropriate putting Airbus at 7x EV/normal EBIT.  

Balance sheet is net cash and, with travel roaring back to life, liquidity risks are nil.  Airlines, lessors and hotels are trading back towards their pre COVID prices on the reopening trade.  Boeing, despite being massively disadvantaged, trades at almost double Airbus’ EV and valuation. 

If, by 2023, the price returns to €140 where it was pre COVID (15x forward EV/EBIT on consensus numbers), investors are underwriting a high teen IRR over the next couple of years.  But, I think the situation actually gets more attractive from there.

·         Commercial aero is a duopoly but Airbus is tilting towards a majority share in the ultra profitable narrow body market (A320s and 737s) because of its product superiority – especially once the 321XLR launches late next year.  Described as a “category killer”, the 321XLR effectively extends the range of Airbus narrow body fleets in a way that Boeing can’t match for engineering reasons.  

Consensus is that narrow bodies (domestic leisure travel) recover much faster than wide bodies (international and business travel).  Domestic airline capacity, dominated by narrow bodies, is now at or near 2019 levels ex. Europe which is experiencing a fourth wave (wide body capacity is still on the floor).  Low cost carriers such as Southwest and Wizz that exclusively use narrow bodies have said that they want to get their hands on new planes because of the superior economics – fuel efficiency and maintenance.  Financing is available and cheap. 

·         The end market is GDP+ as RPKs (revenue passenger kilometers or total demand) grows 5% - 6% a year over the cycle – mostly driven by EM leisure passengers. 

·         Airbus’ contracts contain explicit inflation protection clauses that have historically been a source of pricing. 

·         Large prepayments protect the order book (airlines are on the hook and don’t want to lose prepayments) and mean that cash comes in ahead of earnings.

·         Until COVID, long order books (Airbus and Boeing restrict supply) and improving profitability at airlines ironed out the historical cyclicality in the industry.  2009/2010 deliveries were up and, ex. another pandemic, the industry should return to its relative non cyclicality. 

·         Conventional wisdom was that we wouldn’t see new generation of planes (requiring investment) until new engines become available – thought to be 2030-ish but this is probably getting pushed back.  

·         Competitive entry is near impossible - the COMAC (Chinese) C919 is six years late, a generation behind and the Chinese lessors and airlines won’t take the planes.  Bombardier put themselves into near bankruptcy trying to develop a super regional product (C Series).  

And I think earnings estimates are way too low.  2019 (and consensus 2024) consolidated EBIT margins were ~10% (commercial aero margins are ~11% with some dilution from helicopters and defense – a combined 20% of sales and 10% of EBIT).  This despite the fact that –

·         Program mix shift away from wide bodies and towards the A320 benefits profitability.  As per conversations with the company, sell side and industry contacts, I think margins on the A320 are closer to ~20%.  Airbus makes all of its money on narrow bodies.  As the 320s recover faster, become dominant in the mix and we roll off early neo (new engine) and 321 (long range) contracts, margins should mix much higher.

·         In 2018 and 2019, Airbus was fighting through their production ramp and dealing with a large amount of rushed and out of sequence work.  Lower production rates give the company time to fix this and straighten out problems in the supply chain.  There is some additional automation and efficiency going into the lines.

·         Like all companies, Airbus took out cost in 2020.  It is a little difficult to be precise on this.  But the high level numbers are that they cut ~10% of the permanent work force and a large number of contract workers on the wide body side.

·         Pre COVID, margins for Airbus and Boeing were going up as they ramped from development to production and sold more planes.  Airbus commercial margins went from 5% in 2016 to 11% in 2019. Boeing got to 15% cash earnings (unit cost method) in 2018 before the 737 Max crisis (and yes we should probably penalize the Boeing historical numbers for cutting corners).

·         There is a natural operating leverage on SG+A and R+D that is evidenced in the historical numbers.

·         For evidence, Airbus commercial margins in 20Q4 held at 9% (vs. 13% in 19Q4) despite revenues down 27%.  To me, this says that 1) they are not sacrificing pricing to move planes in this environment and 2) they took out cost and should have operating leverage to the upside.

·         As a sanity check, 10% margins seems low for a duopoly, high ROCE industrial.  The high quality suppliers get margins of 20% and up.

·         Other signs of quality – Airbus has always invested ahead of Boeing.  Skywise is the leading industry data platform – Airbus had 100 airlines, 15 suppliers and Delta Tech Ops signed up to share data as of the end of 2019.  Airbus also leads in clean fuel and hydrogen technology, although this is a pie in the sky at this point.  For 2020, R+D and capex were only cut ~15% indicating Airbus’ relative strength in navigating the crisis and commitment to long term investments.

I see the following risks -

·         COVID – the market is pricing in a full recovery with airlines and lessors now trading back towards their 19Q4 prices, but obviously we don’t know for sure.

·         Uses of cash – Airbus does not have an aggressive, American, shareholder focused management.   They are 25% owned by the French, German and Spanish governments.  Beyond the rising dividend, Airbus has historically held on to the cash.  A number of idiosyncratic operating issues hit the cash conversion as margins rose from 2016 – 2019.   But, Airbus will gush cash as deliveries normalize and grow, production schedules get fixed and prepayments come in.   And my guess is that the government owners will see Airbus as a source of cash as national budgets come under pressure. 

·         Competitive dynamics – Historically, Boeing and Airbus have not used the oligopoly to its full advantage.  Anecdotally, sales remained very competitive despite most airlines being locked in to operating a single fleet.  Tenders were run by the sales guys who promoted customer wins over pricing.  My conversations say that this has changed as exemplified by the exit of longtime Airbus sales head John Leahy in 2018. 

·         Cyclicality – ex. a global pandemic, the large order book and prepayments have ironed out cyclicality – both Airbus and Boeing had flat-ish deliveries over the financial crisis.

·         New programs – Boeing and Airbus blew themselves up on new program costs for the 787 and 380 respectively in the mid 2000s.   Aided by software, the next gen program development (A320neo and A350) has been seamless and profitable.  Analysts aren’t expecting a new program until the next generation of engine technology becomes available in 2030 or later.

·         China – conventional wisdom is that China eventually enters.  But the design and supply logistics have proven difficult despite near unlimited resources.  The Comac C919 is six years late, a generation behind and Chinese lessors and carriers won’t touch it.  And so Chinese entry is pushed back until at least the 2030’s – and then a successful product will be initially limited to the domestic market as FAA/EASA certification will be additionally difficult.

Three additional notes –

·         On the 20Q4 earnings call, CEO Guillaume Faury said “…we should be kind of at a similar margin level when we are at the same delivery rates as in 2019.”   I think this conservatism rather than an actual forecast.  Prior management was explicit that they were sandbagging future profitability in the face of government oversight of a multi national bribery investigation and big delays on the A400M military transport.  My guess is that we are in a similar situation while Airbus is taking government aid.  My experience with Faury, corroborated by industry contracts, is that he is a skilled operations guy with zero promotional impulse.   Airbus used to show a slide in its deck with forward EPS and FCF going up and to the right and there is no way that 10% margins are the logical conclusion. 

·         Safran has a similar setup.  And in a vacuum, the engine aftermarket business is the best business in aero space.  But this is somewhat reflected in the Safran share price.  Engine aftermarket is only about half of Safran earnings and rest of the portfolio is lower quality (with a long recovery in interiors).  And Safran has similar issues with a French ownership stake and conservative culture – they issued shares to do the Zodiac deal and a convert in 2020.

·         It would be disingenuous to pretend that I had any amount of precision around the earnings and margin ramp.  Clearly a lot is unknown here.  And so I benchmarked my pitch to sell side estimates and the idea that this is a premium asset with untapped margin potential at the point when things normalize. 

This report is for informational purposes only and does not constitute investment advice.  The author may buy or sell securities mentioned at any time.   Please do your own work.

Catalyst

Big earnings ramp, earnings ahead of sell side consensus