Description

Have you ever looked at yourself in the mirror and said, “yeah...’time arbitrage’...that’s my edge...”? Are you attracted to the stock of a business that is going through inevitable, yet seemingly unappreciated, positive change? Does “sky’s the limit” earnings improvement sound interesting? If you answered yes, you should meet Airbus.

You know what Airbus does, they make and sell commercial airplanes. Right on the surface, there is a lot to like about this business. First, it is a duopoly (above 150 seats) where, for the first time in 65 years of modern history, the two competitors appear satisfied to pursue stable, tit-for-tat evolutionary competition with increasing profitability, rather than “moonshot” destabilizing, revolutionary developments. Margins and profits are untethered to returns on capital, constrained production capacity, higher-cost suppliers, etc. so earnings are very capable of surprising positively. Second, the industry has insurmountable barriers to entry. As a thought exercise, If you, me, and Xi had 15 years, $25B USD to invest, and Bombardier at a bargain price, I believe it is unclear whether we could make a profitable entry. Third, volume growth has been 4-5% per year for many years (including through the great recession), and this is highly likely to continue - pretty good for an industrial business. Fourth, this is one of the few businesses we can buy into where our production facilities, intellectual property, and property rights are in the developed world, yet we fully benefit from the increasing prosperity of the developing world consumer. This is a highly unusual, above average business. 

Alas, everything has a few cons, and this business has its share. First, it is very capital intensive. Boeing spent $25B+ developing the 787. It takes many, many years for a program to recoup its investment and careful observers often don’t get it right (two examples are the A380 - what were they initially thinking? - and the 737 - Newhouse in the Sporty Game discusses its dubious prospects for profitability - WRONG!). Boeing and Airbus mitigate some of the capital costs by farming out development and capacity to suppliers. Like Coke and Pepsi with the bottlers, I think they largely get this right and still command significant bargaining leverage. And most of the big development spending after the A350 looks to be behind us. Second, the past history has been cyclic - and we aren’t anywhere near the trough of the cycle (wikipedia has very accessible data on past deliveries and orders). This is somewhat mitigated by 7-8 years of backlogs, very high industry capacity utilization (every region except Japan, Australia, and Russia have 80%+ load factors - all time highs), and the diversity of the demand geographically. Both Airbus and Boeing project demand over 20 years which is readily accessible and the numbers appear possible. But this is not a “buy when industry is down on its luck” play. Third, Airbus has a complicated history which has endowed it with European governance, bureaucracy, and conservatism. The French and German governments are large owners and the board has more sway over corporate decisions than a typical US corporation. I think the management is doing a reasonably good job trying to make its owners wealthier, but it is not “all systems go.” And we can expect Chris Hohn will leak more pushy letters to the FT if the company doesn’t move forward with wealth creation. 

Fine, you say, you have checked the box for “discombobulated Porter’s five forces.” Get to the “unappreciated, positive change” and maybe some numbers.

There are two primary sources of positive developments: A320neo and the weak Euro. Combined, the earnings could be explosive, in an FAA sanctioned sort of way. 

To frame this, let’s start with the current price. Airbus made a little less than $1USD per ADR (4 ADRs buys you 1 ordinary share traded in Euros in Europe). If Airbus was like Boeing, it would capitalize the A350 start-up costs, which I guess cost them 17 cents per ADR in 2014, so I will use $1.15 per ADR as a guess at adjusted trailing earnings. The current price of $17.70 per ADR is around 15.4x this figure, so valued at an average company multiple on current earnings - despite the "inevitable" coming improvements. 

Airbus makes “more than the majority” of its commercial profits on the A320 program. Of the 2.5B euros in commercial profits in 2014, I guess that 4.5B+ euros came from the A320 program. We can guess at this because we know: 1) R&D was 2.7B euros, 2) A350 lost ~0.9B euros, 3) the A380 lost ~0.4B euros, and 4) the A330 made maybe around 1.5B euros. They delivered 490 A320s, so they are making 9MM+ euros per delivery, based on these guesses. 

Airbus has a winner with the A320neo, which will become the dominant delivery in 2019 (they are feathering-out the A320ceos). According to John Leahy at the December 2014 GIF, the NPV of the neo is $8MM versus the ceo (on a base price of ~$50MM USD). Half of this goes to the customer, half to Airbus and the engine guys (in the form of higher price above costs), who in turn, split it. So we can expect Airbus to make $2MM USD more per A320neo. 

So profits per unit are going up...well so is volume. They will be delivering ~600 A320neos in 2019, and 700+ is in the realm of possibility based on management’s comments. And remember, this increase in volume should further increase profit per unit, with fixed cost leverage and volume discounts from suppliers. 

The net of all this is I think that Airbus will be delivering at least 600+ A320s in 2019-2020 and making 11.5+ euros per unit, making 7B euros in profits on the program (at a EUR/USD of 1.35). Add in the other moving pieces (a breakeven to positive margin A350, a mildly loss making A380, an A330neo making less than it was in 2014, and reduced R&D of around 2B+ euros) and you have a business that made 2.5B euros in 2014 growing to 7B euros in 2020 - not too shabby. 

But wait...there’s more. What about FX? 

The Euro has depreciated ~20% from prices 18 months ago, the pound ~5%. From a high level, Airbus is very well positioned to benefit from this. 70% of their employees and 70% of their external sourcing comes from the Euro region. For whatever reason, airlines worldwide buy their airplanes in USD. Airbus has sold and “locked-in” 7-8 years of production in USD at prices which provide for an attractive profit premised on an exchange rate of 1.35 USD for every Euro.  Because this is an assembly business, margins are not high (6% commercial in 2014), so changes in costs drive large changes in earnings (play with what a 20% drop in 70% of your costs does to 6% margins!). 

Of course, management is keenly aware they have a currency mismatch, and this could be a real problem for their business if the currencies moved adversely. And Airbus wants to be seen as the world’s premier aerospace company, not a clever foreign currency play, so they rightly deemphasize the impact of FX with customers, suppliers and the financial markets. Airbus mitigates the P&L risk primarily by doing two things. First, they have a large 95B+ USD hedge book, primarily plain-vanilla forward contracts without any collateral posting requirements, to match the net USD cash inflows with their Euro-based (and Sterling-based) cash outflows. So a couple of years out, they know what the currency exchange rate is going to be for their their imminent future deliveries. Unfortunately, this practice is very expensive today with the cost of selling dollars and buying Euros in the future at exorbitant prices compared to the spot rate (1.10 vs. 1.20). Second, as much as possible, they contract with suppliers in USD, even if they are Euro-based, functionally pushing-off the currency risk on the supplier. The net of this is that while sell-side analysts fully understand that foreign currency rates impact Airbus’s results, they overemphasize the modeling horizon of the next couple years and exclude obvious second-order effects, in my opinion. 

Hedges are a way to temporarily delay the impact of changes in currency rates, not to avoid them. And wrapping a Euro-based or Sterling-based supplier in a USD contract will eventually runoff or be renegotiated (Airbus claims 60% of their costs are now USD - which I believe is true only in the short-term and narrowly considered). In the next several years, it will be clear to the financial markets what Airbus and its supply chain already know - barring a change in foreign currency rates, they are sitting on a massive currency-driven windfall with locked-in and future USD revenues and declining Euro-based costs. And with rising volumes, Airbus is well positioned to capture the “lion’s share” of this windfall during negotiations with suppliers. 

Combining the A320neo, current exchange rates and the hedge book, as well as a reduction in shares from proceeds from the Dassault divestment, I expect Airbus to earn $2 USD/ADR and $3+ USD/ADR in 2018 and 2020. Capitalized at 16x in 2018, this implies an 80% increase in the stock price over the next three years. And I believe these estimates could prove conservative depending on the future path of FX rates, A320 volumes, etc. 

Bangladesh Airlines (and Airbus customer) once used the tagline, “We’re better than you think.” Perfect.

Considering the positive surprises in store, the same can be said for Airbus, even more so. 

****

A note: I tried to keep this to the point because there is a 747-8F worth of sell-side material on Boeing, Airbus and the industry. But it doesn’t take much work to decide whether you find Airbus’s common stock attractive based on my thinking. 

Another note: Airbus has other businesses. They make and sell helicopters. They sell defense and space systems to governments. Some of these businesses are wholly owned and some are in joint ventures. And some are being divested. These businesses have generally middling outlooks. You shouldn’t buy into Airbus without learning about these businesses, but knowing more about them won’t inform you on why I think the stock is so attractive today. 

Another note: Boeing’s and Airbus’s accounting is complicated in their respective ways. Boeing uses “program accounting,” which I would describe as the “least worst” accounting system for their business (they provide unit accounting for commercial on their website). But it unduly gives weight to management’s future expectations in determining current results - not unlike insurance. Airbus uses the simpler and more conservative unit accounting. But I find the impact of the hedge book, as it flows through the P&L, also obfuscating. An important point to take away, however, is that because Airbus realizes the costs of its development programs immediately, rather than capitalizing the losses to be amortized later like Boeing, it is inherently much more conservative. 

Another note: Oil. The price of oil and its impact on Airbus’s business is ambiguous. The attractiveness of a new airplane versus an old airplane goes up with higher oil prices, so a drop in oil prices would decrease scrappage and decrease the demand for new aircraft. This is bad. But, oil is 20-40% of the price of an airline ticket, and a lowering of the price would increase demand for air travel, and therefore the need to grow capacity through purchasing new airplanes. This is good. And oil prices usually come with a state of the world that goes with it - and this usually moves inversely with the price (i.e. good times, high oil). So I don’t know. 

Another note: Airplanes are bought on credit and credit is really easy for buying aircraft today. If this were to change long-term, this would be a headwind. I do not foresee this. Low interest rates help, but I do not believe modest changes in interest rates will significantly change demand for aircraft.

Another note: I said barriers to entry were “insurmountable,” but this assumed a profit motive and not a desire to capture “the commanding heights” of an economy. It appears reasonable to believe that China will have a single-aisle competitor that might be competitive outside China in the next 10-20 years. But who knows, they said the same about the Japanese 25 years ago. Given this reality, it seems rationale for Boeing and Airbus to error toward overproduction to give any emerging competitor less of a foothold. We will see. 

Another note: the aerospace business is difficult with significant “execution risks” related to development programs. The possible negative developments (all surmountable) which would not surprise me would be: 1) a temporary issue with the PW engine on the A320neo, 2) the ramp-up of the A350, 3) inability to move down the cost curve on the A350, 4) further setbacks with the A400M. 

another note: numbers at the top of the write-up are ADRs/USD.

Catalyst

the earnings take flight.