Description

Buying investment grade debt above par at ~6% yield may ostensibly sound like very poor risk. Specifically, buying Boeing (par) debt, with MAX headlines and exposure to travel may sound incredibly silly to some. Have we lost our minds?!

We think BA’s newly issued 5.805% 5/1/2050 and 5.93% 5/1/2060 unsecured bonds represent a compelling ~45-50% upside over the next 6-18 months, with asymmetric risk/reward given a highly unusual rate step-up on rating downgrades (if downgraded to junk + each subsequent downgrade). We recommend hedging out the rate risk with the benchmark being T 2 â…œ 11/15/49 Govt.

Securities summary:

Investment Summary

1. Equity-like returns (~45-50% upside) in investment grade paper. These are long-duration and non-callable, where we are playing for a spread collapse vs. the US 30-year yield and thus we’re not playing for ~6% yields. We recommend hedging out the rate risk with the benchmark being T 2 â…œ 11/15/49 Govt
2. Significantly derisked story following BA’s multi-year production guidance given on the latest earnings call. Below we touch on why the world will still need airplanes in the future
3. Production schedule results in rapid deleveraging post-2020 from year-end 2020 net debt of $31bn. The CEO has already guided to positive FCF in 2021
4. Meaningful inventory unwind as BA will finish 2020 with ~425 finished 737 MAX representing $21bn at purchase price ($50mm/plane) or $13bn assuming 40% prepaid
5. Ample liquidity following BA’s $25bn bond offering on April 30th (these bonds were part of that issue). Pro forma, BA has >$40bn of cash and $5bn of revolver availability (net of CP outstanding) vs. a rest of year cash burn of ~$10bn
6. CEO is prioritizing debt reduction and has publicly said they won’t be paying a dividend (for up to 3-5 years) or buying back stock before delevering. There is still $70bn of market cap behind $24bn of net debt - plenty of capacity to raise equity if needed. Plus, BA is a Fed-eligible issuer
7. Downside protection from ratings downgrades, as the coupon increases by 25bps if downgraded by either Moody’s and/or S&P to junk + each subsequent downgrade (up to an additional 200bps in total). BA has already recently been downgraded by Moody’s (4/10) and S&P (4/29)
8. The current ~430bps spread is wide vs. comps and history, as well as vs. legacy BA bonds
9. Big liquid tranches - hard to find this level of liquidity in long duration bonds (where there is a lot of convexity) as most of that paper gets bought and locked away by pension/insurance funds
10. Technical: large $25bn new issue is still being absorbed by the market
11. Near-term catalyst: resuming 737 MAX operations this month and deliveries in 3Q
12. Tail-risk downside protection: 1) BA is too big to fail; and 2) BA’s debt is covered by the Defense business alone if we assign zero value to commercial aero or aftermarket. Unsecured debt should see much higher-than-typical recoveries if they were to unexpectedly default given the lack of secured/senior debt in the structure
13. Call option on a vaccine which we don’t think is reflected in BA’s multi-year ramp back to normal air travel demand

Industry Supply/Demand

We’ll try to keep this section short, especially since we’re pitching the credit and not the equity (and thus we’re covered under a broader set of outcomes), but we think it’s worth highlighting a few points.

To frame the discussion on why the world will need new planes in the future, it’s helpful to have a quick backdrop on where things stood right before COVID. 2019 was the all-time high for passenger load factors (effectively, the utilization of the fleet in service) and were viewed as being at the structural limits. This means that we could not have grown passenger demand with the existing fleet.

Source: IATA, Bernstein

Historically, air traffic has consistently been a ~2x GDP grower and been recession resistant, with the largest drop being LSD percent decline.

Source: IATA

Which brings us to today. Clearly 2020 is going to be a record decline in air traffic, with IATA projecting an air traffic decline of -48% in 2020 (peak quarterly decline of -75% recovering to -33% in Q4).

With the caveat that global air travel will largely depend on the spread of COVID and the development of a vaccine, we wanted to illustrate a rough sketch of how supply/demand could evolve over the next few years vs. expectations coming into this year.

The net implication of COVID is that we are going to see worse air traffic, more retirements and less deliveries - but outside of 2020 we won’t have unusually poor load factors. This view of the world is reflected in our/consensus delivery estimates. An important thing to note is that these are annual figures, but there are seasonal demand spikes that airlines need to manage (thus if we have a weak 1Q21 but a strong summer 2021, then the peak supply/demand may be tighter than is shown).

While not something you need to believe for the credit, to the extent we get a vaccine by spring 2021, peak summer 2021 air traffic demand could be quite strong with pent-up demand more than outweighing negative impacts from GDP. Additionally, because of weak load factors and all-time low jet fuel prices, low airfares could help drive demand.

Will airlines actually take deliveries?

OK so in theory through 2023 we need new planes, but will any customer actually accept delivery? We think so for a few reasons.

First, typically the first thing airlines will do entering a downturn is permanently retire their oldest aircrafts. That’s reflected in the above supply/demand model. These planes do not reenter the fleet when conditions improve. If we zero out 2021-2023 retirements and deliveries, we get to impossibly high load factors as demand recovers. While COVID can disrupt near-term demand, absent COVID, air traffic demand growth has been consistent and strong - simply put, if the demand is there, someone will buy planes to service demand.

Second, there is already significant sunk cost in these new aircrafts and they are under contract. While difficult to have an exact figure, the rule of thumb is that ~50% of the plane is already paid for in progress payments by the time it’s delivered. Also note that these are significantly more fuel efficient vs. older planes in the fleet which they are replacing. What happens in practice is that BA will work with each customer to revise the delivery forecast to something that is mutually agreeable.

Third, airlines are getting significant government aid which should soften the blow from reduced traffic. While not fully offsetting, the CARES act provides $25bn in grants and another $25bn in available loans to US airlines. This compares to US-based air carriers’ 2019A revenue of ~$180bn. It’s also premature to say that the spigot has been definitively turned off.

Fourth, to the extent there are airline bankruptcies, this doesn’t impact air traffic demand. Some airlines may need to restructure, but again, if the demand is there supply will follow.

Just to pull a couple recent data points from earnings season. LUV and UAL both disclosed that they rephased deliveries with BA, and specifically quantified 2020/2021 737 MAX deliveries - they expect 88 through 2021 which is a slightly greater than -50% reduction vs. expectations as of the last quarter. Consensus MAX deliveries have been reduced -60% (i.e., inline with these two data points), and these orders represent 16% of consensus MAX deliveries.

We do expect headlines about order cancellations. So does the market. BA has 4,354 737 MAX on backlog - if they didn’t have any cancellations or order delays, the stock would probably still be at $350. If BA didn’t have any 737 MAX cancellations, it would equate to enough orders to last through 2028.

BA’s recently provided production guidance:

On its recent earnings call, BA provided explicit guidance on its projection ramp in the 737 MAX, plus on future lower production levels of its other commercial programs.

As it relates to the MAX: 1) BA expects to resume production this month (per a subsequent news article); 2) regulatory approvals will allow for 3Q deliveries; 3) BA will gradually ramp MAX production to 31/month during 2021; and 4) beyond 31/month will gradually ramp production based on demand.

While we have no particular insight as to the likelihood of a regulatory approval for the MAX, to the extent the company is correct and approval is granted, we would suspect the credit would tighten meaningfully as it derisks, to a meaningful extent, future deliveries.

There are a few key reasons why this guidance update is important:

1. It clearly sets consensus expectations which ticked down following the update
2. They wouldn’t have provided this information without some insight from discussions with their customers. If they thought customers would not be taking deliveries for the next 18 months, they wouldn’t restart production. It’s important to note that BA does not build “spec” planes - every plane they build has a home
3. BA’s new CEO (started in Jan) is trying to restore the reputation of the company and shouldn’t be incentivized to set goals he can’t fulfill
4. They disclosed their passenger traffic projections, which as you can see below assumes we don’t get back to 2019 levels for ~3-4 years

Putting the numbers together:

Using the latest guidance on production ramp, we get to -$10bn FCF burn for the remainder of 2020 followed by ~$3bn FCF in 2021 and ~$12bn in 2022/2023. Flowing through these estimates are ~$13bn of NWC release over time from the MAX.

While we acknowledge there’s a lot of uncertainty and BA is notoriously difficult to model (project accounting at its finest - hence why we avoid talking about EBITDA), we think BA is well protected given its current war chest. BA currently has $23bn in net debt and $45bn of liquidity pro forma for the new $25bn bond offering.

Just to illustrate, if we were to assume the lowest FCF burn from the street for ROY 2020 and zero FCF in 2021/2022, BA would still have enough cash on hand to fund debt maturities through 2022 (including the $14bn Delayed Draw Term Loan).

Note: Assumes that $5bn of CP outstanding is rolled/re-financed by drawing on the 2024 Revolver

Other credit considerations:

1. Downside protection from ratings downgrades, as the coupon increases by 25bps if downgraded by either Moody’s and/or S&P to junk + each subsequent downgrade (up to an additional 200bps in total). BA has already recently been downgraded by Moody’s (4/10) and S&P (4/29)

2. CEO is prioritizing debt reduction and has publicly said they won’t be paying a dividend (for up to 3-5 years) or won’t be buying back stock before delevering. There is still $70bn of market cap behind $24bn of net debt - plenty of capacity to raise equity if needed. Plus, BA is a Fed-eligible issuer

3. Tail-risk downside protection: 1) BA is too big to fail; and 2) BA’s debt is covered by the Defense business alone if we assign zero value to commercial aero or aftermarket. Unsecured debt should see much higher-than-typical recoveries if they were to unexpectedly default given the lack of secured/senior debt in the structure

Valuation:

These two bonds are trading at a ~50-60bps wider spread vs. legacy long-dated BA bonds despite having better downside protection (interest rate step-up with downgrade to junk) and more liquidity. While one could make an argument around dollar prices (lower dollar price means less downside on a default), we don’t put much weight on this as BA is far from an insolvency discussion. Because these bonds are not callable until very close to maturity (within 6 months), the torque the bonds have to changes in credit spreads is tremendous and is the reason why we find them so compelling.

Just taking a quick look vs. history, BA’s 8/1/59 bonds were trading at a ~150bps spread up until mid-Feb. While the world has admittedly changed, it does speak to the historical credit quality of BA. We think we’re playing for the back-end to compress to 200-over in the next 6-18 months.

Just to highlight a few comps’ spreads: 1) GE’s 5/1/50 bonds are at 360; 2) CAT’s 4/9/50 bonds are at 170; 3) DOW’s 5/15/49 are at 280.

Catalyst

MAX return to service

Passenger air traffic improving off the bottom