Description

Bombardier (BBD) is a manufacturer of trains (transportation segment, LTM revenue $8.5bn, 6.0% EBIT margins) as well as bizjets and regional jets (Aerospace segment, LTM revenue $9.4bn, 4.5% EBIT margins). Within its core transportation, bizjet and regional jet business, BBD has the potential to grow EPS by 50% from its current base of 40+c to 60+c of EPS by improving segment margins to 8%. I believe BBD can grow EPS beyond those levels to 80c-$1.00 as BBD enters the commercial jet market with the CSeries. Additionally FCF will exceed EPS due to increased amortization, so there’s potential for further upside.

The transportation segment currently has a $31bn backlog, which is roughly equivalent to 4 years of LTM revenue. $5.5bn of transportation revenues come from the rolling sock sub-segment, which are light rail vehicles, metros, commuter and regional trains. The remainder is from services, systems and signaling contracts. Segment margins are recovering from historical troughs and management believes it can improve segment margins from current levels to 8% with higher margin contracts currently in its backlog. This seems plausible given the strength of the backlog and the sequential improvement in margins the last few quarters.

$5.1bn of revenues from the Aerospace segment come from BBD’s bizjet franchise, which includes the Learjet, Challenger and Global platforms (their small, medium and large bizjet platforms). $1.2bn is from BBD’s CRJ regional jets, and the remainder is from amphibious planes and services. The aerospace business is enjoying strong growth in both the business jet and regional jet markets. Order backlog by plane, measured in months of LTM production as of Q2 2013 was 11 months for Learjet, 22 months for Challenger, 32 months for Global, 13 months for the Q400 and 55 months for the CRJs. Subsequent to Q2, Ilyushin Finance signed a letter of intent for 50 Q400s which should convert into firm orders in 2014, adding another ~17 months of backlog based on current production levels. As BBD begins to realize the revenue associated with the large bizjet orders from Vistajet, Netjets and Flexjet in its backlog, it will enjoy operating leverage as shipments grow and a mix shift to higher margin Challengers and Globals which will help it realize 8% segment margins for the existing aerospace segment.

There has been some discussion about BBD’s exposure to off balance sheet liabilities related to residual value guarantees and trade-in commitments. It’s unclear how much of the liability resides with older CRJ200 or bizjets, though it’s worth noting that these liabilities should grow as the overall aerospace business grows. Regarding the former, BBD has been actively developing new markets for the CRJ (e.g. Russia, South East Asia and South America) to place older CRJ200s.  With regards to the latter, the recent divesture of BBD’s Flexjet aircraft flight-share unit for $185mm to PE investors should to help decrease the size of BBD’s exposure, though it’s unclear exactly how much. The divestiture also came with a nice $1.8bn order for new Learjets and Challengers which is additive to the already strong Q2 order book.

BBD is currently flight testing its new CSeries plane, a 100-160 seat jet, which targets the smallest platforms of the 737 and A320 family (the 737-7 and A319). The CSeries is the first all new narrow body platform to come to market in decades. It harnesses new technologies, including the P&W geared turbo-fan engine, composite wings and a lighter lithium-aluminum fuselage. Fundamentally the CSeries is advantaged versus the 737-7 and A319, since its purpose built for the 100-160 seat market, whereas the 737-7 and A319 are over-engineered scaled down versions of the 737 and A320 family. Therefore the CSeries will be 15-20% cheaper to operate versus the 737-7 and A319.

The CSeries is probably the most controversial business decision BBD has embarked upon. Since 2010 BBD went from a net debt neutral position to a net debt balance of ~$4bn in Q2 2013 largely due to the ~$2.8bn its spent developing the CSeries (the remaining ~$1bn is from working capital and the development of 2 other new platforms. Note working capital is very seasonal, it’s a big use of cash in H1 and a big source of cash in Q4). The backlog for the CSeries currently stands at 177 firm orders, filling slots for the first three years of production. But it pales in comparison to the orderbooks of Boeing and Airbus’ re-engined legacy 737 and A320 family – the 737 MAX and A320neo. However, because the CSeries is a clean sheet design targeted for the 100-160 seat market with composite wings, it will deliver >10% fuel efficiencies versus its direct competitors the 737 MAX 7 and A319neo. The NPV of those fuel efficiencies are hard for BA and Airbus to compete against, even if you consider the incremental pilot training costs due to the absence of commonality. Overall, high oil prices have driven this aerospace cycle and airlines have ordered the 737 MAX and A320neo family in droves. As the superior product in a niche market, the CSeries should enjoy a similar tailwind.

The primary fear surrounding BBD’s investment in the CSeries is it’s a commercial dud because of the relative weakness of its orderbook compared to the several thousand strong orderbook for 737 MAX and A320neo family. However it’s worth noting that the direct competitors to the CSeries also have weak order books. The order book for the 737 MAX and A320neo is heavily weighted toward the larger platforms within the family – the 737 MAX 7 only has 30 orders and the A319neo has 45 orders. Though there’s some degree of upgauging occurring in the market, as airlines convert their legacy 100-160 seat platforms for larger models, the battle for the 100-160 seat market is clearly still open. BBD estimates demand in this market to be ~7,000 jets over the next 20 years. As CSeries flight testing progresses and BBD proves it can achieve targeted fuel efficiencies, meaningful demand will surface and BBD will build a stronger backlog for the CSeries. 

The CSeries isn’t the only platform BBD is developing. It’s also refreshing its Learjet and Global lineup. So collectively BBD has capitalized $4.5bn for 3 new platforms versus an EV of $12.2bn. As deliveries begin, BBD will begin to amortizing this balance. This has important implications for cash flow. So far the street has dismissed the CSeries as an EBIT dilutive program, mainly because BBD has said it can improve EBIT margins of its aerospace margins excluding the CSeries to 8%, but the CSeries will dilute margins down to 6% when deliveries first begin before recovering after ~2 years. That dilution is due to 1) the learning curve associated which launching new airplanes where EBITDA margins accrete over time, 2) the amortization associated with program tooling, 3) discounted launch pricing.

BBD’s existing business (excluding the CSeries) generates ~40+c EPS, so the shares trade at ~12x earnings. If you assume BBD’s revenues don’t grow and they achieve 8% segment margins in both the transport segment and existing aerospace segment, BBD will generate ~60+c of EPS, so it trades at ~8x earnings. When you include the earnings potential of the CSeries on top of that, BBD has 80c-90c of earnings power, so it trades at 5-6x earnings. Amortization associated with program tooling adds 25 – 30c per share of cash flow on top of the 80c - 90c of EPS, so cash flow per share could be $1.05-1.20. Thus I would argue that BBD is undervalued excluding the CSeries, and including the CSeries it’s easy to see how BBD can more than double.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock. The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time.

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