Description

Introduction

We’d like to try to make up to VIC readers after the Bombardier debacle with another Aerospace company that will hopefully fare a lot better: Boeing.

We will not spend many lines describing the business of this $100bn market cap, Dow member, as pretty obvious to everybody. Very briefly though, Boeing operates under 3 divisions: Boeing Commercial Airplanes (“BCA”), Boeing Defense Space and Security (“BDS”) and Boeing Capital (“BC”):

·         BCA – c. 70% of sales, ¾ of contribution profits (before central costs)

·         BDS – c. 30% of sales, ¼  of contribution profits

·         BC – negligible

Summary Investment thesis

Boeing represents a compelling risk-adjusted investment proposition at current levels. In our estimates, the company will generate over 50% current market cap in free cash flow over the next 5 years and will use 100% of this free cash flow in dividends and share buybacks. Whilst Boeing has been around for about a century, we’d argue it has never been in such a sweet spot as it is today. We believe that cash flow is about to accelerate dramatically, well above consensus estimates. Furthermore, Boeing has incredible visibility over the next 5-6 years with virtually no development program in the pipeline to spoil the party. We think investors can double their money on a 3-4 year time frame with virtually no downside in a more pessimistic bear case scenario.

Brief business description

 Boeing is the largest Aerospace and Defense Company worldwide with nearly $100bn in sales and 165,000 employees worldwide. Whilst the US represents only c. 25% of the civil business and c. 2/3 of the defense business, the company has very little FX exposure as the vast majority of costs are denominated in USD and virtually 100% of sales are in USD. Over 95% of its properties are based in the US. It has about $500bn in backlog, representing over 5 years in sales.

A word on management

It is crucial when investing in aerospace to get comfortable with management. When dealing with multi-year, multi-billion dollar very complex projects, execution is paramount. The biggest risks in investing in aerospace are associated with program delays and cost overruns. Boeing is not immune from this but we’d argue that current management does instill some degree of confidence that such blunders (see the 787) are a thing of the past. Jim McNerney came on board in 2005 when the 787 was already in the pipeline and his contribution in this regard was actually positive. He successfully reduced costs across all other platforms as well as in the defense business and executed his plan to perfection. Over the last 6 years, Boeing has consistently under promised and over delivered. McNerney recently retired as Chairman of the company and is succeeded by Dennis Muilenburg, a true veteran at Boeing with strong operational experience. The choice of McNerney by the Board is telling: Boeing chose a true operational person, someone that will continue to execute and improve operationally to bring further cost efficiency, cash generation and margin expansion. From this point of view we are relieved Boeing didn’t choose an external person that may have been more focused on growth.

BDS

Boeing Defense Space and Security has the DoD as its major customer representing c. 65% of sales. The second largest customer it NASA. BDS operates under 3 segments:

1.       Boeing Military Aircraft

As the name suggests, this division is responsible for the production of a number of aircrafts for combat (e.g. F/A-18E/F Super Hornet, F-15 Strike Eagle), helicopters (e.g. Chinook, Apache), surveillance and engagement (e.g. C-17) and drones

2.       Network Space & Systems

This segment is involved in military applications, such as missile launches, electronic and communication solutions, as well as commercial applications such as regular satellite launches

3.       Global Service and Support

This segment is focused primarily on military applications, offering training, logistics and overall maintenance services to Defense operations worldwide

Whilst BDS contributes to c. 1/3 of overall earnings from operations before central costs and pensions, we will not spend time on this section for a number of reasons. First and foremost, there is very little debate out there on the prospects of this segment. The effects of recent DoD cuts are clearly visible in results with top line declining from a peak of c. $33bn in 2013 to c. $30bn. The outlook doesn’t look much brighter. However – Boeing is well equipped to deal with this and used current market weakness as an opportunity to take billions of dollars in cost out of the system in the last 2-3 years with plans for further cost cuts. For this reason, notwithstanding some notable program headwinds (for example the  C-17, with 10 deliveries in 2013, 7 in 2014 and the program ending this year) margins actually expanded in the last 2 years, from 9.4% in 2012 to expected 10% this year. The company’s focus on lean manufacturing and cost cutting will lead to further margin expansion even in a depressed macro environment. We actually think that risk is on the upside if DoD budget recovers from the trough in 2015. Our assumptions are very much in line with street consensus: zero top line growth and marginal (20bps) annual margin expansion.

BCA

Boeing Commercial Airplanes includes the production of the 737, 747, 767, 777 and 787. In order of importance from a current year delivery standpoint:

·         737 - The 737 is the longest serving, world’s best-selling family of commercial jetliners. During 2014, its 5,000th Next-Generation 737 was delivered. In August 2011, Boeing launched the 737MAX, which is a family of aircrafts build on the 737NG model with new CFM engines and other technological improvements. Since its launch, the 737MAX achieved 2,725 orders. Its first flight is planned for 2016 with first delivery in 2017. This year, we expect c. 500 deliveries of the 737

·         787 – The Dreamliner entered into service for the first time in 2011 after years of delay (and c. $50bn in costs to date). The troubled Dreamliner, whilst a disaster from a financial standpoint, it actually gained quite some traction commercially with over 1,100 orders to date (and 282 deliveries to date). This program has been the biggest cash drainer for Boeing. It is expected to deliver c. 130 planes this year

·         777 – The Boeing 777 was introduced first in 1995 for very long distances and able to carry up to 400 passengers. Before the introduction of the A350, the 777 had basically no competition and enjoyed strong pricing power. Whilst not disclosed, it is widely assumed that Boeing earns up to 30% contribution margin on the 777, the highest margin of all planes. In 2020, Boeing will introduce the next generation of 777, the 777x. Being will deliver c. 96 777s this year

·         747 – The famous “Jumbo jet” is at the end of its glorious career, having been in production is some shape or another for c. 40 years. Demand for the 747 is falling and we expect production to fall to just 1 plane per month in the last years of the program

·         767 – As the 747, the 767 is also destined to be retired soon. Commercially, it fits between the 737 and the 787 and the current economics of the plane make it unattractive. Last year only 6 767s were delivered. We don’t expect a new 767 to enter into service before the middle of the next decade

Acceleration in cash generation

The reason Boeing is attractive today is because of its free cash generation acceleration expected over the next 5 years. There are a number of factors contributing to it:

1.       Unwinding of deferred costs on 787

As mentioned, the 787 has been a total disaster with c. $50bn in sunk costs to date. Of these, c. $30bn are capitalized and will be amortized over the remaining duration of the program accounting. For those that are not familiar with program accounting, Boeing sets a reasonable “block” on a program and calculates an average margin over the life of the program. In the case of the 787, the block consists of 1,300 and the company assumes “low single digit” margins on this program. When cash costs are above average program margins, Boeing capitalizes deferred costs. Vice versa, as we go down the learning curve and costs go down and cash margins improve, Boeing still reports the same margin in P&L but is actually generating cash. The difference is to be found in deferred costs which are being amortized. As of Q1-15, Boeing had over $30bn in deferred costs to be recovered in the program. “At March 31 2015, $22,357 of 787 deferred production costs, unamortized tooling and other non-recurring costs are expected to be recovered from units included in the program accounting quantity that have firm orders and $8,498 is expected to be recovered from units included in the program accounting quantity that represent expected future orders”. Under our assumptions, the program will be completed by 2021. This means that between the time deferred costs will start declining (we think Q1-16) and 2021, the company will generate c. $30bn in cash above accounting P&L. Effectively, this is, on average, c. $5bn in annual free cash flow tailwind pre-tax. Because Boeing pays taxes on cash margin and not accounting margins, net of taxes this represent c. $3.5bn of annual free cash flow tailwind over the next 6 years. Much controversy is going about the exact timing of deferred costs: will they peak in Q4-15? Q1-16? Q4-16? The bear case on Boeing is predicated on the fact that the learning curve on the 787 apparently flattened and deferred costs are not coming down fast enough. After a big deceleration in deferred costs build up in Q1-14, the learning curve seems to have flattened over the last 3 quarters which would imply that further margin expansion on a cash basis will be hard to come by for Boeing.

In reality, the program seems to be progressing as per management expectations. The sell side seems to be missing the fact that Boeing is transitioning from the 787-8 to the 787-9 which has similar (but higher) costs but much higher selling price, so as the proportion of 787-9s increases, deferred costs will rapidly peak and then decline to zero over the next 6 years. For those interested, DB is probably the clearest on the sell side on this point

2.       737 production increase

The second big reason for FCF acceleration is due to increased production of the 737. Whilst undisclosed, we believe the 737 is currently earning margins in the vicinity of 20%. It is effectively sold out to 2020 and production is set to increase markedly over the next couple of years. We believe Boeing will deliver c. 620 737 in 2019 which is c. 130 more than in 2015. Very simplistically, assuming c. $10m of margin per plane, that’s c. $1.3bn in incremental EBIT a year on average

3.       Pension costs

The third reason for the acceleration in free cash flow is linked to pension costs. Historically, Boeing had a sizeable defined benefit pension scheme that had to be funded annually. Beginning in 2016, following a renegotiation with the unions, around 90% of the workforce will be covered by defined contribution plan. At 2014 year end, Boeing’s plan was $17.3 billion underfunded on a GAAP basis, but due to the extension of MAP-21 (the HATFA legislation) for ERISA funding calculations, necessary funding should be very small over the next couple of years (the company assumes zero funding in the foreseeable future). With the recent sun setting of the main defined benefit plan (and with a potential rise in rates…not banking on this), BA significantly reduced its potential liabilities which were once a big drag on cash flow. This is not in consensus and bears like UBS assume c. $1.5bn in annual voluntary pension contributions going forward

4.       Absence of large development programs

This is not a positive factor in cash generation but it does significantly reduce the risk of cash burn due to cost overruns on large programs. The issue with large OEMs has always been the large amount of capital that went into new programs that didn’t earn the required returns because of delays and cost overruns (see A380, B787, and Bombardier C-Series). For the first time in its history, Boeing has probably a decade of visibility on existing programs with no obvious need to invest in new ones. The duopoly is well consolidated and neither Airbus nor Boeing has much interest in diluting returns venturing into unnecessary developments. Boeing will be focused on its 3 core programs to generated shareholders return: 737, 777 and the 787. Each one will be a material cash generator. Looking at the 4 programs under development:

·         787-9 will turn cash flow positive in 2016 as discussed above

·         The 737MAX has full deck commonality with the 737NG, substantially reducing development risks

·         The 787-10 has 95% commonality with the 787-9, hence very low risk

·         The 777x is probably the only program that will absorb some cash in its development over the next couple of years but the magnitude is such not to cause us major worries

5.       Margin upside

We don’t factor much margin upside going forward. However, as program blocks get extended, so will reported margins. Furthermore, Boeing’s R&D spending will provide some operating leverage having now spent most of what was needed on the 787. The next program (767?) will only materialize in the next decade, we think.

The bear case

We wouldn’t be able to buy Boeing at such attractive valuation (see below, forward 10% FCF yield) if not for some bear cases clouding the story. Very briefly, we list some of the commonly cited ones:

·         End of cycle. Conventional wisdom say “buy when book to bill is low and sell when it’s high”. Boeing has had book to bill above 1.0x for years now and at some point it will naturally drop. In fact, book-to-bill was below 1x in Q1 and Q2 2015. Last time it happened it was in 2009. See yesterday’s GS bear note on this. When this will intensify, Boeing will need to adjust its production line, so the bears say. We think we are in the midst of a super-cycle in commercial aviation and a year of lower than 1x book-to-bill is only natural and won’t change things. In the past, lower orders and cancellations had huge impact on Boeing but backlog stood at only 2-3 years. Today backlogs covers c. 8 years of production for most programs so a weak year from a commercial perspective won’t affect planned delivery. Furthermore, airlines have never been so profitable over the last 20 years which diminish the risk of cancellations. Load factors increased c. 15% from 65% 20 years ago to almost 80% today, effectively “eating” some of demand through better aircraft mutilation. We think the industry reached a likely maximum in terms of load factor. Finally, Boeing order book has never been so geographically diversified making it less prone to regional macroeconomic shocks

·         787 deferred costs to disappoint. We touched on this point above. Bears believe that Boeing is a few quarters away from peak deferred costs. In some ways, we don’t really care because the $30bn in deferred costs will eventually be recovered over the next 6 years and trying to model it on a quarterly basis seems useless. It may happen in Q1-16 or in Q3-16, we don’t really mind because it will happen

·         Bridge to 777x. There is a short term gap to bridge in terms of orders to match the expected deliveries of the 777. The 777x will be delivered in 2020 so there are c. 4.5 years of production to fill on the older 777. To date, there are 262 unfilled orders. We estimate that there are currently c. 400-425 incremental 777 to be delivered in the supply chain assumption before the 777x comes into service. This implies c. 150 of orders needed to fill this gap or c. 50 per year over the next 3 years. The risk of production shortfall is material. Assuming $10m in contribution margin per plane, that’s c. $500m downside to cash flow on an annual basis, or c. 7-8% of base free cash flow. This would be a worst case scenario. We are not too worried: a) even a $1.5bn cumulative impact to FCF would correspond to less than 2% of market cap, not material enough to move the needle fundamentally, and b) Boeing has ample time to get these orders given the fact 2015 and 2016 are fully booked already

·         Lack of earnings momentum. Boeing historically guided very conservatively and almost inevitably beat both on EPS and on Free Cash Flow. Over the last 3 quarters, EPS surprise turned negative, partially due to the fact that the Street moved at the high end of guidance given the company previous track record of beating estimates. Furthermore, for the first time in years Boeing had in Q1-15 a quarter of negative free cash flow. We are not particularly bothered by these short term noises to the overall long term thesis

·         Pre delivery payments. Boeing generated significant amount of cash in the past from advances and progress billings from customers. In 2014, advances and progress billings increased from $25.5bn to $29.2bn, generating c. $3.7bn in cash. The bear case is that as the order book will go below 1x, there will be fewer advances (i.e. down payments) and from being a source of cash, advances and process billings will decline, becoming a drag on cash. In reality though, the vast majority of cash comes from progress payments which starts c. 24 to 12 months before deliveries. The down payment part is very small. For this reason, cash from progress billings is much more tied to deliveries than to orders. As Boeing deliveries are set to increase, we expect this to remain a source of cash. Over the last 10 years, pre delivery payments have been a drag on cash flow only in 2009, a year when deliveries actually declined. As long as deliveries increase, it will remain a source of cash for Boeing

Putting the above together

We believe Boeing will be able to generate c. $55bn in free cash flow over the next 5 years, equal to over half of its market cap. Given its net cash position, we believe Boeing will use 100% of free cash flow in dividends and share buybacks. Simplistically:

The above is a very summary view of cash flow generation over the next 5 years. The output of our more detailed model is the following:

Applying a 12.5 forward FCF multiple, we see almost 100% upside on a 3 year basis:

Catalyst

• 787 Deferred cost coming down
• FCF generation coming above expectations
• Continued buybacks