• We believe EADS, ticker EAD_FP is a compelling short idea.
• Target, 11 Euros or 31% downside.

Overview:

EADS is a European aerospace company that was formed from national aerospace companies in Germany, France, Spain and the U.K. the company is operated as an extension of local governments, and its raison d’etre seems to be to provide local jobs and develop leading edge technologies, however unprofitable.

 The company has four businesses:

1. Commercial aviation - 62% of sales and 28% of profits with a 3% EBIT margin in 2009
2. EuroCopter - 11% of sales and 19% of profits with a 5.8% EBIT margin in 2009.
3. Astrium - 12% of sales and 19% of profits with a 5% EBIT margin in 2009.
4. Defense & Security - 13% of sales and 33% of profits with an 8% EBIT margin in 2009.

All divisions are slated to show lower EBIT margins in 2010, and the company will generate no free cash flow this year. Management has cancelled dividends and decreased 2010 EBIT guidance for from 1.6 to 1 billion Euros .  

Despite this, the stock trades at near highs as analysts expect a weak Euro to benefit earnings. This ignores the company’s 66 billion $ hedge book, which makes for nearly ZERO currency translation benefits accruing to the bottom line over the next three years.

Our non-consensus view is that profits will not recover in 2011 due manufacturing issues with the A380, continued high capex from the A400M and potentially A350, decreased military spending in Europe,  lower Eurocopter sales, and an FX hedges that fully cover sales through 2012.

 Thesis:

 EADS is a compelling short for the following reasons:

1. The company has never earned its cost of capital or generated meaningful cash flow. The structure of the entire company including its origination, corporate board and management structure is not established to create shareholder value
2. The stock head meaningfully out-performed European peers as the company is seen as a weak Euro beneficiary – but all its $ exposure has been hedged through 2013 +
3. The company’s defense business is vulnerable to announced European government defense spending cuts.
4. Analysts covering the stock value it on a DCF basis (with positive CF always being one year out) or as a multiple of sales (which makes even less sense given the company’s paltry margins). Further, most analysts seem to miss the full extent of liabilities on EADS’ balance sheet (we estimate that EADS has 9 times debt  to equity)
5.  The company faces a meaningful increase in competitive threat from Boeing's 787 as well as from regional jet manufacturers (including Embraer and Bombardier)
6.    First quarter results demonstrated notable operating and financial performance declines: the company achieved a 0.2% EBIT margin vs 2.6% in 1Q09 and cash flow was -726 million Euros in vs -360 million Euros in 1Q09.  Performance in coming quarters will remain equally paltry.
7. The company's return on capital employed has averaged 6% for the past 10 years and has recently declined to 2% due to large amounts of capital allocated to unprofitable projects such as the A380 (development costs: 14 billion Euros vs an original estimate of 8 billion Euros) and the A400M. note that neither program is likely to generate a positive return on capital for investors over the next 2 decades.
8. EADS’ BV has declined from 13 billion Euros to 8 billion Euros due to charges associated with cost over-runs, losses on FX hedging and restructuring costs.  We believe that problems with the A400 M, the A 380 as well as the A350 project willlikely lead to further, meaningful write-offs.
9. Senior management at EADS is dysfunctional: a French and a German co-CEO are appointed to look after both French and German interests (often at odds with each other) and care about job creation rather than shareodler returns.

Valuation: 

The stock has rallied over 16% in the last two week and is now up 12% year to date based on sell side enthusiasm for a weaker Euro’s benefit at the bottom line. We believe EADS shares are worth approximately 11 Euros, or a generous 1x book value.  At 11 Euros, the stock would be trading on a PE of 22x for 2010 and 18x our earnings estimate for 2012. 

Several sell side analysts note the discount on EV/Sales and EV/EBITDA as a reason to buy EADS.  We note that EADS has demonstarted 2% EBIT margins and zero to negative cash flow over the last three year, compared with Boeing's 8% EBIT margins and $5 to $9 billion in cash flow.  We'd also noted that EADS has a net debt position of approx. 9 billion euros (verified by interest expense rather than income) while some analysts claim a net cash cash position.

 The differences in amounts relates to cash provided by customer financing as well as the opaque accounting for liabilities. . 

Our estimates call for an EBITDA of 1.2 billion Euros in 2010 and 1.5 billion Euros in 2010 placing EADS on a valuation of 10.9x EBITDA 2010 and 8.7x EBITDA 2010 excluding what we view as the large net liabilities of the balance sheet.

Annual General Meeting, June 1st.

Berlin Air Show, June 8th

2Q results July 30th.