Description

Boeing (BA) is significantly mispriced and offers a highly compelling risk/reward profile.  Boeing is one of two key OEMs in the global aerospace industry, which features long-term growth well in excess of GDP, primarily due to increased affordability of air travel.  With a powerful moat, BA has excellent and growing returns on capital.  Boeing generates a 29% ROIC on just 9.5% margins, which management believe can rise to mid-teens over time.  At the low end of our estimates, Boeing will generate $13 of FCF/share in 2017, $15.31 in 2018 and $18.49 in 2019.  Boeing has historically traded at 15-17x; using a low forward multiple of 12x to account for the current position in the book/bill cycle, BA would be worth $184 by YE17 and $222 by YE18. 

In December, Boeing will raise its dividend to $5-5.50/share for a yield at the low end of 3.5%.  On the 4Q release, Boeing will guide to at least $13/share in 2017 with potential for upside.

Since BA is a highly liquid, blue chip company which should be efficiently priced, why does this opportunity exist?

-        First, sentiment on the stock is muted.  Short interest is 8 days to cover.  Another example is BA hasn’t been written up on VIC since 2004 and that write up had no messages. 

-        Second, the market is overly concerned with book/bill cycle.  Sell-side bears are overly focused on a lack of widebody orders this year and the industry book/bill of likely less than 1x this year. 

o    This cycle is different, since it has been driven more by new product introductions than underlying air traffic fundamentals, which led to significant pull forward of orders in 2013 and 2014 as several new models were launched. 

§  Nevertheless, this bear case does have some merit, but was much more compelling in 2013, when book/bill (and, in turn, BA’s multiple) peaked.  By 2016, book/bill will likely be under 1 (again primarily due to a pull forward of demand) and resulting long order books. 

§  Valuation more than takes into account a bear case.  In a severe recessionary scenario, it is difficult to get to trough FCF of anywhere less than $10/share outside of a one-time working capital hit. 

-        Third, BA uses unique program accounting which attempts to average out prices/margins over the course of its programs.   While not diving deep into the details of program accounting here, BA’s adjusted EPS over the past several years was significantly higher than its cash EPS, as BA booked profits on 787 while the 787 actually burned $28bn of cash.  3Q16 results marked the inflection in that trend with the 787 cash flow now significantly outpacing booked profits.    While 3Q16 results marked an inflection, the bears continue to say the program has a long way to go to live up to its promised 25-30% cash gross margin profile.  The 787 will be at least a 20% gross margin business as a result of initial price penalties on the heavily delayed initial deliveries phase out, mix benefit with the -9 and -10s significantly more profitable than the -8s, supplier step downs as the program matures and Boeing’s own productivity curves (i.e., assembling unit 600 will be cheaper than unit 500).

-        Fourth, BA suffers from management credibility issues.  While management is in fact credible, Boeing management speaks to a number of different constituencies and balances their rhetoric when speaking to shareholders as it impacts relationships with their unions, governmental entities, its customers and so on.   Boeing’s slow motion cut to the 777 program is a case in point, as the company seems to be desperate for orders and not willing to manage supply with demand.  In actuality, BA has cunningly used the threat of production cut and impact to its employees to help push the government to finalize the Iran order in a timely manner.  While we model the 777 on a worst case basis, we think it’s likely BA can keep rate at 7/month throughout 2017 (which would be a hike to street 2017 numbers) and manage delivered rate from a currently expected 5.5 in 2018 to 4-4.5 (above the worst case 3.5 most sell side analysts assume). 

-         Finally, the bears model much worse FCF/share estimates due to a misunderstanding of how advanced payments work.  Bears also assume management has significant excess costs on the 777X program without crediting them for tailwinds on other key programs. 

o    BA will face the bulk of the advance payment cash headwind in 2017 as a result of lowered 777 deliveries, so we believe that by the end of ’17, this issue will be moot. 

o    The 777X program, while unknown, is unlikely to generate significant upfront cash outs aside from the actual physical inventory and minor upfront losses as BA climbs the learning curve in incorporating a composite wing.  At the same time, BA will get a tailwind from inventory on both the 737MAX and 787 program that the bears do not incorporate.

Aerospace industry

In a sluggish global environment, air traffic grew a whopping 7.0% in September and 5.9% YTD, as air traffic continues to exceed GDP growth primarily due to increased affordability (including more middle class in APAC, more Low Cost Carriers like Ryanair aggressively expanding capacity, etc.).  In the last recession during the global financial crisis, air traffic was down just 5.5% using the peak to trough on a seasonally adjusted basis; compared to other cyclical industries, that is simply a blip.   While the airline industry itself is brutally competitive, BA and Airbus as well as its consolidated supply base, are the key beneficiaries of this long-term secular growth.

IATA publishes monthly air traffic statistics at the following link

http://www.iata.org/publications/economics/Pages/Air-Passenger-Monthly-Analysis.aspx

The positive outlook for Aerospace is further highlighted by a slew of M&A transactions including Rockwell Collins purchase of B/E Aerospace (despite its heavy exposure to the widebody market), Berkshire Hathaway’s purchase of Precision Castparts, the take-outs of CIT’s aircraft leasing business and Avolon, Solvay’s purchase of CYT (maker of carbon fiber), Alcoa’s purchase of RTI (Titanium), UTX/GR and numerous smaller acquisitions best highlighted by the successful roll up of parts suppliers by Transdigm. 

Boeing Investment Case

While Boeing is a long-term growth investment on the long-term secular drivers of Aerospace, it is currently a value stock at just ~11x 2017 FCF on the low end case with no net debt. 

Boeing is a relatively simple business delivering just 750 units in its Commercial Aerospace division across 3 main models, the 737, 777 and 787, which comprise 96% of Commercial manufacturing revenues.  The 737 (38% of revenues) is a near 30% cash gross margin business that will have increased production in 2017 and 2018 and is undergoing an upgrade cycle with the 737MAX scheduled to be delivered in 2017.  Boeing may add another stretched variant to this product to further support orders into the early and mid 2020s.  The 777 (26% of revenues) is also undergoing a transformation, though larger in scale, to the 777X.  Bridging from the 777 to the 777x will require a significant decline in deliveries with an upturn expected with the launch of the 777X in 2019-2020.  The 777X has already secured 4.5 years of backlog at our expected 6 per month normalized delivery rate.  The 777 is currently mid-20s cash gross margin business, which will suffer from negative operating leverage as rate comes down.  The 787 (32% of revenues) will produce a 4.1% cash gross margin in 2016.  The 787 surprised the market by producing a 6% cash gross margin in the third quarter.  By 2018, 787 will produce a 17% cash gross margin. 

The 787 therefore is the biggest driver of FCF with a 13% cash gross margin improvement expected from 2016 to 2018.  On $20bn of revenues, that’s $2.6bn of incremental FCF not including impact from higher ASP.  This is driven by a few key factors. 3Q was already at 6% cash gross margin, so that bridges 2 of the 13 points.  3Q had 9 787-8 deliveries that were all low cash gross margin.  As the -9s (price 20% higher than -8) and -10s (priced 40% higher than -8s) enter production lines and the -8s decline, BA will benefit from significant mix improvement with minimal added cost with -9 and -10 having very high commonality with the -8.  BA itself has publicly stated that 70% of the way to normalized cash margins on the 787 is mix and price.  Price/mix will add 7.1% to cash margins from 3Q2016 to 2018.  The incremental 390bps of improvement will come from standard aerospace learning curve improvements and supplier step downs.  In our diligence, we have uncovered numerous pricing arrangements were BA’s procurement prices drop as its own suppliers go up their own learning curves.  Often these occur on 100-unit block changes (we just entered unit 500 in 3Q), or they can simply be driven by time (i.e., on Jan 1 of every year, price drops 2% for example).  BA is currently in negotiations with Spirit Aerosystems (SPR), one of its large suppliers on the pricing of the 787 fuselage and cockpit and the question is the magnitude of the decline, not whether SPR will be able to push through an increase.   

We have mostly kept our discussion to Commerical  Aerospace.  Defense, Space & Security will be relatively stable at slightly north of $3bn of EBIT per year.

Below is a summary output of the key drivers of FCF/share for the next several years. The key assumptions here are 737 rate of 52/month (vs. 57 planned), 777 rate of 4, 787 rate of 12 (with an annual rate of 25 on 787-10), and 787 cash gross margin of 18.6%. 

Free Cash Flow Per Share YoY Bridge                                                                                      

                                                            2014     2015     2016E   2017E   2018E   2019E

Beginning FCF per Share              $7.90     $8.98    $9.93    $11.32  $13.04  $15.31

737                                                      0.77       0.25      (0.13)   0.54      1.31      0.87

777                                                       0.11      0.04      (0.34)   (0.89)   (1.84)   0.03

787                                                      0.63       1.67      2.77      1.93      1.54      0.73

Working Capital                                (1.50)    (0.22)   (3.32)   (1.13)   1.44      0.61

Capex                                                  (0.18)    (0.29)   (0.50)   0.31      0.33      -  

Share Repurchases                           0.34      0.54      0.83      0.78      0.61      0.73

Other                                                   0.90       (1.02)   2.08      0.17      (1.11)   0.21

Ending FCF per Share                        $8.98    $9.93    $11.32  $13.04  $15.31  $18.49

YoY Growth                                          13.6%   10.7%   13.9%   15.2%   17.5%   20.7%

To address the numerous bears on Boeing, we look at a highly unlikely bear case scenario in 2019.  If we assume a monthly rate of just 42 737s (this would compare to BA’s plan of 57 and a backlog of 4,300), 3 777s (despite a backlog of over 300 777X orders to date and a 2017 rate of 7/month), and 10 787s (vs. a plan of 12-14 and despite a backlog of 715 currently). If all those decreases happened at the same time (which would be highly unlikely), then BA will face a significant one-time WC headwind of $4.72/share.  Adjusted for that one-time headwind, FCF/Share, would be $11.09/share in 2019.    

Free Cash Flow Per Share YoY Bridge                                                                                       

                                                            2014     2015     2016E   2017E   2018E   2019E

Beginning FCF per Share              $7.90     $8.98    $9.93    $11.32  $13.04  $15.31 

737                                                      0.77       0.25      (0.13)   0.54      1.31      (2.57) 

777                                                       0.11      0.04      (0.34)   (0.89)   (1.84)   (0.73) 

787                                                      0.63       1.67      2.77      1.93      1.54      (1.01) 

Working Capital                                (1.50)    (0.22)   (3.32)   (1.13)   1.44      (4.72) 

Capex                                                  (0.18)    (0.29)   (0.50)   0.31      0.33      -   

Share Repurchases                           0.34      0.54      0.83      0.78      0.61      0.30 

Other                                                   0.90       (1.02)   2.08      0.17      (1.11)   (0.22) 

Ending FCF per Share                        $8.98    $9.93    $11.32  $13.04  $15.31  $6.37 

YoY Growth                                          13.6%   10.7%   13.9%   15.2%   17.5%   -58.4%

Conclusion

With the 787 performance now exceeding expectations, the path for BA’s FCF/share to continue to improve through the end of the decade is apparent.  At just 9.3x 2018 FCF and 7.7x 2019 FCF, there exists significant long-term upside in BA.  Near term, there is total return of 33.3% to YE16 based on 12x 2018 FCF and a $5 dividend.  Downside is protected by strong FCF, a sustainable and growing dividend, (modeling in $5.23 in 2017 or a 3.7% yield and $6 in 2018 (4.2% yield), a fortress balance sheet, an extended backlog, the resiliency of air traffic as shown in the GFC, and significant capital returns (estimate BA will return over 30% of its market cap via dividends and share buyback over the next 3 years). 

Risks

Significant global recession; Declines in air traffic from terrorism or oil price shock; Longer-term growth rate hit by viable Chinese competitor; Program risks on the 777X or a launch of a new 757.  

Catalyst

There are strong catalysts that will highlight the value in the near term.  Dividend increase in December, 4Q results demonstrating further 787 cash improvement, and 2017 guidance.  Given where sentiment is around aerospace and the “cycle”, orders will be viewed positively, particularly an executed Iran order would fill the 2017 production line for the 777 and give some further visibility to 2018.