Summary Investment thesis

For long term investors who can bear short term volatility, Bombardier (“BBD”) represents a compelling long opportunity. BBD shares are currently depressed because of a number of overhangs / fears / misconceptions which will go away in the next 12-24 months, namely:

• Excessive leverage – BBD’s current leverage is high at 2.7x Net Debt / EBITDA and over 5x Gross Debt / EBITDA
• Low (negative in fact) cash generation – share price dropped 7% after Q1 results because cash burn was higher than expected
• Low margins – in particular, in its aerospace division, BBD has the lowest margins in the sector
• Program delays – BBD is in the midst of the development of three large aerospace programs, some of which were hit by delays
• Perfect storm on its main development program (CSeries) – during May and June 2014, the company suffered a number of blows to this program (order cancellations, expected orders not materialising, test engine accident)
• Weakness  in its business aviation segment
• Sub-par margins in its trains division

On top of these overhangs depressing the stock, the market also fails to recognise the substantial upside embedded in BBD’s aerospace business and to a lesser extent in the Train division, due to typical short termism. In particular, the market fails to appreciate the following:

• Steep top line acceleration from 2015-16 onwards due to the introduction of new business and commercial aviation programs
• Cyclical recovery in the business aviation segment where we expect orders (and deliveries) to pick up considerably after 4/5 years of inventory draw down post-recession
• Margin recovery in the train division as loss making contracts are rolling off in 2014-15

The margin of safety here is wide. Bombardier trades on current 2014E 10x earnings where aerospace comps trade on mid to high teens and train comps trade on mid to low teens. In our base case scenario we believe there is c. 150% upside over 3 years, or a compounded annual return in the mid 30%.

Also, this is a stock very much out of favour, under the radar screen that didn’t participate in the recent market and aerospace rally. Large US brokers (GS, ML, JPM) are all negative on BBD with a SELL recommendation. The scope for re-rating in the stock is substantial.

(All figures in the below sections will be in USD unless otherwise stated except for the share price, which is in CAD).

Brief business description and recent developments

BBD was founded as a snowmobile manufacturer in Montreal in 1942 and grew through a number of acquisitions to become a leading rolling stock (trains) manufacturer and Aerospace OEM. As of FYE 2013, the balance of revenues was equally split between trains and aerospace. Going forward, the aerospace division is expected to grow much faster. Margins in aerospace are currently depressed (little over 4% in 2013) so the majority of profit comes from the train division. In terms of cash flow, the train division is very cash generative with cash conversion of c. 100% over time (FCF over EBIT) while the aerospace division is currently consuming large amounts of capital.

The aerospace division has really 3 components to it: a commercial division focused on regional jets, a business division (business jets) and a service division. The 3 segments have very different characteristics. The commercial division follows the traditional long cycles of the aerospace industry (like Airbus and Boeing) where backlog tends to cover many years of production and margins tend to be more resilient. The business division on the other hand is much more susceptible to the business cycle and backlogs typically don’t go over a year. The service division is much more stable.

The train division is stable and is expected to grow in line with GDP. Its main division, Rolling Stock, drives demand for the other 2 divisions, Services and System & Signalling:

Share price in BBD stagnated since market selloff in 2008-09 and didn’t recover like most other aerospace OEMs for a number of reasons:

• Whilst the commercial aviation cycle picked up quickly after the recession in 2010, the business aviation cycle was in a state of significant oversupply from 2010 onwards. Corporate and rich individuals around the globe found themselves with too much inventory of business jets. Between 2010 and 2014 the industry witnessed a steady retirement of older jets and draw down in parked jets. Such conditions caused new orders to plummet. Bombardier historically benefitted from its leading position in business jets and suffered both volume collapse and margin compression given the difficult market environment
• Whilst the commercial aviation and the regional jet market picked up, Bombardier didn’t quite benefit from it because it started losing market share to Embraer on its CRJ jets and to ATR on its turboprops Q400. Again, lower volumes there affected financials
• In 2008, Bombardier announced that it would start its first large commercial aviation program, the CSeries, aimed at the 100-149 seats market, which would put it in direct competition with Airbus and Boeing. Such programs require many years (6-7) of investments before any return can be made. BBD is at the very cusp of this investment phase, not only on its CSeries but on 2 other programs concurrently. The research and development which includes investments in tooling on these 3 programs caused massive cash outflows in the last 4 years that led to increase in leverage. The market didn’t like this
• Furthermore, it appears that following the recession, in order to fill the pipeline, Bombardier bid very aggressively on a number of large train projects at low, and sometimes negative, margins. This caused overall decreased in EBIT margins in train segment from 7% in 2011 to less than 6% in 2013. The market projects these low margins going forward

Furthermore, in recent months, Bombardier was hit by a number of negative events that caused share price to fall further:

• Q1 results released on May 1^st 2014 were in line with expectations but showed worse cash burn than expected. Share price fell 6% on the day
• On May 15^th, Air Canada had results and its CEO announced intentions not to place an order with Bombardier on its CSeries, something that was widely expected. Share price fell 7% on the day
• On May 21^st, Republic Airways Holding, a regional jet operator in the US, announced that the previous order for 40 CSeries planes from Bombardier will not be cancelled at this point in time but the planes will no longer fit in RJET’s business plan
• On May 30^th the company announced an accident on its test plane regarding an engine. All test flights were suspended
• On June 10^th, the company announced that engines tests restarted but the test planes are still on the ground and that the CSeries won’t appear at the Farnborough show in July as somewhat expected by the market

This (rather incredibly unlucky) set of events spooked the already nervy investors about possibly further delays on this program, which is currently expected to come into service in H2 2015.

We believe that most of the fears and misunderstanding above described will go away in the next 12-24 months and at the same time, the company will exhibit tremendous acceleration in top line, margins and cash generation. Details below.

Understanding long cycle programs

Everyone that ever invested in aerospace should know that new programs are long, costly and prone to unexpected surprises. The CSeries for Bombardier is no different. The problem with Bombardier though was that it stretched itself too thin, both financially and operationally by developing 3 new planes contemporarily. This is something that in hindsight was a major mistake as all large OEMs are careful when developing a new aircraft not to stretch itself too thinly. For example, Boeing had many years between the B787 and the B777. Equally, Airbus allowed a number of years between the A380 and the A350.

Bombardier’s 3 large programs are the following:

1. CSeries – single aisle small commercial jet for 100-149 passengers. It’s a revolutionary plane in many respects, with new technologies including a new Pratt & Whitney Turbofan engine. Total development cost of the program: in excess of $4bn (just as indication of its size, the Boeing 777 development cost was c. $6bn). EIS (Entry in Service) expected in H2 2015
2. Learjet 85 – this is the largest in the Learjet class, which is a light business jet. Development cost is c. $1bn, EIS at the end of 2014 / beginning 2015
3. Global 7000/8000 – these are large corporate jets with the highest performances in the industry in terms of range and speed, competing with Gulfstream. Development cost is c. $2bn, EIS in 2016

Those 3 programs combined represent a cumulative investment in development, research and tooling of approximately $7bn. What is important to realise here is that for many years, BBD sees only the cash outflow with no returns from it. Once the deliveries will begin, there will be no more tooling associated with these programs and, on the contrary, the programs will start generating cash. In other words, even assuming zero cash generation from these new programs, the aerospace division is currently cash generative, even if it doesn’t appear so. From 2016-17 onwards, it will be very cash generative.

We think investor short termism is the reason why the market worries about current cash burn. In reality, we are at the very end of this long and large investment programmes. In our numbers, by the end of next year (2015), BBD would have increased its net debt position by $4.5bn between 2010 and 2015 but would have spent over $6.3bn in program tooling over the same period. From 2016 onwards, those programs will turn from use of cash to sources of cash. This long term dynamic is misunderstood by the market and is part of the reason why the opportunity exists today:

Aerospace division

The main value driver for BBD future appreciation is the Aerospace Division where we expect top line to grow by c. 75% between 2013 and 2018 and EBIT to double. In forecasting top line, we took a bottom up approach, estimating deliveries per type of aircraft multiplying them by an estimated price which is based on the list price plus a constant discount to list price as typical in Aerospace. The actual price paid by airlines is always a secret. In order to estimate aircraft deliveries, we took management estimates of market growth and market share in each market and cross checked these with OEM’s and competitors assumptions and consulted a number of industry executives to triple check these. On top of this, we took a haircut on all of the above to add a layer of conservatism in our numbers. See below our summary revenue breakdown estimates for 2018 for the division:

Commercial

In commercial, there are basically 3 segments:

1. Regional aircrafts (60-99 seats) – this is comprised by the CRJ family. In the past, it used to have a market leading position but lost market share to Embraer. We estimate that in 2013 this family of aircraft contributed $700m in turnover and it will fall to c. $340m by 2018. This is in stark contrast with company estimates as it believes it will continue to retain c. 30% market share in this segment. We think our assumption is particularly draconian in light of recent large orders for the CRJ900 Next Gen (Delta and American ordered a combined 70)
2. Turboprops (20-60 seats) – this is comprised by the Q400. In the past, the Q400 dominated the turboprop category but in recent years, they lost market share to ATR. Our industry calls suggest that ATR gained market share in developing markets as it’s cheaper than the Q400 but significantly less performant. The Q400 is a phenomenal aircraft as much cheaper than a jet of similar dimensions and yet almost just as fast. As developed market airlines will need to replace their older turboprops, we think BBD will gain a large share of the market for its new refreshed Q400 NextGen. We estimate than in 2013 revenues were c. $530m from the Q400 and that they will grow to c. $800m in 2018
3. CSeries (100-150 seats) – the crown jewel of BBD Aerospace. We spent quite some time discussing this program with potential customers and industry experts and came away with a rather constructive view of this plane. To cut the story short, this is the first commercial plane designed specifically for 100 to 150 passengers in 30 years or so (we may have to go back to the MD-80 or even further back to the DC-9). Interestingly enough, if one looks at the passenger distribution by number of passenger per departure, the 100-130 passengers is the most regular category in the US. Still, it’s not served well at all by the industry. Some OEMs try to stretch planes that were originally designed for smaller configuration (Embraer) and others try to shrink larger planes into smaller configuration (Boeing and Airbus). The net result is that the C-Series is, on paper, a much more efficient aircraft, also thanks to its Turbofan engine from Pratt & Whitney. Bombardier announced that it will have 300 firm orders by the time it enters into service in H2 2015. The order book today stands at 203. The market doesn’t believe BBD will get to 300, we do but we don’t believe it’s absolutely crucial to get there before EIS. Whilst orders came in possibly at slower pace than expected, it is important to note that since the CSeries launched, its competitors (A319 Neo, B737 Max) received significantly less orders than Bombardier. From market share perspective, they gained much more than 50%, it’s just that the market wasn’t there yet. As the programme goes through certification, we think more orders will flow in. The company expects a market of c. 6,900 deliveries over the next 20 years (or 345 per year on average) and capture 50% market share (implying c. 170-175 annual deliveries). In our model we estimated 2018 deliveries of 90, about 40-50% below company implied estimates. We have also done comparative analysis of the CSeries against its peers and it’s by far the most cost competitive aircraft in its range

The commercial aerospace division should therefore accelerate top line from $1.2bn in 2013 to over $5bn in 2018. In terms of margins, we will look at Aerospace margins on a consolidated basis as the company does not break down margins by business / commercial / other divisions. See summary assumptions below. Please note that under “market assumptions”, we used other OEMs estimates:

Business jets

Bombardier produces 3 families of aircrafts that correspond to 3 sub-segments in the market: light, medium and ultra-long range distance. The lighter segment has the lowest barriers to entry, it’s the most competitive and it’s has been hit the hardest during recession. Consequently, the light segment is the one most cyclically depressed, following by the medium segment and finally the high-end segment where demand and supply is back in balance today. Since there is a substantial element of fixed costs in this business, any cyclical recovery would have a very positive effect on margins as they are currently significantly depressed.

Just to put things in perspective, in 2009 the company delivered 70 Learjet, in 2013 only 29. The families of aircrafts are the following:

1. Learjet family – light business jets. It operates in a highly competitive market, competing with Cessna, Embraer, Gulfstream and Hawker Beechcraft. We assume that the new Learjet 85 (which according to the company should contribute over $1bn in revenues) will be somewhat successful but that overall, Learjet will be losing market share. The company assumed it will retain 20-25% market share, we assumed c. 13%
2. Challenger family – medium business jets. The market is competitive but Bombardier is doing a decent job at defending its market share. Key competitors are Embraer, Dassault and Gulfstream. The company delivered its first Challenger 350 this year. The company expects to capture 30-35% market share going forward, we assumed only c. 26%
3. Global family – large jets. This is actually a healthy market where at the very top end; it’s a near duopoly between Bombardier and Gulfstream. Conversations with industry experts confirmed that the new Global 7000/8000 will be the top of the range in the industry and will set a new standard when it will enter the market in 2016. The company expects to capture 35-40% market share. We assumed only 32% in our model.

The Business aerospace division is therefore expected to grow c. 7% annually to 2018 which is c. 20% below where the company is implicitly guiding:

Summary Aerospace assumptions

The final bit which we haven’t explicitly modelled is the growth in maintenance and other services revenues. We have conservatively assumed 6% CAGR to 2018 which we think it’s very reasonable considering that manufacturing sales will be growing at 14% CAGR. Summing it all up, we get total revenues of over $16bn in 2018 from $9bn in 2013. We have basically assumed $7bn in incremental sales which is below the low end of company guidance of $8-12bn increase in sales over the period. Below, we show a bridge from 2013 to 2018 by “mature” vs “new” programs:

In terms of margins, the company current generate a cyclical low of 4% EBIT margin. Last year, the company provided an indicative 8% EBIT margin target for 2014 that included a 2% dilutive effect from the CSeries. This target has been withdrawn and 2014 guidance stands at 5% EBIT margin with no dilutive effect from the CSeries as it comes into service in 2015. However, long term, we believe the company will be able to achieve 8% margin before dilutive effect from CSeries. This will be driven mainly by a sharp recovery in business aerospace margins as cyclically depressed volumes will pick up. Whilst very hard to estimate now, we assume that in 2018 there will still be 150bps of margin dilution from CSeries so we set EBIT margin 2018 at 6.5%. To put things in perspective, adjusted EBIT margin in 2008 (FYE Jan 2009, they then changed financial year end) was 9% so 6.5% target is certainly not an aggressive assumption.

Train division

The segment operates three divisions: Rolling Stock, Services and Signalling & Systems.

It is a market leader worldwide with large competitors being Siemens and Alstom. This segment is exposed to a number of secular tailwinds including urbanisation in developing countries, move towards clean energy and congestion reduction, liberalisation of public transport plus the normal replacement cycle. Bombardier is also exposed to the Chinese market where it operates a JV and offers high speed train solutions. Segment EBIT is currently below 6% but the long term target is 8%. A new CEO was appointed in 2013 from Boeing with the clear mandate to restructure the business, extract efficiencies and lift margins. We believe he will be successful in doing so. In our model, we assumed annual top line growth of 3% (against company target of 5%) and modest margin expansion annually to reach the stated target of 8% in 2018.

A word on cash flow

Much of the fear in the market is caused by Bombardier high leverage (c. 5x debt). This is very much mitigated by the large cash balance (c. $3bn) and access to debt facilities that ensures Bombardier has plenty of liquidity to finish its development programme without liquidity concerns. We note how CAPEX in aerospace peaked at $2.2bn in 2013 but it expected to decline already in 2014 to c. $1.75bn and then decrease until 2016 when it will drop below $1bn. At the same time, cash from operations will accelerate throughout the period so we are at the very nadir of cash generation in BBD corporate history.

Please note that in our cash flow analysis we factored increased usage of cash to service interest payment as a large portion of debt associated with development programs was actually capitalised. In 2013 for example, only $150m of interest was recorded in the P&L when the total actual interest cost was $359m.

It is noteworthy that the company regularly pays a decent dividend (2.6% dividend yield).

Summary financials and expected returns

Below we show summary financials and valuation metrics. On our numbers, Bombardier trades at c. 5x P/E 2018:

Looking at comparable companies in both aviation and trains, we get to an average comps multiple of 15x forward P/E:

Even applying a 20% discount to Bombardier, we would get to a forward P/E fair multiple of 12x. Applying such multiple to our estimated 2018E EPS of $0.69, we would get a fair share price of c. $9 in 2017, 3 years from now, or c. 150% upside. At $9 in 2017 Bombardier would still trade at 30% discount to peers on EV / EBITDA basis:

Alternatively, looking at SOTP valuation we get to very similar results. The key assumption here is what value to attribute to all future programs that are being developed. We assumed a 1x book value valuation for those. Even under this scenario we would get to 150% upside:

No matter how we look at this, the upside and the margin of safety appear to be very large.

Risks

In a way, a lot of what could have gone wrong already did go wrong in the last 2 months: customer cancellations, cash burn and even an accident during the program! We think that most of the risks are already more than priced in the stock but we would be remiss not to mention the following risks:

• Further delays to CSeries EIS past H2 2015
• Further customer cancellations
• Economic turndown delaying recovery in business jets
• Lower margin than anticipated on new programs and higher margin dilution than expected
• Liquidity crunch (but we think liquidity is sufficient even in worst case scenario)
• Corporate Governance – the family Bombardier controls the Board. The CEO is the son in law of Mr. Bombardier and his motives may not be align with shareholders best interest

• Quarterly results showing improvement in cash generation and margin recovery in train business
• Confirmation of Entry In Service of CSeries for H2 2015
• Large orders announcement, especially for CSeries
• Time