- Boeing shares have dropped 10% on conservative guidance, but Boeing should earn $7.25 in 2014
- Boeing will benefit from a consolidated and more profitable airline industry
- Defense faces near term headwinds but should stabilize in 2015
- Capacity ramp should increase earnings beyond 2014 as Boeing meets its $441 billion backlog
- With growing capital returns, BA should hit $145 this year
After having a stellar 2013, Boeing (NYSE:BA) shares have experienced a bit of turbulence so far in 2014 (see the following chart). After rallying 80% in 2013, Boeing was due for a bit of profit taking, and the company's 2014 guidance has disappointed some investors. However, Boeing shares are down over 10% from their 52-week high and make sense at current levels. In fact, research firm Argus Research has just come out and urged investors to buy the dip (information available here). Frankly, I couldn't agree more.
(chart from Google Finance)
In 2014, Boeing forecasts core earnings of $7.00-$7.20. This guidance was the major reason for the recent sell-off as analysts had been looking for $7.57. Moreover, Boeing has rallied so much over the past few years as it is seen as a growth stock. Thanks to the fuel-saving Dreamliner and new 777x, Boeing has been regaining share and benefiting from a newly profitable commercial aerospace sector. Thanks to consolidation in the U.S. and better fuel prices globally, airlines are making more money than ever and can afford to purchase new fleets. Further, increased fuel efficiency from the Dreamliner makes the plane much cheaper to operate, improving the long-term economics for the airlines.
Boeing's guidance forced some to rethink their growth optimism. In 2013, core earnings were $7.07, so the company isn't forecasting much earnings growth while it forecasts revenue growth in the 1-4% range. Given this backdrop, it would seem the pullback is merited. After all, shares are still trading 17.9x 2014 guidance, which doesn't seem that cheap for a company predicting minimal growth. This view is overly simplistic and ignores several factors within Boeing's guidance.
First, Boeing's management led by CEO Jim McNerney is notoriously conservative. Boeing would much rather under-promise and over-deliver than the reverse. We all know that Wall Street prefers a company that consistently beats guidance rather than one that consistently misses. Boeing plays this game well, and to do so, guidance always provides a small margin of safety to ensure a beat going forward. I tend to think Boeing will report 2014 earnings ahead of the top end of guidance. In fact, Argus Research is looking for $7.32 or 2% ahead of guidance. After a stellar 2013, Boeing wanted to bring expectations down a little bit, but with a production ramp, it should beat its projections with relative ease.
Next, Boeing's commercial aviation unit gets all of the headlines, but Boeing also has a significant defense operation. The Pentagon has not been exempt from the age of austerity in the United States as we exit a decade of war. In fact, half of sequester cuts are focused on the defense budget. In 2013, the Pentagon took maneuvers to limit the impact of these blunt cuts in order to maintain long-term contracts, but these measures (like delaying maintenance) were only temporary. While the Ryan-Murray deal will alleviate some of the pain, defense was inevitably going to be a headwind in 2014. In fact, Boeing expects defense revenue to drop 7-10% in 2014.
In 2013, Boeing's defense unit generated $33.2 billion in revenue or 38% of total revenue. As a consequence, this decline will have an appreciable impact on results. Fortunately, its larger commercial unit will make up for this weakness. Further while 2014 will be a bad year for defense, spending will start to stabilize in 2015 and beyond with near term deficit headwinds shrinking and a pivot to the Pacific that will require investments in new technology. The Obama Administration is reallocating defense resources from the Middle East to Asia to combat the rise of China, which will require a larger focus on naval and air capabilities, which should benefit firms like Boeing.
While Boeing appears to be predicting minimal growth, that stagnation is driven by a predicted decline in defense, an area where no one expected growth. In fact, Boeing is looking for commercial revenue to grow 10%, which represents an acceleration from 2013 (up 8%). The Dreamliner and 777x have been the primary bull thesis, and they will deliver growth this year. Long-term investors need to remember that the company has a backlog that exceeds $441 billion. Basically, Boeing could run production at capacity for five years without receiving another new order. With airlines continuing to make new orders, Boeing will be running at or near capacity for a decade.
There are two primary reasons why a company doesn't grow: stagnating demand and constrained supply. If demand is flat, a company will struggle to grow revenue no matter how much excess capacity it has. With such a massive backlog that continues to grow every quarter, Boeing clearly does not have a demand problem. Rather, it has a supply problem. Boeing has been unable to meet demand. Now, Boeing is expanding capacity by adding shifts and equipment. That is why it was so critical that the company reached a deal with its union in Washington. The biggest risk to the Boeing bull thesis are supply disruptions like a strike. With a long-term deal, this is far less likely.
The company is expanding its capacity to meet demand. Around the middle of this year, Boeing's monthly 737 deliveries should total 42 compared to 38 currently. With guaranteed labor and a capacity ramp-up, Boeing will be able to increase its delivery rate and better meet demand. The demand side of Boeing's business is incredibly robust, and the risk to the thesis is the supply side. With investments in capacity and a long-term labor deal, Boeing is poised to increase its production pace, which will result in commercial revenue growth of 8-12% over the next three to five years.
Aerospace is a very volatile business, but Boeing's massive backlog provides it with a cushion to grow even during a sluggish economy while airlines are more profitable than ever as excess capacity has been taken out of the market. Boeing is planning ten years out, and investors with that sort of time frame will do extremely well in the stock. At the same time, the company is returning cash to shareholders with a 50% hike to the dividend (currently yielding 2.3%) and a $10 billion buyback that should be completed within 3 years. After the capacity increase this year, the company will also see significant growth to free cash flow, which will facilitate continued capital returns.
Argus Research has a $150 target, which is a reasonable estimate. With strong revenue growth that should continue for years, investors should be willing to pay 20x earnings for Boeing or about $145. At current prices, Boeing shares have about 10% upside to fair value while sporting a solid yield. We are in a commercial aviation super-cycle, and Boeing is a prime beneficiary. Long-term investors should use dips like this to buy a great company at a fantastic price.