Russia: Near-Term Pain, Long-Term Gain For Boeing

Mar. 6.14 | About: The Boeing (BA)

Summary

Russian involvement in Ukraine has raised the possibility of international sanctions.

Sanctions could threaten Boeing's supply chain and investment in a Russian joint venture.

Increased tensions will limit the cuts to the U.S. defense budget.

While sanctions would cause near-term problems, tensions will help defense revenue.

Sanctions are unlikely, and investors should buy on weakness.

Since Russia invaded Crimea last week, investors have been trying to figure what companies are exposed to increased tensions between Russia and the United States. During the crisis, President Obama has floated the possibility of imposing economic sanctions against Russia; however, to be truly effective, Europe would have to agree to sanctions as well (details on potential sanctions are available here). While tensions have eased a bit since Putin's press conference on Monday, sanctions remain on the table, and Russia has indicated it would enact sanctions in retaliation to any Western imposed ones. While sanctions are far from certain, it is a worthwhile exercise for investors to examine their holdings to determine if there are potential problems. For Boeing (NYSE:BA), these tensions pose near-term problems but long-term potential.

Boeing sees Russia as one of its major growth markets as a growing middle class flies more frequently. Since 1991, Boeing has invested $7 billion in Russia, and in the next seven years, that figure is poised to grow to $27 billion via a manufacturing joint venture (details of Boeing's dealings with Russia are available here). Sanctions could jeopardize this JV, and in a very extreme but low probability situation, Russia could seize Boeing's stake. Also of great importance, Russia plays a critical role in Boeing's supply chain. Rustec, a state-owned firm, supplies 35% of Boeing's titanium. In the near term, with inventory and other suppliers, Boeing should be able to continue to get the titanium it needs to keep production on schedule. If sanctions were imposed and lasted for a prolonged period of time, Boeing might face problems maintaining the production schedule or be forced to purchase more expensive titanium elsewhere.

This potential plays into the primary risk Boeing faces. Thanks to its massive backlog, Boeing has comparatively little revenue uncertainty. It is really a matter of delivering its planes according to schedule, and doing so in a cost-efficient fashion. A prolonged trade dispute with Russia does jeopardize this. For perspective, Boeing has a backlog valued at $441 billion (financial and operating data available here). Absent a single net new order, Boeing could keep its plants running at capacity for the next five years, thanks to this backlog. To generate revenue growth, Boeing is expanding capacity, which should translate to a notably faster production schedule by the summer months. Sanctions could make this more difficult.

It is also worth noting that Boeing sold about $2.1 billion in planes to Russian carriers last year. If there were sanctions, this revenue would likely vanish, but that should not be a major concern. Given the large backlog, cancellation of Russian orders would just move other carriers up the priority list. Boeing would still be running at capacity; the planes would just go to different carriers. In other words, sanctions pose a bigger challenge to the supply side than the demand side for Boeing. In the longer run, Russia should be a strong growth market, and Boeing would benefit from doing business there. For now, its backlog is large enough to negate Russian cancellations. Conversely, asset seizures could force a loss and sanctions could threaten the supply chain. I reiterate that seizures are a very low-probability event, and sanctions of physical trade also are relatively unlikely. Still, it is important to consider these risks when making an investment decision.

While investors tend to focus on Boeing's high-growth commercial aviation business, it also does a lot of defense contracting. In 2013, Boeing's defense unit generated $33.2 billion in revenue, which accounts for 38% of total sales. Put simply, the Pentagon has been hit by the age of austerity, with half of sequestration targeted at the Pentagon. While the Ryan-Murray budget deal attempted to alleviate some of the pain, defense spending is heavily constrained. In fact, Boeing expects defense revenue to drop 7%-10% this year. After all, in his budget, President Obama recommending cutting troop levels to pre-World War II levels (details available here).

Some Republicans opposed these cuts, arguing they would threaten America's national defense (details of the opposition available here). During times of tension and war, defense spending is naturally higher, which is why the past decade was good for defense contractors. Increased tensions with Russia will not fully offset the end of two wars in the Middle East, but it can provide some support for funding. Similarly, China announced plans to increase its defense spending by 12% this week, which will further embolden defense hawks to argue for more spending. While the defense budget will remain under pressure, that pressure may be less than anticipated, especially with the Pentagon focused on more technology-focused spending. I think Boeing can outperform its defense guidance in 2014, and the longer term is starting to look more stable than it did a month ago.

Therefore, Boeing is both helped and potentially hurt by rising tensions in Eastern Europe. If sanctions are not put in place (which is the appropriate base case), Boeing will still benefit from a U.S. military budget that will be cut less than feared. However, sanctions could pose problems by undermining a planned joint venture and causing problems in the supply chain via titanium sales. Russia does account for over $2 billion in revenue, but with the backlog, this can be quickly replaced. All in all, I am staying long Boeing, as I do not expect a worst-case scenario. Even in the worst case, Boeing should be able to deal with the challenges by reconfiguring its supply chain, though there could be temporary production and margin impact. Stiff sanctions would likely push Boeing shares lower, but if investors could buy at $120, I would definitely advise doing so, as the firm still will benefit greatly from its large backlog and strong markets in America, Asia, and the Middle East.

Disclosure: I am long BA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.