From concerns over the financing risk related to Boeing Capital Corp. (NYSE:BA) to worries about the development of its revolutionary and game-changing 787 Dreamliner during the depths of the Great Recession, Boeing has come a long way. The company and peer Airbus have paved the way for outperformance in the aerospace supply chain, and while a few of our favorite ideas reside there, including Precision Castparts (BATS:PCP), Boeing's equity is no slouch either. Let's calculate an intrinsic value assessment of the commercial aerospace giant and run its shares through the Valuentum style of investing.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Boeing posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. Though a rating of 3 is not fantastic, the firm's equity has come a long way in just five years. We tend to like ideas that register a 9 or 10 (a "we'd consider buying" rating) on the Valuentum Buying Index, and hold them in our portfolio until they register a 1 or 2 (a "we'd consider selling" rating). Boeing doesn't fit the bill for addition to either the Best Ideas portfolio or Dividend Growth portfolio given its valuation at present, but that doesn't mean that it's not a great company with a solid dividend. Let's dig into the report.
Boeing's Investment Considerations
- Boeing earns a ValueCreation™ rating of EXCELLENT, the highest-possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 41.1% from 29.7% during the next two years. In Valuentum parlance, the company has an Economic Castle.
- Boeing is the largest manufacturer of commercial jetliners and military aircraft combined. Boeing also makes rotorcraft, electronic and defense systems, missiles, satellites, launch vehicles and advanced information and communication systems. The firm is a major service provider to NASA.
- The aerospace giant is benefiting from a benign operating environment. Global economic growth continues (albeit modestly), air passenger traffic is healthy, defense markets are firming with renewed threats, and commercial aviation remains a long-term growth market.
- Boeing's massive commercial aerospace backlog of unfulfilled deliveries gives it excellent visibility and a growth trajectory better than most other firms of similar size. Its revolutionary 787 has changed the economics of air travel, and we expect deliveries to surge in the coming years. But while technical concerns with the plane are a big risk, the company is the strongest it's ever been.
- Boeing earns an 'A' rating from the credit agencies, and the firm's cash and marketable securities were comfortably higher than both Boeing's and Boeing Capital Corp.'s debt. We think the firm has learned from the recent global financial crisis.
- Boeing registers a Valuentum Buying Index rating of 3. Though it's hard for us not to like the strength of its end-market, other firms register higher scores on the scale.
- The commercial aerospace giant pays a nice dividend, with an annual yield of 2.2% at the time of this writing. Boeing's Valuentum Dividend Cushion score is solid.
Boeing showcased its enviable revenue visibility when it posted strong first-quarter results. The company ended the quarter with a total backlog of $440 billion, nearly five times the high end of its revenue guidance range for 2014 ($90.5 million). This measure is roughly flat from the end of 2013, up from $390 billion in 2012 and $355 billion in 2011 (shown in image below). Compared to revenue of just a few years ago, the current level of backlog is nearly 8 times 2011 revenue, for example - a staggering multiple given that 2011 can likely be considered mid-cycle performance, despite Boeing almost being over its head developing and producing the 787 Dreamliner at the time.
Image Source: Boeing
During the first quarter, the firm booked 235 net commercial airplane orders, and its commercial backlog swelled to over 5,100 planes valued at $374 billion. The value of the commercial backlog is more than 6 times the expected top line results of its Commercial Airplanes segment in 2014, and the tally of unit orders is roughly 7 times expected deliveries for this year. Boeing has significant flexibility to fill delivery slots in the years ahead, and we think the company remains one of the most attractively-positioned firms across the industrials sector.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Boeing's 3-year historical return on invested capital (without goodwill) is 29.7%, which is above the estimate of its cost of capital of 10.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Boeing's free cash flow margin has averaged about 5.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Boeing, cash flow from operations increased about 104% from levels registered two years ago, while capital expenditures expanded about 31% over the same time period.
Our discounted cash flow model indicates that Boeing's shares are worth between $96-$160 each. Though this is a large fair value range, we think it is reasonable, reflecting the inherent cyclicality of commercial aerospace, combined with the risks related to new plane building. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $128 per share represents a price-to-earnings (P/E) ratio of about 21.4 times last year's earnings and an implied EV/EBITDA multiple of about 12.9 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 10.4%. The top line growth rate is supported by increasing commercial builds, offset in part by a difficult military spending environment. Our model reflects a 5-year projected average operating margin of 10.2%, which is above Boeing's trailing 3-year average. As Boeing continues to perfect the production process with the 787 and pursue cost take-outs through its supply chain, we think profit margins will advance through the course of the ongoing commercial upswing.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.6% for the next 15 years and 3% in perpetuity. For Boeing, we use a 10.6% weighted average cost of capital to discount future free cash flows. Given Boeing's size and its exposure to global air travel, which is tied to global GDP, we think the long-term growth rate embedded within the model is reasonable. Our discount rate is slightly higher than the median in our coverage universe, due primarily to the credit risk associated with Boeing Capital Corp. and the inherent cyclicality of its end-markets.
We understand the critical importance of assessing firms on a relative value basis versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Boeing to peers General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT), and other defense contractors. However, Boeing's commercial exposure offers both opportunities and challenges, and we think the aerospace giant is priced relatively attractively on a PEG and normalized EV/EBITDA basis relative to this group.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $128 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Boeing. We think the firm is attractive below $96 per share (the green line), but quite expensive above $160 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Boeing's fair value at this point in time to be about $128 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Boeing's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $163 per share in Year 3 represents our existing fair value per share of $128 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Additional disclosure: PCP is included in the Best Ideas portfolio.