Boeing (NYSE:BA) has spent nearly $20B on buybacks over the past year. I've been concerned with company buybacks in general since I learned of their danger to the overall economy. In short, the increasing amount of buybacks in the market right now implies that businesses have few other choices in investing their cash, implying that earnings are falling and that asset prices are being artificially inflated.
But not all buybacks are inappropriate. If a company's buybacks are engaged in at a time when the stock is trading below its intrinsic value, the buybacks can actually trickle down to the investors in the form of inflated asset prices. Still, such a phenomenon pushes down the yield of dividend stocks such as BA, precluding new investors from buying.
If a company engages in buybacks it should have good reason to do so - namely, few other alternatives on which to spend its cash. Do the recent BA buybacks adhere to this principle? This is the question I hope you to consider.
BA has been growing its free cash flow (NYSE:FCF) since 2012:
As a running five-year average, cash looks to be at an all-time high:
Naturally, with so much cash, BA's management could easily put the issue of buybacks on the table. A $20B buyback program looks huge to other companies but might seem moderate to the guys in charge. But BA analysts are stating that BA's cash growth will stop next year, implying that BA's use of cash in since 2012 to 2017 should be the most crucial time to properly allocate it.
The production cut of the Boeing 777s will hit the company in terms of FCF. With not much in the pipeline, we should wonder whether BA should have spent that $20B on acquisitions, R&D, or even simple dividend hikes. The answer comes when we can properly valuate BA's stock since 2012 to now.
I use a discounted cash flow (DCF) model that has worked quite well on most stocks that have positive FCF. BA is likely suitable for a target of this analysis. Instead of looking at a single number, I prefer to look at the trend of the discounted cash flow, plotted as a graph.
I do so below:
My DCF looks to fit rather well until around 2011, when the stock and the valuation diverge. While it might seem that the model is wrong, wildly swinging from a $10 valuation to a $350 valuation in the course of four years, the fact is that the model is highly sensitive to dramatic changes in underlying fundamentals in the stock. Let's see why the DCF blows up after 2011.
The first issue is the estimated cash, which we saw in the previous section. BA went from a six-year cash decline, implying an impending debt-to-equity issue in around 2014. Shortly afterward, BA started to generate cash quickly, alleviating said issue.
Second is the growth rate of the company. This is calculated by a running average on the cash returned on invested capital. We can see a pattern much like that in the cash:
In other words, the negative growth rate in the mid 2010's implied bad things for the stock. However, BA quickly rebounded in growth, and to all-time high levels. The model interpreted this and the cash issue as a wild swing from impending doom to a new takeoff in the company.
But does that me we should trust the model? I do not think we should trust the prices in the model past 2012 because they are overreactions to fundamentals to which the model is highly sensitive. However, we should trust both the direction of the DCF price and where the DCF price lies relative to the stock.
In this respect, BA's buybacks were poor decisions prior to 2016. BA was buying back stock when the valuation was likely lower than the price of the stock. It seems natural for a company to want to bolster its own stock during hard times - reasons including maintaining investor trust and insider benefits.
The height of the buyback program was last quarter, when BA spent $3.5B on buybacks. This was a justified buyback, as the stock is likely undervalued at the moment. Still, that leaves roughly $16B of misallocated funds.
Most worrisome is that BA spend more money on buybacks when the stock was trading at higher prices. In other words, the company spent more money on $140 BA stock than it did on $100 BA stock. Wouldn't that money have been better spent on dividend increases, which would both attract new investors and make the current investors happy?
As it stands, buybacks only benefit current investors in that they artificially inflate the stock price. But if you hold BA and are not dedicated to the company, what is stopping you from recognizing that the price has risen via buybacks - not fundamental changes - and selling the stock? Even if used when the stock is trading below its intrinsic value, the cash spent on buybacks do little for fundamental investors.
With $20B spent on buybacks in the last three years, we must wonder how much of BA's stock growth has been organic and how much is attributed to buybacks. The current DCF valuation points to BA being undervalued. However, the buyback program and the (lack of) future growth for the company should send messages to investors that management might not have their heads in the right place.
While the stock looks bullish for the short term, I would suggest investors to plan their exit strategies now. Keep your eyes on 787 and 737 profitability and on the news of the upcoming 777x. If you don't like what you see, consider dropping the stock - at least temporarily - while you wait to ensure that the current growth rate can continue into the future.
Seasonally, June to August is the down season for BA stock. If you do not want to drop the stock for tax-related reasons, at least hedge your BA investment with an appropriate options strategy. I predict consolidation of the stock as a mix of weak short-term future prospects and a potential drop in the growth rate.
Such consolidation is not bad for dividend stocks because at least you gain the dividends. And if you know what to do, you can also profit from sideways options strategies. For BA, I recommend a long calendar spread, which allows you both theta income and vega income.
The June to August down season must fight against the buybacks, leading to consolidation. My price target for August, therefore, is $130. The following calendar spread accounts for this and allows 100% ROI if BA is still trading at $130 in August:
As long as the stock is between $119 and $141 in August, you will profit from the strategy above. This, in addition to the dividends, can make your BA holding a lot less stressful in the coming months. That said, BA looks to be a strong company making less-than-optimal management decisions; I say buy - but buy with a hedge.
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