Bombardier's CSeries Is A Game-Changer For The Industry

| About: Bombardier Inc.B (BDRBF)

Summary

Boeing and Airbus are stuck with their narrow body designs for the foreseeable future.

Bombardier has disrupted the market offering a clearly superior product.

Delta mega-order has provided the foundation for the CSeries to establish a foothold in the market.

The CSeries has further room to grow, and will eventually compete with the entire B737/A320 line.

Patient investors should expect high dividends to eventually come out of the program.

Despite Bombardier's (OTCQX:BDRBF) past troubles with the program, the CSeries is fundamentally a superior product. Prior to a series of events which delayed the program and resulted in corporate liquidity issues, the market was rather upbeat about Bombardier's prospects. In my view, investors should now once again be optimistic about Bombardier's future.

On May 29, 2014, Bombardier's first prototype aircraft, Flight Test Vehicle #1 (FTV-1) suffered a rather spectacular engine failure while undergoing testing. The engines equipped on the Bombardier CSeries line of Aircraft are Pratty & Whitney's new Geared-Turbofan ("GTF") PW1500G engine. The failure caused Bombardier to halt the flight test program for over 100 days. The root cause of the failure was identified and fixed. However, this unplanned event precipitated a series events, with a few order cancellations and liquidity issues arising from the prospect of having to further delay the CSeries's entry into service. Standard & Poor's issued a ratings downgrade in early 2015 in light of the events and challenges it faces due to "market conditions and the company's continued large capital spend program." To address these concerns, Bombardier cancelled the Learjet 85 program, a business jet which borrowed technology from the CSeries. In addition, Bombardier went on to shed thousands of jobs in order to maintain the cash on hand to protect the CSeries' entry into market. Bombardier then went on to raise $1 billion in debt from the Province of Quebec in exchange for 49.5% of the CSeries program, which was converted from Bombardier's sole ownership to a Limited Partnership (the "CSeries Aircraft Limited Partnership" or CSALP). Not only did the Province of Quebec get virtually half of the CSeries program, but in addition, stock warrants for 100,000,000 Class B shares (4.3% of the outstanding shares) at a price of CAD$2.21 per Share. In other words, Quebec got a phenomenal deal in exchange for its investment. However, to its credit, Bombardier may buy back the province's joint venture position, however, the key conditions and details on how and when they may do this is unclear. The CSeries is reported to need another $1 Billion to ramp-up production to the point where the program would become cash-flow positive. At this time, Bombardier no longer has an acute liquidity crisis, with current cash flows largely funded through the end of 2018. Despite this, Bombardier remains engaged in talks with the Canadian Government for an additional investment of $1 Billion. This is largely needed to ensure present orders are funded.

In the midst of the above events and transactions, the Bombardier share price took a severe hit dropping even below CAD$1 for a period of time. Since May, 2016, the share price has found significant support around the CAD$2 share price level. In large part, the share price has been reflecting the performance of the CSeries program and the concerns surrounding it. Future share price performance would reflect the ability of Bombardier to continue to execute the CSeries program, make deliveries and gather more orders which would bring the program into cash-flow positive territory. In my view, accelerated sales and expansion of the CSeries product line has the potential to be significantly earnings accretive to Bombardier resulting in a rebound in the share price to the CAD$5 range in 1 year (equal to a CAD$10 Billion market cap for Bombardier, as it should for a major aircraft and rail transportation manufacturer).

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To evaluate the potential for Bombardier's share price to continue to rebound and grow, one needs to review and understand, fully, the core program in which the company's fate is now inextricably linked to - the CSeries, and its ability to compete in the market to garner orders.

The CSeries aircraft was designed for the high-fuel price environment. The structure and engines are optimized to save fuel and deliver a comforting, quiet passenger experience. The latest offering from Airbus and Boeing the A350 and 787, are built in the same vein - both fuel efficient, and are very comfortable aircraft to fly in: you actually can talk to your neighbor while in flight, and even to the person all the way across the row. This is something you cannot (easily) do in an A320 or 737. The A320 and 737 are classics at this point - with designs dating back to the 60s and 80s. And not much has changed since then. When a new Boeing 737 is certified, its certification is based on the original type certificate dating back to the 1960s. In certifying each new aircraft model, the FAA looks at what has changed from the previous model focusing their scrutiny on how the changes effect the safety of flight. For example, the entire Boeing 737 family is on the same type certificate in the FAA registry.

By working under the same type certificate, Boeing (and Airbus) saves money by avoiding a costly full-blown certification program. Similarly, since the CSeries has certified the initial CS100 model, it was then able to certify the CS300 under the same type certificate. Regulatory authorities are focused on the differences from the fully vetted CS100, which requires just a lower incremental amount of flight testing to validate the design. Future stretches of the Airframe can be accomplished similarly as long as the Aircraft retains the same fundamental design.

So why is this important? Well the A320 and B737 use basically the same 60s and 80s airframe with enhancements made along the way - including many stretches both in the wingspan and the cabin length. The newer A320neo and B737MAX basically adds winglets and new engines to a dated design. While it improves fuel efficiency to a degree, but it offers nothing new on the inside.

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Images: The Boeing 737-100 (left) versus the Boeing 737-800 (right)

As an example, the above image captures the original Boeing 737 versus the latest model 737-800. A peculiarity behind the -800 model: you'll notice the engine has a flat bottom. This configuration, nicknamed "the vacuum cleaner" is due to the fact that the designers behind the original 737 designed the aircraft for slim line turbojet engines (on the left). They did not envision the advent of Turbofan engines which have larger intakes. To fit these new engines, Boeing had to relocate engine equipment from the bottom side of the engine to the top side, and then flatten the bottom in order to make sure that as per the original design specifications there is sufficient ground clearance. This is not an ideal configuration as most other aircraft have aerodynamically rounded intakes.

As evident, there are only so many things you can do to an old design to make it new. To maintain the aircraft under the original type certificate, you cannot rock the boat too much from a regulatory standpoint. If you do, then you would trigger a full certification campaign which Aircraft manufacturers are loathe to do.

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On the left, the Airbus A320 cockpit. On the right, the CSeries Cockpit. All "new" A320s have the same 1980s-era cockpit design.

With many orders already in the book, both Airbus and Boeing are entrenched in their existing narrow body offering, opting only to make incremental changes to the airframe. Announcing a new narrow body design would send the wrong signal to their existing customer base. Besides, why spend billions on a new design when what you have sells fine in the market? This theory works well because there are only two manufacturers offering products which operate similarly. When a new market participant (read: Disruptor) challenges the status quo, others have to react or risk losing market share down the road. With thousands of orders already on the books for Airbus and Boeing, they do not have the ability to launch a new aircraft design. This provides Bombardier with the perfect opening to offer the next-generation CSeries. At minimum, Boeing and Airbus are 7 plus years away from certifying a new design even if they were to make this decision tomorrow. With such an announcement unlikely anytime soon, the CSeries will find itself with room to maneuver and grow as it proves the design in commercial service. Both Airbus and Boeing are rumored to be using strong-arm tactics and heavy discounting to prevent Bombardier from establishing a foothold in the market. For example, Boeing is rumored to have prevented United from ordering the Bombardier by offering the now classic 737-700 at a bargain basement price. United snatched the opportunity provided by Boeing despite the fact that the 737-700 production line will end with its order and further, it is not an optimal aircraft for its routes. It is important to note that Boeing would not have won this competition had it not provided such a low-ball price. This clearly shows that the Boeing 737 cannot compete with the CSeries on performance, so it must do so on price instead.

Aircraft manufacturing is a tough business. Especially when a manufacturer is introducing a new design. Consider the industry to be full of curmudgeons - they will not accept a design until it has proven itself in service. While some airlines buy aircraft "on paper" - many do not. Airlines typically prefer not to be launch customers because they do not want to sort out the teething problems associated with the aircraft. Every new design has initial operational issues. The Boeing 787 had its share of issues early in its entry into service. With the CSeries just recently having entered commercial service with SWISS, actual operational data will prove out the design further - showcasing its reliability, performance and suitability in service. A further concern to Airlines is the level of support the aircraft will have in the future - which is largely based on the market acceptance. Airlines are wary of buying an "orphan" aircraft - one that would be abandoned by its manufacturer and lack ongoing support. This occurs when an insufficient number of aircraft is sold for a given model, and parts/support is thin. With the 125 aircraft Delta order, the CSeries has solidified a base number of aircraft that will enter service. This firms up the number of aircraft that will be in operation and will require manufacturer support.

When you compare the CS300 to the A320/B737, you find that the CS300 has a state-of-the-art airframe that is totally optimized for the engine it is coupled with. Fuel savings are derived not only from the new Geared Turbofan ("GTF") Pratt and Whitney Engine, but also due to the new aircraft design that is similar to the Boeing 787 and Airbus A350. Like these two new aircraft, it has an overall lower airframe weight and optimized aerodynamics using 21st Century design software (not a 60s era slide rule!).

While the A320 and B737 offer a 3x3 seating arrangement, the CSeries instead offers a 3x2 seating arrangement. While I am a fan of symmetry, I do appreciate the fact that 80% of the seats on a CSeries accordingly are either a more desirable window seat or aisle seat (for those who are perplexed - yes, the math works: only 1 seat out of 5 in a single row is a dreaded "middle" seat).

The original B737 which started out with around 100 seats now tops out with close to 200 in the largest model. The CSeries similarly has plenty of room to grow through future stretches of the airframe. Accordingly, this would not command a comparatively high investment to certify. Therefore, the rumored CS500 (which Bombardier has trademarks for, in addition to the CS700) will have even greater capacity than the CS300. Higher capacities would put the airframe in more direct, end-to-end segment competition with the Airbus A320 and Boeing 737. Offering a higher capacity CSeries would even allow some airlines to plan their entire fleet around Bombardier products replacing aging A320s and B737s entirely. This has Boeing and Airbus concerned that they will have to live in a new paradigm - they cannot sustain the heavy discounts they are providing on airplanes.

Going forward, the market continues to look for more CSeries orders signaling greater acceptance by the industry and ultimate success. At a certain number of aircraft orders, the CSeries will reach a tipping point whereby it becomes an established industry player considered to be widely accepted by all. With a greater number of orders on the books, the CSeries can further amortize the close to $4 billion in development costs, giving Bombardier the ability to offer volume discounts and further value to the Airline industry compared to Boeing and Airbus. Previous "break-even" points were noted at the 350 aircraft order target. Current orders stand at 370, which exceeds Bombardier's original target. Investors should expect that each Aircraft order should book around $10-13 million in net margin (25% margin). Therefore, for every 100 aircraft orders, approximately $1 billion in enterprise value would be added. In my view, the CSeries should be easily able to cross the 1,000 order mark delivering $6.5 Billion in enterprise value to the CSeries Partnership. Bombardier should be looking to buy back Quebec's share in the Partnership once sufficient capital has flowed through into the Corporation, largely on the back of orders already in the books. This should occur at some point after 100 - 200 aircraft deliveries are made:

Year

2016

2017

2018

2019

2020

Expected Deliveries

17

33

50

80

105

Cumulative Total Expected Deliveries

17

50

100

180

285

Cumulative Enterprise Value Added ($MM)

$170

$500

$1,000

$1,800

$2,850

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In addition to the enterprise value added, the share price should further reflect the further reduction in risk associated with the program with continued proper program execution, continued deliveries of orders and a further increase in the size of the order book.

Disclosure: I am/we are long BDRBF.

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.

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