By Neal Dihora, CFA
Bombardier's (BDRAF.PK) stock currently reflects negative sentiment about its weak position in the regional aircraft market. Its anemic orders and deliveries are casting a shadow over the rest of the business, which we believe continues to perform well, particularly in rail transportation. We agree these concerns are warranted, but the problematic regional aircraft segment only generates 15% of total company sales. Our estimates call for continued weakness in regional aircraft and a gradual improvement in rail transportation to arrive at a fair value estimate of CAD 7. Still, a new recession could reduce demand for business jets and worsening conditions in Europe have the potential to cause contract delays in rail transport, thus pressuring the stock somewhat from current levels. But considering the many scenarios, we think the stock currently provides a good entry point for investors.
Planes, Trains and Snowmobiles
Bombardier started operations back in the 1930s as a snowmobile manufacturer and launched the world-famous Ski-Doo brand in the late 1950s. The 1973 oil crisis forced the company to move away from snowmobiles and enter the rail transport business with the acquisition of Lohnerwerke. Bombardier entered the aerospace arena with the 1986 acquisition of Canadair, which manufactured the Challenger business jet. Bombardier launched the 50-seat Canadair Regional Jet, or CRJ, program in 1989, followed by the 70-seat CRJ 700 in 1997. Both divisions continued to expand products and geographies through acquisitions over the last 25 years. The fallout from 9/11 and a weakening global economy led the company to narrow its focus and divest several assets, including the recreational products division, in 2003.
Today, Bombardier's rail transportation division is a market leader in most of the areas in which the company has a product or service offering. This division, which competes against large conglomerates such as Alstom (ALO) and Siemens (SI), generally provides locomotives, passenger vehicles (light rail, high-speed trains, metros, and commuter trains), automated systems (monorail and rapid transit), rail control solutions, and services (repair, refurbishment, fleet management and support).
Bombardier has increased its total sales by 25% since 2005, from nearly $15 billion to just above $18 billion. Rail transportation has driven this growth, while the aerospace segment has been volatile. Rail's expansion could continue in the near term as the regional jet market remains weak following the 2008-09 recession. However, the new CSeries regional jet expected in 2013 should help aerospace revenue.
Bombardier's overall operating profitability has improved at a much faster rate than sales, a good sign that management is executing a strategy focused on the bottom line. This is highlighted by the rail business' impressive improvement in operating profitability to 7.2% in 2011 from 1.6% in 2005. Bombardier has been able to do this with enhanced contracting that includes input price increase pass-throughs and better supply-chain management. We believe the firm can continue to improve margins, but our base case calls for an 8% operating margin to arrive in 2015, two years after the company's target. Because nearly 65% of its transportation sales come from Europe, Bombardier's trajectory could be delayed as the ongoing debt-related crisis ripples through different locales. Our estimates assume flat operating margin performance for 2012 and a 30-basis-point improvement to 7.5% in 2013.
We believe the market is giving Bombardier's transportation business the benefit of the doubt in reaching higher operating margins over time and will not be overly concerned with some delays as long as the trajectory does not change. Therefore, we believe the major driver for shareholders will be aerospace, though we are not suggesting a split of the company. Within that business, the main concern is related to the regional aircraft market, both the turboprop and jet areas, while the business jet market remains strong.
Aerospace Division Is All Business
Bombardier's regional aircraft has lost market share over the years, has delivered subpar performance since the 2008-09 recession, and is unlikely to turn around anytime soon. Bombardier's aerospace division consists of three areas: business jets, regional turboprops and jets, and services. The business jet segment has the broadest offering of any manufacturer in the world and holds more than a third of the market by value (excluding the very light jet market in which it does not have an offering). It competes against Gulfstream, Cessna, and Embraer (ERJ), to name a few. This segment has been able to support the overall aerospace division. However, it is important to put the regional business in context; it represented less than 10% of total sales for 2011 and only 12% for 2010.
Bombardier has lost share to Embraer in the regional jet market as its position shrank from 48% in 2005 to 24% in 2011. The two large drivers of this were moves by Embraer to more seats and to sales in regions outside of Bombardier's stronghold of North America and Europe. The growing wealth of Asia, Latin America, and the Middle East has led to strong business jet orders across the industry, and Bombardier has begun to shift its resources these areas. But Embraer has the incumbent position and surely will try to maintain its dominant share.
Back in the North American market, both Delta and United Continental Holdings (UAL) may be looking to rid themselves of smaller aircraft in favor of those with more seats. Delta has 94 of Bombardier's CRJ 200s and United, which works through different partners, offers strong new order potential for Bombardier, especially within the context of weak deliveries during the last couple of years. American Eagle reports having 281 aircraft, including nearly 200 of Embraer's and 47 CRJs that had fewer than 70 seats, and could receive relief from scope clauses (complicated rules that limit the seats in the aircraft that pilots can fly under union contracts) in order to purchase larger regional aircraft. There appears to be ample opportunity to turn the regional jet backlog trajectory positive. Furthermore, these customers are within Bombardier's strong geographic position.
Bombardier also faces a tough competitor in ATR for turboprops. ATR is a joint venture between Italian firm Alenia Aermacchi and European conglomerate EADS (EAD), owner of Airbus. The lion's share of ATR deliveries is for the ATR 72 that seats 70 passengers and competes directly with Bombardier's Q400, which has similar seat availability. But while Bombardier has a backlog of 36 Q400 aircraft, ATR's backlog sits at 224 and it will be raising production during 2012 and 2013 with projected deliveries of more than 70 and 80, respectively. Should Bombardier produce its current backlog of 36 turboprops, it will post market share of 34% in 2012 and 31% for 2013, with the remaining share going to ATR. We believe ATR has been winning because of its geographic footprint and lower price--at $20 million, the ATR 72 is around 25% cheaper than the Bombardier Q400. So Bombardier will continue to face difficulties in regaining market share as its offering isn't different enough or cheap enough to warrant a revival in the very near term.
The business jet division, on the other hand, is one of Bombardier's strengths. It generates 50% of Bombardier's aerospace sales and 25% of total revenue. But the business jet market is also volatile and cyclical; orders are quickly placed and canceled based on the economic environment.
However, with large orders received from NetJets in 2011 and 2012, Bombardier is in a solid position to maintain its business jet market share leadership. Additionally, the launch of the extra-large and ultra-long-range Global 7000 and 8000 could improve sales and margins in the future. For example, Gulfstream (owned by conglomerate General Dynamics (GD) ) posts double-digit operating margins and we think a larger aircraft mix could improve Bombardier's margins in the future. Large jets represented 84% of Gulfstream's unit deliveries in 2011 and less than 60% for Bombardier. Recent first-quarter results were negatively impacted by the installation of a new and improved cockpit for the Global aircraft (only four were delivered in the quarter versus the annual average of 50), but we believe the 180 planned business jet deliveries still will occur in 2012.
Negativity Not Long Term
We acknowledge that Bombardier has experienced weakness in its regional aircraft business, but we believe the market is already reflecting this negativity in the share price. With good performance in the remaining 85% of its business (we estimate only 15% of sales is related to regional aircraft), we think the stock represents a good investment. We also think that expectations for further orders are likely to be low and many participants already have written off Bombardier's CSeries regional aircraft as "dead on arrival." The transportation business has been dealing with issues in Europe for some time now and while a worsening would be negative for Bombardier, we don't see it as detrimental. Finally, the company has a strong balance sheet with $3.2 billion of cash and an average debt maturity of eight years. The first large repayment of $1 billion is not due until 2016, giving the firm ample flexibility to complete new aircraft programs.
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