Should You Be Boarding Boeing?

About: The Boeing Company (BA), Includes: EADSF, EADSY
by: Wolf Report

The tragedy in Ethiopia marks the second crash of the 737-MAX 8 in less than 6 months.

As a result, the stock is plummeting pre-market and will likely be falling further.

I review and provide a valuation for one of the world's biggest airplane, rocket, satellite and missile companies.

The horrible tragedy that occurred yesterday marks the second accident for the specific Boeing (BA) aircraft 737 MAX-8 in less than five months. In this article, I will take a look at my relatively small portfolio position of Boeing and consider when an increase would be appealing in my portfolio size, including the tragedy and other potential risks that could influence this multinational company.

I will look to fundamental valuations to argue for where I believe you should increase your position (or start one, provided you have none as of yet), and what effects, if any, I believe this development could have for the company. While it's impossible to foresee the full impact of this tragedy as of yet, we can make an educated guess based on fundamental numbers.

Let's get going. A quick presentation for those who don't know what the Boeing company is.

(source: Boeing)

Boeing - Space, Defense, and Commercial Aviation

The company was founded in 1916 in the USA, and its current structure is a result of a merger with McDonnell Douglas back in 1997. It is the world's largest manufacturer in aerospace with over 140,000 employees providing services and sales across 150 nations. Unlike many American companies, the majority of sales are made outside the USA (60%), though the vast majority of company profits are made in the USA.

The company's business is split into 3 segments.

  • Commercial airplanes, constructing jetliners and planes. This is the segment where the 737 is being made, and also the potential problem in the company.
  • Defense, Space & Security, constructing military craft, satellites and space exploration technology. In my view, this is a big part of the reason for investing in the company.
  • Boeing Global Services, providing aftermarket maintenance and service for both the military and commercial customers worldwide.

There's a fourth segment (though not really a segment, more of a footnote), which finances customer purchases.

Boeing had been investing very heavily into facilities, construction, R&D, and personnel. These investments are now largely complete, which has to lead to incredible margin growth of over 6% in 2017 compared to 2016. Boeing has a large order backlog of, among other things, 4783 737-MAX planes as of September 2018 (source).

The company is in the process of starting to develop electric, autonomous airplanes for both the commercial and military market, pending regulatory approval. These plans were cemented back in 2017 when the company announced plans to acquire Aurora Flight Sciences.

In 2018, the company generated record levels of revenue, earnings, EPS and cash flow. Not only did Boeing repurchase $9B worth of its own shares, the timing of which can be argued with, it also paid out almost $4B in dividends. Its new popular model, the 737 MAX was delivered 256 times, out of the company's 806 deliveries during the full year. Boeing also won several key tenders/franchises with military/defense department customers.

(source: Boeing 4Q18 presentation)

In short, the company had one of the best years, if not the best, on record. And it seems to, with its massive order backlog and interest for its products and services, be humming at rarely before-seen levels. With its investments finished and operating margins up to over 10%, this company is doing well on paper. Really well.

Or is it?

Enter the 737-MAX crash - the second one in 6 months

Sunday at 8.38 AM local time, Ethiopian Airlines flight 302 crashed 6 minutes after takeoff, giving the accident eerie similarities between the crash that occurred, with the same plane model, en route to the island of Bangka (source). These accidents have claimed hundreds of lives.

(source: Seeking Alpha)

Authorities across the world are now reacting to what seems to be the last in a small series of crashes of the same plane. China and Ethiopia have grounded their entire fleets of 737-MAX planes and issued a temporary stop for the use of these planes as of Monday the 11th of March 2019. The air traffic authority in China messages that with "the two accidents happening both related to the newly-delivered 737-8 planes during the start/takeoff phases. There are certain similarities between them." This is the cause of the grounding of the entire lineup (source).

As a result of this crash and the current fallout, the stock has shed nearly 12% of its value as of the time of writing this article. During the Lion Air crash back in 2018, Boeing's share value dropped almost 12% but has more than recovered since that time. It seems that we may see a repeat performance of this stock at this time. I expect it to drop once more.

At this time we do not know what has happened. We do not know if there are serial technical flaws in the airplane, operator errors or malfunctions that Boeing needs to look into. There are airlines like Norwegian who will continue to fly their planes until more data is available, and there are experts here locally in Europe who go on record with having full confidence in the airplane/model (source).

Airline traffic director Pekka Hanttu, employed by Traficom, the Finnish transport and communication agency, says that it's very difficult/almost impossible to determine anything, including cause at this point. What is clear at this stage is:

  • Both of the accidents occurred at relatively low altitude
  • The pilots supposedly had no room to react
  • Both accidents show problems with vertical steering/maneuvering, as both accidents show the planes hitting the ground with a high vertical flight speed.
  • Boeing communicated clear instructions for all airline personnel involved with the new 737 MAX after the accident in Indonesia, and it is not as of yet clear if the personnel/pilots in Ethiopia heeded this or had received this.
  • Ethiopian Airlines is not an airline company atypically prone to accidents, with accidents involving fatalities on record in 1988, 1996 and 2010 (source).

Mr. Hanttu went on record saying that he has full confidence for the type/model of plane, and he would be personally ready to step on board, and fly, with a 737-MAX.

My use of a Finnish/Swedish source is due to my investor profile as a European investor. As the story develops, there will be commentary enough from other, international sources as well.

Risks with Boeing

Obviously, the current main risk is a design or technical flaw within the 737 MAX model. The correction of such an error would require incalculable (at the moment) investment to correct, the short-term stock drop related to sentiment and emotion notwithstanding. However, as of right now I'm fairly certain that we won't see any conclusive evidence that this is the case. Any investigation into the planes is likely to take some time, and as such, we must know how we'd like to react when short-term sentiment hits and sends the share price falling.

Let's look at some more general risks with Boeing.

A duopoly

Boeing has a virtual duopoly with Airbus (OTCPK:EADSF). While one could argue that Boeing is ahead of its European competitor here, it's also important to understand some key risks with the dynamics between these two companies. While Boeing may be the world-leading manufacturer of wide-body jets today, the Airbus's model A321 is gaining market share due to its (before the release of the 737 Max) lower operating costs - record-low operating costs in terms of per passenger mile. The 737 Max has closed the gap here, with a lower estimated operating cost that's also reflected in the company's current order book.

However, the 737 is the plane model that crashed. What will happen if there actually proves to be some design flaw with the 737 Max? I estimate orders may be canceled (if this is possible), and airlines will tend towards the Airbus model, despite slightly higher operating costs.

At this point, however, this is only speculation.

The Chinese may be coming

There's also the Commercial Aircraft Corporation of China (Comac). While the barriers for new entrants into this market are immense, we can easily argue that China has the funds to break into this market, or at least try to, on a global scale. The lack of political structure among the lines we have in Europe and America could be a boon to this company, and to China. And this doesn't take into account the effect a general, technical issue with Boeing's newest model could have on the desire for its products. The Comac C919 has already garnered attention from Chinese airlines, and if Boeing manages to fumble the ball with their newest, most-technically advanced product, it would be an invitation for this company to begin biting off market share and customer base from Boeing.

The new 797

Developing new planes and new models is an incredibly cost-associated business. We can see this in the spending Boeing has had to do over the past decade, which has only now come to an end. If Boeing greenlights the new project with its new airframe, we as investors would need to be prepared for a new series of cost-intensive years - and this on top of a potential 737 debacle.

In addition, I don't need to tell anyone (I'm hoping) that defense spending in its nature is a highly cyclical business. With federal deficits in the U.S. reaching in the trillion during 2018/2019 ($1.2 trillion), it's entirely possible that we'll see spending cuts that could affect this great company.

The Good and Valuation

(Source: F.A.S.T Graphs)

I entered Boeing at the relatively fair valuation of ~$322 during December of 2018. This company generally speaking trades at an incredible premium of 20 in blended P/E ratio, and my purchase was close to this. As of today, the company is overvalued at blended P/E-ratios of between 25-26. This accident, however, could bring the stock back down to earth and back towards what I consider to be more humane valuations.

Such a development would open up for further investment, and for the following potential returns. Since my purchase, I've garnered a return of almost 30%. I won't be selling my shares, but I'll be looking to add more if the valuation once more becomes appealing at P/E ratios of 18-20. I believe the company's track record and future warrants a premium valuation at its core, and though I rarely invest in companies with premium valuations, this is one I will continue to invest in and like to own, even with a more general technical issue with the 737s.

A lot to like about Boeing

There's, simply put, a lot to like about the company. The massive entry barriers notwithstanding, global competition is limited to one (perhaps two) companies. Developing new types and models of airplanes is an incredibly cost-intensive business, requiring nearly a decade of research and development for a new model, and roughly five years for an existing one, looking at Airbus and Boeing from a historical perspective.

I don't want to fail to mention that Airbus actually required three governments in Europe to step in with a total of €22B-€23B in subsidies before the company became self-sufficient and profitable. Boeing required no such actions, and very few governments in the world are interested in taking on such a burden. As such, competition and likely competition in the future is likely to be small. Boeing is likely to maintain its industry-leading position.

This enormous competitive advantage translates into some really excellent profit margins, as we've seen in earlier portions of the article, and we can see below in terms of earnings, FCF and payout ratios.

(Source: SimplySafeDividends)

SimplySafeDividends awards the company a near-record score of 98/100 in dividend safety, marking it as "very safe" and extremely unlikely to be cut or frozen, despite potential competitive headwinds from China and even despite technical issues with its 737 MAX (though the latter portion is my own analysis, not something that SimplySafeDividends actually writes).

(Source: F.A.S.T Graphs)

While an investment in Boeing at current levels doesn't yield the most fantastic returns, with just about 12.70% annually provided a maintained premium valuation holds until 2022, I hasten to add that this does not take the coming drop in share price into consideration. Should the thesis change meaningfully over the coming days, I will address it.

The purpose of this article is not to encourage you to buy Boeing as of today, but to look at the company and determine when you believe the valuation is appealing enough to warrant an investment. I believe the coming drop in share price over the next few days could result in a nice opportunity for share purchases.

So - where are we with the company and the investment?

The thesis is that despite the coming share price drop in the company, despite even the potential pattern of technical flaws that could result in Boeing needing to "fix" several hundred aircraft, not to mention the 4,000 in the order backlog, the company represents an appealing investment opportunity. This is due to its global market position and market share, its rich and profitable history, and its august future in the markets of commercial aviation, military technology and space technology.

I do not own Boeing to garner enormous amounts of annual return - though, for my current investment, this has been the case. I own it to own a share in the future of aviation, and I love companies that are active in the development of space launch and spacecraft-technologies while earning respectable compound interest.

Boeing built large parts of ISS, built the Lunar Rover, built the Space Shuttle, the Delta rockets - they've been in the space game for a long time. That, combined with their expertise in commercial aviation technologies makes it a company that I love to invest in - at what I consider to be a fair price.

So - my advice is to watch the stock as markets open for the next few days, and see where this story develops. I know my own purchase price for the company's share, and if you are a value-conscious dividend investor, I suggest you do the same.

While the situation presents a multitude of risks, the biggest of which currently is (in my view) a true technical flaw in the Boeing's new 737-MAX aircraft, I do believe the company likely, based on track record, to find and solve potential issues with their product and return from any low valuation to which it may drop as a result of this.

My recommendation

Boeing is a 'BUY' for me at a price of $330-$340/share (at which point I'll be adding more), representing a blended P/E of about ~20.5. It's important to note that should the company's profit expectations/revenues be met for 2019, a blended P/E of 20.1 will be roughly $405/share, and there is little - besides the current potential problem with all 737 MAX - to say the stock shouldn't go there.

Disclosure: I am/we are 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.