Boeing: A Significantly Undervalued Play On A Cyclical Recovery
- Emerging signs of a travel recovery in May is a key positive for the Boeing bull case.
- Order activity in April has been depressed, as expected, but the resumption of 737 MAX production is a step in the right direction.
- The defense business remains cash-generative and should offer a stable funding source in the meantime.
- At current levels, the Civil business trades at a compelling normalized FCF yield of ~16-17%.
Following my last Boeing (NYSE:BA) article, I've only gotten more bullish on the stock. With travel on the mend and Boeing's defense business providing a stable cash generator to fund ongoing development across both sides of the business, Boeing remains an underappreciated stock, in my view. At current valuations, Boeing offers investors an undervalued play on a cyclical commercial demand recovery, with the potential re-certification of the 737-MAX and the ramp-up of its defense platforms, serving as additional catalysts. At current valuations, BA remains significantly undervalued, in my view, with the civil business trading at an implied normalized FCF yield of ~17%, by my estimates.
Encouraging Travel Data Points Toward a Recovery
Per the latest TSA checkpoint numbers, May has seen a notable uptick in travel across key markets, with airlines slowly adding capacity to their June-July schedules – likely in response to a pick-up in leisure travel. So while passenger numbers are still down >90%, the sequential improvement signals that we have likely reached the bottom.
Source: Ailevon Pacific Aviation Consulting
The recovery seems to be in-line with China's travel recovery, which also continues to trend in the right direction. For context, domestic air travel capacity in China has already recovered ~50% of pre-COVID levels (see chart below). With COVID seemingly under control, I expect continued steady improvement in domestic travel, especially with summer on the horizon.
International travel, on the other hand, remains a key question mark – both with regard to the timing and how the shape of recovery will look like. Without a vaccine, my base case remains for international travel to come under pressure until 2021, which should drive increased pressure on wide-body demand.
Order Activity is Also Key
The outlook for order activity is understandably bleak - BA booked zero gross orders in April, which compares to 246 gross orders in FY19 (net orders of -87) and four gross orders in April 2019. Meanwhile, incremental cancellations stood at 108, which, coupled with an additional 101 ASC 606 adjustments, pushed April net orders to -209. On a YTD basis, this brings the net figure up to -516, including 108 contractual cancellations and 101 from ASC 606 adjustments.
Source: Boeing Orders & Deliveries
From here, BA is assuming a slower production ramp post-return-to-service, with ~31/month targeted for FY21. From the 1Q20 call:
We expect to gradually increase the production rate to 31 during 2021, with further gradual increases that correspond with market demand. – 1Q20 Transcript
While bears will likely latch on to the bearish order outlook as well as elevated inventory levels, I would point out that the ~450 undelivered 737 MAX's built over the last year offer an additional source of working capital in the interim. Assuming a significant portion of that inventory is delivered by FY21 (~50%), this should drive a positive FCF inflection, in my view. The extent of the inventory unwind will likely depend on the willingness of airlines, which will, in turn, be dependent on a demand recovery post-COVID.
Source: Company Filings, Author's Est
Given the market is a forward-looking discounting mechanism, BA stock should bottom well before orders trough. Using travel demand as a proxy, I think we may have seen the worst of order activity for now, before a more notable pick up in FY21, which would imply that the stock may have bottomed. That said, there are still plenty of risks here – not only is the extent of the current downturn unknown, but additional MAX risk drives more uncertainty than prior cycles.
737 MAX Production is Back On Track
The fact that BA has also resumed 737 MAX production in Renton as of end-May is a key positive. Per the press release, workplace safety and product quality enhancements have driven a slower rate of production in the initial stages. In the meantime, re-certification is taking longer than anticipated due to COVID, but progress is ongoing.
With production now resumed, the prospect of deliveries resuming in 3Q20 looks increasingly likely, in my view. Should BA achieve the 31/month rate guided on the 1Q20 call, the stock should re-rate, given the positive FCF implication and the pessimism currently being priced into the stock. That said, there are ~450 units already built in inventory, and thus, the delivery schedule may not reflect the production ramp in the near term.
Don't Overlook Defense
An often overlooked part of the Boeing bull case is its exposure to defense via the Boeing Defense, Space & Security (BDS), and partially through the Boeing Global Services (BGS) segments. BDS holds leading market positions in most of the verticals it operates in, and is a consistent cash generator, producing ~$2.6bn in EBIT as of FY19. Given its relatively cycle-proof exposure to the military, the segment represents a valuable funding source amid turbulence in the commercial space, while also allowing BA to tap into the debt markets at (relatively) more favorable rates.
Source: Company Filings
As of 1Q20, BDS only posted ~$191m in operating losses, which reflects the breadth of its programs, with exposure across mature and development programs and internationally and a healthy level of bookings to boot. Current BDS book-to-bill stands at 1.0x on an LTM basis (vs. -0.73x for Boeing Commercial Airplanes (BCA) and 1.2x for BGS).
Source: Company Filings, Author's Est
Key drivers for BDS include execution on the KC-46 tanker, as well as the MQ-25 and MH-139 program ramp. While a positive outcome across either of these drivers would serve as a positive catalyst, the defense business remains a cash-generative asset through the cycles and should help fund commercial losses through COVID. As a result, my base-case scenario calls for BDS becoming the majority revenue contributor for the full year. The BGS segment will also offer some resilience, given its ~50% government exposure, though lower commercial service demand will provide the offset.
Separately valuing Boeing's defense business (both BDS and BGS' defense contribution) based on FY20 numbers helps to contextualize the extent to which BA is currently undervalued, in my view. Assuming ~$4bn in defense EBIT (BDS + 50% of BGS), deducting interest expenses and taxes, and assuming a ~100% FCF conversion, this would imply ~$4.50 in FCF/share from defense alone. If we were to then value the defense business in line with the average FCF yield of its peers (~6-7%), this gets us to ~$70/share from defense, leaving ~$84/share in equity value for civil. If we do see a normalized FY22, this would imply an FCF yield of ~17%, by my estimates. Given Boeing has historically sustained ROICs in the mid-teens, this makes BA shares exceedingly cheap at current levels. Key risks to the thesis include a COVID resurgence and a below-par travel recovery.
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