- Boeing's position as one member of a virtual duopoly (along with Airbus) doesn't provide as much protection as many investors think.
- Aircraft demand over the next decade is likely to be significantly lower than previous projections and is shifting from widebodies towards narrowbodies.
- Airbus is well positioned to achieve big market share gains in the narrowbody market, as production capacity becomes less of a constraint on deliveries.
- Even if global annual deliveries of mainline jets reach a new record by the mid-2020s, Boeing's narrowbody and widebody deliveries could remain significantly below 2018 levels.
- Boeing stock remains overvalued relative to its likely cash generation potential over the next 15 years.
There were two big themes in the comments on my recent article arguing that Boeing (NYSE:BA) stock had rallied too far in recent weeks. First, many readers commented that air travel will bounce back from the COVID-19 crisis and eventually return to long-term growth, even if it may take a few years. Second, many noted that Boeing and Airbus (OTCPK:EADSY) hold an effective duopoly in the market for large commercial jets, ensuring strong long-term profits for Boeing.
I don't dispute that global air travel will continue to grow over the long term. However, it is not likely to grow as quickly as it did over the past few years.
Similarly, I expect Boeing and Airbus to retain their effective duopoly for the next decade at a minimum. (In the long run, China's COMAC could become a significant challenger.) However, Boeing's market share within the duopoly could decline significantly.
As a result, even though air travel will grow and Airbus and Boeing will remain a duopoly, it does not follow that Boeing will return to its historical level of aircraft production or cash flow generation, even looking out 5-10 years. Analyses that assume everything goes "back to normal" within a few years underestimate the long-term pain Boeing may be facing.
Slower air travel growth ahead
The decade ending in 2019 was one of astounding growth in air travel. Global passenger air travel grew at least 5.5% annually for every year from 2010 to 2018, before slowing to 4.2% growth last year. This long stretch of rapid growth drove a production boom for Boeing and Airbus. Between 2015 and 2018, nearly 70% of all new aircraft delivered were for growth rather than replacement.
(Source: Boeing 2019 Commercial Market Outlook, p. 21)
However, the recent pace of growth wasn't sustainable. Even before the COVID-19 pandemic hit, many airlines that had grown rapidly in recent years were struggling to digest that growth. (Prominent examples include Norwegian Air, Etihad Airways, and AirAsia.)
Historically, air travel has followed a boom-bust cycle, albeit with secular growth layered on top. After a period of overexpansion, an economic shock leads to sharp contraction, and it typically takes several years for air traffic to return to the previous peak.
Boeing tacitly acknowledged this in its Q1 earnings presentation. While management expects global air travel to return to its previous growth trendline, the chart also clearly shows that growth has been well above the trendline in recent years. It would take two or three years of zero growth to get back to the long-term trend.
(Source: Boeing Q1 2020 Earnings Presentation, slide 3)
This has two major implications. First, demand could be quite low over the next few years. If airlines are (collectively) buying mainly for replacement rather than for growth, new aircraft demand could temporarily fall 50% or more from pre-pandemic levels.
Second, even after air travel demand surpasses the 2019 peak and returns to long-term growth, global aircraft demand could be somewhat lower than recent levels if it stays on the pre-2015 trendline rather than the more rapid growth pace seen over the past five years. Since growth accounts for a far greater share of demand than replacement needs, a modestly lower long-term growth rate would have a significant dampening effect on annual deliveries.
Indeed, as recently as 2015, Boeing and Airbus delivered fewer than 1,400 commercial jets combined. By contrast, their initial plans for 2019 (prior to the 737 MAX grounding and more modest production setbacks for Airbus) called for nearly 1,800 deliveries combined.
Weak widebody demand will hurt Boeing
Even before the 737 MAX crashes and the resulting grounding, it was clear that Boeing's next-generation narrowbody wasn't quite as popular as Airbus' competing A320neo family. To the extent that the two aircraft manufacturers were evenly matched, it was due to Boeing's strength in the widebody market (led by the 787 Dreamliner). Boeing delivered 253 widebodies in 2019, compared to 173 for Airbus. A year earlier, it had a similar margin of victory, delivering 226 widebodies against Airbus' 154 widebody deliveries.
Unfortunately, for Boeing, widebody demand has been weakening for several years. Even before the COVID-19 pandemic fully spiraled out of control, Boeing planned to cut 787 production to from 14/month to 10/month by early 2021 in response to weak demand.
Whereas it used to be common to operate widebodies on routes of 2,000-3,000 miles (such as a transcontinental flight or mainland-Hawaii flight in the U.S.), airlines have discovered that the largest narrowbody jets are just as efficient on a per-seat basis. Using smaller aircraft helps airlines gain pricing power and makes it possible to operate more frequent flights on key routes for business travelers.
In addition, Airbus has been cannibalizing the widebody market with ever-more-capable narrowbody jets. Its A321LR (with a stated range of 4,000 nautical miles) entered service in 2018. A year ago, Airbus launched the A321XLR, which is set to offer 4,700 nautical miles of range when it enters service in 2023. That will be sufficient for a wide variety of routes served by widebodies today.
The current market environment will make matters worse. Industry executives universally expect long-haul international travel to recover much more slowly than domestic and short-haul travel. And as longer-haul travel bounces back, some airlines will look to reduce their risk and trip costs by substituting long-range narrowbodies like the A321XLR for widebodies where possible. As a result, Boeing will further reduce 787 production to 7/month and 777 production from 5/month to 3/month over the next couple of years.
(Source: Boeing Q1 2020 Earnings Presentation, slide 4)
Narrowbody market share will tilt towards Airbus
In recent years, Airbus has maintained a significantly larger backlog than Boeing, particularly for narrowbody jets. Airbus averaged over 1,000 net orders per year during the just-concluded decade, far outpacing Boeing and driving this backlog expansion.
The discrepancy between the two companies' narrowbody backlogs has grown over the past year or so. Order activity remained strong at Airbus last year and in early 2020, while the 737 MAX grounding caused Boeing's orders to plummet. As of the end of May, Airbus had 6,726 outstanding orders for narrowbodies, compared to 3,776 for Boeing. That works out to a 64%/36% split.
However, prior to the 737 MAX grounding, Airbus' larger backlog had hardly any impact on its market share within the duopoly. As recently as 2018, Airbus only accounted for 52.7% of the two companies' combined narrowbody deliveries. And thanks to its strength in the widebody market, Boeing delivered more aircraft than Airbus overall in every year from 2012 to 2018. With demand outstripping supply, market share was mainly a function of production capacity.
Looking ahead, it could be a long time before production capacity becomes a constraint on Airbus' deliveries. Up until a few months ago, it planned to boost A320neo-family output to at least 65/month by 2023. Just last month, Airbus formally inaugurated its new A220 production line in Alabama, which (combined with existing facilities in Canada) could allow it to build at least 10-12 A220s per month.
As demand recovers, Airbus should be able to ramp up to produce 900 narrowbodies annually within a few years. So, even if combined annual narrowbody deliveries for Boeing and Airbus stabilize at 1,400 units per year in the mid-2020s (lower than previous aspirations, but more than 10% above the current record), it's entirely possible that Airbus will account for 900 deliveries, leaving only 500 for Boeing. That would put Airbus' narrowbody market share within the duopoly at 64%: right in line with its share of firm orders.
A nightmare scenario
Thus, even after Boeing gets past the extremely weak market conditions it will face over the next 2-3 years, it won't be smooth sailing to record profits and cash flow.
Instead, the aerospace giant may find that the global market for new aircraft remains near 2018 levels. Moreover, demand is likely to shift away from widebodies (Boeing's strong suit) and towards narrowbodies, both due to slower growth in long-haul travel and cannibalization of widebodies by increasingly-capable narrowbodies like the A321XLR. Meanwhile, Boeing will likely cede market share in the narrowbody segment to Airbus, bringing its delivery share more in line with its 36% share of firm orders.
In addition to lower widebody volume, weak demand will give widebody buyers more bargaining power, potentially driving down pricing and margins. The net result is that Boeing's steady-state free cash flow could be $10 billion in the mid-2020s, compared to $13.6 billion in 2018. (Any cash flow growth from Boeing's defense or services segments would do little to offset the weakness in its commercial jets business: its main source of profit and cash flow.)
Towards the end of the decade, the transition to an all-new 737 replacement will sap cash flow, as new products must be sold below cost initially. So, an appropriate valuation for Boeing in 2025 should incorporate the likelihood that cash flow will deteriorate in the late 2020s and early 2030s before potentially recovering (depending on the success of the 737's replacement).
Based on this outlook, I think Boeing stock could have a fair value between $200 and $250 five years from now: around 11-14 times projected free cash flow of roughly $10 billion. Considering the risk involved, the stock isn't remotely attractive above $150, and it would have to drop closer to $100 to offer an adequate margin of safety for long-term investors.
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