May 12, 2015: Boeing held its annual investors day May 12. Note in particular the Buckingham and Wells Fargo commentary on the 777 bridge to 777X.
BA’s investor meeting conveyed a tremendous amount of information, but expectedly, not a lot was incremental to the story. Investors were primarily focused on commercial aerospace and raised a number of concerns including: 777 pricing and margin pressure, weak 1Q FCF, 787 cost reduction, and weak orders YTD. Bottom line – Bears on the stock (including us) went into investor day thinking there would not be much that would change our view. Bulls likely came out of the meeting thinking there was nothing to change their view. People who were Neutral on the stock probably didn’t hear anything new to change their view either.
The two major concerns investors had with the 777 program are the potential for margin degradation due to pricing pressure and the potential for lower production rates due to recently weak widebody demand. BA stated that 777 pricing has stabilized and while we think that is true currently, we would not be surprised if 777 prices have declined meaningfully since 2012/2013. In our view, BA has been able to sustain 777 program margins largely due to effective supply chain management, automation, and productivity initiatives which have resulted in a 30% reduction in factory flow time.
Another investor concern was weak orders YTD. BA reiterated its guide that book to bill would be about 1x for 2015 and also noted that demand is such that they expect book to bill of about 1x after 2015. But the 777 bridge remains an investor focus and the potential that BA could lower 777 production rates has been core to our bearish Boeing thesis. BA indicated the 777 Classic is about 55% sold out in 2017 and acknowledges that getting sufficient orders for the 777 to fill all open delivery positions could be a challenge. However, BA also states that they have the flexibility to move around the skyline – which after 2017 consists mostly of options and LOIs. That flexibility plus expected results from ongoing sales campaigns gives BA confidence they can maintain stable 777 production rates. We think that’s going to be very difficult. BA needs to alert its supply chain as much as 18 months in advance of any production rate change. Consequently, 777 orders over the next few months could be critical to BA and the ability to bridge the production gap between the 777 Classic and 777X. While we believe a modest rate cut (of 1/mo) is likely in the stock, we think BA could reduce 777 production by 4/mo which we estimate would be a $1.25-$1.50/share impact to BA’s 2017E FCF.
Boeing hosted its 2015 Investor Day and, as expected, there were few surprises. The company set out to increase investor confidence in both the commercial aerospace cycle, the company’s ability to execute on the 787 and the cash flow upside as commercial rates continue to increase, and the cost structure is improved. We believe the company was largely successful as investor confidence in the out year cash flow upside has increased, in our view.
Regarding the commercial cycle, Boeing management is indicating it is seeing no increase in pricing pressure; cancellations and deferrals are running at historically low levels; and replacement rates are holding at 40-50% of deliveries. Moreover, management is confident it will see a renewal of the Ex-Im charter this summer, potentially for up to 5 years. There has been over ordering by some LCCs in Asia, but limited to under 5% of the backlog.
Management also went out of its way to try and clarify confusion around pre-delivery payments (PDPs) and customer advances. The company believes advances will go up as rates are going up, and reiterated that FCF will be stronger in 2016 than in 2015. However, there will be volatility in Q-o-Q cash flows. Q2/15 should benefit from 2 C-17 sales, and the full year as BA sells the remaining 5 C-17s.
Management sounded increasingly confident on the 787. All of the early 787s are sold (except for line units 4 and 5), management stated that South Carolina is ahead of where Everett was on the learning curve, and it is testing units in SC at a rate of 4/month (June 2015 is the scheduled rate break in SC on the 787 to get to 4/month). The 787 block is likely extended in late-2016, and with 95% commonality between the -9 and -10, the -10 is expected to be meaningfully accretive to margins and cash flows.
We continue to believe 737 rates are going to ~60/month. Boeing needs to have confidence in a 3-year run rate at these levels, and does not believe it is just pulling forward production, but the industry can support these levels at a normalized level. We believe the master contract with Spirit AeroSysetms (SPR) is a hold up here, and we believe BA management is frustrated with push back from SPR, which is positive for SPR.
BDS is confident it will win at least one major new program, Long-range strike or the T-X (trainer), with the Army’s heavy lift requirement also possible. We believe LRS is essentially a must win, and the cost reductions at BDS are all about increasing competitive pricing on new program starts. For Industrial base purposes, we believe Northrop has the inside track on the LRS. The first tanker is scheduled to fly this June, and management is confident in its risk reduction on the program.
We are maintaining our $165 price target and our BUY rating on BA. We see upside to 2015 FCF guidance (we are at $7B), and we believe that as confidence in 787 execution and the commercial cycle hold up, they will be positive catalysts for the stock.
Extremely High Conviction:
While BA’s senior management has expressed confidence in both its macro and micro dynamics for the past few years, the company’s recent enthusiasm around its cash and earnings potential is notable. This was again the case at its Chicago investor event (Monday/Tuesday) during which BA affirmed expectations that FCF would rise in 2016 and beyond, while reminding investors that quarterly FCF (negative in Q1) is volatile and should be viewed over a 12-month, if not a 24-month time frame.
We agree, and while we think both 2014 and 2015 FCF benefits from positive trends in advances, we do not value the shares on near-term free cash flow.
Instead, we look to higher quality (unencumbered FCF) in the out-years as the basis for our valuation.
787 Improvement & 777 Bridge Remain the Levers:
If everything works out perfectly, the continued rate ramp, solid defense performance, and buybacks could drive peak FCF (2018 or so) approaching $20 per share, which should yield a $200 share price or better.
However, this assertion heavily relies on 787 hitting its targeted cost curve and 777 bridging its backlog gap without disruptive rate cuts or profit shortfalls.
If these items do not progress quite as smoothly as planned (and we won’t know for a while), peak FCF could be closer to the mid-teens, yielding a valuation around our $152TP.
With many investors still (right or wrong) driven by orders, lackluster YTD book/bill (0.5x) is not helping.
Mgmt does target 1.0x for the year, but we do not sense Paris will be the venue, and so shares could linger into and through the June 15-17th show, after which things might get interesting, especially if FCF is to pick up in H2.
Lastly, one under-appreciated item is the company’s laser focus on execution. BA dedicated significant air time today to a variety of performance initiatives under way in both businesses that should, at worst, hold margins steady on softer businesses (777 and defense) while providing upside elsewhere.
We think this is an effort that gets lost in the macro and 787/777 discussion and could provide meaningful support if successful.
2015 investor day: all must go well to meet high expectations; Sell
We attended the Boeing 2015 Investor Day in Chicago. Boeing continued to offer an optimistic view of the new aircraft market. In our view, when Boeing was building 450 aircraft per year, risks to that were manageable and few were prevalent. Now that it is building 750 aircraft per year, with a plan for 3-5 more years of unabated growth and a stock that discounts it, these risks matter a lot, while likelihood of manifestation of those risks has grown. We continue to expect new aircraft order intake and production growth to slow, and expect cash flow to disappoint. We see risks from global growth, lower fuel, a stronger dollar and heightened supply.
Aircraft supply & demand: Boeing still sees BCA book-to-bill near 1.0X for the year. We expect orders to keep slowing. It appears Boeing sees 5-6% traffic growth and 40-50% of deliveries for replacement as needed to support its production plan through 2020. Boeing seemed to suggest if either of those are missed, depending on the degree of the variance, there are scenarios where it could potentially need to change supply (though noting it sees any major change as very unlikely).
Productivity focus: Boeing spent a large portion of the event outlining productivity initiatives, in addition to PFS, on both sides of the business. At BCA, many are not in current program accounting assumptions and could therefore generate upside. Boeing sees higher margins going forward.
Cash flow and financials outlook: Boeing essentially reiterated guidance. It expects cash flow from operations to grow yoy in 2016 and be strong through 2020. We see risk to cash expectations as 787 cost improvement is very challenging and because advances help so much today.
Investor conference highlights
BA investor day focused on continued productivity and cost improvement drive across company and benefit of investing and going to market as one Boeing across BCA and BDS. No change to prior 2015 financial guidance and capital deployment outlook while providing longer term target to achieve “industry leading margins.” BA reiterated its confidence in strength of the commercial cycle including forecast for 1x book to bill in 2015. At BDS, view was expressed that it would “be hard to believe” that it wouldn’t win one of two major near-term program awards, LRS-B and T-X.
Productivity seen fueling growth
BA stated it is still in early stages of reaping benefits of its productivity initiatives with very little upside assumed in current program accounting margins. BA did not specify forward productivity targets or how much it expects to keep vs passing on through pricing. While most of what we heard around productivity initiatives was similar to recent pronouncements including lean, Partnering for Success (PFS) and BA’s own focus on more efficient program development and cost of quality, detail provided around automation investments at BCA was mostly new. PFS has expanded from top 100-150 suppliers to >500 with BA having reached long-term agreements with 40-50% of its supply base.
BCA automation investments
BCA highlighted investments in automated wing panel assembly for 737 and fuselage assembly automation for 777 (fasteners) that it sees driving further improvement in flow time. On 787, BA sees 787-8/9 unit costs converging with commitment to end surge line by end of year indicative of improving performance. 787 block extension (1,100 airplanes currently vs 1,300 block) seen towards end of 2016 driving improved program acct margin.
On May 12 we attended Boeing’s annual investor conference. As expected, there were no changes to the 2015 EPS and cash flow outlook. We continue to believe a formal EPS guidance increase is likely in July following Q1’s margin performance, but given the H2-weighting of 2015’s cash flow profile, we would not expect a FCF increase. While near-term targets were unchanged, we believe a key take-away from the meeting is that management thinks its various productivity initiatives could drive operating margin (2015E: 10%) into the mid-teens over time. If the company is only able to get halfway there (i.e., 12-13%), Boeing would generate margin expansion well-ahead of consensus 2018-19 expectations (10-11%). These higher margins should mean a significant upward bias to our and consensus EPS and cash flow estimates. Boeing reiterated that 2016 free cash flow would exceed the 2015 level; we project about $13 per share in 2016 – which is why we remain positive on BA shares. We expect the cash to support an aggressive near-term share buyback program.
Boeing expects to maintain 777-family production at 100/year (8.3/mo). Beginning in late 2017/early 2018, we expect Boeing to begin layering in 777-X units into production. Essentially, Boeing will add “blanks” to the production process because initial 777-X manufacturing will take longer than the time for one existing 777. For example, if one 777-X is feathered in it may replace two or three 777-300ER production slots. Therefore, Boeing can still assert it has maintained its 8.3/mo production rate, but might be delivering at a lower rate – perhaps 6/mo – and therefore would need to sell fewer units to bridge production to the 777-X.
Margin Expansion Potential.
Boeing discussed the significant opportunities afforded by its “productivity framework,” which includes partnering-for-success (supply-chain savings), Lean+ (working capital), affordable development, and other initiatives. Although there were no post-2015 specifics, we sensed Boeing believes that a mid-teens operating margin (2013A-15E: 9-10%) is achievable by 2020 – well ahead of the consensus view. Even if this is “half-right” – i.e., operating margin gets to 12-13% – we believe there would be significant upward bias to our and consensus EPS (and cash flow) estimates.
Defense Investing for Affordability.
Boeing says the defense market is still one that wants more – for less money. The company has focused on bringing down the cost of its products. Management thinks those investments will pay off in winning competitions, and 2015 could see the result with the decision on the long-range strike bomber (LRS-B) and the new trainer (T-X).
The Puget Sound Business Journal reports that Boeing Commercial Airplanes CEO Ray Conner raised the prospect of the production rate for the 747-8 being reduced to 1/mo (which is what we’ve been predicting for months).