Dec. 22, 2105, © Leeham Co.: The sell-off in Boeing stock last week tied to the Delta Air Lines purchase (Letter of Intent) of a 777-200ER for $7.7m was overblown.
The stock was off 2.6% Thursday after Delta CEO Richard Anderson Tweeted an LOI had just been signed to buy a 777-200ER. This sell-off, and an earlier one when Anderson said the -200ER could be acquired for $10m, prompted hand-wringing over 777 values and the potential impact on new 777 Classic sales needed to build the bridge to the production of the 777X.
If these same people had been paying attention, the concern over 777 Classic sales have been brewing all year. LNC and several aerospace analysts have noted that sales of the 777-300ER have slowed and those that have been made have come at a substantial price discount to the historic levels Boeing wants to maintain.
Most of the Classic sales this year have been freighters, and this market is sliding backwards, according to IATA data, not forward. The smaller Boeing 767-300ERF is in more demand, driven by the express carriers, than is the larger, long-haul 777F.
Delta acquiring some tired, old 777-200ERs that require major MRO has no effect on the potential sales of 777-300ERs. These aircraft have very different passenger and cargo capacities and serve different markets and missions.
The -200ERs coming out of the Malaysia Airlines fleet, as this carrier restructures, and the -200ERs coming out of the Singapore Airlines fleet as part of its renewal program, aren’t the worry.
The greater worry is and should be the plethora of 777-300ERs coming on the market. These are the airplanes that can depress new Classic sales. Transaero and Kenya Airways -300ERs, many of them only a few years old, are coming on the market. Emirates Airline has a number of -300s/ERs nearing the end of their lease terms. (Emirates also has 12 Airbus A330-300s coming off lease next year.)
There is a narrow customer base for new (or used) -300ERs, and Boeing has run through them all in attempting to generate sales. A new customer was obtained this year, United Airlines, which has a large fleet of -200s/ERs from legacy United and the former Continental Airlines. It ordered 10 -300ERs in a swap for Boeing 787s. Boeing hopes to obtain a follow-on -300ER order from UAL before the end of this year.
Wells Fargo downgrade
The aerospace analyst at Wells Fargo downgraded Boeing last week from Outperform (Buy) to Market Perform (Hold).
“We are downgrading BA shares to Market Perform from Outperform as we believe the risks/reward heading into 2016 are less favorable,” Wells Fargo wrote in a Dec. 18 note. “This includes the likelihood of below-consensus initial guidance (January 27), offsetting the favorable cash-generation story. We highlight lower price escalation for commercial aircraft as a potentially under-appreciated headwind. While the free cash flow return to shareholders remains attractive, we think the concerns about economic growth and the general aerospace cycle will make it difficult for BA to Outperform.”
Wells Fargo also wrote:
Some of the concerns we think are already well appreciated by investors include: (1) the likelihood of a 777 rate cut from 8.3/mo to 7/mo; (2) very weak 747 demand; (3) lower oil + higher interest rates = lower demand for new planes (i.e., book/bill <1x); and (4) lower medium-term defense revenue growth relative to peers following the competitive LRS-B (bomber) loss.
…Under-Appreciated [concerns]: We believe other potential risks are perhaps less recognized, including: (1) the impact of lower price escalation, which could affect Commercial Airplanes (BCA) sales, EBIT, cash flow, and backlog; (2) the likelihood that the 757 replacement will be a clean-sheet (not derivative) aircraft, which could raise R&D by 2018 and crowd out some share buybacks; and (3) a further 777 rate cut below 7/mo.
Lowest Escalation Since 2009. Commercial aircraft pricing is adjusted by inflation, and we believe escalation factors are at their lowest levels in six years. In early 2009 Boeing cut EPS guidance by 7%, mostly for these lower-escalation effects; we believe the 2016 effect would be less severe but still non-trivial (perhaps 2-3% of EPS).
Credit Suisse cash flow analysis
Credit Suisse (Neutral [Hold]) last week issued a lengthy analysis of Boeing’s cash flow, which has been the focus of aerospace analysts for more than a year. Boeing is returning billions of dollars to shareholders through stock buybacks and increased dividends. Boeing has been boosting cash flow by agreeing with some customers to advance pre-delivery payments—in some cases, by several hundred million dollars—and in some cases through up-front cash purchases of airplanes to be delivered in the future, as opposed to on-delivery.
These cash advances are helping fund the return to shareholders, but mean lower cash receipts at some point in the future. As an inducement to customers to participate in the cash advance program, Market Intelligence indicates discounts over and above the usual negotiated purchase price discounts are being offered. These are described as being in the low single-digit percentages.
Credit Suisse writes:
[Free Cash Flow] harvest remains the driver: Boeing’s valuation centers on peak FCF. If all goes well this could be both powerful and tangible, given the ongoing capital allocation program. Book:bill remains important to many, but appears to be a more directional valuation factor at present.
Peak FCF of >$20/share could drive ≥$210 valuation: With five remaining planned rate hikes (2x 737, 1x 767, 2x 787), BA should be able to largely weather a decline in 777 rate and defense mix (as mature products roll off) and still deliver $20 of FCF/share in 2020, or higher given the major profit initiatives underway (not in our model). If BA can hold mature rates beyond 2020, a valuation on peak (at 10.5x) could instead become a valuation on plateau, warranting a higher multiple of 12-13x for a valuation of $242-262. Within this, 787 cash profitability remains the biggest lever, potentially worth ≥$5.00/share from 2014’s ~$4.24 headwind. To better illustrate the pieces, we deconstruct BA’s FCF by program in our new FCF bridge (Exhibit 10).
But, Macro sets up poorly for now: Broader macro concerns (weakening Asia/EM, low oil, strong US$, potential for further interest rate hikes) could compromise the market’s ability/willingness to discount peak (2020) in the short-term, which drives our Neutral rating. In addition, other nearer-term friction items such as 787 curve progression, 777 bridge, MAX ramp, and a soft patch in bookings, could continue to hold back valuation. Thus, shares look range-bound until the malaise passes, basing our TP of $158 and Neutral rating on a mid-cycle multiple of 14.6x on ’16 FCF of $10.84. We see ample time to recalibrate on potential peak of >$20/share in 2020 once prevailing macro worries abate.