Note: LNC begins today a weekly synopsis of select analyst notes we receive in the previous seven days.
Weekly Insight: June 13, 2016
We would remain Defense bulls regardless of the election outcome. Our favorite names: L-3 Communications (LLL), Raytheon (RTN), and Lockheed Martin (LMT). Investors are increasingly looking at how the November elections could impact Defense. We think Defense stocks are attractive on their own merit. We see a Clinton win as a neutral to the stocks, however, a Trump win could be bullish for Defense – both as a move to safety (since Trump priorities are relatively unknown) and because we think a Trump administration will consider substantive increases to Defense spending.
Top Weekly Data Points:
Defense; first the bad news. A CR for FY17 is likely because on Thursday, Senate deficit hawks defeated, in a 56-42 vote, Senator McCain’s (R-Az) bill to increase Overseas Contingency Operations (OCO) by $18B (60 votes needed to pass). This was one of several efforts to plus up Defense spending above the President’s FY17 request. The good news – flat y/y spending was already in street estimates. Also, it was a close vote and we don’t think it will be difficult to pick off the four opposition Senators needed to pass. This is a mild set back to efforts to increase the Defense budget and we still expect FY17 Investment spending to grow high single digits.
There were two A&D CEO changes this week. While the July exit of Spirit Aerosystems (SPR) President and CEO Larry Lawson and promotion of COO Tom Gentile to CEO was expected, the timing and brief transition period was a surprise. That surprise drove SPR to underperform this week on concerns about what Lawson’s departure might imply for SPR’s negotiations with BA over a new pricing agreement. Also a surprise, Embraer (ERJ: Not Covered) President and CEO Frederico Curado will be replaced by Paulo Cesar Silva.
Russia rolled out the 160-211 seat MC-21-300. On paper, it appears to be an attractive competitor to Boeing/Airbus narrowbodies, however, we doubt it will have commercial success in international market. What’s interesting is that the MC-21 sets the trend for the future use of composites in airplanes. – 30% of the MC-21 structure is composite. ‘New technology’ widebodies are 50% composite. It’s generally accepted that widespread use of composites are less suited to narrowbody aircraft than widebodies given the higher cycle times. As such, we expect future Boeing/Airbus narrowbody designs to have comparable composite content (about 30% of the structure).
Boeing updated orders and B787 net orders total 13 YTD vs. 45 at the same point last year. B787 orders are a watch item for us. At its investor day, BA noted that it needs to “sell the additional 787s which will solidify the 14/mo production rate”. We think many already factor in a 14/mo rate break in mid/late 2019 which implies a step up in advances in mid/late 2017 as progress payments start 2-yrs prior to delivery. If insufficient orders drives BA to delay a 14/mo rate or not achieve it at all, we think that poses risk to consensus 2017/18/19E FCF estimates given the delay or elimination of the step-up in advances.
B/E Aerospace (Buy) June 13, 2016
Forty percent of BEAV’s sales are aftermarket, and of this approximately 50% are spare parts and 50% are services and retrofit programs . . . We recently spoke with over 15 interior OEMs and MROs and the retrofit outlook into 2017-2018 remains very positive. Specifically, we believe the industry is looking for double digit growth after a slower 2014-2015. Specifically, retrofit RFP activity is up in all regions, and our checks support our confidence in BEAV’s 2017 retrofit and the industry outlook.
Cowen and Co.
Delta Air Lines, June 13, 2016
At an investor conference last week, Delta discussed the current state of the airline and now forecasts operating margins to be at the low end of their initial guidance of 21% – 23%. The guide to the lower end of the range is because PRASM is at the low end of expectations and fuel costs are moving higher. Delta stated 2Q16 PRASM is forecast to be at the low end of initial guidance of down 2.5% – 4.5%. Management stated the company is also tracking below the low end of guidance in June and will need to see improvement in the next two weeks to hit the low end of the range. Comment: Delta should have lowered the range to negative 3% – 5%. We are lowering our estimates to reflect the update. We forecast 2Q16 EPS of $1.77, down from our prior estimate of $1.86 and compared to the consensus estimate of $1.83. We forecast 2016 EPS of $6.30, down from our prior estimate of $6.45 and compared to the consensus of $6.47. We forecast preliminary 2017 EPS of $6.65, down from our prior estimate of $6.70 and compared to the consensus of $6.95
Boeing (Sell) June 14, 2016
Spirit Aerosystems (Sell) June 14, 2016
The 787: A deferred-production-dreamliner-dream, deferred
Volume input should be getting more attention on the 787
We think margin assumptions in the 787 accounting block are aggressive. But it may be simple demand that makes or breaks the program, more than margins. With enough demand, Boeing may keep extending the block size, and slowly absorb costs with more volume (though even this would mean much slower cash generation than consensus expects). With little new demand, an extension may be far from a foregone conclusion.
The challenging math of current 787 supply & demand
The current amount of units yet to be ordered as a percentage of the block, is near the highest ever on any aircraft; and any block extension would only increase that gap. 787 demand has been soft with book-to-bill below 1.0X since first delivery, and could stay there given lower crude and more competition. At current production, if orders pace at their last five year average, Boeing would exit 2020 with an unsustainable 1.9X backlog/sales on 787. The current skyline is near-full through 2018, then holes open in 2019 and beyond. We think back to 10/month is more likely than up to 14/month.
The pure margin input to the deferred unwind, also a big hurdle
Achieving the margin assumptions currently implied by the 787 accounting block, looks extremely unlikely to us. With enough demand, Boeing could continuously extend the block, providing more units over which to spread costs. However, doing that is not a cure-all. It causes a much slower unwind of deferred over a much longer period of time. We estimate the current block implies ramping quickly to a mid-20% margin in 2018, then mid-30% in 2020; which we think would require surpassing the historically high margins of the 777 and 737. If BA were to approach a 25% cash margin late in the current block and exit there, we estimate it would need to write-down half of the $32bn deferred production balance (without an extension). The combination of mix of variant and price assists the challenge; but does not fully solve it and carries risk given the need to sell more aircraft and escalator headwinds.
Sell Boeing (BA) and Spirit (SPR)
We think 787 demand and volume disappointment would drive shares of BA lower. We think 787 will be one of several drivers of worse than expected free cash flow at BA. For SPR, 787 is a meaningful driver, and lower volume would impede its cash generation potential. We also see margin risk given SPR’s ongoing negotiations with BA on new pricing contracts.
On the Radar: June 13, 2016
|Coming up this week…
Some aerospace/defense companies will present at a competitor conference this week.
Our commercial aerospace coverage outperformed a flat market by ~50 bps last week (unweighted average). BEAV and BA led the way, returning 3.8% and 3.0%, respectively, while SPR underperformed on news of a CEO transition and TXT underperformed following a jump the prior week on a potential takeover report that we consider unlikely.
With sentiment moving toward “risk off” through the week, we would have expected defense to do relatively well and each of our defense stocks outperformed a flat market, returning 1.5% (unweighted average). LLL momentum continued, with the stock gaining 3.0%, and RTN stood out on the plus side as well. GD continued to lag other defense names but finished up 1% on the week, ahead of the market.
Spirit AeroSystems CEO Larry Lawson announced his retirement effective July 31st. COO Tom Gentile, who was hired in April, will take the top spot.
Latam, the largest airline in South America, is looking to push out or cancel deliveries of some widebodies amid continued weakness in Brazil. The carrier has 26 Boeing 787s and 27 Airbus A350s on order.
Canada’s Innovation Minister said the federal government is willing to “find a solution” to the dual share structure at Bombardier that has reportedly been a sticking point in the company’s effort to secure additional Canadian financial support for the C Series. The current share structure allows the Beaudoin-Bombardier family to control the company. This latest report is from Reuters.
TransDigm moved ahead with plans for $1.9 bn of previously announced debt offerings. The company has now raised $950 mn of 6.375% subordinated notes due 2026 plus $500 mn from a new 3.75% term loan maturing in 2023 and received a commitment for a delayed draw term loan for an incremental $450 mn. In addition, TransDigm modified existing credit agreements to allow restricted payments – including dividends and repurchases – of up to $1.5 bn, or just over 10% of the current market cap. Pro forma, we estimate that with the $1 bn acquisition of DDC and a potential $1.5 bn dividend, net-debt to pro forma LTM EBITDA would be > 6.5x.
Embraer unexpectedly announced plans for a CEO transition that will see Commercial Aviation chief Paulo Cesar de Souza e Silva take over from Frederico Curado in July with the transition complete by year end. Mr Curado led Embraer for nine years.
Commercial Aero News
The chief of Indonesia’s Garuda said the carrier would take its time in placing an order for up to 250 aircraft, according to Bloomberg. Arif Wibowo stated that it is a “buyers’ market” for aircraft and that other airlines have rescheduled deliveries. The comments clearly advance Garuda’s cause and must be viewed in this context but they are also consistent with investor perceptions regarding pricing pressure on new aircraft orders.
Emirates is moving toward an order for either A350s or 787s but an announcement is not expected at the Farnborough Air Show, according to Flightglobal.
TAP Portugal is considering a purchase of 35 aircraft in the 100-150 seat segment within the next 24 months, according to Air Transport World. The airline is looking at the Embraer E195 E2 jet.
Christoph Mueller, the outgoing CEO at Malaysia Airlines, said the carrier is evaluating an order for a large narrowbody and considering both the A321 and 737-9.
Iran may order ~100 aircraft from Boeing, potentially matching its commitment to Airbus earlier this year, according to Reuters. The airline is also talking with Boeing about providing support for its existing fleet. We believe the report is consistent with existing expectations.
Boeing delivered 71 aircraft in May and secured orders for 125. Through May, net orders and deliveries stand at 268 and 301, respectively, for a book-to-bill of 0.9x, vs the 1.0x target for 2016. Backlog at the end of May was 5,762 aircraft. Large potential orders remaining this year include the Iranian opportunity referenced above and conversion of ~100 737 MAX options from Ryanair.
Airbus secured 83 orders and delivered 57 aircraft in May. Backlog at the end of May stands at 6,759 aircraft. YTD net orders and deliveries stand at 162 and 234 respectively.
China’s Sichuan Airlines ordered 15 A320s, according to Air Transport World. Separately, Boeing reported one 787 order last week from an undisclosed customer.
Boeing announced plans to consolidate the 787 leadership team under program manager Mark Jenks. Beverly Wyse who has lead Boeing South Carolina since January 2015, will move to head the corporate Shared Services Group.
Airbus delayed delivery of China Airlines’ first A350 from July to September and three more A350s for the carrier will be late as well. Issues with interiors continue to slow the pace of A350 final assembly and push out deliveries.
Qatar Airways canceled its first A320neo, citing delivery delays. The airline can exercise walkaway clauses on four other delayed aircraft.
Emirates is considering a premium economy class as first- and business-class bookings have fallen. Emirates would be the first of the big-three Middle East carriers to offer this level of service.
Irkut, the Russian aircraft manufacturer, rolled out its MC-21 narrowbody aircraft. Deliveries are slated to begin in late 2018 but a delay seems likely. We do not think the aircraft poses a serious threat to Airbus or Boeing.
Alcoa and Alumina agreed to a hearing on September 20, 2016, to address the AWAC JV issues surrounding Alcoa’s planned separation.
May investment account outlays were $12.0 bn, down 16% vs. May 2015. Fiscal YTD, investment accounts are down 1% vs. 2015 while O&M is down 3%.
The Danish parliament approved the purchase of 27 F-35s. The government previously recommended buying Lockheed’s F-35 over competitors including the Eurofighter Typhoon and Boeing’s F/A-18.
Lockheed indicated it would move $825 mn of F-35 work out of Canada if the country backs away from plans to purchase the jet. The news comes as Canada considers ways to fulfill the current government’s campaign promise not to purchase the F-35 in the context of commitments from previous governments. One possibility floated last week could see Canada purchase Boeing F-18s to fulfill capability gaps near term while deferring a final decision on F-35.
· Honeywell is seeking to sell a unit that provides engineering and operations support for NASA, DoD, and other government agencies, according to a Bloomberg report that says the business may fetch up to $450 mn.
The Army awarded Boeing a $668 mn FMS contract for 24 Apache helicopters for Qatar. Deliveries will start in 2019.
Northrop Grumman was awarded a $600 mn modification to previously awarded contract for missile defense technical integration.
Turkey signed a $3.5 bn contract for 109 Black Hawk helicopters, manufactured by Sikorsky, now part of Lockheed. The agreement firms up Turkey’s selection of the Black Hawk for its utility helicopter requirement five years ago and a 2014 preliminary contract.
The Department of Homeland Security reaffirmed the award of a cybersecurity contract to Raytheon worth up to $1 bn over 5 years plus two option years. DHS awarded Raytheon the contract in Sept but recently completed “corrective actions” following questions from the GAO. Separately, Raytheon received a $249 mn contract to refurbish vehicle parts for the Marines.
The GAO recommended that Congress consider not funding the Littoral Combat Ship (LCS) in FY17 due to concerns over the ship’s survivability and lethality.
LLL announced that Heidi Wood is joining the company as Chief Analytics Officer. Wood had been at SPR since 2013.
Under the Radar, June 13, 2016
Defense News reported Lockheed Martin’s Sikorsky signed a $3.5B T-70 Black Hawk utility helicopter contract with Turke