Boeing earnings preview: doubts about Global Services target

April 25, 2017: Boeing’s first quarter earnings call is tomorrow. Focus is expected to be on its plans for expanding after-market services with its new business unit, Boeing Global Services.

Earlier today, LNC posted a Special Report from Kevin Michaels in which he believes it will be challenging for Boeing to meet its target of $50bn in revenues.

Separately, the aerospace analyst for Wells Fargo reached the same conclusion. His report is below, followed by other analyst previews of the earnings call.

Wells Fargo: (Market Perform)
  • Summary. Boeing Global Services – a new unit that will combine the company’s existing commercial and military service businesses – is to be formed in July 2017, with aspirations of nearly tripling sales to $50B/year over time. Investors should understand this potential opportunity that could change the current debates about the aerospace cycle, Boeing’s cash flow growth, and whether the stock’s Free Cash Flow (FCF) multiple is too low. With Q1 earnings to be reported on April 26, services growth could be an increasingly discussed topic.
  • Conclusions. Our key take-aways are: (1) the company already has taken steps to drive services growth; (2) there are sizable organic growth opportunities, but those alone are likely to fall short of the $50B goal; (3) acquisitions almost certainly would be part of the strategy, but names of logical targets are unclear; and (4) share buybacks are likely to be as accretive to EPS as acquisitions – though with far less execution risk.
  • Organic Growth Sources should include: (1) growth in the installed fleet of military aircraft – notably, P-8 and KC-46; (2) an increasing number of airlines signing up for GoldCare (MRO/reliability programs) and information-based services; (3) strategic partnerships with suppliers; (4) bringing certain work “in-house” that use Boeing’s intellectual property; (5) potentially changing the business model on the new middle-of-the-market commercial jet such that Boeing gains aftermarket share; and (6) winning services on future defense programs that are not yet decided (e.g., the T-X trainer, JSTARS recapitalization).
  • Acquisitive Growth. We do not believe Boeing would make a large investment in “wrench-turning” or defense IT services. On the other hand, companies with sizeable aftermarket or products that can be supplied through its Aviall distribution channel seem more likely. We have a hard time identifying logical M&A candidates that are large enough to impact a company the size of Boeing – and our estimates imply Boeing would have to acquire the equivalent of roughly one $1B+ sales company every year for ten years to reach the $50B target.
  • Buybacks. Given the risks we identify below, a case could be made that share buybacks should remain Boeing’s primary cash deployment option. Buybacks are a less-risky strategy (i.e., no operational/integration issues), and by our calculations similarly accretive to EPS. We think a crowding-out of buybacks would be a negative for the stock.
  • Strategic Risks. We note that some risks associated with rapid services growth could include: (1) losing the “single face” with the customer; (2) internal conflicts between product and service units; and (3) crafting the appropriate selling / pricing strategies. Also, we note that in any potential M&A any work on non-Boeing platforms may be lost over time.
R. W. Baird

We are previewing 1Q17 for BA, which we expect a solid report that should be at least in line with the current consensus expectations. We continue to see upside in the BA stock, despite a 14% gain YTD reflecting the solid execution on major production programs coupled with our outlook for robust cash generation enabling ongoing buybacks and an attractive dividend at 3.2%. We are increasing our price target by $26 to $208 based on 14x (up 2 points) on our 2018 FCF estimate.

Expecting 2017 outlook to be reiterated. Current 2017 guidance for core EPS (ex-non-cash pension) is expected in the range of $9.10-$9.30 based on revenue guidance of $90.5-$92.5 billion. BA set 2017 cash from operations guidance at ~$10.75 billion, with 1Q17 expected to be weakest quarter with the consensus at only $246 million.

Bernstein Research (Outperform)

We see Boeing as a strong investment opportunity for 2017, with rising free cash flow through 2020, driven mostly by the 787 program and the 737 production ramp, which more than offset 777 declines. Free cash flow has historically driven Boeing’s share price. Cash flow growth on the 787 should come from higher pricing and unit margins on the 787-9 and 787-10 models, and elimination of penalty overhang from late delivery on most of the first 500 units.

Higher unit margins as mix shifts to primarily 787-9s and, eventually, adds 787-10s – Boeing extensively redesigned the 787 between the 787-8 and the 787-9, to incorporate lessons learned from the -8 about design for manufacturability. As a result, the company has said that a 787-9 should cost about the same to produce as a 787-8, although it is a larger airplane with a higher purchase price. Similarly, the purchase price step-up from a 787-9 to a 787-10 should be larger than the cost step-up, offering a further unit margin increase for the -10. We expect that approximately three out of four 787s delivered in future will be a -9 or -10 model.

Buckingham Research Group (Underperform)

We reiterate our UNDERPERFORM rating and $140 target ahead of BA’s 1Q17 earnings on April 26th. BA recently reported 1Q17 orders and deliveries and we think consensus may not have lowered estimates sufficient to reflect a worse mix and fewer than expected commercial and defense aircraft deliveries. Our 1Q17E of $1.91 is below consensus of $1.99 but slightly above BA’s implied 1Q17 EPS guide of $1.82-$1.83. Despite our view of a 1Q17 miss vs. consensus, we think the stock could trade down modestly as BA has talked down expectations ahead of the quarter and a quarterly miss is not likely to change the sentiment of long term holders – which remains decidedly positive given strong traffic demand and a near 8% FCF yield. No change to our negative view driven by expectations for continued weak orders, lower widebody production rates, and disappointing capital deployment vs. expectations.

We think consensus revenue estimates for BCA may be too high. In 1Q16, BCA revenues were $14.4B on 176 deliveries. For 1Q17, consensus expects BCA revenues of >$14.5B (up 1% y/y) on 169 deliveries (and a worse mix given fewer higher margin 777s and 737s delivered versus 1Q16). Although BA recently raised list prices, we think the ‘true” pricing environment remains under pressure due to weak widebody demand and competition from Airbus (airline customers typically get 40-60% discounts to list prices). BA’s aftermarket business could account for some of the y/y revenue and operating margin improvement, however, we still see downside risk to consensus and our estimates. In 1Q17, consensus expects about 70bps of margin improvement – 1Q17 BCA operating margin of 9% compare with. 8.3% for 1Q16 adjusted for the $162M KC-46 pre-tax charge.

In a separate note following the first quarter earnings call of Boeing supplier Hexcel, BRG wrote:

Commercial Aerospace sales of $347M missed our expectations for $380M. Sales decreased <1% y/y due to legacy widebody program production rate declines. While HXL was aware and factored in production rate declines for the B747, B777, and A380 when they reported 4Q earnings in January, HXL notes that they underestimated the steepness of the supply chain correction. As a direct result, HXL notes that they are improving channel checks and conversations with customers.

An interesting point speaking with HXL is Commercial Aerospace results were also impacted by tightening of the 787 supply chain. In our view, that could be an indication that BA may have already decided against raising 787 production rates to 14/mo. While that may seem obvious to some, we think some bullish investors may factor in another increase in 787 production rates as BA stated previously that a rate of 14/mo remains under consideration.

(Emphasis in the original.)

Canaccord Genuity (Hold)
The company has recently been reminding the Street that Q1/17 EPS is guided to ~20% of the full-year EPS (implied ~$1.85) and that FCF faces a number of Q1/17 headwinds. We are adjusting our Q1/17 EPS estimate to now $1.94 and our full year 2017 “core” EPS estimate to $9.22. Lower 737 deliveries in the quarter, as well as softer deliveries of several military platforms, are driving the lower estimates. Our Q1/17 FCF estimate is now basically beak-even, roughly in line with expectations.

Commercial orders have started off well for Boeing, with net orders of 198 (including commercial derivatives) through March. Note that the average of Q1 commercial orders for BA has been just 97 over the past two years, but the 2017 order activity is roughly in line with the Q1 average of 218 from 2012-2016. BA stock is not as correlated with order activity as it has been, so we do not believe near-term order activity (or lack of) will be significant for the stock. However, we believe a large 767F order from a customer such as Amazon (>100) would be a positive catalyst considering the potential margin benefit (absorption), even if pricing is very low.

We do not expect Boeing will alter its full-year 2017 guidance, which is consistent with the past few years. However, we believe estimates now largely reflect the lower deliveries and weaker FCF, so we expect limited downside risk associated with the Q1/17 results. However, the larger questions involve the 2017 FCF upside potential (787 and 737 important here), the health of the wide-body market, BA’s evolving product strategy, and the implications for R&D as well as performance relative to its longer term margin and FCF targets.

We continue to see incremental risk to the wide-body market, but we believe BA is well positioned to hit its 737 delivery targets. Moreover, we believe there is a perception that much of the negative WB news is already priced into the stock, and our view that 787 rates stay at 12/month, rather than hitting 14/month, is generally regarded as the consensus view. We believe a potential step-up in R&D, and execution risk, to address the MOM sooner than anticipated could be a risk for the stock, but aside from this, the capital deployment (buybacks and dividends) should keep a floor on the stock.

We are maintaining our HOLD rating and slightly increasing our price target to $170. Our price target is based on the blend of a 10x EBITDA multiple and a 16x EPS multiple, applied to our 2018 estimates. We believe absolute FCF growth will be limited (upside is from buybacks) and see increased uncertainty in the commercial market, but with better defense fundamentals, keeping the stock in a near-term trading range, in our view.

 JP Morgan

Boeing [is] focused on cost cutting..

BCA employment is down from 83.5k at YE15 to 74.2k by March 2017, with Washington State accounting for 60% of the decline. BCA has been cutting costs aggressively since 2016 began and we believe this is a combination of efforts to expand margins and to counteract airplane price pressure. The

company’s target for a mid-teens EBIT margin at BCA by roughly the end of the decade seems unlikely to us but we are modeling ~200 bps of expansion off the 9.7% we forecast this year with potential for upside. In addition to lower headcount, we believe that Boeing expects price pressure on suppliers through Partnering for Success, extensions of the 787 accounting quantity, and migrating the workforce to defined contribution plans to drive margins higher.

 

5 Comments on “Boeing earnings preview: doubts about Global Services target

  1. ‘Similarly, the purchase price step-up from a 787-9 to a 787-10 should be larger than the cost step-up, offering a further unit margin increase for the -10. ‘

    I don’t see this happening, the B789 is to some extent in a monopoly position in its segment whereas the B781 competes closely with the A359. The B781 has broadly similar economics but is considerably less capable so I would expect the pricing to be under much more pressure than its sibling.

    • “The B781 has broadly similar economics but is considerably less capable”

      Can you support this?

      • Hi Geo

        Capable in terms of range I think is common knowledge unless you know something I don’t. As I understood it EK were concerned about the ‘hot and high’ limitations of the B781 during the interminable discussions about their order. This predominantly comes down to a lack of wing on the B781. That is my understanding anyway, similar capacity but limitations on range/ payload. Please educate me if you believe this not to be the case.

        • Hi Bob,
          I prefer to be educated actually!
          Regardless the EK situation is rather special due to their unusual conditions, I’m not sure that translates to a market wide view. Since EK still has not made up their mind so I guess we will find out…. eventually. 😉

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