Boeing: Lika köpvärd med 737 Max i luften

While the resumption of U.S. 737 MAX deliveries is a critical step, aircraft are sold globally, and the plane remains grounded in Europe and China, the two other major aviation markets. We’ve seen optimistic news out of Europe that the MAX is well on its way to returning to service and may receive authorization to resume operations by the end of the year. We are unsure of its progress in China, and we worry that it might be used as a tool in the escalating tensions between the U.S. and Chinese governments. That noted, we are encouraged by the coming change in the U.S. government and think the new administration may have a less combative trade policy, which we think increases the chance of Chinese recertification. Broadly, our fair value assumes that the MAX returns to service globally in relatively short order and that Boeing can deliver aircraft outside of China in the meantime.

Looking forward, we see several longer-term steps in Boeing’s turnaround. First, we believe there is substantial operational risk in Boeing’s plans to simultaneously ramp up production of the 737 MAX and sell the 450 MAX aircraft in storage during the current aviation crisis brought on by the pandemic. Second, Boeing needs a postpandemic boom in air traffic and a resumption of 737 MAX orders to rebuild its backlog. Finally, Boeing needs to ramp production beyond its previous peak of 52 per month, which we think would generate the free cash flow necessary to service debt.

Business Strategy and Outlook | Nov 18, 2020

Boeing is a major aerospace and defense firm and primarily generates revenue from manufacturing commercial aircraft. Boeing’s commercial aircraft segment can be split into two parts: nimble narrow-bodied planes that are ideal for efficiently running high-frequency short-haul routes, and wide-bodied behemoths that are generally reserved for transcontinental flights. Recently, sales volumes for narrow-bodies have increased substantially due to the worldwide rise of low-cost carriers and improved technology that allows smaller airplanes to operate flight paths that were previously unprofitable.

We think Boeing’s 737 MAX is a solid narrow-bodied aircraft, but we recognize that its grounding (recently rescinded in the U.S.) has dented Boeing's reputation and its order book. The key questions in the narrow body market are: how quickly will new orders rebound after the 737 MAX aircraft is recertified and how long will commercial aviation remain depressed from the COVID-19 pandemic? We think the tailwinds favoring narrow bodied aircraft are more powerful than the bad press surrounding the MAX and expect new orders after recertification. We do not think the COVID-19 pandemic has structurally impaired commercial aviation and anticipate a rebound in airlines' revenue passenger kilometers after lockdowns are lifted. We expect that wide-body demand will recover more slowly from the COVID-19 downturn than narrow-body demand because wide-bodies are used for longer haul trips, which are unlikely to recover until a COVID-19 vaccine is distributed globally. We think Boeing’s concentrated backlog for the 777X aircraft presents a risk for Boeing, but that Boeing's 787 Dreamliner gives it a dominant product lineup for the long-haul market.

Boeing has segments dedicated to the production of defense-specific products and aftermarket servicing. These businesses together generate about 35% of our midcycle operating income. We are broadly assuming that defense spending as a percentage of GDP remains constant in the U.S., and look for above-market growth in the services market once revenue passenger kilometers recover.

Economic Moat | Nov 18, 2020

In our view, Boeing possesses a wide moat that will allow the company to generate economic profits for the long haul. Morningstar’s definition of a wide-moat company requires a high degree of confidence that a company can achieve a normalized excess return over the next 10 years, and more likely than not over the next 20. Despite Boeing's troubles with the grounding of the 737 MAX, we believe that structural barriers to entry in the aircraft manufacturing market and the substantial expense and difficulty required for customers to switch suppliers provide incumbents with intangible assets and switching costs that solidify their place at the top of the commercial aerospace value chain.

Boeing’s commercial aircraft manufacturing segment assembles and sells airframes, generally with 130 seats or more. Many of Boeing’s advantages in this segment, such as an extensive backlog that reduces revenue cyclicality, a large installed product base that generates sustainable aftermarket sales, can be attributed to intangible assets surrounding the regulatory and manufacturing environment for airframes, which constitutes a steep barrier to entry. These barriers to entry have prevented all but two global firms, Airbus and Boeing, from entering the aircraft manufacturing market. We think that the most important sources of intangible assets in airframe manufacturing are the stiff regulatory burdens imposed on manufacturers and the long, complex and capital-intensive product cycles.

Civil aviation authorities have arduous requirements for new aircraft certifications, involving a thorough review of proposed designs, flight tests, and an evaluation of the aircraft’s maintenance procedures. The United States’ Federal Aviation Administration (FAA) estimates that this process can take between five and fine years for a new aircraft. Incumbents have several advantages with regard to regulation. Existing manufacturers have a substantial amount of specialized knowledge on the regulatory process that would be costly to replicate; the 2019 Joint Authorities Technical Review report on the Boeing 737 MAX estimates that Boeing has 1,500 people on staff working to ensure that Boeing complies with the regulatory process and that the FAA delegates a substantial portion of the compliance process to Boeing. While we recognize that controversies surrounding the fatal accidents that caused global regulators to ground 737 MAX may challenge some of Boeing’s authority on the matter, we believe that the continued cost-efficiency of certification delegation will allow Boeing to retain an advantaged position within the regulatory framework. Second, Boeing has a large array of existing aircraft that are certified for flight, and the FAA’s regulatory framework allows for an expedited certification for derivative aircraft and estimates that this requires only three to five years to complete. Third, the most likely contenders to enter the market, COMAC and UAC, are Chinese and Russian companies, respectively. The FAA does not have reciprocal acceptance of aircraft design approval with these nations, so we anticipate material frictions in the international approval process. Indeed, COMAC’s regional jet, the ARJ-21, has been in service within China since 2016 but is still not certified by the FAA or its European counterpart, the European Air and Space Association.

The long, expensive and capital-intensive process of designing and manufacturing an aircraft is a second major barrier to entry into the commercial aviation manufacturing business. Aircraft design takes years, and many would-be competitors have faced development cost overruns and extended development cycles. It is quite difficult and expensive to replicate Boeing’s 13,000 company supply chain, to build a skilled workforce and develop the knowledge base required to properly assemble an airframe. Firm data on the exact cost of developing an aircraft program is rare, but there have been notable examples of well-capitalized competitors failing to develop a suitable product on-budget. The most prominent was Bombardiers’ C Series, which suffered from chronic delays resulting from issues with suppliers that extended development for years, and program cost overruns that caused the company to take a quarterly charge in 2015 that was roughly the market capitalization of the company at the time. Further, the government of Quebec, Bombardier’s native province, took a stake in the program to protect the company’s workforce. Even after governmental support, Bombardier was unable to secure crucial United States customers without deep discounts and gave control of the program to Airbus following a subsequent trade dispute. Other aspiring competitors such as COMAC and United Aircraft Corporation have faced similar problems over their development cycle and have thus far generally failed to secure orders outside of their home countries. This example illustrates the key problem with breaking into aircraft manufacturing: if a competitor goes through the arduous process of developing an aircraft, potential customers face massive switching costs and are thus quite conservative in their purchasing habits.

Switching costs for airlines are predicated on the high cost of switching, conservative customer purchasing habits, as well as lack of viable alternative suppliers. Pilots and crew must be certified for each family of aircraft that they fly and retraining large blocks of pilots would be costly and time-consuming. Further, many pilots in the developed world are unionized, which would likely complicate the matter. Airlines hold a sizable inventory of spare parts for aircraft, which would need to be liquidated and repurchased for the comparable aircraft, a process that would require time and potentially a discount for liquidity. Maintenance procedures are also designed for each aircraft product. While exact customer terms are opaque, there are several tangible ways of estimating switching costs. One example is low-cost carriers. Since the savings from consolidating processes onto a single aircraft are so significant, many low-cost carriers, such as Southwest, Ryanair, and Spirit Airlines, base their entire fleet on a single aircraft family. We used data from the Bureau of Transportation Statistics form 41 to estimate the cost savings on a per seat-mile basis. This form allows us to examine specific costs per available seat mile by single-aisle and twin-aisle aircraft for each carrier. We found that Southwest, which bases its fleet entirely on Boeing 737s, has saved a tiny fraction penny per available narrow body seat mile in maintenance and pilot training expense from 2014-2018 relative to large U.S. network carriers. Since Southwest has capacity of over a hundred billion available seat miles, our estimated savings per available seat mile add up to a figure in the hundreds of millions of dollars. We recognize that there are other factors beyond the choice of aircraft contributing to this efficiency, but we think these savings demonstrate that aircraft consolidation is a viable cost-saving strategy.

A second major factor preventing customers from switching is the long product cycle for aircraft. Airplanes generally have useful lives of about 20-30 years, depending on how the airplane is used, and airlines expect the manufacturer to service the aircraft over the life of the aircraft. Given this long product cycle, airlines tend to be conservative purchasers because they want to be reasonably certain that the manufacturer will be operating and able to service the aircraft over its useful life. Finally, since there are steep barriers to entry and thus only two viable aircraft manufacturers, customers would have difficulty switching even if they wanted to. The backlogs for the most popular narrow-body products at both major aircraft manufacturers last over five years, and the manufacturers actively manage their production to maintain these backlogs. An airline that wanted to switch would need to wait years for a new aircraft or to pay hefty fees to cut in line. Due to these massive switching costs, a potential competitor would have difficulty garnering customers even if they brought a competitive product to market.

We believe the defense side of the Boeing’s business, possesses a wide moat based on intangible assets and switching costs. Boeing’s intangible assets are deep knowledge of the esoteric contracting rules governing defense contracting, and strong relationships with U.S. defense contractors. The military contracting space is highly concentrated and regulated, and we do not envision much disruption here. Given the mission-critical nature of these products, customers tend to be conservative purchasers. Boeing’s long-standing relationships should not be underestimated, Boeing has been a primary manufacturer of presidential aircraft since Franklin D. Roosevelt’s administration, which we think demonstrates the immense trust that the government places in Boeing’s aircraft. Beyond this, given that Boeing employs people and supports supplies in all 50 U.S. States and according to the Senate Lobbying Disclosure Act database has spent at least $10 million a year lobbying since 2007, we believe that Boeing has developed lasting relationships with congresspeople. On the switching cost side, Boeing benefits from a large installed base of product and conservative customer purchasing tendencies. Just under half of Boeing’s $16 billion dollars in servicing revenue comes from governments, and much of this is earned from the military, which demonstrates the size of the current installed product base. The government would need to update its fleet considerably to unseat Boeing, and we see no pressing reason for the government to do so. Generally, the U.S. Department of Defense typically funds much of the nonrecurring costs on major programs, so it would take a long time before a new competitor could be built from the ground up.

Fair Value and Profit Drivers | Nov 18, 2020

After incorporating third-quarter results into our model, we're lowering our fair value estimate for Boeing to $260 from $264. Our valuation implies a 2021 price/earnings multiple of 26.2 times, though we don’t believe this is especially meaningful as near-term earnings are skewed by abnormal earnings from the MAX. The biggest determinants of our valuation are the rate at which Boeing can ramp up production of narrow-bodied aircraft, which is determined by how quickly commercial aviation recovers from the COVID-19 pandemic, and the margins on narrow-body products.

The COVID-19 crisis has shocked the aviation industry and we expect a severe near-term decline in global revenue passenger kilometers. Critically, we assume that a COVID-19 vaccine will be well-distributed by mid-2021, which would allow a sharp rebound in air traffic. Beyond the pandemic, we assume steady but slowing low-single-digit growth in global revenue passenger kilometers, largely driven by GDP growth in emerging markets. We anticipate that about three quarters of fleet growth will be in narrow bodied aircraft, as advancing technology unlocks the commercial viability of new routes.

We expect that the shift toward newer, premium aircraft, such as the 737 MAX and the 777X, and learning curve-based cost efficiencies should help the company improve margins. Critically, we're anticipating that volume increases in the high-margin 737 MAX will bring Boeing Commercial's operating margin to a midteens level. Overall, we expect operating margins to improve to about 14% at midcycle, versus 11.9% in 2018 (the MAX grounding makes 2019 an abnormal year for comparison).

We’re modeling steady growth and reasonably consistent margins within the defense business. We anticipate that defense spending as a percentage of GDP remains constant in the U.S. and we don’t anticipate substantial growth in higher-margin international defense sales. We note that Boeing's defense unit is exposed to more fixed-price development contracts than other defense primes, which introduces more operating income variability than peers.

On the services side of the business, we’re expecting a sharp slowdown near-term, and that the company can continue to take share in the fractured aftermarket over the medium-term.

Risk and Uncertainty | Nov 18, 2020

Broadly speaking, the biggest risks that Boeing faces are operational risks. Boeing’s backlog offers visibility into future sales, and right now the backlog covers a substantial amount of future sales. While commercial aircraft customers are highly cyclical, they are also reluctant to renege on orders because of down payments of 1%-2% of contract value on signature and another 20%-25% in the 24 months preceding delivery. With aircraft prices generally starting at $100 million (though we recognize this is heavily discounted ), this is a material down payment. Nonetheless, production increases are not a foregone conclusion, and deferrals and cancellations can occur. The headline uncertainty at the moment is the extended grounding of the 737 MAX aircraft, which has flooded Boeing’s balance sheet with excess inventory as the aircraft continues to be produced but not sold. Although the 737 MAX has been cleared to return to service in the U.S., we see substantial operational risk in Boeing’s plans to simultaneously ramp production of the aircraft and sell those in storage during an aviation crisis.

A second operational risk Boeing faces is the supply chain. If Boeing’s suppliers are unable to increase production levels, it would likely limit Boeing’s ability to increase production. Given the bespoke components required to produce an aircraft, if a key member of the supply chain falls into financial distress, then Boeing’s production rates would likely be limited. We think one major reason why Boeing has been reluctant to pause production while the MAX remains grounded is to protect the health of the supply chain.

The ongoing COVID-19 outbreak presents substantial risks to near-term air traffic demand, which calls into question customers' demand for new aircraft. While we think the pandemic is a stern test to the aviation industry, we think that this is a difficult temporary setback rather than a structural change.

Stewardship | Oct 29, 2020

We assign Boeing a Standard stewardship rating and do not view Boeing’s corporate governance as a material problem to shareholders. In December 2019, Boeing announced that David Calhoun has relinquished his chairmanship and became CEO in January 2020 after exiting his non-Boeing commitments at Blackstone. Calhoun has been on Boeing's board since 2009 and brings substantial aviation experience from his time at General Electric.

After the two fatal accidents leading to the grounding of the 737 MAX, some might argue that Boeing’s practices have been too shareholder-friendly and the company has underinvested in their product. We think that this argument has some merit, but it also understates the long term improvements in aviation safety. Commercial aviation accident data shows that aggregate aviation safety has improved dramatically over the past fifty years, and that aviation accidents have become newsworthy precisely because aggregate fatalities have dropped so steadily.

Also, the company has made some reforms to address criticisms. The CEO & chairman roles have been split, which provides an additional layer of oversight and addresses a concern raised by shareholders in the past few proxy votes. The company has created a Product and Services Safety organization that reports directly to the board of directors, which directly addresses the criticism that Boeing employees did not have enough channels to express safety concerns. Boeing has also added a safety committee at the board level, to ensure that these issues are continuously being discussed.