Going Long at 30,000 Feet: The Case for Boeing
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There's a moment I love during a long flight when you happen to glance out the window, and a glittering airplane wing suddenly darkens as the plane plows through thick clouds. If you're in a reflective mood, your perspective seems vastly increased versus the dull minutes you spent waiting on the ground, scrolling through messages or flipping through a magazine, annoyed with the limbo of the tarmac.
Investing in The Boeing Company (NYSE: BA) at present is a test of your perspective: if you're in for a trade, you may be wondering when your plane will be cleared to taxi. View this aerospace and defense company from 30,000 feet, however, and it's easier to obtain clarity on areas that at ground level seem fraught with risks.
Boeing's Aerospace Business will Continue to Grow Steadily
This has been a solidly profitable year so far for Boeing, and revenues are projected to exceed 2011's total by at least 16%. Yet a recent order cancellation from Qantas Airways is a manifestation of the fear that airlines -- the primary purchasers of Boeing's aerospace offerings -- may be heading into retraction mode. Faced with poor financial results, Qantas took advantage of production delays and nixed an $8.5 billion order for 35 787-9 Dreamliners in August. If the global economy continues in its current malaise, won't this mean decreased orders for Boeing and rival Airbus?
The answer is not necessarily. As jet fuel prices continue to rise, many established airlines will be forced to replace aging fleets with more fuel-efficient mid- and long-range planes in order to remain competitive. Take note of American Airlines, which ordered approximately 100 737s from Boeing last year, shortly before declaring bankruptcy. The economical planes are key to American's cost-reduction strategy, and the company is fighting to preserve the order. American's bankruptcy trustee approved delivery of 11 of the 737s last month.
American's forward view during restructuring will be echoed by pragmatic CEOs and CFOs in airlines large and small in the coming years. This past weekend, Japanese airline ANA, the 787's first customer, announced an order for 11 more Dreamliners, citing fuel efficiency and route profitability as factors behind the decision.
Impact of the 787 Dreamliner
Boeing recently added a third line to its 787 production facility in Everett, Washington, and upped capacity at its North Charleston, South Carolina manufacturing operation, to help increase output of 787s to a projected 10 planes per month by the end of 2013. These changes will ease the multi-year task of filling its current firm order book of over 800 of the aircraft.
Boeing endured well-publicized stumbles in the 787 development phase, and delays have cost it in the form of a longer payback period, as well as compensation costs to carriers that pull orders or absorb unacceptable delays. As Boeing's management maximizes the "learning curve" period of 787 manufacturing in the near future, deliveries will accelerate. With stepped-up deliveries, the incidence of delay compensations to airlines should decrease. Both of these themes will contribute to improved operating margins going forward.
Skeptics theorize that it will take years for Boeing to break even on the 787 program, when all costs (including R&D, prototyping, revisions, etc.) are considered. I have seen at least one well-reasoned analysis that puts the break-even period beyond 20 years. Most models assume that Boeing will max out its production at 10 aircraft a month -- a year 2013 goal that while ambitious, is achievable. Beyond next year, Boeing's ability to break even at a faster rate is entirely within its control should it decide to add additional production lines either in Washington State or South Carolina.
Long-term investors should take note of the greatest benefit of the 787. Through the advanced use of aluminum and carbon fiber composite materials, Boeing has developed the capability to deliver lightweight aircraft to international airlines for several decades -- in a future market the company assesses to be in the trillions. Technology developed for the 787 will be utilized in almost every commercial plane Boeing produces going forward. Spurred by Airbus, a worthy competitor, Boeing has monetized the proposition that airlines can offset uncertainty in the oil markets by reducing consumption in the air.
Rising Inventories are a Positive Indicator
As of its latest quarterly report, Boeing's inventory has reached a multi-year high, and has nearly doubled since 2010. What may be a warning sign for some corporations in other industries is a net plus in this case. Boeing realizes revenue when it delivers planes, although it does recognize some revenue when it achieves completion milestones along the way. The higher inventories are a function of greater production levels. They are also to some extent a forward indicator of sales.
From the chart you can see a correlation between inventories (net of recognized revenue) and sales. Both are growing steadily.
BA Revenue data by YCharts
What happens if an order is canceled while a customer's planes are in the production process? Boeing manages its factory lines and assembly so that an order revoked by one customer can result in an earlier delivery to another.
State of the Backlog
Sometimes a longstanding strength or market advantage can be taken for granted by investors, despite the effort required to maintain it. In sports, teams that always win are expected to...always win. Boeing enjoys an elephantine backlog of orders (Commercial and BDS combined) that would take eight years to work off if orders stopped coming in today. Incredibly, Boeing's backlog as a dollar amount ($374 billion at the end of Q2 2012) is bigger than the market capitalization of all but two companies in the world -- Apple and Exxon Mobil.
Source: Company SEC Filings 2007 - 2012
Ultimately, Boeing would like to deliver planes at a swifter clip and realize more revenue per year in the process. But such a huge stack of orders gives the company flexibility to react to unforeseen events and tweak its business model over long periods. As the graph shows, the backlog has also been fairly consistent for the last five years, with smooth rather than volatile year-to-year changes.
Does the Runway End at the Fiscal Cliff?
Boeing's second largest operating segment after commercial airplanes is "Boeing Defense, Space and Security," or "BDS." The BDS segment sells a staggering variety of military planes and weapons, satellites, cybersecurity systems, and space exploration technology to governments around the world.
Its grand sugar daddy, however, is the U.S. government, which supplies roughly 76% of the segment's revenues. The company has been preparing for reduced U.S. military spending for the last three to four years. In 2008, the U.S. government was Boeing's largest single customer, accounting for 46% of overall revenue. As of last year, the company had reduced the concentration to 38%. While the current concentration is still high, the BDS segment has an order backlog of $72 billion, which the company estimates is double the amount of 2012's projected BDS segment revenue. Even if mandated defense spending reductions get triggered (due to the budget impasse in Congress) and cut this number by as much as half, Boeing has time to make adjustments to protect its P&L statement and re-configure BDS for the long-term.
Should "sequestration" indeed occur, investors may want to keep an eye on Boeing's debt-to-equity ratio as it is reported each quarter. The deeper the cuts, the less insulation will be provided from the company's defense backlog, and in the worse case, it may have to use more debt financing than it would prefer to rebalance this segment of the company. From a recent peak of nearly $13 billion in 2009, Boeing has slowly and steadily worked its total debt down to $11.2 billion as of Q2 2012. Its debt-to-equity ratio now stands at 1.9. While well below competitor Lockheed Martin's ratio as the following table shows, Boeing's ratio is not nearly as clean as some other defense peers:
| Company | Debt/Equity Ratio* |
| Boeing | 1.901 |
| Lockheed Martin | 2.946 |
| Northrop Grumman | 0.367 |
| General Dynamics | 0.2879 |
| Raytheon Company | 0.5236 |
| *as of the most recently reported quarter |
Interestingly, while the debt ratios for Northrop Grumman, General Dynamics and Raytheon look more appealing than Boeing's, each of these companies is constrained by a much higher reliance on the U.S. government: all derive at least 60% of their revenues from U.S. defense spending, with Northrop Grumman topping out at a troubling 90%.
An Additional Caveat
Boeing is facing a new concern in the proposed merger of European companies EADS (partial owner of Airbus) and BAE systems, a major British defense contractor. BAE has prime contracts with the Department of Defense, and the reach of the combined entity would instantly challenge U.S. defense companies and their ability to garner stateside military contracts. There is not enough information yet on the merger to assess the immediate effect on Boeing, and multiple governments in Europe as well as the U.S. Department of Defense will be weighing in over the next two to three weeks. Long-term, however, the combined entity may spur Boeing's competitiveness for U.S. contracts, as well as provide an incentive to further execute on its desire to diversify its BDS segment beyond the U.S. government. Stay tuned for more details.
Take the Flight
In business since 1916, Boeing is used to taking a long view of things. Most large-scale manufacturers like to read economic tea leaves for one to five years when planning production. Boeing forecasts world GDP growth rates out 20 years (the company thinks world GDP growth will average somewhere over 3% out to 2032). If you're the type to take a long view on your investments, these shares, at a forward PE ratio of 12.46, are attractively priced: the risks dissipate at 30,000 feet, and Boeing exhibits significant potential from cruising altitude.
Finosus has no positions in the stocks mentioned above. The Motley Fool owns shares of General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
