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Boeing: Why This Dow Stock Is Not A Buy Yet


Updated on June 20th, 2019 by Aristofanis Papadatos

Boeing (BA) has become remarkably volatile since early March, when an aircraft of Ethiopian Airlines crashed shortly after its takeoff.

Since then, Boeing stock has remained under pressure and as a result is now trading 16% off its recent all-time high, which was recorded just nine days before the crash.

Still, Boeing remains a highly profitable company and one of the best dividend growth stocks in the Dow Jones Industrial Average in recent years. You can see the entire list of Dow 30 stocks here.

 

As there are serious concerns over the safety of the company’s 737 MAX model, which will remain grounded for months, the big question is whether the stock is likely to reward those who purchase it after its recent correction or the risk outweighs the return potential of the stock.

 

Business Overview

Boeing is the world’s largest commercial jet manufacturer and the second largest producer of military weapons. The company was founded in 1916 and operates in three segments: Commercial Airplanes, Defense, Space & Security and Global Services.

Boeing stock has been under pressure since the aforementioned plane crash in early March. When a Boeing 737 MAX of Lion Air crashed in late October, Boeing shares plunged 7% on that day but it retrieved all its losses within just three days, as there was no evidence that Boeing was responsible for that accident. However, things changed on 3/10/2019, when Ethiopian Airlines Flight 302 crashed in a similar manner, shortly after its takeoff.

Investors considering the stock should try to determine the potential risks for the stock of Boeing. In its 737 MAX model, Boeing added a safety feature, which corrects the angle of the plane during the takeoff phase. If the angle becomes too steep, the plane runs the risk of losing the support from the upward force of air on its wings.

Therefore, the automatic mechanism of Boeing causes the nose of the aircraft to head downwards, to the safe range of the angle of the airplane. While higher safety is always welcome, the mechanism was fatal in the above two instances.

The mechanism was receiving signals about the angle of the plane from two sensors but one of those two sensors was transmitting wrong signals. Consequently, shortly after takeoff, the mechanism erroneously caused the nose of the aircrafts to dive.

The pilots were not aware of this automatic mechanism and had not been trained adequately to turn the mechanism off and operate the aircraft manually. Boeing has been accused of not informing air carriers that their pilots needed to go through additional education courses in order to become familiar with the new safety feature.

In fact, Boeing recently admitted that it had to correct flaws in its 737 MAX flight simulator software used to train pilots, as the simulator could not replicate the actual conditions caused by the wrong signals of the above mentioned sensors. The company also admitted that it made mistakes in its communication with regulators, customers and the public.

Due to the resultant safety concerns, the 737 MAX aircrafts have remained grounded since March and Boeing has reduced its production rate of this model due to depressed demand. A top FAA safety official recently stated that he expects the 737 MAX aircraft to return to flight mode in December.

This estimate is in line with a recent statement of the CEO of Boeing, who expects to get the green light towards the end of the year. However, investors should not take these expectations for granted, as the initial expectations were for late May or early June.

Boeing’s performance in the first quarter was negatively affected by the grounding of 737 MAX aircrafts and the safety concerns. Boeing delivered 149 commercial airplanes in the quarter, which were 19% lower compared to last year’s quarter.

BA Summary

Source: Investor Presentation

Earnings per share fell 13%, from $3.64 in last year’s quarter to $3.16 in the first quarter, while the company incurred a $1 billion charge due to the increased production cost of its 737 series, which will result from higher input costs due to lower production volume. Moreover, management pulled its guidance for this year’s results and stated that it will provide a new guidance in the near future, when the uncertainty over its business outlook subsides.

The impact of the safety concerns over the 737 MAX model will be felt much more in the second quarter. The deliveries of Boeing in May fell 56%, from 68 in last year’s period to 30, as deliveries for the top-selling 737 MAX model remained halted. Net orders remain negative, with a total of minus 125 net orders in the first five months of the year.

Airbus has taken advantage of the issue of Boeing and has grown its deliveries by 59% in May and 40% in the first five months of the year on an annual basis. Unfortunately for Boeing, as long as the safety issues are not fixed, its performance is likely to remain under pressure. As the 737 MAX model will remain grounded at least until December, the company could post poor results this year.

The impact of the safety concerns was prominent in the first day of the Paris Air Show, when Boeing did not announce a single new order whereas Airbus received orders for 123 planes. However, Boeing astonished everyone on the second day of the event, as it announced that it received an order for 200 aircraft of its 737 MAX model from British Airways owner IAG. That was the first deal of this model since it was grounded, in March.

Surprisingly, the supplier of British Airways was Airbus until this deal was announced. It was quite a surprise that British Airways chose to switch from Airbus to Boeing during the most adverse period of the latter. Boeing stock rallied 5% on the announcement of this surprising order.

Since the accident in March, several airlines have been cancelling flights due to the grounding of their 737 MAX aircraft. Southwest Airlines (LUV), the largest global operator of this aircraft model, has cancelled the flights of this model until at least early August. United Airlines (UAL) has cancelled 40-45 daily flights until early August while American Airlines (AAL) has extended its cancellations to September.

Moreover, many airlines, such as Qatar Airways, the three biggest Chinese airlines and Turkish Airlines, have requested compensation from Boeing for the losses they have incurred due to the grounding of the 737 MAX model.

Finally, Boeing is adversely affected by the ongoing trade war between the U.S. and China. The uncertainty caused by this trade war has been partly responsible for the poor orders submitted to the company this year. For instance, Chinese airlines have been in talks with Boeing for a potential order of 100 aircraft but the airlines are waiting for guidance from the Chinese government before finalizing the deal.

While no one knows when the FAA will give the green light to 737 MAX to return to flight mode, it seems that the worst is behind Boeing. It is also reasonable to assume that the revamped airplanes will be safe, as least with respect to the above mentioned faulty mechanism, as this issue has attracted dramatic attention in the media.

Boeing management will certainly want to minimize the risk of triggering public outrage once again and further hurting the reputation of the company.

Boeing benefits from a strong secular trend, namely the increasing tendency of people to travel by plane. While one trip per year was the norm in the past, people have steadily increased the frequency of their flights. This trend should remain in place for the foreseeable future.

Over the next 20 years, Boeing and Airbus expect average annual passenger growth of 4.6% and 4.4%, respectively. While it is unclear which of the two jet manufacturers will prove the most precise in its forecast, one thing is certain; both companies will greatly benefit from the sustained, multi-decade passenger growth.

According to the latest 20-year global demand forecast of Boeing, the airline industry will need about 44,000 new commercial aircraft worth $6.8 trillion over the next 20 years. This is more optimistic forecast that the one issued by the company last year, which expected about 43,000 new commercial aircraft worth $6.5 trillion.

Moreover, airlines need to replace their fleets quite often for several reasons. First of all, they need to do so in order to acquire new airplanes, with lower fuel consumption. As the fuel cost is their largest and most volatile operating expense, airlines invest hefty amounts to replace old aircrafts with much more economical ones, which will help them remain competitive in this highly competitive business.

Due to the suppressed oil prices in the last four years, the incentive for renewal of fleet has decreased and hence this tailwind has somewhat attenuated for Boeing.

However, as soon as the price of oil rises, it is likely to trigger much higher demand for new, economical airplanes.
In addition, airlines sometimes have to replace old airplanes in order to comply with new, stricter safety standards. These investments are burdensome for the airlines and lead them to carry high amounts of debt and post poor free cash flows. However, they are highly beneficial to Boeing.

Boeing has grown its earnings per share at a 16% average annual rate in the last decade. This growth has been consistent, as the company has grown its earnings every single year since 2009. Thanks to the above tailwinds, the jet manufacturer is likely to continue growing its earnings at a fast rate for several more years.

As mentioned above, the company forecasts that approximately 44,000 additional airplanes will be needed over the next 20 years in the commercial market. Almost half of the additional airplanes will be directed to Asia, driven by increased demand in China and India, while almost half of them will be used to replace older and less efficient models.

Moreover, management sees significant growth potential in the Aerospace Services segment, which is a $2.8 trillion market that grows at a 3.5% average annual rate.

Furthermore, Boeing currently has a backlog of more than 5,600 airplanes, which are valued at $399 billion. This means that the backlog of the company is equal to the revenues that the company achieves in four years.

BA Airplanes

Source: Investor Presentation

Therefore, it is evident that the jet manufacturer has ample room for future growth while its excessive backlog will provide a great cushion in the case of an unexpected headwind.

It is also important to note that Boeing has significantly enhanced its growth rate via its consistent share repurchases. In the last five years, the company has reduced its share count by 26% or 5% per year on average.

As the jet manufacturer spends less than a quarter of its operating cash flows on capital expenses, most of its earnings end up in its free cash flows and hence they are available for shareholder distributions. As a result, share repurchases are likely to remain a significant growth driver in the upcoming years.

It is worth noting that Boeing has temporarily paused its share repurchases due to its major issue with its 737 model. While the company reduced its share count by 1.2% in the first quarter (before the plane crash), it is not likely to perform meaningful share repurchases this year.

Nevertheless, as soon as the uncertainty from the above safety issue subsides, the company is likely to resume its buyback program, with accelerated share repurchases.

Competitive Advantages & Behavior In Recessions

Boeing is an industrial manufacturer. The stocks of this sector usually operate in highly competitive markets, with very narrow margins. However, Boeing is an entirely different case. The company operates in an essential duopoly, as Boeing and Airbus have a dominant position in this business.

As a result, Boeing has strong pricing power and enjoys one of the strongest competitive advantages investors can hope for.

In fact, Boeing probably has the widest moat in its business among the 30 stocks of Dow Jones, with the possible exception of Apple (AAPL). The competitive advantage of Boeing is clearly reflected in its performance record, which is characterized by a remarkably consistent and strong growth rate.

On the other hand, Boeing may face some competition from Airbus in the upcoming years, as the latter recently announced that it plans to manufacture the first hybrid-electric aircraft. Such a move will be negative for Boeing, as it will trigger a battle between the two companies for developing the most competitive and efficient, environmental-friendly aircraft.

Nevertheless, this is mostly a long-term concern, as hybrid technology in airliners will probably not be available for at least another decade.

Boeing is highly leveraged to the underlying global economic growth. As long as the global economy continues to grow, even at a lackluster rate, the airplane manufacturer will keep thriving. This is clearly reflected in the growth pattern of the company, which has grown its earnings per share at a double-digit rate almost every year in the last decade, even though some years were characterized by modest economic growth.

On the other hand, Boeing is vulnerable to recessions. During rough economic periods, consumers curtail their discretionary expenses and travel less often. In addition, airlines drastically reduce their investments in order to preserve cash and navigate through the rough periods without any liquidity problems. Consequently, the business of Boeing is adversely affected during economic downturns.

To provide a perspective, in the Great Recession, the earnings per share of the company plunged 64% between 2007 and 2009 while its stock price plunged 72% from top to bottom, making it hard for the shareholders to maintain their shares throughout the downturn.

As Boeing is a cyclical stock, it is highly vulnerable to recessions and hence investors should not expect the stock to outperform the market during such periods. On the other hand, it is important to note that it took the company just three years after the Great Recession to return to its pre-crisis earnings per share.

Moreover, the company has a remarkably strong balance sheet. Its net debt of $109.4 billion is only 10 times its annual earnings while its interest expense consumes just 4% of its operating income. Despite the headwind from the 737 MAX issue, Boeing still has $7.7 billion in cash and an A credit rating from the three major rating firms.

BA Cash and Debt

Source: Investor Presentation

It is really hard to find an industrial company with such a strong financial position, as most companies have accumulated significant amounts of debt due to their capital expenses and their shareholder distributions.

Thanks to its rock-solid balance sheet and its strong competitive advantage, Boeing will easily recover from any future economic downturn. Its shareholders only need to wait patiently for the subsequent recovery.

Dividend Analysis

Boeing is offering a lackluster 2.2% dividend yield. As a result, it is not a popular stock in the income-oriented investing community.

However, it will be a great mistake for dividend-oriented investors to dismiss the stock for its modest current yield. To be sure, the company has not cut its dividend for more than 30 years.

This dividend record, which is an impressive achievement for a cyclical industrial manufacturer, is a testament to the strength of the business model of the company and its business execution. Moreover, Boeing has raised its dividend at a 17% average annual rate in the last decade. Furthermore, it has a healthy payout ratio of 51%.

Given the exciting growth prospects of the company, its low payout ratio and its strong balance sheet, Boeing is likely to continue raising its dividend at a double-digit rate in the upcoming years. If Boeing raises its dividend at a 10% average annual rate over the next seven years, it will result in a 4.3% yield on cost in seven years from now.

It is therefore evident that the stock is suitable even for income-oriented investors, as long as the latter can maintain a long-term investing horizon.

Valuation & Expected Returns

Due to the issue with the 737 MAX model, we expect earnings growth to stall this year. However, as we believe that this issue will soon prove a one-time event, we are confident that the worst is behind the company. As a result, we expect the company to earn approximately $23.50 per share by 2024.

It is also worth noting that Boeing has traded at an average price-to-earnings ratio around 17.0 over the last decade. Thanks to its strong growth prospects, we expect the stock to trade at a P/E ratio around 18 in five years from now.

If our above forecasts prove correct, the stock will trade around $423 by 2024 for a 2.5% annualized stock price appreciation. If we add the 2.2% dividend yield of the stock, we conclude that the stock is likely to offer an approximate 4.7% annualized return over the next five years.

While this is a positive return, it is not attractive, particularly given the cyclical nature of the stock. If the exciting growth potential of the stock leads it to achieve a price-to-earnings ratio around 20 in five years from now, the stock will offer a 6.9% average annual return over the next five years.

Therefore, in either case, investors should probably wait for a better entry point.

Final Thoughts

Thanks to the duopoly status of its market, Boeing enjoys one of the strongest competitive advantages that investors can hope for. As a result, it is hard to find this stock attractively valued.

We believe that the recent safety crisis that has hurt the stock will prove a one-time event and the company will soon return to its growth trajectory.

However, the expected return of the stock is not sufficient to justify an investment in the stock right now. Therefore, we recommend waiting for a lower entry point.

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