One of my goals with this blog is to publish a short investment thesis for various companies that I’m interested in. I’m writing them for a number of reasons; the first is to provide myself clarity in my thesis, the second is to get feedback from readers, and the third is to provide readers with a starting point for their own research. I would like to be clear that I am not making a recommendation for investing in any of the businesses I write about. I am only providing my thoughts on why I may or may not purchase shares of a business. There is no substitute for performing your own research on businesses. It’s important to note that there could be mistakes and errors throughout this research and I do not guarantee the accuracy of the information. This does not mean I do not try to be thorough and accurate in my research; it just means that I don’t want you to hold it against me if there is an error.
In the interest of full disclosure, I will tell you at the end of each post about a specific company whether I own shares in the company that I’m researching or possibly plan to purchase shares in the next three months. Most of the above information will eventually get added to a general disclosure page, but for now, this will suffice.
On to the good stuff. The first business I’m going to analyze is Boeing. Each investment analysis will be broken up as follows: 1. Business Description, 2. Quantitative, 3. Qualitative, 4. Price, and 5. Final Thoughts.
Boeing (BA) – Current Price: $134.85 (04/29/16)
Boeing (BA) is an aerospace company that designs and manufactures commercial airplanes, military aircraft, and network & space systems. The company also has a global services and support segment, along with Boeing Capital. The company has five principal segments:
- Commercial Airplanes
- Boeing Military Aircraft
- Network & Space Systems
- Global Services & Support
- Boeing Capital
The Commercial Aircraft segment includes the 737 narrow-body model, as well as the 747, 767, 777 and 787 wide-body models. BA continues the development programs for the 787-10, 737 MAX and the 777X programs.
Major programs in the Military Aircraft Segment include the EA-18G Growler Airborne Electronic Attack, F/A-18E/F Super Hornet, F-15 Strike Eagle, Joint Direction Attack Munition, CH-47 Chinook, AH-64 Apache, V-22 Osprey, ScanEagle, Integrator, C-17 Globemaster III, P-8, and the KC-46A Tanker. Production on the C-17 Globemaster III ended in 2015.
Major programs in the Network & Space Systems Segment include the Ground-based Midcourse Defense and the Space Launch System.
The Global Services & Support Segment provides military customers with mission readiness through total support solutions. Products and services include integrated logistics, supply chain management, engineering support, maintenance, modifications and updates, training systems, and government services.
Boeing Capital supplies various customers with financing to be able to purchase Boeing’s products. The portfolia consists of equipment under operating leases, finance leases, notes and other receivables, assets held for sale or re-lease and investments.
Throughout this analysis, I’m going to refer to Boeing as having two segments for ease of discussion; Commercial and Defense. The Defense portion includes the Boeing Military Aircraft, Network & Space Systems and Global Services & Support, which Boeing aggregates in its financial statements as well.
Earnings Consistency and Growth
Boeing has reported positive earnings since at least 2000. In most years BA has shown earnings-per-share (EPS) growth. Boeing stuggled through the first half of the 2000s but started growing again in 2006. Absent the large drop in earnings during the financial crisis, Boeing has been growing EPS. I am using EPS as a proxy for cash flow in this section because Boeing does an outstanding job of converting earnings into free cash flow. When looking at past growth rates, which are by no means a good indicator of future growth rates, you must be careful with where you start and end. Boeing operates in a cyclical industry, so earnings growth will not be steady and consistent as you may see with other companies and industries.
For instance, if you look at previous growth rates for Boeing starting with 2003, your growth rates will be much higher than if you start with 2000. 2003 was a large dip in earnings, as EPS in 2000 was almost 3x what it was in 2003. To get a rough EPS growth number, I averaged the five years ending with 2004 and the five years ending with 2015 to come up with an approximate compounded EPS growth rate; 10% per year compounded.
Cash Flow Conversion
It’s important that a company can turn reported earnings into free cash flow. A high growth business may have capital expenditures (CapEx) in excess of depreciation and amortization and therefore convert less than 100% of its earnings into cash. Boeing does a great job of converting reported earnings into free cash flow, with a typical ratio above 100%. I have excluded any working capital adjustments from my free cash flow calculations and assumed for conservatism that all capital expenditures are maintenance CapEx and should be subtracted.
|Free Cash Flow||$5,118||$5,725||$5,003||$4,925||$4,445|
|ROIC (FCF Basis)||30.1%||27.1%||24.5%||30.6%||28.6%|
Over the past 9 years, FCF conversion averages 115% and ROIC averages 28.1% over the last 7 years. Both items must be looked at positively, showing a robustness of earnings while identifying the possible presence of an economic moat. I’ll discuss economic moats in the qualitative analysis section.
Boeing uses a significant amount of financial leverage (assets/equity) to fund itself. The average over the past 7 years is 17.7x, while the most recent ratio is 14.9x at the end of 2015. While this could be concerning, I find it important to dig through the balance sheet to see where the financial leverage comes from.
During the most recent year, almost 26% of assets were funded through advances from customers and billings in excess of related costs. Although this is a real liability, it is interest-free financing and an important way for Boeing to earn high returns on its invested capital. Another 26% of assets are funded through accounts payable and accrued liabilities, which are two more sources of interest-free financing. Healthcare and pension liabilities cover another 26% of funding. Deferred income taxes and other liabilities cover 5% of assets, leaving approximately 18% of assets funded by debt and equity. Long-term and short-term debt fund 10.6% of assets, while equity funds only 6.8% of assets. Boeing does an outstanding job of funding itself through the use of interest-free liabilities, allowing its returns on invested capital to be well in excess of the norm. Advances from customers and billings in excess of related costs can be similar to insurance float. As long as Boeing keeps building planes, it can continue to fund itself through these means.
Interest Coverage Ratio
Boeing does have a relatively high debt/equity ratio of over 1.5x. It is critical to make sure that Boeing can cover it’s interest charges. In conjunction with that, I also want to make sure BA doesn’t have any significant amounts of debt due in the near future that could cause issues.
|Earnings from Operations||$7,443||$7,473||$6,562||$6,290||$5,823|
|Interest and debt expense||$275||$333||$386||$442||$477|
|Interest coverage ratio||27.1||22.4||17.0||14.2||12.2|
Boeing seems to be more than able to cover its interest charges. It should be noted that BAs interest coverage ratio dropped to 6.2x in 2009, continuing to provide adequate coverage during a deep recession.
According to BA’s 2015 10-k, there are no significant principal payments due over the next five years. Most of the company’s debt is due from 2043 to 2045.
In the Commercial Aircraft segment, Boeing’s main competitor is Airbus for wide-body aircraft. Embraer and Bombardier are also competitors, but do not make the larger-size aircraft that Boeing and Airbus make. BA also mentions “other entrants from Russia, China and Japan” in its 2015 10-k.
In the defense side of Boeing’s business, they face competition from Lockheed Martin, Northrop Grumman, Raytheon and General Dynamics. Non-U.S. companies, such as BAE Systems and Airbus are also competing in this space.
Competition is limited in Boeing’s industry because of a number of barriers to entry that I will discuss below.
Once a customer, either commercial or military, chooses a Boeing aircraft, it’s prohibitively expensive to change aircraft. Switching costs include procurement of new aircraft, pilot and mechanic training, facility modifications, etc. This keeps customers coming back to Boeing.
All of Boeing’s aircraft are unique to Boeing. Customers will choose aircraft based on the customer’s specific needs. These needs may include passenger count and fuel economy to name a few examples.
The costs and time associated with getting a plane approved for commercial flight and sale to customers are prohibitively long and expensive for new entrants. This creates a large barrier to entry in the aircraft manufacturing business. It is nearly impossible for a small scale airplane manufacturer to enter this market and probably one of the largest barriers to entry in the industry, keeping competition low for Boeing.
Boeing operates in a highly regulated industry, which is another barrier to entry for outside competition. On the government side of things, the U.S. government, which spends massive amounts of money on defense, wants to buy its military aircraft from a U.S. company. The U.S. government buying from a U.S. company keeps future R&D investments and technological advancement inside the U.S. border. Regulation goes hand-in-hand with the scale required to operate in the industry. Heavy regulation in the industry makes it expensive and slow to get approval for a new airplane, keeping new entrants from entering this market.
The commercial airline business is a terrible business. Since the turn of the century, American Airlines, U.S. Airways, Delta, Northwest and United Airlines have all filed for bankruptcy. U.S. Airways actually filed for bankruptcy twice since 2000. CNN Money has an interesting graphic showing that there were 10 major U.S. airlines at the turn of the century. This is now down to just 4 major airlines because of mergers and bankruptcies. Not only have Boeing’s customers experienced major financial difficulties, the commercial airline industry has experienced major consolidations.
Directly from Boeing’s 2015 10-k, “Traditionally, the airline industry has been cyclical and very competitive and has experienced significant profit swings and constant challenges to be more competitive.”
It should also be noted that Boeing relies on its non-U.S. customers being able to access financing through the Export-Import Bank of the United States.
Airplanes are Major Capital Expenditures
It probably goes without saying, but the purchase of airplanes is a major capital expenditure for airlines and governments. If an airline is struggling financially, it may reduce its budget for new airplanes. Similarly, government budget cuts could result in lower defense spending.
Airplane manufacturers continually need to come up with lighter, faster, cheaper, more fuel-efficient airplanes. In order to stay ahead of the competition, Boeing must continually spend money on research and development. Although Boeing has a long history of being a leader in the aerospace industry, it must continue to innovate to stay ahead of the competition.
At the end of 2015, 36% of BA’s 161,400 employees were covered under collective bargaining agreements, including 13% of which are professional aerospace engineers. In 2013 and 2014, Boeing was in contentious negotiations with the machinists’ union in the Seattle area over the location of the production of the 777X jet. Boeing was ultimately successful in the negotiations without a strike from the union, but future negotiations could result in production disruptions.
You’ll notice I’ve put this in both the good and the bad qualitative categories. The U.S. government must approve Boeing to sell any military aircraft to any foreign governments. While I agree with this policy for what I believe are fairly obvious reasons, it should be noted that the government has the ability to stop Boeing from selling to certain countries, even if we freely trade with them.
When analyzing an investment, price is one of the most important factors, but it’s not price alone. Price must be compared to the value you’re getting. You want to try to pay less than what the company is worth. Of course, the price you pay may fluctuate, but it’s readily available and knowable. On the flip side, the intrinsic value of a company does not fluctuate very much, but is difficult to obtain and at best, only an estimate.
With all of that said, the intrinsic value of Boeing should be estimated based on the future cash flows of the business discounted back to present value. To get a feel for what Boeing may earn in the future, it’s good to look at past earnings. The last five years of Boeing’s free cash flow (excluding working capital adjustments) are shown in Table 1 above. The average free cash flow per diluted share over the last 5 years is $6.81, with a most recent year of $7.36 per share.
Boeing’s current price is $134.85, which is 19.8x the five-year average free cash flow and 18.3x last year’s free cash flow. At these ranges, it doesn’t seem to me that Boeing is significantly over-priced or under-priced. I don’t intend to provide a recommendation for the business I’m analyzing, at least not an actionable recommendation. I will tell you whether I think the price of the business is near the range of what I believe to be the intrinsic value of the business, but that is only a starting point. Again, performing your own research and estimation of intrinsic value is crucial to the investment process.
Quantitatively, Boeing has consistently high returns on invested capital on a free cash flow basis and does a great job of converting reported earnings into cash. Although BA has a higher debt/equity ratio, it covers its interest payments well in excess of what would be concerning to me. Advances and costs in excesses of billings is a great way for Boeing to fund its operations with a liability that is perpetual in nature and interest free.
Qualitatively, Boeing has some significant competitive advantages, which include high barriers to entry due to scale and regulation. Competition in the aircraft manufacturing business is limited, with Boeing being one of the largest. On the flip side, Boeing’s customer base, specifically commercial airlines, are in a terrible business. Having struggling customers that are forced to file for bankruptcy on what seems like a relatively regular basis can be detrimental to a business. Airplanes are also a major capital expenditure for Boeing’s customers. In this cyclical industry, Boeing’s commercial sales can fluctuate based on investments made by commercial airlines. On the defense side of the company, Boeing is also subject to the swings in the U.S. Department of Defense budget. A few other qualitative issues I see with Boeing are the constant need to innovate and stay ahead of the competition, as well as the large quantity of union workers Boeing has to hire.
Quantitatively, I like Boeing as an investment. Qualitatively, I’m not sure that the good outweigh the bad, but I do believe that the competitive advantages that Boeing has show up in the numbers. From a price standpoint, I don’t believe that Boeing is either significantly over-priced or under-priced at current levels. As always, there is no substitute for performing your own research, but I hope this provides you with a good starting point.
Disclosure: I/We have no investment in Boeing at this time. I/We may initiate an investment in Boeing within the next three months.