Narrow-Moat Boeing Leaves Troubles on the Ground

We believe  Boeing's (BA) commercial segment is poised to deliver strong sales and operating margins as production rates increase, major development programs mature, new programs' complexities decline, and productivity measures take hold. The defense segment has proactively rightsized its footprint for the opportunity at hand, and international orders have helped maintain flat revenue results. Its strong positions in the refueling tanker program, fighter aircraft, helicopters, unmanned aircraft, and satellites give us confidence that our forward estimates are reasonable. Furthermore, the clearing of inventory and working capital from the balance sheet will lead to strong cash generation that will flow to shareholders. The company posted record revenue and backlog in 2012, offering strong visibility for years to come. Over the long run, we see strong, sustained returns on capital for Boeing. Its narrow economic moat, which stems from customer relationships, know-how, engineering talent, and incumbency, generates powerful competitive advantages.

Commercial Product Margins to Improve
We see commercial operating margins improving over the coming years even in the face of the dilutive 787 Dreamliner, as Boeing increases production rates and spending on research and development declines. For example, Boeing has reduced floor space on 737 production by 42% over the past decade, even as production rates have increased, leading to higher incremental profitability. We think our assumptions of higher margins are well grounded, as the company has experienced similar improvements in its other platforms.

In 2012, Boeing introduced its margin-enhancement program, Partnering for Success, with goals of reducing costs by double-digit levels and sharing the savings with the supply chain. While it has tried such programs in the past, the company appears to be more determined today, given the strong backlog providing visibility for suppliers. Internally, Boeing has improved its margin profile by implementing productivity-enhancing strategies. Furthermore, R&D costs should decrease materially in the coming decade to less than 4% of sales compared with more than 5% over the prior decade, which should provide relief for both Boeing and its suppliers.

A Look at the Dreamliner
The 787 represented 6% of total sales in 2012 and we see it growing to 20% by 2016, helping to drive sales and profit dollars. Boeing uses program accounting for cost of sales, where it applies a percentage to the actual negotiated sale price of the aircraft. It has decided that the accounting block of 1,100 aircraft will come in at a low-single-digit operating margin as a result of delays and cost overruns during program development. While productivity enhancement could allow Boeing to change its profit assumptions in the future, the 787 will remain dilutive to the overall margins of the commercial division.

In estimating the 787's operating margins, we estimate the discount to list price and build in a cost curve over the years to arrive at sales and profit estimates annually from 2011 through 2022. This allows us to calculate the average margin implied by those estimates. The company said during the first-quarter earnings call that costs for recently manufactured aircraft are down 60% from those initially produced, but it offered no actual dollar amounts. We have assumed that costs will decline to a trough of $165 million per aircraft in 2014, a 53% decline from our estimate of $350 million for the early costs. We increase prices by 2.5% for inflation and costs by 1.5% as we factor in Partnering for Success and other productivity-enhancement programs. This corresponds to a 3.2% operating margin estimate for 2011-22, which is consistent with Boeing's commentary. The estimates are highly dependent on the trough cost per aircraft estimate. For example, a trough cost level of $160 million per aircraft leads to a 5.6% operating margin for the period, while a low point of $170 million per aircraft leads to an average margin of only 0.3%.

Boeing expects to deliver more than 60 Dreamliner aircraft for 2013 and many more in future years. The Federal Aviation Administration approved the new battery design on the 787 in April, and aircraft with the new systems were allowed to resume flights in May. This followed the grounding in January after a couple of incidents in the United States and Japan. Boeing delivered 11 aircraft in December 2012 and kept the production rate increase on plan throughout the grounding. Therefore, the "more than 60 deliveries" seems sensible, and there may be upside for 2013, depending on customers' desire to accept delivery.

The company remains on plan to reach a production rate of 10 aircraft per month by year-end. Once it attains that rate, the growth of inventory on the balance sheet should begin to decline. Our view is that the company would like to burn off some of the inventory before deciding on another rate increase for the 787.

R&D Spending Set to Decline
The past decade saw high levels of research and development that are unlikely to be repeated in the coming decade, in our opinion. R&D increased to 15.8% of commercial sales in 2009 from 2.4% in 2001, an astounding increase. Looking at the R&D and the commercial operating margins reveals the strong improvements the company has made in the face of escalated spending, with the strong rebound in margin performance for 2009 in the face of significantly higher R&D spending showing the high incremental dropdown inherent in the business. (Note that 2008 included a labor strike that depressed margins.) We believe the next generation of products will include more modest changes and require significantly lower R&D spending. Additionally, the firm will use many lessons and experiences from prior programs to better manage the process and costs.

Using our current estimates for 2011-15, we expect a 9.8% average margin against R&D spending that constitutes 4.6% of sales. We do not expect the operating margin potential of the core products (which we estimate at 13.7%) to be revealed as the 747 and 787 overwhelm the reported results. However, after the current 787 block is completed in the next decade, Boeing could deliver double-digit margins in its commercial segment.

Twin-Aisle Product Strategy Leaves Little Room for Competition
Boeing looks to continue its dominance of the twin-aisle market against Airbus with its product lineup: 747, 767, 777, and 787. There is a hole between 350 and 450 seats that Boeing wants to fill with 777X variants. Given the popularity of the 777, we think the strategy makes sense. Airbus originally slated the smaller A350 to launch in 2008, but given the already-long delay, it's unlikely that the company can come up with a competing offer in this seat range before the end of the decade. It does appear that Airbus will dominate the very large end of the market with the A380, and that has caused weakness in 747 sales, leading Boeing to announce a rate reduction in 2014 to 1.75 per month from 2 per month currently.

Twin Aisle Backlog by Platform

In this table, we include backlog (undelivered aircraft) and total orders as of April. For current market share calculations, we only include those in production, excluding the A350. It shows that Boeing really dominates the twin-aisle market, with 75% of backlog and more than 60% of total orders. Even including orders for the A350, Boeing still has a lead, though not as significant. Airbus launched the A350 to challenge the popular 777, while Boeing seems to have launched the 787 to enter the A330 market. Boeing's new 777X variant will include longer range, a composite wing, a smaller engine, and a 40- to 50-passenger capacity increase. We do need to be careful regarding extended range, though. For example, Airbus' A340-500 has extremely long range at 9,000 nautical miles (compared with 7,930 NM for the 777-300ER) and yet only 40 or so aircraft were sold, making it seem more like a niche market. Still, the smaller engine, composite wing, and more seats will help fuel economics, and Boeing believes there is strong interest from customers.

Boeing Losing Single-Aisle Market Share to Airbus
Boeing seems to be losing share in the single-aisle market, where Airbus' A320neo dominates orders and backlog. In the next table, we see the single-aisle aircraft (roughly 200 seats and fewer) are very similar and compete head-to-head in sales campaigns. We show the new engine variant single-aisle orders, cumulative and new, along with market shares since launch. Airbus holds 63% of the new engine orders, while the total single-aisle aircraft (including current engine option) backlog is 56% in favor of Airbus as of April. Boeing is clearly aware of these dynamics, as its goal is to "maintain market share" in single aisle, while "dominating" in twin aisle.

Next-Generation Single-Aisle Aircraft Market

The market share losses are perplexing to us because the 737 family is more fuel efficient than competitor aircraft. The airline industry has evolved into a market with nonexistent switching costs for customers, and air travel is essentially commodified, forcing firms to compete by means of a cost advantage. As such, the need for a fuel-efficient aircraft is one of the primary decision factors that airlines consider when seeking to expand their fleet, as jet fuel constitutes anywhere between one third and one half of operating expenses. Fuel efficiency is one of the primary factors that Boeing and other aircraft manufacturers tout during sales campaigns.

Profitability logic would dictate that airlines place orders based on what translates to higher returns, though it appears that Airbus customers are forgoing the cost savings of the 737 for what is likely a variety of other factors. Perhaps Boeing's salesforce in Asia Pacific is not as skilled as that of Airbus. Airbus has more than 2,000 orders in backlog from Asia Pacific compared with more than 1,100 for Boeing. Perhaps Airbus is offering steeper discounts; however, we will not know this until some years in the future, when it reports financial results. Finally, there is a possibility that Boeing has neglected its customers. There was chatter in the late 1990s and early 2000s that Boeing's arrogance led customers-- even core North American customers such as JetBlue--toward Airbus. Still, the fuel efficiency of its aircraft is one metric that points to a strong argument for Boeing to capture future orders, even in the face of weak market share results to date.

Defense Systems' International Strength Offsets Domestic Weakness
Boeing Defense Systems proactively set a course to maintain profitability in a difficult environment. It has reduced the workforce by 15% since 2008 and increased profit per employee. Fundamentally, cost savings are shared with its customers, so the real performance is reflected with business wins, and the backlog has been expanding for BDS. Still, we see pressure on overall operating margins in the next couple of years, as evidenced by dramatic actions taken by management, allowing margins to only remain about flat.

We believe the budget for the remaining portion of fiscal 2013 will allow the Department of Defense flexibility in meeting the required cuts. This is a key factor, because indiscriminate cuts could lead to erratic margin performance for defense contractors and thus would not allow for a smooth transition of fixed costs to match sales. This flexibility should allow defense companies to maintain margins and support cash flows. Boeing has important long-term businesses in the KC-46 Tanker program, P-8, EA-18, FA-18, and satellites. Furthermore, international sales made up 24% of total defense segment revenue for 2012 and are 42% of the current backlog. BDS' international sales have grown to $7.8 billion in 2012 from $3 billion in 2009, helping to offset domestic weakness. Higher military aircraft business, including the P-8 to India and F-15 to Saudi Arabia, drove these sales.

Retirement Obligations Have a Negative Impact on Our Fair Value Estimate
Retirement benefits have escalated over the past five years and have a large negative impact on our fair value estimate of $93. With the significant decrease in discount rates (3.8% in 2012 versus 6.1% in 2008), the per-share impact has increased to $24 from $14. Each positive 25-basis-point move in the discount rate will reduce Boeing's pension benefit obligation by a staggering $2.4 billion, or $3 per share. Starting in 2013, Boeing started reporting core earnings that exclude pension costs, and we believe that much of the Street also excludes these costs from its estimates and price targets. Furthermore, we believe that rates are more likely to rise in the coming years, adding to our fair value targets. If the retirement liabilities' discount rate moves back to 2009 levels (5.8% versus the 3.8% currently in use), our fair value estimate would increase to $105.