Boosting Boeing's Moat Rating to Wide

In contrast, we expect the defense business to be a no-growth business over the next several years. In our view, a tight U.S. fiscal environment will constrain increases in defense spending regardless of which political party is in power. In addition, Boeing faces some headwinds specific to its business, such as the recent closure of the C-17, the probable ramp-down of the high-margin F-18 program, and its recent bomber loss to Northrop Grumman NOC.

As a result, we think Boeing's future earnings power derives primarily from its commercial aircraft business, where we forecast operating margins expanding to double digits by 2017-18 from around 9% today. The 737 production ramp-up drives most of this expansion. Falling research and development expense in the commercial business driven by a ramp-down in 777X nonrecurring costs plus improved 787 margins should also help after 2017. Boeing has demonstrated an ability to contain costs in its defense unit, maintaining margins at or above 9% from 2010 to 2014 despite the U.S. defense budget (Defense Department baseline budget authority plus overseas contingency operations) falling roughly 16% over this period. However, squeezing efficiencies out of the defense business will become increasing difficult, in our view.

Commercial Opportunities Widen Boeing's Moat We are moving our Morningstar Economic Moat Rating to wide from narrow. Boeing's wide moat is built on intangible assets and switching costs in both its commercial and defense divisions. The intangible assets are derived from the highly regulated industries Boeing operates in, and the switching costs emanate from the high cost of failure associated with both commercial aircraft and military hardware. Our rating upgrade is driven chiefly by the competitive trends we see emerging in the commercial aircraft market, which indicate to us that the Boeing-Airbus duopoly is well protected.

Boeing has leveraged its competitive advantages to deliver average returns on invested capital of 22% over 2005-14. These returns were generated during a period in which the company suffered 787 challenges, resulting in a significant inventory and deferred production buildup from $6.5 billion to $46.8 billion. Boeing also managed to maintain defense division margins in their historical range of 9%-10% from 2010 to 2014 despite the U.S. defense budget falling roughly 16% over this period. Also, the world economy was not exceptionally strong from 2008 to 2010. Boeing's ability to achieve these returns despite increasing capital intensity due to the 787, a declining defense budget, and a weak macroeconomic environment provides quantitative evidence to support our wide moat rating.

In Boeing's commercial business, barriers to entry are imposed by the technical knowledge required to design, assemble, and certify commercial aircraft. These barriers should not be underestimated and span everything from building a skilled engineering and blue-collar workforce to managing a complex supply chain. One can observe the complexities inherent in developing and marketing a new aircraft by observing the challenges that Bombardier BBD.B faces on the C Series programs, which is suffering from significant cost overruns, delays, and few orders.

The Federal Aviation Administration's aircraft certification process, only one step during the development of a new aircraft, illustrates the value of Boeing's know-how. The process takes years and requires a manufacturer to meet thousands of regulations and generate over 4,000 documents to prove its aircraft meets stringent safety and performance standards. Certification includes elements such as aircraft design approval, rigorous flight testing, and an audit of manufacturing and quality processes in order to ensure production reliability. Indeed, new entrants into the lower end of the commercial aircraft market have struggled with certification (for example, the Chinese with their C919 aircraft).

The defense segment also enjoys intangible assets via its knowledge of the arcane and byzantine contracting rules governing international and domestic defense procurement, which bolsters its economic moat. For example, large U.S. defense contractors are governed by special cost accounting standards that can be quite complex and difficult to comply with in a consistent manner. Furthermore, international defense deals are subject to numerous regulations on technology transfer (for example, the International Traffic in Arms Regulations), and these international contracts often work their way through the Foreign Military Sales program, which proceeds like a U.S. domestic defense contract but has some unique features.

In addition to these intangible assets, Boeing benefits from customer switching costs in both commercial aerospace and defense. In the commercial market, airlines are loath to choose an unproven aircraft manufacturer given the high costs of failure (for example, fleet groundings or crashes). Moreover, airlines expect the manufacturer to support and service an aircraft over the two decades of its operational service. Switching costs related to pilot and crew training along with maintenance supplies further dissuade established airlines from venturing into purchases of completely new products. Airbus AIR is the only other large commercial aircraft manufacturer that enjoys switching costs similar to these.

Boeing benefits from an entrenched position with its U.S. defense customer, a client that is typically conservative in its buying patterns and hesitant to switch to new contractors, particularly for mission-critical systems like aircraft and weapons. Examples of Boeing sole-source awards (not opened to any competition) include missile defense, U.S. presidential transport, satellite terminals, and space launchers. In the government's fiscal 2012, Boeing garnered the second-largest amount of sole-source awards from the DoD, with $17.1 billion worth of contracts that were not competed or about 50% of Boeing defense revenue in 2012. In comparison, Raytheon RTN captured $7.0 billion of sole-source awards, representing only 30% of its revenue in 2012, and Lockheed Martin LMT, which captured the most no-bid contracts ($17.4 billion), only won sole-source awards worth 37% of its 2012 revenue.

Although a market with only two competitors--Boeing and Airbus--might tempt one to conclude that efficient scale exists, we do not believe this moat source applies to Boeing at an enterprise level. Boeing does benefit from efficient scale in the twin-aisle (wide-body) market, where volume is simply still too low--even the most successful planes only garner 700-800 orders versus 3,000 in the single-aisle segment--and nonrecurring costs are too high for new firms to enter the market. However, the size of the single-aisle market at around 26,000 aircraft deliveries forecast from 2015 to 2034 clearly could support more competitors, as evidenced by the entry of several new firms (Bombardier, COMAC, and Irkut). In addition, Boeing faces multiple competitors in the defense business, which strengthens our case not to apply efficient scale to Boeing as a whole.

We believe Boeing's ability to generate returns above its cost of capital will remain strong well into the next decade and most likely beyond, given the nature of its moat sources combined with its large backlog. Our forecast reflects this, and we model average returns on invested capital of 20% through 2019 (23% excluding goodwill).

Despite Backlog, Deliveries Can Still Vary Boeing's backlog offers visibility. Commercial aircraft customers are reluctant to renege because of cash down payments of around 1%-2% of contract value on signature and another 20%-25% in the 24 months preceding delivery. Nonetheless, commercial deliveries can vary with the economy and air travel demand. Production rate increases are also not a given and could lead to a situation of oversupply, should demand soften.

The 787 represents a cash flow risk. Boeing uses program accounting, which assumes an average operating margin reported on the income statement. At the beginning of a program, actual margins are lower than these average margins. Boeing captures the difference in inventories, calling it deferred production. The 787's deferred production has been increasing significantly to over $28 billion currently from $17 billion in 2013. Boeing expects 787 deferred production decreases starting in 2016, which will provide a cash tailwind. However, if Boeing fails to reduce 787 unit costs as expected, this tailwind will be delayed.

Boeing has launched the 777X, which is complex, given its all-composite wing. Delays or disruptions to 777X development could undermine financial performance. On the other hand, we view the 737 MAX as largely under control, noting some engine supplier risk. In commercial aircraft, management suffers from poor union relations. Roughly 34% of the workforce is organized; a 2008 strike caused significant damage, and the next negotiations are to be held this summer. Boeing's transfer of some production to South Carolina represents management's first steps into a right-to-work state.

In defense, procurement is arcane and lengthy, involving multiple stakeholders ranging from procurement officials to politicians to the general public. In light of the current fiscal environment, U.S. defense spending could face budgetary pressures that may lead to lower revenue, lower profits, or both.

Boeing is in good financial shape, with $9.8 billion in cash and securities versus $9.0 billion in debt. The balance sheet has grown considerably as the firm increases monthly production rates on multiple platforms, including the 787. Inventories and deferred production net of advances increased to $48.6 billion at the end of the third quarter of 2015 from $43 billion at year-end 2013. Management expects deferred production to peak in the second half of 2016, when the 787 production rate reaches 12 per month, and decline thereafter.

The firm uses a combination of debt and equity to fund investments. While historically it maintained a net cash position, the firm issued $5.9 billion in debt in 2009 to make advance payments to its suppliers on the 787 program. Boeing's inventories have increased with delays in the 787 and 747 programs. Getting the 787 back on track should lead to a significant decline in inventories thanks to a deferred production decrease, but planned production increases, particularly for the 737 MAX, will partially offset this decrease.

Overall, the debt/capital ratio was 51% at year-end 2014, with debt/EBITDA at 1.01 times and interest coverage of 28 times. Boeing's debt load relative to its profitability and cash flow levels is manageable. As of the third quarter, the company has already executed about half of its current $12 billion share-repurchase authorization, and we expect it to exhaust this authorization by mid-2017. Boeing's annual dividend stands at $3.64 per share; we estimate this to consume $2.6 billion in cash in 2015 and project it will grow over time.