Written by the FALCON Team
We regularly provide our monthly shortlist of wide-moat companies passing our rigorous 3-step stock selection process exclusive for Seeking Alpha readers, with the November edition about to be published any minute now. Following our recent coverage of Apple (AAPL), we decided to assess another iconic wide-moat company, Boeing (BA), to see whether the aerospace juggernaut fares favorably in our shareholder value focused framework, in spite of its latest operating turmoil.
In light of Buffett’s teachings distilled from his 50+ years of shareholder letters, our analysis is based on the three dimensions that truly matter: operations, capital allocation, and valuation. Before we do that, however, let’s jump into what makes Boeing an interesting candidate today.
So, what’s the story with Boeing?
Boeing is the world’s largest aerospace company and leading manufacturer of commercial jetliners, defense, space and security systems, and service provider of aftermarket support. Its three major reportable segments are defined accordingly (note that “peacetime” 2018 revenues are taken as a comparison basis to better reflect true ratios): Commercial Airplanes (~57%), Defense, Space & Security (~26%), and Global Services (~17%).
Boeing’s largest, commercial aircraft segment took the first hit in 2019, as the severe safety problems, revealed by two fatal crashes, led to the grounding of its most popular, narrow-body 737 MAX fleet. The tragedies triggered a series of actions to change Boeing’s corporate culture, in an effort to address criticism on underinvesting in key areas of product safety. These included the appointment of a new CEO whilst splitting the chairman and CEO roles to add an additional layer of oversight, along with the addition of a safety committee at the board level. In the meantime, Boeing is making steady progress towards the safe return of the 737 MAX to service, working closely with the FAA and other global regulators, with expectations to resume deliveries during Q4 2020.
On top of all that, the pandemic-induced travel restrictions pose an additional headwind for Boeing, as the company estimates that it will take around three years for travel to return to 2019 levels, and a few years beyond that for the industry to return to long-term growth trends (underpinned by Boeing’s strong backlog of more than 4,500 commercial airplanes valued at $326 billion). The company’s defense segment, on the other hand, is holding up steadily, providing a critical layer of stability for Boeing amid the current operating challenges, with a continued positive outlook marked by a stable defense spending forecast relative to GDP going forward.
As a general rule of thumb, a company has authentic earnings power when it has both defensive and enterprising profits. Thus, when assessing a firm’s operations, we care about two fundamental aspects: it has to pass the cash flow-based stability test, and it must be a consistent shareholder value creator measured in the EVA (Economic Value Added) framework.
Stability: Assessing Cash Flow Consistency
The most ruinous mistake you can make as a buyer of common stocks is to own a company that goes bankrupt. For this reason, the defensive investor judges the quality of a firm’s accrual profit based on its ability to self-fund. That is, whether it produces more cash from ongoing operations than it consumes, and not go deeper into debt or dilute current stockholders. When we look at the conventional financial statements, our primary concern, therefore, is the stability of the company’s cash generation.
From 2010 through 2019, growth in passenger air travel averaged 6.5% per year, somewhat above the long-term average of 5%, benefitting Boeing’s operating cash flow generation handsomely. The impact of the major fleet grounding and COVID-19 events is readily apparent in the above table, resulting in a sharp drop in the company’s OCF figures starting from 2019. It is also clearly reflected that Boeing operates in a fairly capital intensive industry, with CapEx levels averaging ~25% of OCF between 2010 and 2018. While the near-term cash flow figures remain at severely depressed levels, Boeing’s management sees a path to positive FCF in 2021 (subject to the 737 MAX returning to service), by reducing inventory and ramping up production. Despite the daunting performance of the recent past, Boeing’s strong cash generation capability allows it to pass our first criteria regarding stability (although management’s accountability will highly depend on their ability to deliver on their promise going forward). In the next step, we move on to the EVA framework, examining if the company can consistently create shareholder value, as EVA cuts through accounting distortions and charges for the use of capital.
Value Creation: Is A Wide-Moat Rating Warranted?
We tend to prefer companies whose businesses are protected by large and enduring economic moats, as buying those companies at the right price generally leads to outperformance, as outlined in our research article. In the EVA framework, the EVA Margin (EVA/Sales) will be our ratio to define a company’s moat. A 5% EVA Margin can be used as an indicator for a “good” company, whereas persistence of a 5%+ EVA Margin for 10 years makes a company great and thus “moaty”.
Let’s start by looking at the chart: Boeing’s EVA Margin expansion during 2010-2018 was largely correlated with the underlying uptrend in air travel, while it also comprehends a full cycle without factoring in the impact of the 2019-2020 “black swan” events. Numerically, Boeing’s EVA Margin has averaged 2.6% over the period, which reflects the company’s mid-cycle, long-term level of profitability. As the rigorous 5% mark tends to be out of reach most of the time (not counting the exceptional late-cycle periods), Boeing fails to pass our quantitative wide-moat threshold, reflecting its exposure to the cyclical nature of the commercial aerospace industry.
Assessing incremental EVA returns
EVA Momentum measures the growth rate in EVA, scaled to the size of the business (measured by its sales). It is the EVA framework’s equivalent for Return On Incremental Invested Capital or ROIIC. Any positive EVA Momentum is good because it means EVA has increased, and it is an indication that it is worthwhile to reinvest capital in the underlying business. Instead of pinpointing any single-year performance, we prefer to look at the long-term trailing averages in EVA Momentum.
Source: Author’s calculation based on data from evaexpress.com
We see little value in looking at the average EVA Momentum figure of the past decade since it is heavily skewed by the recent drop in EVA, reaching an underwhelming -0.7% over the period. With the aim to reflect the true potential of the underlying business (which was certainly overshadowed by a serious level of mismanagement up until recently), we look at the period of 2010-2018 instead when Boeing was able to generate a positive 0.7% EVA Momentum, slightly better than the long-run average of 0.4% for the 50th percentile of the U.S. stock market (represented by the Russell 3000). Considering the fact that the long-term growth prospects of the aviation industry remain intact, it is definitely worthwhile to invest capital in the profitable growth of Boeing, as every reinvested dollar could lead to incremental EVA generation for the company’s shareholders over the long run.
Our take on the moat
The EVA framework enabled us so far to prove from a rearview-mirror perspective, whether the company has an economic moat based on its historical consistency of shareholder value creation. From a qualitative standpoint, Boeing’s wide-moat rating seems well established since the aircraft manufacturing market is characterized by considerably high barriers to entry. The stiff regulatory environment (requiring compliance to rigorous safety standards) along with the long and capital-intensive process of designing and manufacturing an aircraft led to essentially two companies, Boeing and Airbus (OTCPK:EADSY) dominating the landscape, accounting for a ~90% share in the commercial aircraft market globally.
Besides high barriers to entry, Boeing’s moat also springs from the significant switching costs its airline customers would face in case they wanted to replace their fleet with competitor products. These costs include retraining pilots and crew for each new family of aircraft, along with an added layer of complexity and increased maintenance costs. As a consequence, especially low-cost carriers like Southwest (LUV) or Ryanair (RYAAY) are sticking to one plane type in their entire fleet. As airplanes have useful lives of about 20-30 years, this leads to a secure, recurring source of higher-margin maintenance service revenue for manufacturers over the long run.
Boeing’s defense side of the business further enhances the company’s wide moat, resting on similar traits as its commercial arm, namely the enormous entry barriers of the regulated military contracting space, along with highly complex technology and capital-intensive development and manufacturing processes. With respect to switching costs, Boeing benefits from a large and established installed base of defense products (with government spending accounting for ~50% of Boeing’s service revenue), while a major fleet update which could blackball Boeing seems highly unlikely at this stage.
As a conclusion, we argue that (despite the highly volatile quantitative figures) a wide-moat rating seems warranted for Boeing from a qualitative standpoint, as it continues to benefit from the duopolistic landscape of the commercial aircraft market, thus it will enable the company to outearn its WACC for decades to come.
Taking a brief snapshot at the company’s debt profile, Boeing has an S&P Credit Rating of BBB- coupled with a long-term debt-to-capital ratio of 117%, following a recent downgrade, as the rating agency expects Boeing’s cash flow and credit ratios to remain depressed for the next few years. That being said, the recently completed $25B bond offering highlights the confidence of the market in Boeing’s long-term survival.
Summary of operations – the Quality Score
The EVA framework’s Quality Score is a comprehensive way to assess a company’s overall quality, by combining its EVA-based Performance (EVA Margin and Trend) and Risk (e.g. Volatility and Vulnerability) metrics into a single score, measured against the broader market. In the case of extraordinary companies, we would like to see a Quality Score consistently above 80 over a long period. As outlined in our research article, the upper quintile tends to outperform the market historically.
In the case of Boeing, the company’s Quality Score has fluctuated between extreme highs and lows over the past 15 years, clearly showcasing the cyclicality of the underlying business. While the average Quality Score of 72 underpins Boeing’s favorable competitive position throughout economic cycles, the metric is currently pushed to unprecedented lows due to both the EVA Margin and Momentum taking a nosedive, coupled with a debt-induced increase in vulnerability.
As a final assessment, despite the pronounced volatility of the company’s profitability and the recent struggles, Boeing passes our operating criteria based on a qualitative wide-moat rating, although the quantitative side of the story leads to a mixed picture. It should be readily apparent by now, that Boeing is a far cry from a “buy and forget” type of holding (prone to a series of pitfalls in both running the business and valuing the company), thus risk-averse investors might look elsewhere for sleep-well-at-night alternatives.
After looking at the operations dimension, we continue investigating the company through the capital allocation lens. Remember, the incremental return on invested capital (measured by EVA Momentum) is a crucial element when it comes to the assessment of successful capital allocation by management. If the company can earn a positive EVA by reinvesting all the cash generated by the underlying business, shareholders are better off if the firm retains most of its earnings. In the table below, we have dissected all the possible uses of cash for Boeing for the past decade.
As outlined earlier, Boeing reinvests relatively high levels of capital to keep the business running and growing, with CapEx amounting to ~25% of OCF on average over the past decade. Up until the disruptive circumstances of the recent past, Boeing demonstrated a substantially positive EVA Momentum, thus the reinvested capital translated to incremental shareholder value creation during the aviation boom. As opposed to a prudent, countercyclical approach, Boeing was firing on all cylinders to return cash to shareholders during the upturn, which led to heavy criticism in hindsight. We believe that the argument has its merits, that the company seriously underinvested in product development, failing to fulfill its core mission of safety. To keep the company afloat during the current crisis, all shareholder distributions were halted for the time being:
To bolster our near term liquidity, we’ve taken a number of actions since early this year. We suspended our dividend and terminated our prior share repurchase authorization. We’ve proactively drawn down on our $13.8 billion term loan in mid-March and raised $25 billion of new debt”
Gregory D. Smith, CFO, Q2 2020 Earnings Call
Source: Author’s illustration based on Morningstar data
As visible on the chart above, Boeing has returned all the available free cash (and then some) to its owners over the past decade. Between 2010 and 2019, the company generated an aggregate of $62 billion in free cash flow, while buybacks and dividend payments amounted to $69 billion, or 111% of FCF.
The single most significant capital allocation blunder of Boeing’s recent past has been its excessive, ill-advised buyback spree, retiring ~200M shares and reducing the number outstanding by ~25% between 2013 and 2018, for a total cost of over $40B. This immense repurchase program is rather atypical of such a capital intensive, cyclical business as Boeing. Some argue that the company could only pull this off by bleeding out its 737 MAX program, as Boeing realized significant savings on the development costs by simply bolting new fuel-efficient engines on an existing airframe. Although the tragic implications of this are widely known by now, we argue that management also destroyed a serious amount of shareholder value by the series of ill-timed buybacks. Repurchases can provide much value to shareholders, however, in case these happen at a premium to the intrinsic value of a business, they are actually value-destructive, not value-enhancing.
The above chart clearly reflects the value-destructive nature of the gigantic buyback program, as over 50% (~$20B) of it was spent during the timeframe of 2017-2019 when the stock traded at historically elevated valuation levels, measured by the Future Growth Reliance metric. Overall, Boeing’s buyback was anything but opportunistic during the upcycle of the past decade, as management recklessly tried to fulfill the “100% FCF return to shareholders” mantra at all costs.
Nothing signals more the importance of dividend payments in Boeing’s overall capital allocation strategy than the new CEO’s initial comment on ruling out the possibility of a dividend cut “unless something dramatically changes”, even in the midst of the 737 MAX grounding turmoil. The second strike in the form of the pandemic has turned out to cause such financial distress for the commercial aerospace sector that the elimination of Boeing’s dividend was inevitable. Nevertheless, this seemed like a prudent move (along with halting buybacks) to preserve liquidity. Although the company’s previously immaculate dividend history gives us confidence that some level of payout will return sooner than later, we would not expect this to happen before 2022, depending on whether the efforts to return to positive free cash flow bear fruit until then.
In general, Boeing’s growth has been almost entirely organic (fitting into the above described duopolistic nature of the industry) since the substantially positive EVA Momentum of the past decade was relying mostly on the company’s internal development programs. A noteworthy exception has been Boeing’s 2018 acquisition of KLX (a leading aerospace parts distributor) for a total consideration of $4.25B (including the assumption of $1B in debt), which was rather a bolt-on transaction to strengthen its Global Services segment, in an effort to triple sales from services to about $50 billion over 10 years.
Another planned deal worth mentioning has been Boeing’s intention to acquire a majority stake in Embraer’s (ERJ) commercial aircraft business for $4.2B, which collapsed eventually due to the sudden fundamental headwind on the aerospace industry. While Boeing was put under pressure to raise cash and slash production, the agreed-upon price was looking increasingly rich with Embraer’s market value tumbling to ~$1B. In light of the internal and external challenges Boeing needs to cope with, we believe walking away from the deal was a prudent thing to do by the company’s new leadership team.
Future Growth Reliance
Our prime historical valuation indicator in the EVA world is the Future Growth Reliance (FGR), which is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA. As outlined in our research article, it is the best-of-breed sentiment indicator that addresses accounting distortions, thus gives us a true picture of which companies seem attractively valued in historical terms.
Looking at the chart of Boeing, we can clearly see how the market sentiment followed the improving fundamentals during the upcycle, applying a steadily increasing growth premium to the company’s shares. It is important to note that the cyclicality of the underlying business makes it hard to draw any conclusion solely based on the historical average level of the FGR ratio. It is readily apparent though that the market does not give any credit to the current doomsday scenario lasting forever (with rock-bottom EVA Margin and Momentum levels), underpinned by an elevated FGR ratio standing at 112% as of October 23. When we put the numbers into our discounted EVA model (based on the conservative assumption that Boeing’s annual EVA generation capability will rebound to midcycle levels of ~$3.3 billion and grow 4-5% annually for the next 10 years), we arrive at a fair value range of $160-$180, implying that Boeing trades roughly in line with its intrinsic value at today’s levels.
As a second step, we use Morningstar’s valuation system, where analysts create industry and company-specific assumptions, and then all the inputs are used in a discounted cash flow model. In order to reflect all moving parts within the business, the analyst firm also evaluates the level of uncertainty with all the stocks they cover. Morningstar assigns Boeing a very high uncertainty rating with a $264 fair value. The thresholds between the different star ratings are illustrated below:
Source: Author’s illustration based on Morningstar data
With the stock currently trading at $167.36 as of October 23, a 4-star rating is warranted, implying that Boeing’s shares are moderately undervalued based on Morningstar’s estimate. It is worth noting that our $160-$180 EVA-based fair value estimate is on the conservative side, falling in line with Mornigstar’s 4-star band.
Summary of the investment thesis
PRVit score – heat map vs. market
After all our due diligence, we turn to the PRVit model for a final judgment of the overall attractiveness of a stock. The PRVit is a multifactor quantitative stock selection model based on EVA-centric measures of Performance, Risk and Valuation. Combining a company’s Quality Score with its actual Valuation Score can be visualized on a heat map like the one below, where the gradient diagonal line signals fair value. We want to see a stock in the upper-right hand corner of this heat map, but we are more concerned with the Quality Score, as we believe that over the long-run, we are better off with a truly exceptional business bought at a fair price, rather than a fair company bought at an exceptionally attractive price.
As visible on the above heatmap, Boeing’s currently distressed operating performance is clearly reflected in its Quality Score, which is dragged down tremendously by the sluggish EVA performance. Boeing’s valuation, on the other hand, is not depressed enough to compensate for a fair trade-off in the purely quantitative PRVit model. We must add, however, that we firmly believe that the company’s current fundamental weakness is a temporary phenomenon, while Boeing is well-positioned to profit from the long-term growth in commercial aviation and the duopolistic nature of the industry. We believe that an entry position might be warranted below ~$160 for enterprising investors (translating to a rather pessimistic scenario of 0 baked-in EVA growth from 2018 levels). Conservative investors might pass up on this name entirely or should at least stay on the sidelines until Boeing’s shares reach truly bargain-basement territory below ~$120, from where it was nearly impossible to come up with a single-digit total return scenario (however, hard we tried), especially with a good chance of reinstated dividend payments during the post-pandemic era.
One more thing
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Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.