A high-flyer with multiple tailwinds

I am one of three brothers, and most Sundays in our childhood Dad would pack us all in the car and take us for a drive to see or do something interesting. This was clearly to give Mum a well-deserved break from us for a few hours.

Many Sundays we would decide to head out to Sydney Kingsford Smith Airport. If we went in the early afternoon, we knew we would get plenty of action as that was when the international flights started departing. There was nothing we enjoyed more than watching a Qantas B 747, “the Queen of the skies” take off fully loaded on runway 34-L. It was a phenomenal display of engineering and raw power. I’ve actually continued the tradition, occasionally taking my own young children out to “Shep’s Mound” at Sydney Airport (SYD.ASX) to watch the action.

Boeing and Airbus - who's flying higher?

Clearly, the airplane manufacturing sector is a classic duopoly between Boeing (BA.US) and Airbus (AIR.FP). This is an excellent industry structure with extremely wide moats restricting another genuine competitor entering. A classic duopoly in a structural growth sector will lead to high levels of economic rent being extracted by the duopoly players in what is becoming an extended “supercycle” for next-generation plane demand. Boeing estimates 42,730 new commercial planes will be required over the next 20 years.

While there’s a clear argument for holding both aircraft manufacturing players, we believe the outlook for Boeing is superior to Airbus. We also think the potential disruption to supply chains in Europe around a possible “hard Brexit” is another reason to favour Boeing over Airbus in the short-term.

Recent results bode well

Boeing’s Q4 result and 2019 guidance further confirmed our conviction in Boeing. Let me explain why.

The Q4 2018 result for Boeing capped an excellent year. Boeing generated record revenue, earnings, EPS and cash flow. They repurchased US$9.0B of shares and paid US$3.9b in dividends. Going forward, the company has committed to returning 100% of free cash flow to shareholders via buybacks and dividends. 

Boeing delivered a record 806 commercial airplanes, including 256 737 MAX’s. They increased the 737 production rate to 52 a month, and recent industry speculation is they will ramp up to 57 per month from July 2019. Almost unbelievably, Boeing's just in time supply chain and manufacturing process for 737’s is so efficient they assemble a 737 on the production line in just 9 days. Yes, you read that correctly, 9 days. 

In Q4 Boeing delivered 238 commercial airplanes, this included 111 737 MAX’s and the first 737 MAX from the China Completion Centre. They also delivered the 787th 787 Dreamliner.

In terms of new orders in Q4 Boeing won 262 net orders, for a total of 893 in 2018. The 777 program exceeded 2,000 orders since its launch, while the 737 MAX family surpassed 5,000 in net orders. Orders valued at $16b in Q4 and $62B in 2018.

Boeing finished 2018 with a commercial airplane order backlog of 5,873 airplanes (8 years) valued at a list price of US$412b spread geographically as illustrated below.

A defensive sector

Defence, Space and Security was also strong. Revenues (+13%) and operating margins improved as illustrated below:

I am bullish on US Defence spending, and Boeing has clear leverage to that theme. It’s easy to forget that Boeing manufacture and support a wide range of fighter aircraft, attack helicopters, missile systems and refuelling tankers for the US Military and its allies including Australia. These include F/A-18 Super Hornet, EA-18G Growler, F-16, B-1B Lancer, B-52, C-17 Globemaster, AH-64 Apache, AH-6 Light Attack Helicopter, H-47 Chinook, U-22 Osprey, Minuteman III Missile, and even Air Force One for President Trump.

More than just making planes

A major positive for the Defence division was that the US Air Force accepted the first delivery of the KC-46 Tanker. This tanker program has been fraught with problems and the fact the US Air Force took delivery was a definite positive. The Defence division saw new orders of US$5b in Q418 and US$36b in 2018. The order backlog is valued at US$57b.

In the midst of an upgrade cycle

The Global Services Division which is just over 10% of the earnings base also experienced strong growth. Boeing is not all about aircraft manufacturing. This is increasingly becoming a services business, where Boeing saw +17% year on year revenue growth on expanding margins as illustrated below:

Boeing Global Services captured new and follow-on business in the Q4, including securing a sustainment contract for the C-17 Globemaster III, being awarded an F-15 Qatar Performance Based Logistics contract, capturing F/A-18 services support to the US Navy and was selected by Shenzhen Airlines to provide crew management solutions. The Global Services Division saw new orders of US$6n in Q4 and US$18b in 2018. The backlog was valued at US$21b.

In terms of the overall business environment, CEO Dennis Muilenburg gave an upbeat assessment. Muilenburg pointed to:

1. Robust airline profitability, strong passenger traffic, and a healthy cargo market
2. Diverse and balanced geographic, customer and replacement demand
3. Domestic support for key defence and space programmes
4. Continuing international defence and space demand
5. Growth opportunities over a 10-year period in the $2.8 trillion services market

The strong end to 2018 and clarity into 2019 led to Boeing UPGRADING their 2019 guidance. 2019 BA.US upgraded guidance is below:

This was very encouraging news and led to strong consensus earnings upgrades (+8%) by the analyst community. The 2019 Boeing consensus earnings upgrades are below via various timeframes.

2019 consensus EPS for Boeing is now US$19.79. My view is that estimate will prove conservative, potentially by 10% as Boeing ramps up 737 MAX production in the 2H of 2019. I also believe 787 Dreamline production could surprise in the 2H. On that basis I also expect cashflow and buybacks to surprise positively in 2019.

Despite my view that Boeing's consensus earnings will prove conservative, on current consensus earnings estimate the company remains undervalued. 2019 sees consensus EPS growth of +24%, yet the current P/E is 20.7x. The 2019 price to growth ratio (PEG) is just .86x. The dividend yield is 2%, and the balance sheet is exceptionally strong due to low debt and very high free cash generation. The free cash flow yield is currently 8.8%.

Boeing is a classic top-down meets bottom-up investment. The demand for flying remains structurally strong as the “Instagram generation” increase their discretionary spend on “experiences”. We forecast the overall aviation sector to grow at double GDP over the next 10 years. On that basis, Boeing is wonderfully positioned to grow revenue, earnings, and cashflow at a multiple of that underlying sector growth. I don’t believe Boeing is cyclical, I believe it’s a structural growth stock still priced as a cyclical.

While BA.US shares are up +27% year to date in 2019 to a fresh all-time high, and are potentially a fraction over-bought in the very short-term technically (RSI 79), on any pullback we will add to our holding. Boeing is one of the greatest businesses in the world and a core long investment for the fund.

“ If it ain’t Boeing I’m not going”.

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Aitken Investment Management employ a high-conviction thematic long-short strategy, investing primarily in listed global equities, as well as selected commodities, currencies and derivatives. For more information please visit our website