Olivia Pratt
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Olivia Pratt in Forecasts and everything related,

Why Boeing Shares Could Take Off

Worries that Boeing is near a cyclical order peak have grounded its stock. But its shares could still climb 20%.

Boeing shares have dropped 8% this year, while the Standard & Poor's 500 index has climbed as much. Investors can now board: This is a buying opportunity.

Sellers may see surging plane deliveries as a signal that Boeing, whose earnings per share have quadrupled since the end of the last recession, is nearing a classic cycle peak. But growing demand for flights, especially in emerging markets, combined with fuel-efficiency gains and cheap financing, should keep earnings moving steadily higher—and free cash flow soaring. A massive order backlog reduces risk. Look for the shares (ticker: BA), recently around $125, to climb 20% over the next year to $150. And dividends provide a 2.3% yield.

Boeing and Airbus (EADSY) hold a duopoly in passenger jets with 100 seats and up. The latest company to challenge them is Canada's Bombardier (BDRBF), a maker of smaller regional jets. Last year, it unveiled its CSeries, which can seat up to 160 and sips fuel. However, orders have been weak. One reason is that prototypes have been grounded after engine trouble. Another is that potential buyers, rather than take a risk on an entirely new airframe, can simply order the forthcoming Boeing 737 MAX or Airbus A320neo. Both add highly efficient engines to well-traveled narrowbody platforms.

Airbus is expected to deliver the A320neo next year, two years ahead of the 737 MAX. It has so far led in orders, with 60%, mostly because it started selling sooner.

THAT'S LESS WORRISOME than it seems, for two reasons. First, aircraft aren't like smartphones, where sales opportunities are short-lived. The 737 was introduced in 1968. Boeing has sold 8,000 of them, making it the best-selling plane ever. Second, Boeing's existing 737 is selling so well that the company is struggling to keep up with demand. The aircraft maker says it will increase production to 47 a month by 2017, from 42 now. Analysts think it will push output even higher.

In general, aircraft manufacturers lose piles of money on the first sales of a new model and later turn hefty profits as sunk costs are paid off, and production costs are driven lower. The widebody 787 Dreamliner may grab the headlines, but the humble 737 is estimated to bring in more than half of Boeing's commercial-airplane profit.

As for the Dreamliner, its deliveries nearly doubled to 30 in the second quarter from 16 a year earlier. Overall deliveries rose to 181 from 169. That offset declines in Boeing's defense business and sent revenue 1% higher, to $22 billion. Core earnings, adjusted for pension expense, jumped 45% to $2.42 a share. For the full year, Wall Street expects much the same: surging commercial jet sales offset by military declines, driving revenue 3.5% higher, to $89.6 billion, and earnings per share, up 16.7%, to $8.25.

One cause for investor concern is that the backlog was unchanged during the second quarter at $440 billion. Some investors take rising deliveries against an unchanged backlog to mean that the sales cycle is nearing a peak, and that Boeing could soon be producing too many planes. Two firms downgraded the stock recently, one of them, Buckingham Research, to Underperform, Boeing's first such rating since 2009, when it was mired in Dreamliner production delays. Buckingham points out that Boeing's 777 has a three-year order backlog, but its replacement, the 777X, won't be delivered until 2020. Boeing eventually will have to cut 777 production, which could dip into profits, predicts Buckingham.

BUT DON'T UNDERESTIMATE Boeing's ability to adapt, says Howard Rubel at Jefferies. It can continue to take costs out of 777 manufacturing, so that profits remain robust at lower production levels. And competing planes are largely sold out, so 777 orders might hold up better than expected. As for next-generation widebodies, the outlook is bright. The 787 and 777X have accounted for close to two-thirds of orders, and Airbus's A350, the rest. All told, Boeing reported 941 plane orders this year, through Sept. 2, net of 63 cancellations, compared with 722 for Airbus through August, after 279 cancellations. Airbus says that many cancellations came from A320 customers switching to the A320neo.

Boeing's modest cancellation rate, combined with an order backlog equal to nearly five years' worth of revenue, provides excellent visibility into near-term demand. Long-term, better to look at broad trends in flight demand than to guess what's next for the economic cycle. Global air traffic is growing at a 6% annual pace. Boeing predicts that it will rise 5% a year over the next two decades as middle classes expand in emerging markets. That will create a need for the global airline fleet to expand from 21,000 planes now to 42,000 by 2033. To get there while replacing old planes, the industry will have to deliver 36,770 planes over the next two decades, close to double what it did during the past two.

Boeing's management, led by CEO Jim McNerney, successfully overcame some early problems with the 787, and still faces challenges. For Boeing, the near-term keys to success include bringing down 787 production costs and successfully transitioning to the 737 MAX. Several years out, the 777X transition will be critical. The best that can be said about the defense side is that Boeing made cuts there early, and the business is likely to make up just 31% of sales next year, down from half in 2010. This past summer, Barron's wrote that U.S. defense spending is in danger of being crowded out by a massive medical bill for former soldiers ("The Lingering Costs of War," June 9).

Boeing shares look plenty affordable at 14.8 times projected earnings for the next four quarters, a 8% discount to where they have traded over the past 15 years, and a 6% discount to the S&P 500, versus a 4% premium, historically.

After this year, earnings per share are expected to grow 23% cumulatively by 2017, to $10.17. But that vastly understates the improvement in cash profit, which was held back by 787 production costs and will be unleashed as output there scales up, and lessons learned are put to work in other new planes.

Wall Street expects free cash flow to approach $11 billion by 2017. That's more than double the current level and equal to more than 12% of Boeing's stock-market value. A rise in the stock price to $150 a share over the next year would still leave Boeing with a projected free cash yield exceeding 10% two years hence.

With that kind of cash pouring in, expect years of healthy dividend hikes, too. 


http://online.barrons.com/news/articles/SB518857837249642736...