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Boeing and the losers in aerospace

(Matein Khalid) / 30 April 2012

The high point of an English summer for me is not Ascot or Wimbledon but the airshow at Farnborough from July 9 to 15 because it provides a great insight into aerospace order flow.

The scale down of the US wars in Afghanistan and Iraq as well as rollbacks in the Pentagon budget mean bad news for defence shares (L3, Northrop, Lockheed, BAE Aerospace) and makes me reluctant to buy Boeing, given its franchises in Hellfire missiles, F-18 Super Hornet, war plane, and Apache attack helicopters. Yet I cannot deny that commercial aviation shares offer extraordinary opportunities given the record backlog, replacement cycles and rollout of new fleets across the Pacific Rim, the Gulf and Russia.

It is impossible for me to diss Boeing after its stellar Q1 results, though I would like to sell 72 and 74 strike puts when the market corrects to obtain a 64-66 accumulation price. Boeing was a laggard this year due to the stock market’s scepticism about the 787 Dreamliner delivery schedule but it is on the precipice of a free cash flow tsunami now that its R&D development budget winds down even as its global order backlog strengthens. In the business jet market, there is no doubt in my mind that Brazil’s Embracer will emerge as a global market share leader and its three per cent dividend yield, fortress balance sheet and huge EPS upside mean $40 on the ADR sometime in 2012 is all too possible. Textron, with its Cessna fleet and Bell military helicopters, is a Cinderella in global aviation that is a candidate for a possible turnaround, now that new management is in place. However, it is far too early to embrace the Textron turnaround thesis for now. It is far easier to focus on the revenue windfalls I see for Rolls Royce as the global civil aviation fleets expand offshore oil and gas budgets rise. Against a Rolls Royce long, I would short BAE System, who will be hit most by the decline in USAF, RAF and Nato budgets.

Boeing beat not only Q1 Street earnings estimates but also raised its full-year 2012 estimates with the BCA backlog rising by 17 per cent and the book to bill ratio is above 2.12. Boeing 2012 EPS guidance is now 4.15-4.35 but I would not be surprised to see Boeing deliver $4.50 in 2012. The shares are not cheap above 16 times current earnings and almost eight times enterprise value/Editda. Of course, the Dreamliner ramp, the Pentagon budget and the woes of the European aircraft finance markets are the biggest risks for Boeing. Yet I simply cannot gloss over the $305 billion commercial aircraft order backlog and BCA operating margins will only rise as deliveries rise while R&D expenses fall.

The exponential growth of airline fleets in China, Southeast Asia and the GCC could well increase Boeing’s order backlog above 4,000 aircraft even as American airlines upgrade Stone Age fleets. However, Boeing is really a classic tale of two cities (OK, divisions). The commercial aircraft business (BCA) is a beauty, with the 747, 767, 777, 787 wide body jets and the Next-Gen 737 and Jumbo 747-8 Freighter. BDS, the military side of Boeing (Islamic bankers should really not fly in Boeing aircraft or invest in its shares, since the boys from Seattle also make Hellfire missiles and Chinook/Apaches helicopters. Why?) is a hostage to Pentagon and Nasa budget, though they won the last USAF aerial refuelling tanker contract. My trading range for Boeing is 64-84.

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