Boeing: Smooth flying now, turbulence ahead

By Jon Markman

It seems like not a week goes by without word that some airline, country or 11-year-old girl has put in an order for a dozen Boeing jets.

These contract announcements must give a lot of comfort to recent buyers of Boeing (BA, news, msgs) shares, because they bid the stock up to the upper atmosphere in the past 3½ years, tripling during a time when the market is up far less.

Optimistic investors appear to believe that these announcements signify ongoing strength at the world's largest commercial airplane maker that will continue indefinitely. But what they are missing is that sales momentum has tapered off a lot lately. And it is likely to decline a lot more over the next two years, to the extent that the company's earnings may be headed for a hard landing.

I wrote about the problems that Boeing faces on its 787 Dreamliner program a couple of months ago, but after news surfaced last week of technical fiascos and long production delays in its program to build 12 global positioning system (GPS) satellites for the Air Force, I wanted to remind you that Boeing is just not the smooth-sailing enterprise that bulls have conjured up in their dreams. Indeed, I received e-mail from its production workers, former quality-assurance officers and suppliers that the upbeat sales and engineering culture at Boeing have kept management in denial about costly setbacks. Although one can never determine the veracity of letter-writers, they were views that I think should be shared.

The blame game

One writer, who said he was a former Boeing quality-assurance manager, observed that executives at the company, who are largely engineers, are eternal optimists who blame the manufacturing division when things go wrong, and only admit production delays at the last minute. "Poor design, late design releases and the inability of manufacturing to build what's designed" are long-standing problems stretching back to the 1970s that Boeing never wants to face, the correspondent said.

The latest troubles at Boeing seem relatively minor on the surface. New GPS satellites for the Air Force that were supposed to be launched in January have been delayed until May 2008. The Air Force said the "more realistic schedule" was set after an independent program review, which also recommended adding more research and development expenses to the program. The Air Force complained of delays due to the complexity of the satellites' circuit design, the magnitude of the far-flung assembly and integration chain and late deliveries by subcontractors.

Does any of that sound familiar? While the money involved in the satellite program is a drop in the Boeing bucket, these are exactly the same concerns that my sources have raised in relation to the Dreamliner's super-complex design and construction, which also is spread out across the globe. Only there is no independent program review or Air Force overseer.

From a business standpoint, the trouble ahead for Boeing is twofold:

• First, orders last year and through the spring of this year for the Dreamliner were so strong that investors' eyes bugged out and greed overcame their good sense. Every flaw in the Boeing story has been ignored, while every little sparkle has been polished.

• Second, Boeing's buyers are highly leveraged, and in some cases bankrupt, airlines whose ability to pay for big, heavy things is utterly tied to global economic growth and low interest rates. Yet last I checked, the world's central bankers in France, Great Britain and Japan are raising interest rates hand over fist in an effort to blunt inflation by choking off growth.

In other words, Boeing makes products that are primarily purchased by the worst-managed and least profitable industry in the world, which has a hard time paying bills even when times are great. And now the airline biz is heading into a period when growth is faltering. Specifically, air-traffic growth has declined over the past two years while airline profits -- the source of their ability to buy new planes -- is flat. Does a financing gap really fly?

Citigroup analyst George Shapiro points out that the company's book-to-bill ratio -- the balance of orders booked for delivery divided by the orders that have already been billed for -– is expected to fall to 1.8 by the end of this year from a peak of 4 in April. The next big wave of orders won't come in until a replacement for the venerable 737 is launched.

Dream on

What about the Dreamliner? The funny thing is that the 787 isn't even in production yet, and yet the current stock price assumes a fantastic release and trouble-free rollout. The stock won't get any credit if production goes smoothly, and will get hit hard if goals are not met, as happened with those wayward GPS satellites.

Boeing has repeatedly insisted that the first Dreamliners, scheduled for final assembly next spring, rollout in the summer and commercial launch in 2008, are still on track. I hope they're right, because it would be an awesome American achievement.

The two key metrics now for investors are Boeing's profit margin and the price-to-earnings multiple, and in many ways they go hand in hand. Most Wall Street analysts covering the company figure Boeing needs to achieve peak commercial airliner profit margins of more than 14% to justify the current P/E multiple of 24, yet the historical peak is just 10%.

The danger to margins in airliners is the same as the company faces in GPS satellites: It's probable that Boeing will have to commit significantly more money to research and development to overcome design flaws than it has currently allocated. Higher R&D expenses would pinch margins, which in turn would reduce investors' confidence and shrink Boeing's sky-high P/E multiple. Last quarter, Boeing's boost of R&D estimates already were called out by analysts as a big and scary surprise.

Bulls argue that Boeing's key role in Pentagon spending growth will save the day. Yet I wonder if that's really true. Its Future Combat Systems and Joint Tactical Radio System programs are likely to get smaller, not bigger. And the big old C-17 program, which provides about 40 cents per share to earnings, is on track to end as early as 2008.

Citigroup's Shapiro does a nice job of pulling the bullish and bearish arguments succinctly together:

• Bulls believe Boeing will break from historical precedent and defy the cyclical nature of the business. They think earnings will get to $7.50 by 2010 due to demand from emerging markets and the replacement of older planes in mature markets, and that Airbus won't recover from its current travails.

• The consensus believes the airline business is cyclical, but this cycle -- highlighted by the Dreamliner -- will be particularly long and strong as Boeing executes better under its new chief executive, W. James McNerny Jr. The consensus also believes the defense business will improve rather than flatten, and that Boeing will fix its tattered relationship with the Air Force.

• Bears believe that each airliner cycle is essentially the same, and that slowing economic growth paired with a declining book-to-bill ratio will pack a potent 1-2 punch on the stock. Bears also believe that peak margins and earnings will not be achieved due to Dreamliner delivery slippage and higher R&D costs; that Pentagon spending is a risk, not a promise; and that Airbus will get its act together and pressure Boeing to make costly new investments in 2007 through 2009.

You know my view. I don't think Boeing can pull off the Dreamliner production without a hitch, that a global growth slowdown will lead to aircraft order cancellations and that the Pentagon will trim its sails. If you apply a generous 16X multiple to my estimated 2007 earnings of $4.50, you get a target for the next 12 months that is slightly below the current price. Even if that's accurate, it won't be a straight, flat flight. Expect turbulence.

Fine print

Right on cue, Boeing on Monday announced an order for 10 737-800s from mighty Air Sahara, which is based in India. Delivery of the $700 million order is scheduled to start in 2009. The airline's motto: "Emotionally yours." … At a time when airline stocks are not faring so well, two are running at new all-time highs: Air France-KLM (AKH, news, msgs) and Panama-based Copa Holdings (CPA, news, msgs), a Continental Airlines affiliate, … To learn more about Boeing's GPS program, click here. ... Since I wrote about the energy-drink business a couple of weeks ago, I've received a lot of e-mail from readers about their favorites and samples from companies. Most taste terrible and failed to lift me out of my post-vacation lethargy. The fad has produced products based on the thinnest of marketing ploys. The weirdest might be a San Diego outfit that sells an energy drink called Who's Your Daddy. Here's its mission statement: "The company will achieve its goals by extending licensing and marketing initiatives to capture those consumers that respond to the appeal of the popular phrase, 'Who's Your Daddy.'"

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Jon D. Markman did not own or control shares of companies mentioned in this column.