History
Founded in 1916, Boeing’s success has and continues to be predicated upon the size and durability of its strategic competitive advantages (economic moats) and the high barriers to entry that characterise the industry. Boeing benefits from different economic moats including its distribution and operational scale, intangible assets (brand, patents and regulation), and switching costs. Today, Boeing is the leading aircraft manufacturer globally and operates in a allocate capital, which has led to strong free cash flow genduopoly with Airbus, together commanding over 80% of the aircraft manufacturing industry.
Figure 4. Market share deliveries 2017. Source: Bloomberg
Industry
Both the structure and stability of the Boeing-Airbus duopoly can be explained by high barriers to entry. There are four of these:
- The extremely high cost of developing aircraft programs where large losses can be incurred for many years before a program becomes profitable and delivers cash flow.
- Navigating a very complex supply chain that cannot be internally replicated.
- The intellectual property and technical know-how required to design, assemble and certify commercial aircraft, which requires excessive amounts of monetary and human capital investment and a long developmental time horizon.
Since the recession in early 2000, the cyclical nature of the industry has been greatly reduced, making Boeing a more stable and steady quality compounder of value. This is attributable to Boeing’s rational management with regards to production rates, which has led to an accumulation of a vast delivery backlog for aircrafts, equivalent to approximately 7 years at current production rates. Moreover, the nature of the backlog is very diverse from a geographical and customer base perspective (e.g. low cost carriers & network carriers) which, reduces concentration risk. The advantage of a vast backlog is evidenced by deliveries being virtually uninterrupted during the 2009-2010 financial crisis compared to 2001-2003 (Figure 5). Today, the backlog is even bigger than it was in 2009-2010 providing a greater margin of safety.
Strategic competitive advantage (Economic moat)
In addition to high barriers to entry, Boeing’s strong competitive position is a consequence of the size and durability of the strategic competitive advantages it has been able to build to fend off competitors. Boeing’s wide moat is derived from 3 primary sources:
- Its extensive operational and distribution scale allow it to provide its customers with timely worldwide technical expertise, which is critical given the nature of the industry.
- Boeing has strong intangible assets in the form of a brand that customers value and rely upon – their intellectual property and technical expertise (15600+ worldwide patents) are extremely difficult to replicate.
- Switching costs arising from the high cost of fleet groundings and aircraft crashes make customers reluctant to purchase aircrafts from an unproven aircraft manufacturer. There are also switching costs related to training pilots, crew members and maintenance staff.
Figure 5. Total combined annual deliveries by Boeing and Airbus. Source: Company Financials, Northstar Asset Management.
Management
Boeing Management have displayed the ability to prudently allocate capital, which has led to strong free cash flow generation and the subsequent return of vast amounts of capital to shareholders in the form of dividend and share buybacks. Over the last 5 years, dividends have increased more than 250% and in total Boeing has returned more than $40bn of capital to shareholders. Vast amounts of capital will continue to be returned to shareholders in 2018 with Boeing having a further $18 billion set aside for share repurchases. More impressively, Boeing have consistently delivered returns on invested capital (ROIC) substantially in excess of its cost of capital with an average ROIC of 31.9% over the past 5 years despite operating in a very capital intensive industry.
Free cash flow, the primary driver of value
Boeing uses a unique accounting methodology known as program accounting. Program accounting causes a disconnect between Boeing’s cash flow and earnings trajectories. In the early stages of a new aircraft program earnings are overstated relative to cash flows but as the program matures, earnings become understated relative to cash flows. As a result, earnings are a poor indicator of Boeing’s value and therefore likely share price performance. On the other hand, cash flow is a better indicator of Boeing’s value and therefore share price performance as evidenced in Figure 6.
Conclusion
In 2017, Boeing delivered 95% share price appreciation and in excess of 100% in total returns including dividends. Despite this stellar performance, we believe that it still has the ability to deliver steady free cash flow growth over the long-term due to its enduring competitive advantages, high barriers to entry and improving industry dynamics.
Figure 6. FCF per share vs Boeing share price. Source: Bloomberg; Northstar Asset Management estimates