Boeing Plays Defense

It's getting by with Pentagon contracts while astutely cutting costs, but the stock isn't likely to rise until civilian orders pick up

By Stanley Holmes

Investing in the builders of commercial jetliners has always been risky. But it's more so today than at any time in the 50-year history of commercial jet aviation. At the beginning of the decade, the bursting of the dot-com bubble and the September 11 terrorist attacks walloped the airline industry. The Iraq war and SARS epidemic have made things worse in 2003. Boeing (BA ) Chairman and CEO Philip M. Condit is not exaggerating when he says, "We're in the midst of the worst downturn" in the industry's history.

Boeing has managed to remain the industry leader, and the Chicago-based aerospace giant has made monumental changes to try and smooth out the volatile nature of the commercial jet business. The biggest shift is that, for the first time, the revenues for Boeing's integrated defense business -- a combination of military aircraft, missile defense, satellites, and computer network systems -- will slightly exceed revenues for commercial airplanes in 2003. The question investors should ask is whether Boeing's military diversity is significant enough to offset the ongoing deep slump in the commercial jetliner business.


  With Boeing shares trading at about $30 a share, the stock strikes some as undervalued. Standard & Poor's equity analyst Robert Friedman, believes the shares are trading at a whopping 40% discount to fair value. Based on the more than $2 billion in cash flow Boeing is expected to generate this year, Friedman calculates its shares to be worth $41 to $47 a piece. But Friedman is in the minority when it comes to Boeing's outlook. "We see considerable risks," wrote JP Morgan analyst Joseph Nadol in a May 27 report.

Condit argues that the strategy of buying defense contractor McDonnell-Douglas, Rockwell Aerospace, and Hughes' satellite division in the late 1990s "has done us well." He says Boeing is more balanced and can absorb the sharp cyclical swings of the commercial airplane business. Wall Street tends to agree -- but with some caveats. The Street currently value Boeing's commercial airplane business at nearly zero, assigning almost all of the value of Boeing's $30 share price to the defense business. At the same time, many analysts argue that the stock will stick in a trading range until a clear sign of recovery in the airline business emerges. So for all of Boeing's hard work to diversify, the paradox of investing in Boeing is that its stock price still depends on commercial airplanes for momentum.

The key challenge for Boeing in the next two years will be to finesse the production shutdowns of planes no longer in demand while launching a new midsize aircraft. Both are expensive enterprises and likely will erode operating margins at a time when the outlook for travel demand is murky at best.


  Boeing management wants to launch the midsize 7e7 in early 2004. But analysts predict it could cost up to $6 billion to develop the superefficient, 250-seat airliner. Meanwhile, Boeing Commercial Airplane CEO Alan Mulally concedes that Boeing plans to shut down production of the slow-selling 757 in the near future. The 737-900 will replace the 757, Mulally says. "We're managing the business so we can close the airplane down for the best value," he recently told investors. "We'll do everything ahead of time to minimize any value destruction." And there may be other shutdowns eventually, including the 100-seat Boeing 717 and the 420-seat 747 jumbo jet.

The financial impact of ending production while developing a new jet could sharply squeeze profit margins, analysts fear. Assuming Boeing can launch the 7e7 in 2004, R&D spending is set to peak in 2006. That gives Boeing breathing room to take the financial hit on one or two line closures in the next year or two -- and then prepare for the heavy spending needed to develop new aircraft.

Boeing got some good news in late May, when the Pentagon approved a $15 billion deal to lease 100 Boeing 767 tankers. The announcement keeps the 767 production line rolling as a military airplane, even though the aircraft's commercial sales had virtually dried up and the line was also in danger of shutting down.


  To his credit, Mulally's team has excelled at cutting costs and making airplane production more efficient. That's illustrated by the commercial unit's realistic goal of generating 3% to 4% operating margins on volume of about $22 billion for 2003 and 2004 -- and doing so during a record slump. Moving production lines, consolidating suppliers, simplifying parts manufacture, and eliminating excess factory space -- not to mention 35,000 lay-offs -- have reduced costs and increased flexibility. "We regard these elements as game-changers for the company, which is clearly better positioned to make money in a broader set of volume conditions," writes Chris Mecray, Deeutsch Bank analyst, in a May 27 report.

Still, it may not be enough to offset additional order cancellations and the cost of potential line closures. Boeing says it will deliver 275 to 300 airplanes this year and in 2004, but many analysts predict Boeing will lower those projections again soon. And questions remain about how strong demand will be for the 7e7. Condit told investors a "naked" launch (without orders in hand) was a possibility. Even if demand materializes, what happens if rival Airbus builds a similar plane? Boeing estimates a potential market of 2,500 aircraft over the next 15 to 20 years. If the market is indeed that big, it would be hard to see Airbus stay on the sidelines.

On the bright side, Boeing can count on defense revenues to carry it in the next two years. The Integrated Defense Systems unit expects revenues of about $26 billion and operating margins of 8% to 9% in 2003. Sales growth should exceed 10% in 2004 and churn out 9% margins. CEO Jim Albaugh has restructured the business to reflect the Pentagon's new priorities. The defense unit now consists of four key areas: network systems, 33% of 2002 sales; aircraft and weapons, 42%; support systems, 14%; and launch and orbital systems, 11%.

Boeing still builds fighter jets and cargo planes as well. The F-18 and C-17 programs are some of its biggest profit producers today. Though they're mature programs, they should be viable until the end of the decade. Less viable has been the management of its satellite business, particularly commercial satellites. The combination of a slumping market and production and quality problems has been a drag on earnings.


  Still, Albaugh's team continues to transform Boeing's defense business to meet the Pentagon's vision of a new kind of warfare. As a result, it has won several key initial contracts that could pay off big in the future. Among them: future combat systems, joint tactical radio systems, and the ground-based midcourse missile defense. These new military contracts move Boeing into a new business opportunity -- away from the construction of platforms such as airplanes to an attempt to connect various military platforms with software-based communication networks.

The aim of these early but ambitious programs is to provide pilots, tank commanders, infantrymen, and military planners with instant, real-time information. It's a huge task and fraught with some risk, especially in how Boeing ultimately makes money. Even so, Boeing has grown the value of its missile defense, intelligence, and what's known as "integrated battlespace" to about $3 billion each. Writes Adam Weiner, analyst for Credit Suiss First Boston: "The future looks promising for this business based on the projected U.S. defense budget growth."

The future may hold promise, but it's already reflected in today's stock price. From a long-term perspective, Boeing's low valuation is attractive. The stock will appreciate as Boeing continues to run healthy programs and generates gobs of cash. And Boeing is working hard to remake itself into a more balanced company. But the industry continues to fight daunting challenges, and there's no guarantee the commercial jet side of the business will rebound anytime soon.

Holmes covers Boeing for BusinessWeek in Seattle

Edited by Beth Belton