Why This Defense Stock Could Take Off in 2017

Richard Saintvilus's picture

Thursday, December 15, 2016 - 9:30am

by Richard Saintvilus

Shares of jet-maker and defense specialist The Boeing Company (NYSE: BA) haven't delivered the level of returns in 2016 that investors expected. As of Thursday, December 8, the stock had risen 7.5% for the year, compared to gains of 12.5% and 9.9% in the Dow Jones Industrial Average (DJI) and the S&P 500 Index (SPX), respectively.

The Seattle-based aerospace giant attracted unwelcome attention after President-elect Donald Trump complained on Twitter about the cost of the new Air Force One, currently in development. Driven by the resulting negative headlines, Boeing stock fell more than more than 1%, though the shares ended in positive territory after cooler heads prevailed. Despite these setbacks, Boeing stock can still take off in 2017 if the company can achieve a few operational objectives.

Where Things Stand Today
It's become a challenge for Wall Street to celebrate Boeing's recent accomplishments, which include two straight earnings beats and raised guidance. This is because, when looking at the company's strong earnings reports, it comes with the understanding that Boeing also benefits from favorable tax adjustments. And its third-quarter earnings report, which resulted in a beat on both the top and bottoms lines, was the perfect example.

While the headline earnings numbers highlighted the fact that the jet maker crushed the consensus EPS by 89 cents with $3.51 per share (up 40% year over year), smart investors realized Boeing would have missed the consensus estimates had it not recorded a tax adjustment of 98 cents per share. Third-quarter revenue of $23.9 billion beat consensus by about $260 million, but declined more than 7% year-over-year from $25.8 billion a year ago.

Boeing was impacted by lower deliveries in the Commercial Airplanes segment, resulting in a $719 million decline in segment revenue. Likewise, the Military Aircraft segment's revenue of $777 million reflected lower delivery volume, leaving the Global Services & Support segment as the only group showing positive year-over-year gains. And when looking deeper into the numbers, there were other areas of noticeable weakness, including contractions on both top and bottom lines, as well as operating margins.

The company saw a 10% drop in third-quarter segment earnings from the Commercial Airplanes business, falling from $1.7 billion a year ago to $1.6 billion, driven by a combination of lower revenue and margin pressure. Likewise, but not surprisingly, Boeing's Defense & Space segment suffered a margin contraction of 23%, though this was due to $124 million charge the company had warned about ahead of the quarter.

Cash Is Still King
Despite all of the apparent operational pressures, the company delivered higher third-quarter free cash flow, suggesting that the management is making good on its promise to extract value from various cost-cutting initiatives. With third-quarter free cash flow rising 13% sequentially to $2.6 billion, this puts the company's nine-month cash flow at $5.65 billion, marking a 30% rise from the same period a year ago.

With cash flow widely regarded as the strongest health metric of companies, it's tough to ignore how attractive of an investment Boeing is. The strong cash flows give the management multiple routes to either grow the company's investments or return some of that cash to shareholder in the form of dividends and buybacks. Boeing CEO Dennis Muilenburg has touted the company's commitment to investing in its future.

Muilenburg was quoted as saying that the company remains focused on "delivering better capabilities and economics to customers around the world." To that end, it would make sense for the company to deploy its cash towards areas that support both near-term and long-term growth. Ramping up production rates for the Boeing 737, the Boeing 787 and Dreamliner program would be good examples. Not only is the company is poised to realize favorable delivery mix in 2017, but possibly better tax rates as well under President-elect Trump.

Outlook For 2017 And Valuation
Despite Trump's Twitter rant that caused a temporary dip in Boeing shares, the President-elect is broadly regarded as a positive for companies like Boeing. After all, Trump campaigned on policies such as his desire to increase defense spending. The likelihood of higher defense budgets in 2017 and beyond should drive optimism that Boeing is poised to be one of the beneficiaries of Trump's policies.

This means it is now possible that Boeing can still improve its margins without having to make additional cuts on the Boeing 777 program as the management earlier this year promised to do. Not only is the company aiming to grow operating margins in the mid-teens in the coming years, analysts projects average annual earnings growth of more than 11% in the next five years. And from a valuation perspective, this makes Boeing stock, which has underperformed the market, even more compelling.

At around $154 per share, Boeing stock is priced at a forward P/E of 16, which is about two points lower than the S&P 500 index. This is based on fiscal 2017 earnings estimates of $9.39 per share, which calls for year-over-year earnings growth of about 32%. And these projections don't yet factor the lower tax rate and increased defense budget from which Boeing may benefit under a Trump administration.

Combined with the company's strong cash flow multiples and share repurchase program, Boeing stock, which also pays a  2.9% annual dividend yield, should enjoy a nice cruising altitude towards $170 to $180 sometime in 2017.

Risks To Consider: The margins contraction and lower volumes in the Commercial and Military segments may pressure the company's revenue and earnings in the near term. As the company's cash flow continues to support the share price, this means a dip in cash flow can land Boeing stock in short order.

Action To Take: Boeing should be kept on the watch list of investors who are looking for an undervalued defense stock that is trading at a meaningful discount to its long-term potential and also pays a decent yield.

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Richard Saintvilus does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.