This Dow Stock is Overvalued by at Least 25%

David Sterman's picture

Tuesday, September 21, 2010 - 6:18pm

by David Sterman

Cyclical stocks have always been tricky for investors. At the bottom of an economic cycle, they can appear to have fairly high price-to-earnings (P/E) ratios as investors look ahead to better times. When the cycle improves and approaches a peak, the P/E multiple then tends to shrink as investors brace for an earnings downdraft. That's why a company like U.S. Steel (NYSE: X) can trade for 30 or 40 times profits during bad times, but end up trading for only six or seven times profits when earnings growth has maxed out.

In that light, it's a bit curious that shares of Boeing (NYSE: BA) trade for 13 times next year's earnings. Because by my math, 2011 could wind up being a peak year for Boeing, and profits look set to slump in subsequent years. Don't blame the economy. For the broader economy -- and many cyclical stocks -- the economic cycle has only just begun to turn and we may not see a peak until the middle of the decade. Boeing is peaking for an entirely different reason. One of its core markets is about to flatten out and then shrink. And the other market is about to see a sharp spike in competition.

A sea change at the Dept. of Defense
In recent weeks, Defense Secretary Robert Gates has made it increasingly clear that his department will have to tighten its belt along with everyone else. For now, that means the never-ending budget increases in defense spending will need to come to a halt. And after the war in Afghanistan concludes, defense spending could start to fall at a steady clip. During the past 10 years, spending at the Department of Defense has gone up an average of +6.4% every year. That works out to an +86% increase in the past 10 years. That looks set to reverse course, unless we enter into another war. In the 1990s, defense spending reductions were called a "peace dividend." This time, those spending cuts could be known as "budget saviors."

Boeing's defense business, which represents half of company sales, focuses on weapons and aircraft capabilities, intelligence and surveillance systems, communications architectures and extensive large-scale integration expertise. Demand will always remain for these types of items, but Boeing is already seeing certain potentially lucrative programs get cut from the budget. And the process is just getting started. "Based on our reading of the 2010 Quadrennial Defense Review (QDR), we believe long-term major development programs will come under more scrutiny, and therefore we expect to see more disciplined spending on these programs in the future," note analysts at Imperial Capital. In addition, Boeing is the fourth-largest vendor to the Department of Homeland Security (DHS), with $2.3 billion in sales last year. The DHS budget is also at risk of a pullback in spending as industry analysts increasingly agree that the DHS has become bloated and unwieldy.

Commercial airline competition heats up
For many years Boeing and Airbus enjoyed a virtual stranglehold in the commercial aerospace market. But in the last decade, Canada's Bombardier and Brazil's Embraer (NYSE: ERJ) developed impressive new planes, cannibalizing market share in the regional jet category.
[Read: This Unknown Brazilian Stock Could Unseat Two Global Powerhouses]

Boeing and Airbus' grip on the jumbo jet market has been untouched and is likely to remain that way. But the market for smaller planes is about to get a lot more crowded, creating real competition for the Boeing 737 and the Airbus 320. Industry publication AirInsight recently noted that: "New entrants for the 150-seat market segment in China, Russia and potentially Japan will have an impact on Airbus and Boeing. While we don't expect these programs to be particularly successful outside the home markets, these domestic sales will significantly eat into the market shares of Airbus and Boeing."

Action to Take --> Boeing can still count on a fairly hefty backlog in each of these divisions. So sales and profits are unlikely to plummet once a peak has been reached. Instead, look for orders in both divisions start to slump, beginning in 2011. That should lead to a steady downdraft in backlog, which is the key metric that most investors focus upon. As noted, Boeing is entering the peak phase of its cycle, and this business should be worth no more than 10 times peak earnings -- implying nearly -25% downside.

David Sterman 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.