After close today (7/18/19), BA announced a $5.6B pretax charge (or $8.74/share) associated with estimated costs from potential customer concessions and other considerations for disruptions related to the 737 MAX grounding and subsequent delivery delays. In addition, BA noted 737 program margins would absorb an incremental $1.7B of expenses driven mainly by higher costs related to a longer-than-expected cut in build rates (recall pre-crash, BA was gearing up to hit 57/mo in 2019). BA expects higher program costs will weigh on 737 program margins starting in 2Q19 and extending into the quarters (and, we believe, years) ahead. In total, BA called out $7.3B of MAX-related charges, in line with our $7-8B estimate, but we expect BA will book additional period expenses as it gets more clarity.
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BCA delivered 90 planes in 2Q19 matching our expectation and comes as no surprise given the MAX grounding and subsequent delivery suspension. Mix was slightly favorable driven by three more 787-9s and -10s, two fewer very low-margin 787-8s, and one more 777. At BDS, there were 36 total deliveries (18 new builds and 18 remanufactured), somewhat less than what we were expecting. Recall, the Air Force slowed tanker acceptances to 1/month from 3/month after discovering more foreign object debris (FOD) in newly assembled tankers even after the Air Force halted deliveries twice this year over the same FOD issue. Tanker deliveries declined by two aircraft sequentially: BCA transferred six 767-2Cs to BDS in 2Q (vs. eight in 1Q) and BDS delivered five tankers to the Air Force in 2Q (vs. seven in 1Q). Overall, our 2Q19 sales estimate moves 2% higher to $20.3B and our EPS inches up $0.03 to $1.68.
We estimate the MAX issue will cost BA $2M per month for each MAX that is out of service for a total impact of $7-8B. We derive this from public comments of MAX operators. Of course, it isn’t that simple. But we lower our target price from $431 to $404 for BA, with ~$14/share coming from direct MAX penalties and the rest from second derivative issues we foresee. For example, we are now working under the assumption the NMA won’t happen, lowering R&D spend but also lowering our BGS sales and margin estimates since aftermarket work was a key component to an already suspect NMA business case. NMA may still very well go ahead as planned – key customers want it – but BA has its hands full and the competing A321XLR is off to a strong start. We assume BA accelerates the so-called Future Small Aircraft (FSA) program with R&D starting to ramp in earnest in 2022.
Last week (6/19), the House passed H.R. 2740, a package of four FY20 appropriation bills including defense. The vote was 226-203, largely along party lines with seven Democrats opposing the bill including Rep. Alexandria Ocasio-Cortez (D-NY), who we believe may be emerging as a prominent voice against robust defense budgets. For the DoD, the House appropriations bill provided $690B for the defense discretionary budget comprising $622B for base and $68B for OCO. This level of funding falls below both the President’s budget request and the Senate NDAA mark-up of $718B, and the bill transferred $98B of otherwise base budget requirements tucked in OCO back to the base budget. The White House has already threatened to veto the bill.
We attended the House subcommittee on aviation hearing in D.C. today, where members of the House asked questions to a panel of five industry experts about the 737 MAX. Our takeaway: while the tone of the hearing and the nature of the questions were downbeat, there was no further damage done to the probability of the MAX returning to service (at least by U.S. airlines) around the current goal of ~Labor Day. Though that’s still an optimistic goal we believe it is doable. After the hearing we spoke to a few regulatory people in attendance, and we gather a few quick hit takeaways here.
Heading into this year’s air show, we were expecting a total of ~400 orders and commitments between Airbus (~300) and Boeing (~100). We weren’t surprised by the tepid order activity so far: Airbus announced a total of 112 orders and commitments (O&Cs), while Boeing booked only 10 orders (excluding UAL’s firm order of 20 E-175s). In comparison to the last four air shows (2015-18), Airbus averaged 105 O&Cs and Boeing averaged 96 O&Cs on Day 1 (see Exhibit 1 on page 2). We continue to believe order activity will be muted at the Paris Air Show and throughout the year with 2019 B:B likely to come in well below 1x.
Bombardier announced plans in early May to consolidate its aerospace assets into one integrated business unit called Bombardier Aviation. Under this reorganization, the company’s aviation business would focus on business and regional jets, namely its Global, Challenger, Learjet, and CRJ brands. Bombardier will retain its nose-to-tail aerostructures capabilities in Montreal, Mexico, and Red Oak but divest its Belfast and Morocco facilities. Yesterday (6/5), Bombardier disclosed discussions it’s currently having with Mitsubishi Heavy Industries (MHI) over the sale of its CRJ program given recent media reports.
On Friday 5/24, the Trump administration declared an emergency over concerns with Iran to bypass the normal 30-day Congressional approval process to sell arms and other military equipment to Saudi Arabia, Jordan, and the UAE. We believe this decision was in response to Sen. Bob Menendez’s (D-NJ) year-long hold preventing the sale of precision-guided munitions to Saudi Arabia and the UAE. Secretary of State Mike Pompeo indicated a total of 22 pending, individual sales worth $8.1B would be cleared through this emergency provision. Not surprisingly, this prompted outcry from Congress since it parallels earlier actions by Trump over the border wall. While Trump does appear to be circumventing the decades-long working relationship between the White House and Congress over international arms sales, Friday’s action isn’t unprecedented. Four other administrations (Carter, Reagan, Bush 41, and Bush 43) have invoked this exemption. Still, we expect greater pushback this time around given the current political environment.
Last year amid allegations of TDG earning excess profits on DoD contracts and a request by Rep. Ro Khanna (D-CA), the DoD Inspector General (IG) launched an investigation reviewing 47 spare parts purchased by the Defense Logistics Agency (DLA) and the Army during Jan 2015 and Jan 2017. The IG issued its report in Feb 2019 concluding that TDG made excess profits on 46 out of 47 parts and recommended TDG voluntarily refund $16.1M to the government since the company didn’t technically break the law. The House Committee on Oversight and Reform held a hearing on 5/15/19 and asked five witnesses to testify consisting of 1) Kevin Fahey, the Assistant Secretary of Defense for Acquisition; 2) Glenn Fine, the Acting IG for the DoD; 3) Theresa Hull, Assistant IG for Acquisitions for the DoD; 4) Kevin Stein, TDG president and CEO, and 5) Nick Howley, TDG executive chairman who attended but didn’t give a separate prepared remark.
At the 2019 Sea-Air-Space exposition last week, Navy acquisition head James Geurts voiced some concerns over the industrial base’s ability to sustain the accelerated production cadence of the Virginia Class submarine (VCS) program. Geurts noted delivery delays on Block IV submarines and the potential that this causes problems with the upcoming Columbia Class submarine (CCS), which he indicated is the Navy’s top priority. While we believe there are challenges the submarine industry needs to overcome, namely shortage of qualified workers, some of the issues that Geurts brought up appear to be gamesmanship in part to persuade Congress to provide more funding to both the VCS and CCS programs and also to motivate the private sector to improve its performance and make further investments. For instance, the expected 4-7mo delays on Block IV are against a 60-month start of construction to delivery timing vs. a 66-mo target under the previous Block III. In addition, we believe this delay won’t
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