There are lots of reasons to like shares of Boeing Company (NYSE: BA), but when was the last time that the company's defense business was on the short list of reasons to own the stock.
With so much of the story of Boeing wrapped in the potential of the commercial aircraft business, it's no wonder that there tends to be little said of the defense unit (Defense, Space and Security) outside of a passing comment about a recent win or a program sun-setting or the occasional poke of the business to ensure there isn't excessive downside in sequestration.
Given a closer look, much of the upside versus expectations seen quarter-to-quarter in the last couple years has come from performance in the defense business.
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"Integrated Defense Systems (IDS) on a number of performance measures has been among the top large defense businesses in the US (with those more pure-play defense stocks up 30-50% on the back of strong cash dynamics and a "less-bad" down cycle environment than feared)," Deutsche Bank analyst Myles Walton wrote in a note to clients.
The P-8 and KC-46 Tanker are the two programs that are in the portfolio as foundations of growth in the next 5years while the UCLAS (Unmanned Carrier Launched Airborne Surveillance) and the Long Range Strike bomber are the two opportunities that the company needs to solidify its portfolio in its post-C-17 (and potentially F-15/F-18) world through the end of the decade.
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"The P-8 was awarded to Boeing in 2004 and represents a potential $25B program with the P-8 procurement budget set to double from FY!2 to FY15," Walton said.
The good news is that the program seems to be hitting all of its milestones on-time with little in the way of obvious performance issues. The 12th P-8 was delivered recently to the Navy out of a total of 117 plann! ed to be bought by the service.
Similarly, the KC-46 is one of the top-three priorities for the Air Force and, in fact, is the #1 priority for the Air Force under sequestration as a program to protect given what the Air Force views as a favorable contract for the tax-payer.
"With the development program expected to stretch out another couple of years, there is still risk that could materialize. However, the $47B program could change columns for investors from a risk to an opportunity as the Air Force starts to pick-up production options in the next couple of years," Walton noted.
The two biggest pursuits for Boeing defense are the Long Range Strike (i.e. bomber) and UCLASS (Unmanned Carrier Launched Airborne Surveillance and Strike System). These programs combined will be roughly the same level of planned F-35 funding (DoD only) over the timeline displayed, which highlights the potential significance to the winner.
Looking ahead, the biggest challenge facing Boeing defense is working through the transition of some of its more mature programs to either lower rates or production cessations. The last C-17 is planned to roll off the assembly line at the end of 2015. Simultaneous to that the V-22 production rate will likely be in the low-to-mid 20s vs. today's 40 per year.
"We estimate the revenue headwind from the two programs is $2.5-3B. Offsetting these two roll-offs are the growth opportunities afforded by the P-8 and KC-46 Tanker program," Walton noted.
At the same time, the company is working to maintain its strong F/A-18/E/A-18 offering, as well as its F-15 and Rotorcraft portfolio.
The key to management of platform transitions is the behavior of the defense unit's margins. On that topic, management is confident that the margin profile of the defense business will be maintained/improved over the next several years despite the program transitions.
The company has been successful to date in pulling out $2 billion to $3 billion in cost structure, and there ! appears t! o be another $2 billion in costs in the next couple of years to take out.
"Boeing's Partnership for Success has received quite a bit of attention as a tool management is using with suppliers to reduce overall cost and improve its quality of products. Of the top-20 Boeing suppliers, over three-quarters seemed to have a full developed strategy while the next 100 suppliers have recently had their engagement with Boeing on what their role might entail," Walton wrote.
The NSS and GSS segments account for half of IDS sales and profit and so as much as the Military Aircraft segment, these two units play a role in keeping defense from being a distraction to the commercial aircraft driven thesis.
The most important takeaway from a look at Boeing's IDS business it that it is unlikely to get in the way of the strong commercial story and is more likely to secure a bit of upside opportunity to expectations.
"The risk on the C-17 production wind-down and the ability to absorb the absence of that high margin mature production program is the highest risk in our view from a production perspective while keeping the KC-46 Air Force Tanker on track is the most important from a fixed price development risk perspective," Walton added.
Nevertheless, upside opportunity from the defense unit could come from the company's continuous cost actions allowing margins to continue at pace or even have some upside.
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