Boeing Bet Rides on 787

Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on

Investors admired the ambition, complexity, profitability and market dominance of industry leaders Fannie Mae ( FNM) and Intel ( INTC) all the way up to the point when their earnings forecasts were proven wildly overoptimistic and blew up.

Could the same now happen at Boeing ( BA)?The parallels are eerie, if not at all perfect. Boeing -- the third-best gainer in the Dow Jones Industrials over the past year -- is priced for perfection, much as the techs and banks were in 2000. And perfection, as we know all too well by now, is rarely attained.

Investors in the European consortium behind Airbus found that out all too well last month when executives had to backtrack from laughable assurances that production of their new super-sized A380 commercial aircraft was on track. The bad news sent the consortium's shares down 25% in a week.

Boeing investors celebrated the Europeans' bad news, figuring it meant new business from frustrated Airbus customers. But really, they should have taken it as a warning, for it is very hard to believe that the U.S. aircraft maker will manage to escape a similar fate with the construction of its own new plane, the 787 "Dreamliner."

Sky-High Optimism

Boeing rarely built a new aircraft on time when the planes were built start to finish in the greater Seattle area. But somehow it has managed to persuade investors that this time -- when much of the plane is being built overseas from hard-to-get materials and organized with a glitchy new software system -- Boeing cannot only keep production on schedule, but actually build planes at a record clip.

A couple of analysts have been sounding the alarm, but have not made much of a dent yet with Boeing bulls. One bearish analyst, David E. Strauss at Swiss-based brokerage UBS, has told clients that the Dreamliner is even more likely to blow deadline than the Airbus A380. "Risk to the 787 production schedule will continue to increase from here as the program heads toward first flight in late summer 2007," he wrote.

If shares of Boeing do go into a nosedive over production delays, as I believe they will, bitter holders will shake their heads over the nosebleed altitude to which valuation has ascended this year. On a trailing basis, over the past 10 years Boeing's price-to-sales multiple has run from 0.69 to 1.1. It's now well above the top end of the scale. Boeing's price-to-book multiple has run from 3.5 to 5 over the past 10 years. It's now almost 6.

Investors pay a premium for an industrial company's shares when they believe it is halfway through a business up cycle and recent earnings growth will extend at least three years into the future. They pay absolute top dollar when they think a company whose growth has been cyclical in the past has found a way to smooth out its ups and downs and bring in steadier cash flows through diversification efforts.

So what are investors thinking? Forgetting the risk of production delays and the loss of face that would entail, steady cash flows could hardly describe Boeing, which is now, and will forever be, tied to the ups and downs of the worldwide demand for commercial and, to a lesser extent, military airplanes.

With energy costs persistently high, global stock markets reeling, worldwide economic growth flattening and the threat of pandemic hanging over travel, the airline business does not look like an ideal place for investment capital at this time -- and that goes double for companies that provide capital equipment, like Boeing.

The case for Boeing shares over the past three years has rested on its brilliant campaign to best its only major rival, Airbus, in obtaining orders for next-generation commercial aircraft. Airbus made a big bet on offering a gigantic new double-decker, wide-body jet that would transport up to 800 people at a time; Boeing made its own big bet on the 787, a more fuel-efficient aircraft that proposes to save airlines money. So far, Boeing has won the race for new orders by a handsome margin.

A Source of Concern

But orders are one thing, and producing the darn thing is quite another. And this is where we get deeper into the intersection of ambition, complexity and risk. For if the plane misses its 2008 delivery deadline and fails to perform as Boeing's salesmen-engineers promise, then dreamy investors can kiss many of those orders goodbye before the first plane ever takes off.

In its marketing material, the Dreamliner has been sold as a plane that achieves its fuel efficiency and streamlined manufacturing costs through an unprecedented reliance on large quantities of titanium, aluminum and carbon-fiber composites, and on a global supply chain held together by a new software system. Boeing has said that its suppliers and software are performing up to par and that it has not encountered any difficulty in securing enough specialty metals.

Yet persistent rumors have surfaced over the past six months, denied by the company, that the 787 schedule has been plagued with technical, production and supply hitches.

Fear of the loss of a ready source of titanium was in large part behind the company's stunning pledge to spend $27 billion over the next three decades on engineering and raw materials in Russia, an economically and politically unstable country that happens to house most of the world's supply of the key metal.

Two weeks ago, Business Week reported that the passenger-seating section of the 787 fuselage has failed in testing. The company blamed the problem on faulty quality controls, but denied that construction problems at Asian or European airframe contractors would force it to bring more of the work back to the U.S.

Cancellations Coming?

Citigroup aviation analyst George Shapiro notes that, historically, Boeing shares have not performed well during development cycles, and adds that their recent success "reflect(s) a lack of concern about problems developing" with the 787 and its outsourced research and development efforts.

Shapiro also warns that the 787 production cycle may be shorter than normal, as airline profitability has not recovered enough to support the order surge. He expects a wave of order cancellations, even if delivery schedules are met.

Why so glum? Shapiro says new planes containing significant technological innovations inevitably encounter manufacturing problems. Already, Boeing has acknowledged that the 787 is overweight, and with a big advance in electronic complexity, my guess is that some variation of the wiring snafus that have tripped Airbus are virtually a lock to appear.

It's precisely due to manufacturing crises that Boeing shares have typically underperformed during development cycles and outperformed once planes are finally delivered. The company ultimately fixes the problems, of course, but the solution comes at the price of higher research costs that depress profit margins.

Meanwhile, investors are treating orders as if they were booked revenue, even though past cycles have seen up to a third of orders canceled. Although some 787 orders are still coming in, many were made in an environment of much lower oil prices and interest rates, and stronger economic growth.

Tech Echoes

You may recall that, in early 2000, tech companies boasted that tremendous order backlogs would lead to fantastic earnings growth, only to learn later that buyers had speculatively double- and triple-ordered. Jets also are ordered by companies that speculate on traffic boosts that never materialize. Citigroup notes that the Indian market is seeing air traffic grow by 20%, while capacity is expected to grow by 30% -- an imbalance that increases the likelihood that price wars will sap profits and lead to cancelled orders.

If cracks appear in Boeing shares' uptrend, the stock could come in for a hard landing.

So what are the shares really worth, considering the risk? Boeing has historically traded at anywhere from a 50% discount to a 50% premium to the S&P 500 aggregate price-earnings multiple. Since the index multiple is around 16 and Boeing's multiple is at 25, it's now trading at a 55% premium. Were the multiple to contract to parity with the broad market and earnings were to come in at consensus 2006 estimates, shares would be worth $56, or 35% less than the current quote. And if the schedule slips and the company disappoints on earnings, well, sky-high is not the word that would be used for either the multiple or the price. Personally, I'll take an aisle seat in coach.

And one last note: If the Boeing story falls apart, also look for fallout in the shares of the many public companies that supply components as well, including Titanium Metals ( TIE), carbon fiber composite maker Zoltek ( ZOLT), cabin maker BE Aerospace ( BEAV), parts maker Precision Castparts ( PCP) and LMI Aerospace ( LMIA).

Boeing has a great corporate Web site. Many international airlines are offering Connexion service, which is wireless broadband in the sky. Learn all about the Dreamliner here. It sounds like a great plane, with state-of-the-art acoustics, new lighting, built-in broadband connectivity, wider seats and aisles, extra-large overhead bins and big windows.

At the time of publication, Markman held no positions in stocks mentioned, although positions may change at any time.

Jon D. Markman is editor of the independent investment newsletter The Daily Advantage. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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