Strategic financial management principles and practices

¶ … market capitalization of 23.011 billion, Boeing is the nation's largest producer of commercial aircraft and the world's leading aerospace company. It operates in four principal segments: Commercial Airplanes, Military Aircraft and Missile Systems, Space and Communications, and Boeing Capital Corporation. As the world's market for air travel fluctuates with the risk of war, so do Boeing's revenues. However, as the United States moves towards a footing that may include future wars against perceived 'terrorist states,' Boeing stands to gain from military aircraft and weapons production. As such, it intrigues investors as its market is a careful reflection of the front pages of the world's newspapers.

To successfully evaluate Boeing's stock, we must analyze its fundamentals and the performance of comparables, as well as market performance. A projection of future revenues is necessary, along with an estimation of the cost of capital with which Boeing produces. These allow us to provide a Discount Model-based analysis of Boeing's performance based on revenue projections provided by the company. Such metrics may include a traditional two-staged Dividend Discount Model, along with variants on this model including the Free Cash Flows to Financing and Free Cash Flows to Equity. This may provide us with a more adequate understanding of the company's solvency. Boeing competes with Airbus and several other manufacturers of commercial jets, and its P/E and other ratios can be measured against comparables. These models should be familiar as knowledge of them is required for a Chartered Financial Analyst designation. This report will also contain an analysis of the company's Strenghts, Weaknesses, Opportunities, and Threats as these pertain to its revenue stream and borrowing power.

Strengths:

The company cites "technical excellence" and "innovation" as its key strengths. Its research and development firm, Boeing Phantom Works, is responsible for developing new technologies and disseminating them across the company. Boeing is the only large producer of passenger aircraft in the United States, and also produces aircraft for military use. The United States Department of Defense, with a budget of between 350 and 400 billion dollars a year, represents nearly 50% of the world's defense budget, and is the principal customer of Boeing's Military Aircraft and Missile Systems segment.

Weaknesses:

The market for commercial jets is determined by the volume of passenger air travel. Principal factors that underlie long-term growth in air traffic are sustained economic growth in developed and emerging countries, and political stability. Other notable factors are airline industry profitability, world trade policies, government-to-government relations, environmental constraints, technological changes, and price and other competitive factors. (10-K, 2/03) This market was negatively affected by the recession and September, 11th terrorist attacks and continued to decline through 2002. Boeing's market performance has reflected weaknesses in the airline industry. It should be noted, however, that Boeing enjoys an international market for its aircraft and fluctuations due to political instability are only partially experienced by markets outside the United States

Opportunities

Defense: According to Boeing's latest SEC filing, "Events like nuclear proliferation in North Korea, Operation Enduring Freedom and the continued war on terrorism, highlight the fact that our National Security goals are not rhetorical." It goes on to list military aircraft it produces that may and have been used in armed conflict: "The Company is continuing to invest in business opportunities where it can use its customer knowledge, technical strength and large-scale systems integration capabilities to shape the market. Current major developmental programs include the F/A-22 Raptor, V-22 Osprey tiltrotor aircraft, C-130 Avionics Modernization Program (AMP), the RAH-66 Comanche helicopter and the Unmanned Combat Air Vehicle (UCAV)." The Presidential cabinet is dominated by hawks or 'chicken hawks;' mostly political leaders who have vested interests in international conflict ranging from the reconstruction of countries and structures (Vice President Cheney, former CEO, Halliburton) to oil exploration (National Security Advisor Condoleeza Rice, ExxonMobil Director.) Although according to Boeing, "allocations to DoD procurement are unlikely to increase significantly," there is promise that these leaders will continue to allocate resources for the invasion of small, poorly defended countries.

Counter-terrorism: Boeing is currently working on experimental unmanned aircraft for use in espionage. Given the continued commitment by the governments of the United States and Israel to fighting terrorism, these units should prove effective in the establishment of an unmanned, anti-personnel air force.

Threats

Political instability: The Iraq conflict and SARS epidemic have recently hit the airline industry as well. By appointing a new CEO, one of America's largest carriers, American Airlines, barely avoided bankruptcy this month. Many summer flights have so far been cancelled because the war in Iraq was expected to last longer. Concerns over pilot safety recently prompted many airlines to train their pilots to use handguns.

The SARS Epidemic: According to Byron Callan of Merrill Lynch, the potential impact of SARS would extend beyond civil aircraft demand for airlines serving Asia. "If SARS proves to be a more significant factor affecting the U.S. And other international economies, its ramifications could include far higher U.S. federal budget deficits and weaker corporate profits. Higher budget deficits could negatively impact outyear U.S. defense spending projections, which in turn could impact defense company earnings growth rates and valuations."

Boeing's Debt

Any company that wishes to experience growth must regularly finance throught debt. This is because debt allows a company to invest in Net Present Value-positive projects. The company has 15.008 million in debt. This debt ranges in interest payments from 0% to 8.750% Most of the debt seems to be in the 6%-7.5% range, and has various expiration dates lasting until 2031. According to the compay's 10-Q, it has $4,500 currently available under credit line agreements with a group of commercial banks.

According to Business Week, on May 15, 2003, Standard & Poor's Ratings Services lowered Boeing's ratings, including lowering the long-term corporate credit rating to 'A' from 'A+', as well as on its subsidiary Boeing Capital. Combined rated debt for both entities is about $14 billion. A corporate debt rating of A implies that the company may borrow at approximately 5.99% interest in today's market. We will assume that this is the rate of debt financing when we calculate the Weighted Average cost of capital. Boeing's credit protection measures, not including obligations to pension funds and retirement engineers, (at Dec. 31, 2002), are strong for the rating. Standard & Poor. Some estimates debt-funding in expenses expected to become about 75% in 2003.

Although Business week is expected to improve its revenues over time, the credit profile reveals the fears of investors that consumer Airlines are frightening investors from Boeing. Business Week states that "when adjusted for the underfunded postretirement liabilities, "book equity is largely eliminated, employing Standard & Poor's current methodology, with a significant adverse impact on other credit measures." (Business Week, 5/15/03.) Moreover, the question of pension funding could become a legal issue as well as a material issue of cash in future years.

Regardless, Standard & Poor's expects that Boeing's cash flow will remain energized and sufficiently covering operating needs, sizable R&D outlays, pension contributions (discretionary in 2003 and about $1 billion required in 2004), payments for benefits other than pensions ($440 million in 2002), dividends (about $575 million), and customer financing requirements. Free cash flow is expected to grow. It will be $2.0 billion-$2.5 billion in 2003 and over $2.5 billion in 2004, net of pension contributions. Businessweek concludes that "The very challenging operating environment in commercial aerospace and concern about the sizable underfunded postretirement liabilities should be mitigated to a significant degree by improved growth prospects for Boeing's defense operations, substantial cash generation, and good liquidity." (Business Week, 5/15/03.)

Investor's Recommendations

Of the Analysts covering Boeing, 5 rate it as a buy, 3 as a strong buy, 11 as a hold, and ony one as a sell (Yahoo Finance.) On a scale of 1-5 where 1 is a Strong Buy and 5 a strong sell, Boeing is currently rated a 2.7, placing it between buy and hold. Its industry (Aerospace and Defense) is rated at a 2.31, its sector (Capital Goods) at a 2.65, and the WSJ mean is at a 2.48, whereas the S&P's mean is at 2.58. This indicates that investor's expectations of Boeing is that it is not as worth buying as other simmilar companies.

Comparables

Based on the assumtion that the S&P 500 reflects the market rate of return, Boeing's Beta is.66. The Beta of its industry (Aerospace and Defense) is.47 and that of its sector is.67. As with the beta of each, Boeing is performing in line with its industry rather than that of its sector. Its P/E ratio is also in line with that of its sector, reflecting that Boeing is considered priced more simmilarly to other companies that produce capital goods rather than industries in the aerospace sector. This indicates that it is a better buy, but may also indicate that Boeing's sector is growing at a faster rate. The P/E ratio of S&P is considerably higher, which may indicate that the S&P has more opportunities for growth than Boeing.

Business Week conjectured that Boeing's favorable performance in comparables might be due to the unfunded mandates of its pensions. As is, the company has a favorable Price to Sales ratio of.47 compared to.79 for the industry,.96 for the sector, and 3.14 for the S&P. The company's price to book ratio is higher than that of the industry or sector, indicating wide-scale brand recognition. However, the S&P faired considerably better. The Price to cash flow analysis revealed that the industry was performing slightly better than Boeing. One method of comparing prices is to multiply Boeing's earnings by a competitor's P/E ratio. Unfortunately, this does not provide much insight as EADS, the company that owns 80% of Airbus, is reporting negative earnings. However, when compared to other Aerospace industry equities, Boeing is a good buy in light of its low beta.

All of these indicators reflect what we already know of Boeing. Although it is competitively priced and offers dividends, the company is faced with the prospect of a market for commercial airplanes that evaporates overnight. In addition to the threat of terrorism, there is SARS and the inability of Boeing's traditional partners to upgrade their fleets to the newest standards due to razor thin profit margins.

Valuation Ratios

Company

Industry

Sector

S&P 500

P/E Ratio (TTM)

P/E High - Last 5 Yrs.

P/E Low - Last 5 Yrs.

Price to Sales (TTM)

Price to Book (MRQ)

Price to Tangible Book (MRQ)

Price to Cash Flow (TTM)

Price to Free Cash Flow (TTM)

NM

It is uncertainty that has hindered Boeing's stock from matching or exceeding comparables. The strict market hypothesis holds that any new information is immediately priced into the value of the equity. However, the euphoria of the late 90's has proved to us that this may not always be the case.

Free Cash Flows.

There are several accepted ways of measuring free cash flows. One kind, Free Cash Flows to Equity, measures the cash flows that are left after debt and the repayment of premiums. Another, Free Cash Flows to the Firm, concerns itself with money that services debt and equity and discounts future cash flows at the weighted average cost of capital. This is insightful, as it allows us to create a discount model in order to value a stock in a way that avoids the necessity of making assumptions about the nature of dividends in developing a discount model. These models all assume that the price of the company is equal to the present value of all future cash flows.

Free Cash Flow to Equity is calculated as Net Income - (Capital Expenditures - Depreciation) - (Change in Non-cash Working Capital) + (New Debt Issued - Debt Repayments). This is often simplified as = Net Income - (Capital Expenditures - Depreciation)(1 - a) - (a Working Capital)(1-a) where one minus alpha is the debt to equity ratio. Free cash flows are discounted back to the present at the cost of equity as determined by the cost of equity, which is determined by the capital asset pricing model. This is the company's beta times the difference between the market rate of return and the risk free rate. The two-stage model of a FCFE-based discount model would add future cash flows for several years of growth to a future price divided by the difference between Boeing's growth rate and cost of capital multiplied by one plus the discount rate each year separating the future price from that of the present. However, if growth is thought to be constant, one may merely divide the current free cash flows by the difference between the growth rate and the cost of capital. When we do this, we find the prospective price to be 42.73. However, one may argue that Boeing's beta does not take into account national security issues.