Here’s the deal that could decide Boeing’s future

from Boeing (BA 2.03%) The most important business is Boeing Commercial Airplanes ( BCA ), which is likely to remain so for the foreseeable future. However, in an election year, investors will understand the concept of the swing factor, and in Boeing’s case, its defense segment, Boeing Defense, Space & Security (BDS), is extremely important. Here’s why.

BDS should be a major cash generator

To understand the full significance of BDS, it is essential to go back to the investor day presentation in November 2022, when management set a target of $10 billion in free cash flow (FCF) in 2025/26. At the time, management was estimating $3-5 billion in FCF for 2023 (the actual figure was $4.4 billion), rising to $10 billion.

Boeing outlined the following targets (see table below) for growFCF will reach USD 10 billion in 2025/2026.

I won’t dwell on the production ramp issues at BCA, which have been covered elsewhere, and there has been some positive news lately. Focusing on BDS, it’s clear that management’s plans involve a significant turnaround of the business, but unfortunately, it’s not happening yet.

Data source: Boeing presentations.

Boeing’s defense business

The November 2022 guidance made the following assumptions:

• There would be a return to single digit profit margins and strong cash flow.
• Boeing will pass key milestones (de-risking programs) for three of its four troubled fixed-price development programs in 2024.

Boeing management likes to talk about its defense business in three buckets. The former, accounting for 60% of revenue, is its core business, which already enjoys mid- to high-digit profit margins. The latter, which accounts for 25% of revenue primarily from combat and satellite programs, is improving, with CFO Brian West noting in the second quarter results that “the quarter again saw improved margin trends.”

Image source: Getty Images.

However, 15% of business in fixed-price development programs is causing billions of dollars in losses for the company. There are four particularly problematic programs:

• T-7 Red Hawk trainer aircraft.
• MQ-25 Stingray aerial refueling drone.
• KC-46 Pegasus aerial refueling aircraft.
• VC-25B Air Force One.

The original plan called for the MQ-25, KC-46 and VC-25B to pass key risk reduction milestones in 2024. Management says they are working on the milestones and “game plan to bring BDS back to high single-digit margins. medium to long term remains unchanged,” West said on the latest earnings call.

However, recently departed CEO Dave Calhoun said he was “cautiously optimistic about the long-term prospects of our defense business.” His caution is warranted given the recent history of BDS.

As the chart below shows, BDS has been nowhere near high single-digit margins in recent years and has reported fees and losses for all of these problematic programs. 2024 losses so far include $519 million on the KC-46 and losses on the T-7 and VC-25B.

Data source: Boeing presentations.

A structural problem?

BDS issues might not be so worrisome if other defense companies didn’t have similar problems. from Lockheed Martin CEO Jim Taiclet has previously addressed the issue, arguing that “we’re in a monopsony environment,” meaning “there’s only one buyer” for “almost everything” for the big defense manufacturers, and they’ve “taken advantage of that monopsony power. , if you will, across the industry.

RTX It also continues to experience margin pressure in its defense business, and the company recently decided to end a fixed-price development program and a program with a foreign customer that takes a $0.6 billion charge in the second quarter and a negative impact of $0.5 billion in FCF in 2024. .

Image source: Getty Images.

Where next for Boeing’s defense business?

The glass-half-full view accepts the problems of recent years, sees Boeing scrambling to de-risk these programs as it marches toward high single-digit margins in BDS, and takes heart from the 85% of BDS revenue that performs adequately .

The glass-half-empty view sees the margin problems of fixed-price development programs as a structural problem that will not go away, not least given the rising level of sovereign debt. As such, long-term expectations for margin performance and earnings among major defense contractors may need to be revised downward, including BDS.