Airbus: Unfairly Undervalued Amid Covid-19 Market Panic Sell-Off

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Airbus (OTCPK:EADSF) (OTCPK:EADSY) has become an attractive value investing opportunity amid the Covid-19 panic sell-off. Given the near term uncertainty, the market is pricing a scenario in which the company will deliver fewer aircraft recurrently into the future. At least, I expect that Airbus will eventually recover its current rate level of deliveries in two years from now, given its large backlog in the narrowbody market. Assuming that it will be able to maintain this level of earnings recurrently into the future would imply ~25% upside to current prices. However, plenty of upside (>50%) remains in the long term if the virus crisis proves temporal as: (i) at the current price it is not contemplated any production rate increase beyond the crisis period, (ii) the market is not currently granting a premium to its business despite its wide moat, and (iii) Airbus’ market share may continue to improve given the lack of competition in the long-range narrowbody niche market.

Context

The novel Covid-19 outbreak has triggered a massive sell-off in the stock market. In the last 30 days, both the S&P 500 and the EURO STOXX 50 has dropped ~30%.

The sell-off is indiscriminate, but anything related to aviation is being particularly affected due to the global lockdown measures established by governments. The International Air Transport Association (IATA) estimates a USD 252 bn loss of passenger revenues worldwide for airlines given that travel restrictions last for up to three months. According to the Centre for Aviation (CAPA), given the lack of cash reserves, most airlines would be bankrupt by the end of May.

Figure 1: Airlines’ balance sheet liquidity

Source: IATA Economics.

Despite a potential recovery in air traffic in the second half of the year, overall traffic growth (measured by global revenue passenger kilometers) would be negative for the first time after more than ten years of steady growth since the global financial crisis. The most concerning is that the short term impact will probably be worse than any other previous crisis as airlines’ revenues will virtually be zero as long as the pandemic is being contained.

Figure 2: Worldwide RPKs

Source: IATA Economics.

In this context, the market is panic selling every aviation-related stock (from airlines to manufacturers) regardless of the individual fundamentals of each company. Airbus has lost EUR ~50bn of its market cap in just a month although its short-term earnings do not depend directly on air traffic, giving long-term investors a great opportunity to buy a unique company at a very attractive price.

Figure 3: YTD price change

Data by YCharts

Source: YCharts.

Business analysis

Airbus is a European aerospace and defense company whose main business consists of developing, manufacturing and selling commercial aircraft (>90% of adjusted EBIT in 2019). It also manufactures and develops helicopters, military aircraft, and other defense solutions. It conforms a duopoly together with its US peer Boeing (NYSE:BA) that has remained unaltered since the 90s. In case you are wondering if such market structure leads to high returns, just take a look at the following graphs to get the answer.

Before the Covid-19 sell-off, Airbus’ total return for the last decade stood at ~600%. That’s an impressive 21% annualized return over that period vs the 12% annualized return achieved by the S&P500 in the same period.

Figure 4: 10Y Total return

Data by YCharts

Source: YCharts.

The duopoly incumbents are extremely well protected from new competitors given the plenty of barriers of entry in the sector. Developing, manufacturing and selling an aircraft is a very long, cash consuming process. First, you need to spend billions to develop the aircraft, set up the facilities and secure the supply chain. Then you need to get the regulatory certificate to operate which may take up to five years of compliance demonstration, according to the European Union Aviation Safety Agency (EASA). Besides, you need to secure a backlog from several airlines (which have high switching costs) and wait for another 2-3 years of production ramp-up just to achieve the break-even point. Overall, it may take 10 years to start to recover part of your initial investment.

Such high barriers are the main reason why the aircraft manufacturers earn some of the highest returns among the commercial aviation value chain.

Figure 5: Return on invested capital across industry value chain Source: IATA Economics.

Airbus gets the bulk of its revenues as it delivers aircraft to its clients. Though it may sound simple, it is an important statement to remember. Despite the increased correlation we’ve seen in the recent sell-off between Airbus and the airlines’ stock prices, their businesses are not directly exposed to the same risk factors.

Signing a purchase agreement to acquire some planes is not a decision that airlines make based on short term air traffic demand. It’s an important strategic capital allocation decision that is usually made to expand the operations into new routes or to renew its fleet to get more cost-competitive fuel-efficient aircraft.

More importantly, purchasing an aircraft involves a high level of commitment. When an airline signs an order to get Airbus aircraft, they agree on a delivery schedule for several years in the future which involves pre-delivery payments from the buyer until the final acceptance of the aircraft.

New orders may drop sharply during an economic recession as airlines postpone their capex decisions, but deliveries have proved to be quite consistent increasing steadily during the last 15 years. Even in 2009, deliveries growth turned out to be positive.

Figure 6: Orders, deliveries and backlog evolution

Source: company presentation.

Airbus has achieved average net orders of almost 1,000 units per year during that period which has turned into a 7,670 aircraft backlog today. That means that even if Airbus doesn’t get any new order, they could be delivering aircraft to clients at the current rate for ~8 years.

Airbus will not be immune from the Covid-19 air traffic potential recession this year, as production would likely be temporarily interrupted as it already happened in several facilities in China and Europe, some orders may be canceled, and delivery deferrals are likely to occur. But the point is to understand that its business is by far less cyclical than the airline’s business.

Looking beyond the potential air traffic recession and temporary production rate cuts this year, fundamentals remain strong for the core business of Airbus. At this point, we have to differentiate between the narrowbody (single-aisle) and the widebody segment (two-aisle) within the commercial aviation business. While the widebody market demand remains weak and both Boeing and Airbus have already announced production cuts in their respective programs. However, Airbus is fundamentally exposed to the narrowbody market through its best-seller A320 family aircraft and the A220. Last year, A320 deliveries were 642 units out of a total of 863 deliveries.

Figure 7: Backlog by program

Source: Company website and own elaboration.

The total fleet is expected to double in the next 2 decades with around 40k of new deliveries. Among then, ~70% would be single-aisle aircraft. For the next 10 years, the independent consultant Oliver Wyman estimates a 4.9% CAGR for the narrowbody market fleet. Airbus is positioned in the most promising segment of the commercial aviation market.

Figure 8: Global Fleet Forecast

Source: Oliver Wyman

The A320 family competes directly with the B737 of Boeing, which is now suffering from the grounding of the 737 Max since march last year. Despite limitations to increase the production rate in the short term, Airbus is gaining market share in this segment through new orders, which remain particularly strong for the A321 XLR (extra long range), as more low-cost carriers are getting interested in operating long-range routes using a single-aisle aircraft.

From 2011 to 2016, Airbus has been upgrading its product portfolio offering a new engine option version (NEO) for the A320 family aircraft and later also for the A330, replacing its previous CEO options for all the different models. These new aircraft re-engined with new powerful engines and fitted with sharklets are 15-20% more fuel-efficient than the CEO version.

The ramp-up of these new versions (increasing the NEO share in the deliveries mix) together with the ramp-up of the new A350 (which has achieved the break-even this year) is boosting Airbus’ operating margins.

Figure 9: EBIT by segment and EBIT margin

Source: Company annual reports and own elaboration.

The combination of power pricing from new models and the unit production cost decreases (benefiting from the learning curve and operating leverage) has allowed Airbus’ EBIT adjusted pre R&D per aircraft delivered (for the Airbus commercial segment) to increase from EUR 7.4M in 2013 to EUR 10.2M in 2019. Setting aside the next year, which will be exceptionally impacted by the coronavirus disruption effect, it is expected that this trend continues as Airbus has no plans to develop a new aircraft in the medium term and instead is focusing on benefit from its current backlog by increasing the production rates of its compelling aircraft.

Figure 10: Airbus commercial aircraft financials

Source: Company annual reports and own estimates.

Opportunity

Taking the adjusted EPS of 2019 to perform the calculations, Airbus has de-rated from ~24x P/E to ~ 11x P/E in just a month. What seemed to be a high-quality growth stock trading at a premium valuation, now has turned into a value investing opportunity. On 3/20/20, Airbus was already trading with a 23% discount relative to the Dow Jones Industrial Average Index P/E ratio. Given the uncertainty at this stage, the market seems to have overreacted selling first and asking later.

Can the pandemic start a long-term downtrend in the global air traffic?

I think the structural trend remains strong. GDP per capita growth in emerging markets is acting as a structural driver for global RPKs growth given its high correlation with the number of trips per capita. Each time in the history that this trend was interrupted by an external shock (oil crisis, 9/11, SARS, GFC, etc.) it was then followed by a rebound and eventually the air traffic growth rate returned to the long term growth trend (look again the chart in figure 2). Probably, this time will not be different. In China, the rebound is happening in domestic routes. According to The Economist, the capacity has already risen 50% from its low in February.

Will Airbus be able to deliver its aircraft in the coming years given that airlines are in survival mode?

Airlines will face a big liquidity crisis in the coming months but governments have clearly stated that they will support the industry through unprecedented measures. Not only by giving them liquidity but also buying equity stakes if necessary. The airline industry is pretty dynamic and eventually, it will likely recover from this shock with the proper support from Governments and Central Banks. In 2017, according to anna aero, a new airline was born every 3.5 days.

It’s important to note that before the Covid-19 crisis started, airlines were trying to add more capacity desperately, as demand was rising and the load factor was in a record high, also due to the grounding of the 737 Max. Airlines want the new planes, but they are now trying to defer every cash outflow until the coronavirus lockdown situation is clarified.

I expect no new orders for the rest of the year, as airlines will delay its expansion capex decisions, but deliveries should be less affected for the following reasons:

  • Airbus’ backlog would provide a cushion as it did in 2009. Some airlines which may be in a better financial position may take advantage of the situation and accept deliveries earlier than they previously expected. Airbus could redirect deliveries to other airlines that may be willing to accept the aircraft earlier to get a competitive advantage in the future. Some of Boeing’s customers may also be tempted to take Airbus’ aircraft given that now it is easy to get them quickly.
  • Typically ~40% of deliveries are for replacement purposes rather than capacity expansion purposes. Some airlines may accelerate old aircraft retirement and accept new aircraft without increasing its capacity.
  • Airbus has enough liquidity to provide better payment terms to its top customers until the situation improves.

Even if deliveries are much worse than expected, this is likely a temporary situation. Airbus can adapt its production rates for this year and the next one, and then resume the intended ramp-up in the narrowbody segment by 2022 when the demand has bounced back and the industry is in a better shape. In the meantime, as long as traffic recovers when the virus situation improves, replacement demand should drive Airbus deliveries at lower but improving rates.

At 11x P/E not only the market has removed Airbus from its high-quality stock list, but it is also assuming that deliveries will fall or stay flat at a lower level for several years in the future. If we consider that Airbus can deliver 850 aircraft in recurrence (which is less than it achieved in 2019), its normalized FCF should be ~EUR 5.2 per share (considering no further expansion capex). Assuming an 8% cost of capital and a residual inflation component growth of 1%, it would imply a ~EUR 70/share target price for the stock. That is consistent with applying 13.5x P/E to the normalized 2021 earnings to derive the fair value (scenario 2 below). However, I think that growth will come back in the future, and Airbus will likely recover the premium it deserves. Pricing 60% probability of occurrence for this scenario (scenario 1 below) give us >50% upside from the current price.

Figure 11: Airbus financials and base case valuation

Source: Company annual reports and own estimates.

What is the market missing?

So, at the current price below EUR 60/share, the market is pricing that Airbus will be delivering less aircraft than the last year, forever. Earning the same returns, forever. I think this is a quite pessimistic scenario which doesn’t take into account: (i) the long term expected growth in air traffic, (ii) the oligopoly structure, (iii) less capex requirement in the next years, (iv) the pricing power of Airbus’ new models, and (iv) the increasing market share of Airbus in the narrowbody market.

The last point is really important as Airbus has a monopolistic position in the long-range narrowbody niche market through the A321 XLR. The current crisis may prevent Boeing to compete against an aircraft which is having an impressive success as it allows airlines to offer low-cost transatlantic flights. We have already seen that some airlines are replacing their B757 fleet with the new A321XLR.

The bottom line

There is no doubt that Covid-19 is a worldwide challenge and it will have a huge impact the on economy as a global lockdown is needed to fight back against the virus. Eventually, the most probable outcome is that things go back to normal. Antiviral medicines will probably be created to treat the disease and a new vaccine will probably be discovered. This has already happened several times in history. In the meantime, intelligent long term investors should take advantage of short term volatility to buy high-quality stocks. If you are one of them and don’t imagine a future without air traveling, Airbus may be a great choice for your portfolio.

Disclosure: I am/we are long EADSF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Opinions, estimates, and projections constitute exclusively the current judgment of the author as of the date of this report.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.