It is 100% fair to say that I’ve underestimated the rally in Boeing Co (NYSE:BA) stock. I went from bullish to bearish last summer, far too early in this unprecedented rally for BA stock.
And while I expect Boeing stock to keep rallying as the global economy continues to gain momentum, I also don’t think the party in this name can last forever. At some point, valuation will catch up to BA stock. At some point, competition will creep up and become more of a headwind than it currently is. And at some point, Boeing stock will drop.
But that point is not now. Right now, investors are hyper-focused on the tons of cash flow that will come through the Boeing door over the next several quarters. Right now, aerospace and defense spending is ramping up thanks to tax reform. And right now, Boeing stock will keep tracking higher.
I’m not bullish. But I’m also not bearish. This is a tax reform play. So long as tax reform optimism boosts corporate spending, Boeing will track higher. But once that tailwind is over, Boeing stock may be due for a big pullback as it stares at a historically high valuation without any major catalysts to boost investor enthusiasm.
How Boeing Got to Where It Is Today
When it was languishing around the $120 levels in early 2016 and trading at less than 10-times trailing EBITDA with a near 10% free cash flow yield, I thought BA stock was an attractive asset to own.
Boeing is the headline name in some high-moat, sustainable demand industries like defense and aerospace. The strength of the company’s moat and sustainability of demand for its product line-up was being undervalued at 10-times EBITDA. The 10% free cash flow yield was also compelling against a sub-2% 10-Year Treasury Yield.
But when Boeing hit $250 last summer, I thought the rally was on its last legs. The EBITDA multiple had climbed up to 13-times, notably higher than its trailing five-year average of 11. The free cash flow yield had sunk to 7%. The 10-Year Treasury Yield had crept up to around 2.3%.
I thought Boeing was ripe for a pullback. Expectations over higher spend in the defense industry from rising geopolitical tensions and higher airline spend thanks to a healthy pickup in air travel were already heavily baked into the stock price.
That pullback never happened. Instead, BA stock kept rallying. Then tax reform pulled through in late 2017, and Boeing went (even more) parabolic. Investors were buying up BA on the idea that with all this extra cash, airlines would start buying more planes and corporations would start sending their employees on more business trips.
Oh, and Boeing is a large tax payer with huge R&D credits, so it should benefit from a significantly lower tax rate (one analyst estimates a 12-14 percentage point dip to a high-teens tax rate). Moreover, BA is a capex-intensive business, and the expansion of capex depreciation from 50% to 100% will provide a big boost to cash flows.
So why is BA stock trading at a super low free cash flow yield, a super high EBITDA multiple, and still going higher? Because as 2018 numbers roll in, free cash flow will go up hugely, EBITDA will go up a ton, the free cash flow yield will rise, and the EBITDA multiple will drop.
Thanks to this, BA will continue to track higher in the near to medium term as tax reform optimism grips investors.
But at some point, the valuation on BA will catch up to it. Even if 2018 free cash flow jumps to $14 billion (higher than estimates), that would still only be a 7% free cash flow yield for a stock that has surged to all-time highs.
That is roughly in-line with the trailing five-year average, but interest rates are on the rise and nearing their highest level in five years. This makes BA’s 7% free cash flow yield look a lot less impressive.
Bottom Line on BA Stock
It is a great company with a stock that will keep rising so long as the market remains hyper-focused on tax reform benefits. That should last for another 6-12 months.
But after that, BA stock will likely experience weakness as valuation catches up to reality.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
