Boeing's (BA -2.87%) stock just had an exceptional quarter. It's up more than 56% over the past three months compared to an 8.5% rise in the S&P 500 index. At a share price of around $207, it sits on the cusp of reaching the Wall Street consensus target of $211. Meanwhile, heavyweight analysts at Morgan Stanley recently downgraded the stock, arguing that the valuation reflected the market pricing in the company achieving its 2025/2026 financial targets.
I think both the price target and the analyst downgrade are too pessimistic. Here's why.
Analyst downgrades Boeing to equal weight
In a nutshell, the Wall Street downgrade (to equal weight from overweight) is, in my view, a "sell" recommendation. I reason that it's superior, from a risk/reward perspective, to buy a broad-market index (through an ETF) rather than take on stock-specific risk by buying a stock (in this case, Boeing) that you think should be equally weighted.
The reasoning behind the downgrade is that the appreciation in the stock already reflects Boeing clearing regulatory hurdles that plagued the company in recent years (the 737 MAX and 787 are now back in production) and achieving the $10 billion free cash flow (FCF) target for 2025/2026.
I'm afraid I have to disagree with this thinking for two reasons:
- Hitting the $10 billion FCF target would likely lead to a substantive jump in the share price, so it's far from fully priced in by the market.
- Boeing has plenty of earnings growth catalysts; i.e., the investment case for the stock isn't just based on overcoming regulatory hurdles.
The $10 billion question about Boeing stock
The "financial objective" of $10 billion in annual FCF at some point between 2025 and 2026 implies FCF generation representing around 8.1% its current market cap. Put another way, if Boeing's stock price doesn't change (current market cap of $124 billion) it will trade on a price-to-FCF multiple of around 12.4 times FCF in 2025/2026. That's an excellent valuation. Still, it's worth considering the downside. For example, it will be at least two to three years before Boeing gets there, and a lot could happen between now and then. On the other hand, it's important also to visualize what Boeing will look like if it gets there.
To achieve $10 billion in FCF, Boeing will have avoided another series of multibillion-dollar cost overruns on defense projects while successfully ramping production of its narrowbody 737 and widebody 787 aircraft and starting production of its new widebody 777X.
If Boeing does those things, investors will see a company that's over its defense contract problems and hitting its commercial aircraft production targets. Moreover, Boeing will be looking to ramp them even further given the multiyear backlog it will still hold. Let's put it this way: Boeing aims to produce 50 737s a month in 2025/2026, or 600 a year, compared to a current backlog of 3,510 737 aircraft. Throw in the substantive amount of FCF, and Boeing stock is likely to trade at a significantly higher price -- a 20 times FCF multiple would put it around $340.
I also think that the current valuation suggests a healthy amount of skepticism is built into the share price, and it could climb a wall of worry if the company executes in line with management's expectations.
Plenty of catalysts coming for Boeing
Boeing's biggest earnings growth catalyst relates to the potential for supply chain and labor problems in the aerospace industry to ease through 2023 and onwards. It's no secret that the issues significantly held back production in 2022 -- not least from suppliers like General Electric, whose joint venture, CFM International, provides engines for the 737 MAX. It's an industry-wide problem, with key Boeing supplier Spirit Aerosystems struggling to provide aerostructures.
That said, the industry could find itself in a sweet spot in 2023 if slowing global growth makes hiring and retaining skilled workers more straightforward and takes the pressure off a supply chain already on track for improvement. Meanwhile, Boeing's backlog ensures it can grow revenue for many years.
Is Boeing stock a buy for 2023?
Suppose Boeing hits its financial targets (which implies it hits its operational targets). In that case, sentiment around the stock will be much more positive in the future, and a valuation rerating could follow. In addition, Boeing has plenty of potential to surprise on the upside in 2023 if supply chain and labor availability issues ease.
