We look forward to receiving Lakewood Capital’s investor letters every quarter. Anthony Bozza is a skilled short seller and he provides detailed write-ups in 3-4 companies in each newsletter. We will provide a detailed analysis of Lakewood Capital’s historical 13F stock picks in the coming issues of our monthly newsletter. In this article we will share excerpts from Lakewood Capital’s 2017 Q3 investor letter.
Lakewood Capital delivered a net gain of 3.9% during the third quarter. It is about 50% net long, so this is actually a better risk adjusted performance than the S&P 500 ETFs. The fund’s biggest contributors are Baidu, Adient, and Ally Financial but you don’t need to have access to Lakewood’s investor letter to figure out its best performing positions. You can check out its latest 13F filing to see the entire list of US securities it is invested in.
We want to share some of its new investment ideas in this article. Anthony Bozza believes Airbus is undervalued and on the cusp of delivering a 50% gain over the next couple of years. Here is what he said about the stock:
During the quarter, the fund initiated a long position in Airbus, a global manufacturer of aircraft and military equipment. The company has a roughly 50% share of the duopolistic commercial aircraft manufacturing industry, which is experiencing solid growth due to increased replacement demand, expansion at low cost carriers and growing air traffic, particularly in Asia. We believe Airbus’s earnings are currently depressed as it ramps up some key new programs, and a record backlog (the company is basically sold out until 2022) could drive significant earnings growth in the coming years and lead to a significantly improved valuation for the stock.
Airbus’s A320 family of narrow body aircraft represents the company’s biggest profit contributor. Recently, Airbus launched a new engine option for the A320 with improved fuel efficiency that generates 15% greater profits per plane. However, one of the two engine suppliers, Pratt & Whitney, has encountered challenges with the new engine type, causing delays in the delivery ramp. Based on our research, we believe the issues have been identified and will likely be fixed in the coming quarters. In the meantime, Airbus has been forced to sell additional older engine models at a discount, impacting near-term margins. Airbus should ramp production from 567 planes this year to 690 planes by the middle of 2019, and combined with higher profit margins, the A320 program should drive an incremental €2.25 of EPS for the company.
Additionally, Airbus has recently begun delivering a new, clean sheet wide body aircraft, called the A350, which is temporarily depressing earnings. Clean sheet aircraft are expensive to build with significant development costs disproportionately expensed in the early phase of the program, leading to large upfront losses. In 2016, Airbus lost €1.3 billion on the A350, but as deliveries continue to ramp and upfront costs subside, the company should break even within three years. Longer-term, we believe that the A350 can make around €18 million per plane, which would generate €2 billion of EBIT or roughly €2 per share after tax.
Finally, the company’s true earnings power is being masked by its foreign exchange hedging program. While Airbus sells planes in dollars, a portion of its cost base is in euros. Airbus manages this mismatch by aggressively hedging its currency risk for several years forward. For example, Airbus has hedged its 2017 production at 1.29 dollars per euro versus the current spot rate of 1.18 dollars per euro, but using current exchange rates, earnings would increase by roughly €1 per share.
As Airbus meaningfully grows revenues and profits in the coming years, we are hopeful that shareholders will view the company more similarly to its close peer Boeing (whose shares have gained around 100% in the past year). Despite having a relatively equal market share, Boeing has twice the enterprise value of Airbus. Based on the drivers detailed above, we expect Airbus to generate roughly €8 per share of earnings in 2020 with visibility to higher earnings power in subsequent years as the A350 goes from breakeven to normalized profitability. At a multiple of only 15x forward earnings (a sizeable discount to Boeing and a conservative valuation considering the company’s net cash position), we believe Airbus will be worth €120 per share, or 50% above the current price, in approximately two years.
Basically, Bozza is counting on a 20+% increase in production over the next couple of years, increased profitability of A350, and no losses from currency hedging. Are these developments likely to happen and will they lead to a 150+% increase in Airbus’ earnings in the next 2 years? It seems too ambitious as engineering problems aren’t always easy to solve and currency markets are unpredictable. Nevertheless, Airbus seems undervalued with respect to Boeing so it is definitely worth a look.