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Morningstar | Bombardier Tracking to 2018 Expectations; We’re Shifting Our Focus to 2019 and Beyond

The turnaround continues at Canadian industrial conglomerate Bombardier, which reported second-quarter results featuring higher revenue, expanding margins, and improving cash flow. We think management is tracking to the deconsolidated C Series guidance it unveiled earlier this year, which calls for operating profit, or EBIT, before special items of about $950 million and break-even free cash flow. Based on this quarter's performance and management's initial outlook for 2019, we're planning to move up our CAD 4.40 fair value by around 8%.

With 2018 performance meeting expectations, we're shifting our focus to 2019 and beyond. We think 2019 will feature higher profits helped along by increasing revenues and modest margin expansion at transportation combined with C Series deconsolidation. Our 2019 forecast currently calls for $1.4 billion of EBIT before special items. Capital expenditures should fall, as development programs ramp down. As a result, free cash flow usage should improve, and we are forecasting just under $400 million in free cash flow (operating cash flow less capital expenditures) for 2019.

Despite the growth in consolidated earnings, business aircraft will experience margin pressure due to the ramp on the Global 7500 and we think this business will likely be at the low end of management's long-term EBIT margin range of 8%-10%; we're at 8.1% margins for business aircraft in 2019. In the transportation business, management believes it's already 70% through its transformation plan, so we’re not anticipating a jump in margins, but we are forecasting some expansion on the back of mix improvements (more services and signaling) and more efficiencies.

From mid-February 2019 on, Bombardier has the right to repurchase the roughly 30% stake in its transportation business that it sold off to Caisse de dépôt et placement du Québec in 2016. Based on the terms of the deal, we estimate it would cost Bombardier at a minimum $2.3 billion to repurchase the stake.

Ideally, we'd like to see management gain full operational control over the transportation business, noting that it will have about $3.5 billion of cash on the balance sheet by end of 2018 and doesn’t face any debt maturities until 2020. We hope to receive additional insights into management’s plan vis-à-vis the Caisse's transportation stake at the upcoming investor day scheduled for December.

Turning back to this quarter, Bombardier closed the sale of its Downsview manufacturing facility, netting $600 million (about $50 million more than management was initially expecting) in the process and recording an $561 million accounting gain. The Downsview sale further shores up the company’s balance sheet and ability to handle its debt load that still stood at 7.7 times adjusted EBITDA at quarter-end. Bombardier faces $850 million of refinancing in 2020 and $2.3 billion in 2021. On the C Series the company took a noncash charge this quarter of $599 million ($535 million after tax) linked to the sale of 50.01% of the program to Airbus. Both the C Series charge and the Downsview gain are excluded from EBIT before special items.

Bombardier delivered 34 business jets in the quarter, down from 36 last year due to two fewer Global jets this quarter. The business aircraft unit continues to post solid operating margins, registering 8.5% EBIT before special items this quarter boosted by higher margin services revenues (up 21% year over year in the quarter). Global 7500 certification is insight followed by service entry and due to the 7500 production ramp (15-20 aircraft delivered in 2019), we're anticipating business aircraft EBIT margins in 2019 to fall toward the bottom end of management's long-term guidance range of 8%-10%. Backlog was up in business jets and management remarked on its call that it sees the strongest demand at the high end of the market. But we don't think this is indicative of broader trends in demand patterns because Bombardier's Learjet offering isn't as competitive as its high-end jets.

During the quarter, commercial aircraft delivered 18 aircraft (8 C Series, 5 CRJs, and 5 Q400s) and before special items the unit narrowed its loss to negative $66 million up from negative $118 million. Bombardiers’ regional jet offering, the CRJ, racked up some orders recently and backlog now stands at about three years of annual production. Based on management comments, we believe Bombardier will likely move up CRJ production in 2019. At the same time, Bombardier needs to improve profitability in its regional jet manufacturing business. Indeed, even with the deconsolidation of the C Series and only 33.55% share of the losses going into EBIT, commercial aircraft is likely to still register negative $110 million of operating profit during the back half of the year. Looking further out, management had previously said that C Series would be break-even by 2020 and the overall commercial aircraft business would be profitable in 2020. With the deconsolidation of the C Series, margins and profits should automatically move higher for 2020. We're anticipating some color at the upcoming investor day on long-term commercial aircraft targets under the new C Series ownership structure.