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The Boeing Company (NYSE:BA)

Q3 2006 Earnings Call

October 25, 2006 10:30 am ET

Executives

Jim McNerney - Chairman, President, and Chief Executive Officer

James Bell - CFO

David Dohnalek - IR

Tom Downey - Communications

Analysts

Byron Callan - Prudential Equity Group

Howard Rubel - Jefferies

Heidi Wood - Morgan Stanley

Cai van Rumohr - Cowen

Joe Campbell - Lehman Brothers

Doug Harned - Sanford Bernstein

Steve Binder - Bear Stearns

Robert Spingarn - Credit Suisse

George Shapiro - Citigroup

Ronald Epstein

Robert Stallard - Banc of America

Joe Nadeau - JP Morgan

Troy Lahr - Stifel Nicolaus

David Gremil - Thomas Wiesel Partners

Myles Walton - CIBC

Peter Jacobs - Wells Fargo

Gary Liebowitz - Wachovia Securities

Paul Marion - Chains Chicago Business

Journalists

Lynn Lunsford – The Wall Street Journal

James Wallace - Seattle Newspaper

John Liang - Inside Defense

Paul Marion – Cranes Chicago Business

Dominic Gates – The Seattle Times

Operator

Good day everyone and welcome to the Boeing Company's third quarter 2006 earnings conference call. Today's call is being recorded. The management discussion and slide presentation, plus the analyst and media question-and-answer sessions are being broadcast live over the Internet. At this time, for opening remarks and introductions, I'm turning the call over to Mr. David Dohnalek, Vice President of Investor Relations for the Boeing Company. Mr. Dohnalek, please go ahead.

David Dohnalek

Thank you very much. Good morning and welcome to Boeing's third quarter earnings call. I am Dave Dohnalek. With me today are: Jim McNerney, Boeing's Chairman, President, and Chief Executive Officer; and James Bell, Boeing's Chief Financial Officer. After comments by Jim and James about our performance and our outlook, we will take your questions. As always, we have provided detailed financial information in the press release issued earlier today. As a reminder, you can follow today's broadcast and slide presentation on our website, at boeing.com.

Before I begin, we need to remind you that any projections and goals we may include in our discussions this morning are likely to involve risks, which are detailed in our news release, in our various SEC filings, and in the forward-looking statement at the end of this web presentation.

Now, I will turn the meeting over to Jim McNerney.

Jim McNerney

Thank you very much, David, and good morning, everybody. Let's get started by turning to our third quarter summary on slide 2. Boeing delivered strong results in the third quarter with revenues and core earnings per share growing at double-digit rates.

The productivity improvements we are making and the significant increase in commercial airplane deliveries generated our strong performance. This strong performance is allowing us to offset most of the connection charge and raise our outlook for 2007, which I will discuss in just a second.

We expanded our backlog again this quarter to a new record level of $229 billion, driven by the continued strong demand for our market-leading commercial airplanes, especially the 787 Dreamliner. We also expanded our services business during the quarter with strong organic growth supplemented by the acquisition of Aviall, which will accelerate our growth and enhance our capabilities in the aviation services market.

In August, our Board approved a new $3-billion share repurchase program, an important element of our balanced cash deployment strategy. With this strategy, we continue to deliver value to customers and to shareholders by investing in our growth and returning capital to investors. Today, we have adjusted our EPS forecast for '06 to reflect the previously disclosed charge of $0.25 per share to end our Connexion Service. However, we expect to largely offset this with additional performance improvements across the business totaling about $0.20 per share.

For 2007, we have raised our EPS guidance by $0.20 per share to reflect the discontinuance of our investment in Connexion and the earnings contribution from our Aviall business. As James will elaborate in just a second, our new guidance includes higher forecast R&D expense this year and next, but we expect to offset that higher expense with additional companywide performance improvements.

To put it altogether, I believe Boeing continues to be well-positioned in its markets. We expect our commercial airplanes business will drive strong enterprise growth over the guidance period, while our integrated defense systems business will general excellent profitability in a moderating defense budget environment.

I am proud of the efforts and the results I am seeing across the Company. We are making solid progress in driving growth in productivity, and we have strong momentum. Now, I will turn it over to James, who will take you through the numbers.

James Bell

Thank you, Jim, and good morning. Well, let's start with an overview of our operating performance for Q3, beginning on slide 3. Our revenue grew 19% in the quarter, driven primarily by increased deliveries of commercial airplanes. Reported EPS for the quarter was $0.89 per share, which includes the previously disclosed charge of $0.22 per share for Connexion. Adjusted EPS was $1.11 per share compared to $0.33 per share last year, when our financial results were affected by the IAM strike and include meaningful benefits from tax and a divesture. Our businesses are running well, and our core EPS growth is strong.

Now, let's review our business unit performance on the next slide. Our commercial airplane business is benefiting from a product strategy that's keenly focused on our customers as well as a commitment to continuous productivity improvement. Revenues for the third quarter rose 45%. and BCA's operating margins expanded to 9.7%, despite higher R&D expense.

We delivered 100 airplanes in the quarter, a 61% increase over the same period last year, which as I noted earlier was affected by the strike. These numbers reflect our success in working with our global partner network to efficiently increase production rates across the entire value chain, while at the same time managing for profitability.

We captured 243 airplane orders during the quarter, and our year-to-date order total has grown to 760 airplanes. Our success in the marketplace has enabled us to continue increasing our very large commercial airplane backlog, while at the same time increasing our production rates. BCA's backlog has grown to a record $154 billion or more than five times current annual BCA revenues.

The 787 Dreamliner continues to make great progress with customer orders. As of today, we have won firm orders for 432 Dreamliners from 34 customers around the globe. We also achieved important development milestones on the program, as we prepare for flight tests next year and entry into service in 2008. During the third quarter, we began flight testing of the large cargo freighter, a key enabler of our production system, which will transfer major composite structures for the 787 program from around the world. We also achieved our first shipment of a major assembly between supplier partners. The 787 program continues to experience pressure with respect to weights and supplier implementation. We are raising our R&D forecast to reflect these increasing pressures as well as modified and increased scope on the 747-A program, as we act on customer feedback to optimize this airplane.

The increase in total company R&D reflected in our new guidance is expected to be offset by performance improvements at our other businesses. We continue to expect that the 787 and the 747-A will be delivered on time and in accordance with our contractual obligations.

Turning to our commercial airplane service business. We completed the acquisition of Aviall during the quarter, which will enhance growth and performance in both BCA and IDS businesses. We also announced an agreement to acquire C-Maps, a service that will accelerate growth in our navigation data service businesses. Other milestones we achieved during the quarter included the delivery of the 2,000th 737 next generation airplane and the successful first flight of the new 737-900 ER.

We expect BCA margins to moderate in the fourth quarter due to the timing of costs and the absence of supplier participation payments to offset R&D expense. Despite lower margins in Q4, we expect BCA's full year margin to exceed 9%, which is consistent with our current guidance. And we also expect BCA margins next year to exceed 10%. Clearly, our commercial airplane business is performing very well in a strong demand environment.

Our Integrated Defense Systems business had an outstanding quarter delivering strong financial performance, winning important new business, and completing key program milestones. IDS generated $7.8 billion in revenues and 11.3% operating margins, driven by strong performance in our precision engagement and mobility systems segment.

During the quarter, IDS won the contract to provide the Secure Border Initiative network to the Department of Homeland Security. We received support in the fiscal year '07 defense bill for additional C-17s and for Apache and Chinook helicopters. We are seeing an increased priority for the tanker replacement program.

IDS achieved major program milestones during the quarter. Our ground-based missile defense program had another successful flight test. The future combat systems program completed its milestone review in great shape. And the KC-767 tanker boom was successfully flight tested. Finally, we received FTC anti-trust clearance on the proposed United Launch Alliance joint venture. We're hopeful that that we will complete this transaction in the fourth quarter. IDS continues to deliver strong profitability over its diverse portfolio of development, production and support programs in an environment of moderating growth.

Boeing Capital's earnings increased sharply, to $122 million in the quarter, driven by gains from asset sales underpinned by strong operating performance. The aircraft financing market is healthy, and BCC is executing well on its mission to support Boeing's core businesses, while managing its portfolio size and risks. BCC has returned nearly $300 million in cash dividends to Boeing so far this year.

During the quarter, we announced that we would discontinue our Connexion service by year end and take charges totaling approximately $320 million in the second half of 2006. The process is going as expected and resulted in a charge of $0.22 per share in the third quarter. We expect a charge of about $0.03 per share in the fourth quarter of this year. This decision will add about $0.15 per share to EPS beginning in 2007, and we have updated our guidance to reflect this.

Now, turning to our balance sheet on slide 7. We continue to enjoy outstanding balance sheet strength and liquidity. We ended the third quarter with over $8 billion in cash and liquid investments. Major uses of our cash in the quarter included approximately $2.2 billion to complete the Aviall acquisition; $615 million to pay the previously disclosed legal settlement; and nearly $100 million in cash payments for the Connexion termination. Our corporate debt levels decreased about $400 million to reflect the elimination of Connexion capital leases. Boeing's credit quality is strong, and our credit ratings remain among the highest in our industry.

So moving on to cash flow on slide 8. Our cash flow generation remains very strong. We've increased operating cash flow to $560 million in the quarter, and that's even after making the $615 million legal settlement payment I mentioned earlier. This cash performance reflects strong earnings, another excellent quarter of airplane orders, and solid working capital management.

Also during the quarter, we repurchased 8 million Boeing shares, paid a dividend, reduced debt, and continued to invest in our growth programs, all of which are consistent with our balanced cash deployment strategy. We completed our pension year at the end of September, and we had another very good year of performance. Most notably, our preliminary assessment indicates that our pension plan is now fully funded on a PBO basis, which is an important achievement. The assets in our plan earned more than 10% this year ad we contributed over $500 million of cash to the plans during the past nine months, which helped to achieve this important milestone.

Now, looking to our 2007 pension year. We expect to use a slightly lower rate of return assumption of 8.25% to reflect asset allocation changes that will serve to reduce expected volatility in plan returns. We expect our discount rates for 2007 to be approximately 6%. As a result, we continue to forecast pension expense for 2007 to be around $1 billion. Required cash contributions going forward are expected to be very modest. With the new FASB rules on pension and retiree medical accounting taking effect at the end of this year, we expect our book equity to be reduced by approximately $7 billion. We do not expect any material impact on our business from this new accounting rule.

Now, turning to slide 9, and I will go through our financial outlook. We have adjusted our financial guidance to reflect the Connexion termination, the Aviall acquisition, higher R&D, and increased operating performance across the business. We've raised our revenue guidance for this year to the top end of our previous range due to the Aviall acquisition that closed in September. Our EPS forecast for this year now reflects the charge for Connexion totaling $0.25 per share, offset by meaningful performance improvements in our businesses totaling $0.20 per share. Our 2007 revenue guidance now includes the benefit of the Aviall transaction, somewhat offset by lower revenue growth at IDS than previously forecast.

We have increased our 2007 EPS guidance by $0.20 per share, due mainly to Connexion and the earnings benefit from Aviall. Included in this new guidance is the increase in R&D related to BCA new airplane development. But that R&D increase is offset by our expected performance improvements across our business. We have provided a schedule showing our previous EPS guidance to our current guidance here on slide 10.

Now, with that I will turn it back to Jim for some final thoughts before we take your questions.

Jim McNerney

Thank you, James. Let me sum up by saying that we delivered a strong quarter, and we're positioned to deliver the financial results we are forecasting for '06 and '07. Our businesses are healthy, and our outlook continues to improve. Throughout the organization Boeing has relentlessly focused on delivering value to our customers and our shareholders with businesses that are leaders in their markets. As we continue to do that, we will achieve the strong growth and productivity we're expecting, and we will position ourselves as the preferred global aerospace partner for customers around the world.

Now with that, we would be happy to take your questions.

Question-and-Answer Session

Operator

And our first question comes from Byron Callan - Prudential Equity Group.

Byron Callan – Prudential Equity Group

Yes. Good morning, gentlemen. I am wondering if you can address the specific changes in R&D guidance. What changed since last July?

Jim McNerney

I think I would characterize what we're doing here as pretty aggressive contingency planning. We are at that point in the development program where weight remains a dogged issue. We know what we have to do. Suppliers occasionally need help, and what I am trying to do along with the BCA team is put a contingency plan in place.

Just to give you some context, we have got eight contingency plans that we're looking at. We've funded one right now. We're trying to get out ahead of it just in case. This program has been characterized from the very beginning as a program that cuts across all boundaries within our company and across our company and to other companies that are our partners. We have one database, common tools and processes. We see everything, and what we're trying to do is as we go through this, just be as conservative as we can be; and there is a fair amount of conservatism built into this. We know how to build this airplane. This plane will be done on time and will be done within contractual commitments.

The other point I would make is that half of this increase we're talking about -- obviously I was talking about the 87 -- is for the 747-8 where as we talked to customers, we had some modifications we made to that airplane, and we got at that early, before we really got into the major development.

Operator

Thank you. Our next question comes from Howard Rubel - Jefferies.

Howard Rubel - Jefferies

Thank you very much. Jim, one of the things that we've seen a little bit of is a slip in revenues in IDS. On the other hand, the margins at networks were really quite impressive. Could you address what appears to be a little bit of a push-out in revenues in defense and then also the performance successes in the network systems area?

James Bell

What we have said over time is that the growth in IDS would moderate as defense spending moderated, and we saw the constraints from budgets, but a couple of things. So that's starting to take place, but again it’s offset by where we thought our real growth opportunities would be; one in Homeland Security and another in the international marketplace which would be a little more volatile or lumpy in terms of when we would see the addition of growth. The Secure Border Initiative win was a key win for us, and I think really helps us to understand that we are going to be able to grow in those areas because we have the capability that we believe are going to be very, very important going forward.

We have seen some better performance relative to the earnings, and we're looking forward. Improvements, particularly we saw it in the precision engagement and mobility where we have our platform programs, and we're continuing to see the benefit of the productivity enhancements coming out of that. I think we are going to say better performance. We had good tests under GMD which resulted in pretty good award key scores, and we'll see that.

Howard Rubel - Jefferies

You have a heck of a fourth quarter in a precision engagement relative to what the run rate has been all year.

James Bell

Yes, and it is going to be timing of deliveries. We'll see that we're going to have larger deliveries in the fourth quarter. That's what's going to drive that year, and those are pretty much cast in concrete.

Howard Rubel - Jefferies

Thank you.

Operator

Thank you. Our next question comes from Heidi Wood - Morgan Stanley.

Heidi Wood - Morgan Stanley

Good morning, gentlemen. I have a three-part question on the 787. I am wondering as a follow-up on Byron's question a little differently, I am wondering if you can provide us a bandwidth of kind of the high, low range where as you see now R&D's possible variance could go versus the '07 guidance you're giving us of the 3.2 to 3.4? I mean, obviously, that's a single-figure number, but how much risk do you see to that being up over the next couple of quarters? I mean $100 million to $200 million a quarter through '07?

Jim McNerney

Heidi, thank you for not making me remember the next two parts of your question before I answer the first part. As we see it now, that's a pretty conservative number, Heidi, as was consistent with the answer I gave Byron. We are trying to witch-hunt the issues in this program right now, and we do have some weight issues as I have said. We do have some supplier implementation issues. We are addressing all of them with aggressive recovery plans, and we've planned on more, should additional issues crop up.

So I would characterize this from where we sit today against the delivery commitments and the contractual commitments we've made, a pretty conservative number.

Heidi Wood - Morgan Stanley

But you wouldn’t want to give yourself a little additional cushion in saying, hey, even if we choose to spend an additional amount, if we run through that scenario, it might be an additional $100 million a quarter max?

Jim McNerney

We've got some cushion in this number.

James Bell

And let me add to that. What you're seeing as the spending profile is still well within the business case, well, actually well under the business case for the current spending that had us to launch this program. As you can see by the number of orders today, it is obviously a lot more successful than we ever envisioned at this point in the program.

I think the key here is we've gotten out early and looked at what are the possible risks we can experience given where we are at this stage in the development program, and we decided that now is the time to resource those in case they're needed. That's what what's reflected in the increase.

Heidi Wood - Morgan Stanley

The second part, can you talk about what your pre-R&D BCA '07 margins would look like? I mean you talk about 10% on a post-R&D margin, but on a pre-R&D to sales margin in '06 you're running around 18%.

Jim McNerney

We don't comment on that, Heidi. But you know, you're not too far off track. I think you can almost back into it, because we are expecting to be greater than 10% on operating earnings for our margins for '07, and you see with the new guidance on the R&D that we get close to a range like that.

James Bell

I mean another way to look at it, Heidi, is that we are absorbing this R&D contingency plan without changing guidance or trajectory that we have had in place for the last year.

Heidi Wood - Morgan Stanley

But is this 18% sustainable?

James Bell

Well, you know our plan. I mean our plan is not only to sustain but to grow. We've given the guidance we've given.

Heidi Wood - Morgan Stanley

This is sort of a question for both of you, because it's both a strategic as well as a financial question. But your current market outlook pegs the 787 market niche size at around 3,600 aircraft and assuming a 50% share, that's 1,800 planes. But at the 432 bookings, you're at 25% there before the first delivery. So the business case you guys talked about presumed an Airbus response, but now it's looking like the A350 XWB isn't going to deliver until the 2014 or 2015 timeframe, which gives you sole positioning in the mid-size wide-body niche for a good seven or eight years.

Does the A350 looks like it's more positioning itself to more than fully take on the 787? I am wondering if you guys can talk to us about how you think about the trade-off in production rates and pricing, given that it appears either your market share or the size of your market assumptions have been conservative?

Jim McNerney

No. I'd say the 50% looks pretty good, and there is upward pressure in our planning on production rates. Exactly where that sorts out will be a function of what the other guys do, but sort of keying off your words rather than mine, there is an opportunity there.

Heidi Wood - Morgan Stanley

Would you need to spend additional capital, Jim, to get there, though?

Jim McNerney

Not anywhere near the size of the opportunity.

Heidi Wood - Morgan Stanley

Okay. Great. Thanks very much.

Operator

Thank you. Our next question is from Cai van Rumohr - Cowen.

Cai van Rumohr - Cowen

Thank you, gentlemen. Could you give us more color on the supply issue and the weight issues on the 787 and perhaps answer the more important question: you have increased the R&D here in '06 and '07, but do you still feel as comfortable about the potential for this program to be solidly profitable as we get out to the 2008 and 2010 timeframe?

Jim McNerney

Cai, this program's projected economics are significantly better than any airplane program I have been involved with and that's because of the structure of the supply chain, both in its participation and recurring and nonrecurring costs. I think you know the business model. So the structure of it combined with unprecedented market acceptance leads you to a pretty good conclusion about the concept and the strategy.

As James pointed out a few minutes ago, even notwithstanding some upward pressure on research and development here in the short and medium term, we are well within the business case. Our internal targets are significantly within the business case because that's the way we like to run our business. This pressure hasn't really changed that outlook, so I don't see a fundamental change in an outstanding business case because of what we're talking about here today, at all.

Cai van Rumohr - Cowen

And to the issue of supplier issues and weight issues?

Jim McNerney

Just more color you mentioned. Yes, I would say that we have a significant amount of engineering resources. Now that we've largely completed the engineering release process, there are some places we're going back to get weight out. So the good news is that we completed the majority of the engineering releases within the timeframe we hoped to and we have time to go back with a team. We have a weight reduction team that is going back both on parts that we designed and parts that others have designed. Remember, we're all on the same system. So we understand the design parameters and design specifics on a real-time basis as well with our partners as we do in our own engineering shops.

So we are very agile and very quick in terms of being able to go back and put resources on some of that. Other things we're doing, there has been some production process help we've given a couple of suppliers as they're setting up new facilities and needed some boundary-less kind of collaboration between our production people and theirs to move it along a little faster. It's all the kinds of thing we anticipated. It's all the kinds of things that you do when you share a supply chain with people who have a lot of skin in the game with you.

But the good news about a lot of skin in the game is we are both incented to get it done. It is not us pointing at them and them pointing at us. It's us getting together and so it's a mix of weight reduction and production process facilitation, I would say.

Cai van Rumohr - Cowen

Thank you.

Jim McNerney

You're welcome.

Operator

Thank you. Our next question comes from Joe Campbell - Lehman Brothers.

Joe Campbell - Lehman Brothers

Hi, guys. Good morning, all. I would like to go back to the second part of Heidi's question, which is when looking at the stock, it is a bit upset because it looks like people are assuming over runs in R&D are for sure, and estimates that it will do better in the future on the operating performance are maybe. I am wondering whether or not implicit in the numbers that are the 2007 guidance, or if that will do even better? It looks to me like what you've got is a forecast of the second half of 2006 performance forecast into 2007.

And if it is true that the R&D is really only contingency, it would seem that we might not be so heavy on the R&D, but we could be better on the operating side while the market seems to be worried that the R&D is for sure, and we might not make the operating profit gains they're going to offset the R&D.

So I wondered if you could talk with what you've assumed, in terms of getting better versus I know your hopes are that you will do better.

Jim McNerney

We feel good about the underlying operating plan. You know the ramp up, which will continue next year in a number of our airplane programs, has gone well. I think we have confidence that the underlying operating margins for R&D will be delivered. The R&D I would characterize as a conservative number, one that anticipates contingency actions that could happen. We'll be ready for them if they happen. Could there be an upside? Perhaps, but I think planning on an upside is not the way to run a business. James, do you have any other comments here?

James Bell

Yes. And I think the other thing, Joe, if you look at what we're projecting and normalize our earnings this year that we're projecting to potential charges, I think we're still going to have 30% earnings growth year-over-year. Although we have the ability to see the way the program is being managed, see the risk early and make a decision to make available resources to have contingency plans to offset those risks, should the risks hit the beach; I don't want us to lose sight that we've had a significant number of recent accomplishments on this program that are hitting right on schedule.

For instance, we have begun major assembly of the center wing section. We started fabrication of the landing gear, the APU integration facility is up and running, we completed the first test of the engine pylon. We’ve unveiled the wing test box. We're opening the new production propulsion integration center. We've had the first major partner-to-partner delivery, and that was the keel assembly and the pressure deck. We completed the 787 integration test vehicle, and we're now testing the large cargo freighter.

I mean those things have been hitting right on point. The fact of the matter is, Jim and I are going to run this business from a conservative perspective, and we're going to make sure that we have in place plans early enough that we can implement, so that we can hold to schedule and meet our customer obligations, and I think that’s what you're seeing in this increase in R&D.

Operator

Our next question is from Doug Harned - Sanford Bernstein.

Doug Harned - Sanford Bernstein

Good morning. Over the last two quarters as you've taken up your estimates for R&D, you’ve kept your guidance the same in commercial. I am interested in understanding, I mean that’s better than a 1.5 points in margin. I am interested in understanding where that benefit is coming from? I know you have had a number of initiatives on the operations side, also on the corporate side. Could you talk about what you see that you've captured, where it has come from and how you get comfortable about those savings?

Jim McNerney

Well, I think the two places we've had pressure are R&D and some sourcing pricing inflation on some key raw materials. I think that's well known in the industry and well known as discussed by us. Where we are offsetting that is in conversion productivity. There is a lot of innovative work going on in the PCA factories, whether it is moving lines in Renton, the beginning of moving lines in Everett which is a revolution in the way airplanes are converted; whether it is volume-related leverage as we take up our rates a bit; whether it is labor productivity. There is a lot of great work being done on conversion productivity, which is by in large, along with volume, offsetting these pressures.

That's the business model we run under. I mean when we talk about growth in productivity simultaneously, we mean it. The reason we drive productivity so hard in the Company is to make sure we have resources available to properly fund these huge opportunities we've got.

When you look a t the 787 which we've talked a fair amount about here this morning. This is one of the most competitive airplanes when both measured against the planes it is replacing and against the planes that the marketplace is offering as an alternative as you will ever see. We don't want to you lose sight of that as we have these candid discussions about how we're managing R&D and managing risk as we develop the airplanes. We want to be up front with you. We want to be up front with ourselves as we march through this program.

Doug Harned - Sanford Bernstein

That's good. I am trying to understand, though, on the cost side, what's allowing you to get the better margin? If you put R&D aside, is it also the overhead type initiatives that you have let out of corporate?

Jim McNerney

There is some of that. The answer is yes. I mean, we have reduced some of what you would call corporate and SG&A costs as a percentage of sales. But I think the hard work has been on conversion productivity in our factories and with the way we're working with our suppliers. I think that is leaving aside price inflation on some commodities as a separate issue, as a pressure. I think that is a bigger part of it, and there is more to go on both by the way. There is more to go on conversion productivity, and there is more to go on G&A and corporate costs. We do have, as you point out initiatives in place to address both. A lean plus initiative, our corporate services reduction initiatives as well as our development process excellence initiative which gets at some costs. So we are going to be relentlessly focused on these things.

Doug Harned - Sanford Bernstein

Okay. Great. Thank you.

Operator

Thank you. Our next question comes from Steve Binder - Bear Stearns.

Steve Binder - Bear Stearns

Yes. Just a follow-up on that question for '07, you touched on cost initiatives, Jim. I am just wondering did block adjustments -- I think that helped out in the prior quarter -- block adjustments, a revision of the pricing outlook or even a revision in production rates in the blocked period, has that kind of helped offset the bump in R&D?

Jim McNerney

That's what I meant by volume.

James Bell

Obviously we are upping our production and clearly we're going to get the opportunity there that's associated with the leverage we'll get, Steve. Clearly we're expecting to deliver more airplanes next year than we delivered this year. We're going up to 440, the 445 versus the 395. But we only had a couple of accounting changes this quarter; the 200 for the 737, 25 for the 747 and three for 767, but it is really as we up the production rates and we start getting the full-year benefit of those higher production rates. We'll get better leverage and better cost productivity associated with that.

Steve Binder - Bear Stearns

But under program accounting you're looking beyond just '07 when you look at your '07 rates, right?

James Bell

Absolutely.

Steve Binder - Bear Stearns

Yes. So I am just wondering when I ask about rate adjustments, I am not just talking about '07 deliveries. You're obviously thinking you may go to 31 on the 737 and seven on the 777. We never really know what those rate adjustments are really going to look like in the planning period. Right?

Jim McNerney

No, we don't.

Steve Binder - Bear Stearns

And the same question was about pricing. You know, we have no clue what you're assuming not just for escalators, but for pricing on your model types, especially since you have a compromised competitor. That's why I was wondering have you seen any revision in those estimates, variables.

James Bell

Well, our pricing has stabilized, we think. Clearly, we are expecting more growth going out, we will give you more guidance on that obviously in the fourth quarter as it relates to '08. But we are assuming we're going to get the productivity as we go forward And in fact we've demonstrated it. We've demonstrated we've been able to move up in rate in all the current models and do that effectively and do that profitably. We anticipate to do that going forward, and also to get additional leverage.

Steve Binder - Bear Stearns

You obviously make some additional investments on the 747-8 passenger plane. You've got a very important near-term campaign in Europe with a legacy carrier and another important European legacy carrier next year. How confident are you about capturing at least one of those two campaigns?

Jim McNerney

Well, it's hard to predict, Steve, but I feel optimistic.

James Bell

Without giving you a point estimate as you would expect, I do feel optimistic about the campaigns you just referred to.

Operator

And your next question comes from Robert Spingarn - Credit Suisse

Robert Spingarn - Credit Suisse

Good morning. You know, Jim, as a follow-up to what Steve just mentioned on the 747-8I, could you give us a little bit more color on where you are on that program? Clearly, you have the R&D ramp. It looks like from macro perspective, you may have more opportunity here lately to capture some share just based on some instability perhaps in the marketplace right now, vis-à-vis a competitor. If you could give us more color there.

Jim McNerney

Yeah. I mean I think you have to back off a little bit and get some altitude on it. First of all, this is a derivative program, and the amount of money we're spending on this reflects that. I mean this is taking an airplane we know how to make, we've made for years, one of the world's most successful airplanes and we're modifying it. So as we adjust and tweak to meet specific market requirements, we have to keep the context that it is not a huge development program for us.

Now, having said that, I think the requirements have settled down on that airplane now. We've had a lot of dialogue with not only the legacy carriers in Europe that Steve referred to, but a lot of other people. We've made some modifications. We know what we have to do. We understand the engineering of the airplane, and we know how to do it and we have time to do it. So I think we're in pretty good shape, with the requirements having settled down.

Robert Spingarn - Credit Suisse

Jim, are you still on a back end of 2009 delivery timeframe there?

Just separately, I think James alluded to the 2008 growth you've mentioned in the release in terms of production volumes at BCA, and you don't want to get into that until January. But could you give us your sellout ratio at this point on '08?

Jim McNerney

Well, sellout ratio in '08 I don't have the number. We'll talk about it more specifically in February. The guys aren't going to let me say anything here. There is reason to believe when we talk, it won't a terrible disappointment. But the 747, as you know, the Dash-8, the cargo version is scheduled for the third quarter of '09. We have a very robust pipeline already in place between 40 and 50 solid orders, I believe, on that plane. The intercontinental or PAX version is scheduled for mid-2010. But that will depend on exactly when the first customer wants to take delivery.

Operator

Thank you. Our next question comes from George Shapiro - Citigroup.

George Shapiro - Citigroup

I wanted to pursue the R&D a little bit more. I mean effectively, you've raised R&D pretty substantially now two quarters in a row. When do you think the period of greatest risk in this program is? Or you can't say until we get to say the initial flight test program?

James Bell

Well, I think we're in it. We're in a period of considerable risk, and I think we've identified them early. Obviously, we want to get the contingency plan in place in time and have them resourced in case we need to call on them, George. Obviously, you'll have a different set of risks once you get into the flight test.

But I guess the real point I want to make on this is that we think we understand how to build this airplane. I mean we think we've gone through it. We understand the systems we need to go deal with and how to do them. We don't have the complexity on our airplane that the A380 is, we have a fifth of the electrical wiring in it. So I think if some of the concern is being driven by what you see out there in other places, then I think you have to understand there's some distinct differences in what we're doing here.

What you're seeing here is early risk mitigation. I think we're there in terms of our ability to go look forward and see where those risks might hit the beach and where we can put contingency plans in place and hopefully mitigate it.

George Shapiro - Citigroup

But if something incrementally worse didn't happen in the third quarter, why wouldn't you have raised the R&D by a bigger amount in the second quarter? I guess I am looking for what did you incrementally see in the third quarter that you didn't in the second quarter?

James Bell

Well, again, if you remember in the third quarter half of this increase is associated with the 747-A. The other piece that's associated with the 787 is to look at those other contingency plans that we had on the table and we understood in the second quarter, but we now have another quarter of history or time has passed and so we wanted to make sure we had the resources available.

So, quite frankly if we were going to focus on something big happening, it would be something that would be totally unexpected like somebody dropping a big piece of hardware or a big piece of tooling or something having a major failure. But right now in terms of the technical things that need to be done, we think we understand them pretty well and we just want to get the weight out of it and then make sure we hold the schedule.

Jim McNerney

There has been no dramatic or qualitative change in the risks we're managing one quarter to the next. I think it's a matter of as James said, being at that point in the program where, as the risks exist, you want to get out ahead of them and more than get out ahead of them. I think that's what you're seeing here.

George Shapiro - Citigroup

You left the commercial revenue guidance at $28 billion for '06 despite the fact that you probably put in $350 million, $400 million of revenue from Aviall in the current guidance. Is that just round-off is there some pricing difference?

James Bell

Just rounding, George. It's not anything significant.

George Shapiro - Citigroup

Okay. Thanks again.

Operator

Thank you. Our next question comes from Ronald Epstein.

Ronald Epstein

Yes. Good morning, guys.

Jim McNerney

Good morning.

Ronald Epstein

When we look into the outlook for next year, you increase the margin in BCA but also the R&D and I don't know if you answered this or not. But, how much does block extensions have to do with that, or is that just productivity?

Jim McNerney

It's productivity.

Ronald Epstein

And then a product placement or product development question for you. Lately I think the BCA guys have been out talking in industry conferences and have been a little bit more vocal about Boeing being involved with a small plane, something maybe around 100 seats. Jim, I was wondering if you can speak to that, how seriously Boeing is considering that and any color you can add on a smaller narrow bodied jet.

Jim McNerney

I don't think, Ron, that we have a crystal clear view yet of what the narrow body market of the future is going to look like. Certainly there is a lot of discussion around the 100 packs, and there is a lot of discussion around a bigger version of a narrow body, you know, the 200-plus size as well as the core of the market, the 150 to 180. A lot of discussion, a lot of debate, different camps within our company. Meanwhile, we're just focused on maturing the technologies that we know will fit into any of those versions as that clarifies.

But I hesitate to tell you I know exactly what that market is going to look like eight, nine years from now. Over the next year it's going to get a lot clearer.

Ronald Epstein

When do you expect – I imagine you guys are doing a deep market study on that segment right now. When do you expect that that study to conclude?

Jim McNerney

Well, I think, you know, it's an ongoing study, and you've got to keep in mind, we have a 1,300 plane backlog with our current narrow body that we keep improving and spiraling technology into that makes the bar tougher for the newer airplane. So we've got pretty good market acceptance and a backlog going out many, many years on what we're doing today. So I think it'll be an ongoing discussion that will be measured in years not months in terms of when at that market segmentation settles down.

Ronald Epstein

Okay. That's great. Thank you very much.

Operator

Our next question comes from Robert Stallard - Banc of America.

Robert Stallard - Banc of America

Jim, I was wondering if you could give us a quick update on some of your major defense programs notably, SCS, JTRS, and the AEW programs?

Jim McNerney

I think the SCS is progressing very well. I mean you've seen that all milestones have been hit. It continues as the cornerstone program for the Army and the funding remains as robust as any development program funded by our defense establishment. So going well, tied closely to our customer and some of the capability being spiraled into today's war fighter.

I think I would comment on GMD, ground missile defense. I mean this is one that you all were pushing us on last year. We are back to hitting every milestone. Test flights are going well, on schedule, achieving all objectives and then some with margin and the customer is very pleased in terms of the way we're marching through there.

AEW&C we are still in the process of validating the re-baselining of that program that we went through earlier this year, but we are confident that we're there, but we'll see.

And what was the other one you asked me about, JRTS? That one is also I would categorize as one that got rescoped last year and is delivering on time, on schedule.

Operator

Thank you. Our next question comes from Joe Nadeau - JP Morgan.

Joe Nadeau - JP Morgan

Thanks. Good morning. I was wondering if you could comment just a little bit more on your current production at BCA. You've been running the past couple quarters with unit costs accounting, profits higher than program and this quarter that slipped around. So I was wondering what caused that.

And then also your 777 volume dropped a little from the first two quarters of the third quarter. I was wondering if that was related or not.

James Bell

On the 777 that was just timing, Joe, and on the unit margins it's just we've had the impact of the increased material costs they had a more dramatic impact on unit margins early, and it doesn't have the ability to have the production improvement that we have over time in programs.

So again, with the problem with unit margins, I know you all like them, but they're volatile, because they can be affected by near-term things and doesn't take a program picture into effect. But it's a data point.

Joe Nadeau - JP Morgan

So you characterize the issues you're facing more as just raw material inflation rather than getting the stuff in the door.

James Bell

Exactly. And for the quarter there was a big difference in terms of delivered units which have a pricing impact.

Joe Nadeau - JP Morgan

Okay. Thank you.

Operator

Thank you. Our next question is from Troy Lahr - Stifel Nicolaus.

Troy Lahr - Stifel Nicolaus

Thanks. Recently in some of the conference calls from the domestic airlines they've talked about exercising some option and maybe even accelerating some aircraft deliveries. Have you been getting some pressure from airlines trying to move up a couple slots?

Jim McNerney

Yes. And maybe a little more than normal.

Operator

Our next question is from Myles Walton - CIBC.

Myles Walton - CIBC

Thanks. Good morning. A quick detailed question for, below the segment level. Unallocated expense looked like it was well down from historical run rates, a bigger swing item in the quarter, at least in my model. What drove that in the quarter and also what's embedded in your guidance for '06 and '07?

James Bell

Share-based plan expenses primarily. When we implemented 123R last year, the current plans obviously were when we valued those, the value turned out to be less than the new models. Also we've accelerate a lot of the payouts in the performance share late last year, early this year which also accelerated the expense into those periods. So you're seeing less expense flow through for the old plan, and the new plans are less costly, so that's what you're seeing. And there is a little bit about the stock price going down on the deferred shares associated with that share-based compensation plan. The run rate going forward will be lower than what you saw in the past.

Operator

Thank you. Our next question comes from Peter Jacobs - Wells Fargo.

Peter Jacobs - Wells Fargo

Good morning, gentlemen. James, could you just highlight again specifically where you're seeing some of the weight issues on the 787-A program and any kind of additional color you can give there?

Jim McNerney

No, I don't want to name names. But in general what we have is the airplane is pretty much designed and as you start laying out the components, there are weight opportunities, and obviously the bigger the component, the more generally the opportunity is. So we're trying to attack those that have the highest payback and that we could do within the timeframe necessary to meet our delivery dates and still meet all of our contractual obligations, and so that's the focus.

Operator

Your next question comes from David Gremil – Thomas Wiesel Partners.

David Gremil – Thomas Wiesel Partners

Thanks, good morning. A question on IDS. You touched on part of this earlier, you’re your IDS revenue plan for ’07 is now at the low end of the prior plan, despite the fact that you did win SBI. I was just wondering, what were the swing factors to move that plan toward the lower end? Was it funding issues in the ’07 appropriation or the loss of ED, or what was that?

Jim McNerney

Now remember, we had the funding reallocation as it related to one of our proprietary programs where we lost a piece. Then the funding associated with programs that are now back on track like GMD were affected somewhat last year because of some performance issues again, which we've turned around. But the funding levels haven't come back up to what we had previously anticipated. So its more volume related to that.

And the SBI win, although significant, it is a small program. It's not a very large program on the initial phase; it's timed over a number of years going forward. So we don't see a significant impact in this year.

Operator

Thank you. Our next question comes from Gary Liebowitz - Wachovia Securities.

Gary Liebowitz - Wachovia Securities

I am going to kick the R&D dead horse one more time. Jim, in the beginning of the conference call you were speaking that there were eight contingency plans, one of which you had funded. Are you saying that there is potentially seven more contingency plans to be funded?

Jim McNerney

What I meant by that was that we have around eight, last time I reviewed it, contingency plans in place if we need them. The R&D level that we are talking to you about assumes we fund all of them and more. We've only triggered funding, we've only needed to trigger funding on one of them. I was trying to point out a specific with regard to the conservative posture we have with our R&D. So is that clear? In other words, if we fund them all, we still won't be pressuring the number I gave you.

Operator

Thank you. That completes the analyst question-and-answer session. (Operator Instructions) I will now return you to the Boeing Company for introductory remarks by Mr. Tom Downey, Vice President of Corporate Communications. Mr. Downey, please go ahead.

Tom Downey

Thank you. We'll continue with media questions for Jim and James. If you have any questions after this session, please call our Media Relations team at 312-544-2002. Operator, in the interest of time, we ask that you limit everyone to just one question, please. We're ready for the first question.

Operator

Thank you. The first question comes from Lynn Lunsford – The Wall Street Journal.

Lynn Lunsford – The Wall Street Journal

Good morning. Just one little question and I think it's more looking at nuance than anything else. Up until now you have pretty well said that you expected entry into service for the 787 to be mid-2008. I noticed in your press release that in the graph where you talk about that you just say during 2008. Does that mean you're slipping that or is that just a word?

Jim McNerney

Not at all. I mean that's wording. I believe it’s August '08. It has always been late August, early September has always been the timing and still is the timing. That was advertent, Lynn.

Operator

Thank you. Our next question comes from James Wallace - Seattle Newspaper.

James Wallace - Seattle Newspaper

Yeah. Good morning, Jim. I had a question and in previous interviews that Mike Baird has done with me and others, he has mentioned 2% has been the overweight issue, plus or minus something. Has the weight increased recently or are you just trying to tackle the same weight that he's been talking about?

Jim McNerney

I think it's within the range of what he is talking about. I don't know when you last talked to him, but I would say the weight pressures have increased slightly, but also the opportunities to reduce them have increased. So we're working it, but it's within that range sort of low single-digits.

Operator

Thank you. Our next question is from Paul Marion – Cranes Chicago Business.

Paul Marion – Cranes Chicago Business

Hi, you said that the [inaudible] won’t be significant to the company, but it is a large drop in your book value, I think about 70%. Are you going to do anything to educate investors about that or do anything to explain it further?

Jim McNerney

We have. We already have. I think investors and particularly analysts who investors rely on to provide a lot of the information clearly understand this is an issue. This is no more than a book-keeping issue where in the past, we have always provided the same information for these unrecognized gains and losses for the pension assets in a footnote, because there hasn’t been consistency across industries on how that is done. In the past, we decided to bring it onto the balance sheet.

Clearly, this thing is very, very volatile and as our asset performance improves and our plans are fully funded and we get the rate of return assumptions equaling what the real obligation is, you can see the swing by $7 billion. So I think the investment community really does understand it and we will obviously continue to explain it clearly, and provide the transparency so individual investors will also understand it.

Operator

Your next question comes from Dominic Gates – The Seattle Times

Dominic Gates – The Seattle Times

Good morning a couple of things. I wondered, Jim, if you could give us any idea of what the one contingency plan that you have had to fund, what that was exactly?

Jim McNerney

There will be some work that is going to be brought to Seattle. That was going to be done by a couple of our suppliers that is more efficiently done in Seattle, and so we've made an adjustment there, and that's the one we have triggered.

Dominic Gates – The Seattle Times

Is it major work?

Jim McNerney

Well, I don't know what you would categorize as major work. I mean it is systems installation work, that is systems that are going to be installed in the airplane.

Operator

Thank you. Our next question comes from John Liang - Inside Defense.

John Liang - Inside Defense

Good morning, gentlemen. My question is a little bit broad in the sense that the government’s Electronics and Information Technology Association did an annual survey that just came out last week. In it, it found an increased skepticism among Wall Street analysts and other folks that the Pentagon would continue to use Lead Systems integrators in future acquisition programs.

So my question is basically, how has your thinking or your assessment of the LSI concept devolved as you have been managing programs like FCS and GMD and that kind of thing? I mean, is there anything you think should be done or could be done to improve or make managing the programs under the LSI concept better or more efficient?

Jim McNerney

I think in terms of our programs and the concept of LSI is more comparable to a prime contractor. We are going to have total systems responsibility, we are going to design the system, we are going to do the systems integration, the systems engineering and then we are going to have total system responsibility and accountability for its performance. So I think that is going to be what is key. It is, in my mind and the way we look at it here is that that role is a role that has to be performed and is very valuable because it has capability embedded in it in terms of the overall performance of the system.

Operator

Your next question comes from Dominic Gates – The Seattle Times.

Thanks for letting me back in. I just wanted to go back to one answer that Jim McNerney gave earlier. I was a little surprised when you told Lynn Lunsford that the first deliveries of the 87 would be in late August of ’08, because I certainly understood it was going to be earlier that summer. One of the reasons for that was the Beijing Olympics, the Chinese airlines that have ordered the 87 wanted it for the Olympics. Isn't that going to be too late if you're delivering it in late August? The first one goes to Japan, not China.

Jim McNerney

Dominique, you're right. I may be confusing when we're shipping an airplane to somebody versus when they are implementing it. Our date for delivery to the Japanese and Chinese airlines have changed. If I have confused the date, I apologize. We'll reaffirm that with you. I am not trying to signal any change at all.

Tom Downey – Communications

Operator, seeing there are no more questions in the queue, that will conclude our call. Again, for members of the media, if you have additional questions, please call our media relations team at 312-544-2002. Thank you.

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Source: Boeing Q3 2006 Earnings Call Transcript

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