With Boeing's (NYSE:BA) 787 Dreamliner in the final stages of testing, we thought it would be helpful to clarify the profitability of this program (or perhaps more appropriate, the lack thereof), at least in its early stages. The growth potential of this program has been well-documented, but the 787 platform's profitability will be nowhere near what management had expected before it experienced the first of many delays of its Dreamliner.
We think investors should be made aware of just how much leeway Boeing has in determining earnings, and why Boeing is one of the more difficult firms for the analyst community to get their arms around due to the lack of transparency. We believe Boeing will set the initial 787 accounting quantity in such a way that the program has razor-thin margins initially, perhaps in part to avoid any negative and potentially embarrassing publicity that would almost assuredly arise if it reported an initial 787 program loss. However, management's flexibility to effectively "manage" earnings through program accounting may not result in the representation of the true profitability of the 787 program, in our opinion, due to the over-reliance on estimates.
And while we hold Boeing management in very high regard, we are surprised at the similarities between now (737 and 777 production ramp ups; 787 and 747-8 deliveries) and that of the 1997 debacle when Boeing encountered massive production problems and allegedly masked costs in its brand new 777 at the time. Although it never admitted guilt during the episode in 1997, Boeing agreed to pay over $90 million in a private-securities fraud suit in 2002 as a result of actions taken during that time period.
First, let's review from Boeing's 10-K how much flexibility it has in determining the profitability of relevant platforms through program accounting (note: estimates):
Under program accounting, inventoriable production costs (including overhead), program tooling costs and routine warranty costs are accumulated and charged as cost of sales by program instead of by individual units or contracts. A program consists of the estimated number of units (accounting quantity) of a product to be produced in a continuing, long-term production effort for delivery under existing and anticipated contracts limited by the ability to make reasonably dependable estimates. To establish the relationship of sales to cost of sales, program accounting requires estimates of (a) the number of units to be produced and sold in a program, (b) the period over which the units can reasonably be expected to be produced and (c) the units’ expected sales prices, production costs, program tooling and routine warranty costs for the total program. Several factors determine accounting quantity, including firm orders, letters of intent from prospective customers and market studies. Such estimates are reconsidered throughout the life of our programs.
In short, Boeing can largely dictate how profitable a program is by setting the initial accounting quantity and then adjusting it going forward. In doing so, it allows the massive upfront costs of building a brand new airplane to be spread out over many, many years - and to some degree, disguise cost overruns and potentially record savings from productivity initiatives that perhaps may never come to fruition. Importantly, the results that Boeing reports in every quarter are in part based on projected averages from program accounting - not actual costs or revenues. In other words, it sets its own profit margins for programs based on its own estimates. This is important for aerospace investors to understand, especially those that own Boeing.
Second, let's review the difference between the definition of unit profits and program accounting profits as it relates to Boeing. Analysts have traditionally had a difficult time grasping the program accounting schema, so the jet maker has made an accounting presentation available here. As outlined in the slide deck:
Unit profit: "Represents (profits) for aircraft over a given production block (block sizes vary by program, but on average extend a year or less)."
Program accounting profits: "Represents average (profits) for aircraft over total program accounting quantity."
Boeing makes available a nice graph in its accounting presentation to show the relationship between unit costs and program costs, which we have provided below (Source: Boeing):
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Now that we've laid the accounting background, here's a quick excerpt from Boeing's 1Q 2011 conference call about what the executive suite had to say about the 787 Dreamliner (notice how much influence it has in determining the initial 787 accounting quantity and, by extension, 787 program margins):
Well, the initial block size (accounting quantity) will be discussed at entry into service, and we're going through that. James and his team are going through that right now as we speak. There is very strong demand for this airplane, and so the real story here is we got the airplane right, despite some of the ramp-up difficulties that we've gone through, which have added significant cost as you know as we worked through it. Now obviously, whatever production quantity we decide on, and it will be the result of the process we use always when we introduce new airplanes, the profitability will not be high at the beginning. And it's, I think, however, there is significant, as there has been on every new airplane we have ever built, there are significant opportunities to increase the profitability of it, and we are focused on it. And they relate to a series of productivity and factory efforts and working with our suppliers, and it relates to model mix pricing, model introduction down the line ... As we get to the end of the year though and we start delivering (7)87s and (7)47s, you'll see a departure in unit margins will be a lot lower than program margins because of those deliveries ... Unit goes down dramatically because of the (7)87s and (7)47s. And so I don't know if it's negative but it surely - it probably will be. In fact, I think they will be.
Although Boeing's approach appears to still adhere to U.S. GAAP, as you can see above, unit profits will actually be negative on this plane - not unlike other aircraft that the jet maker rolled out and were mired in controversy (777). The 787 will only contribute to profits as a result of management's estimates - and unfortunately, the existing management at Boeing is well known for over-promising and under-delivering (the 787 was originally expected to be delivered in May 2008).
In all, we think it very important to focus on Boeing's free cash flow instead of reported earnings. In fact, we use a discounted cash flow model to arrive at a fair value estimate for every company in our coverage universe. This allows us to rule out companies that may be reporting strong earnings, but don't have the free cash flows to support them. We also make available our valuation model template for investors who may be looking to value Boeing based on their own assumptions. The model can be found at DCF Valuation Model Template.
We maintain that Boeing may have upside during the current delivery upswing largely because of the market's tendency to place an elevated multiple on peak earnings, which we estimate could reach as much as $7 per share by 2015. However, we think Boeing is fairly valued on a DCF basis due in part to a higher discount rate applied as a result of the use of program accounting. We maintain that investors looking for exposure to the coming boom in aircraft deliveries are better suited identifying opportunities in the supply chain.
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Since we published Sorting Through the Aerospace Supply Chain June 6, our mid/large-cap pick Precision Castparts (NYSE:PCP) has reached a new 52-week high (up about 5%), our small-cap pick Astronics (NASDAQ:ATRO) is up over 20%, and our nano-cap pick EDAC Tech (NASDAQ:EDAC) is up about 10% compared to relatively flat performance from the market, as measured by the S&P 500 Index ETF (NYSEARCA:SPY). We continue to expect further outperformance from these names, and if investors are interested in learning more about our Best Ideas list, please click here.
All things considered, investors should focus more on cash flow in the aerospace industry rather than reported earnings. And if new development programs and how to account for them aren't enough trouble for Boeing, Airbus (OTCPK:EADSY) seems to be out to an early lead in the narrowbody segment with its refined A320neo, pressuring sales of Boeing's 737.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.