The Medium Term Bull Thesis is Unraveling
I have repeatedly written about the multi-decade global trend supporting Boeing's (NYSE:BA) commercial product portfolio, while still raising concerns last fall about the likely cut in current generation 777 production as well as the confusion surrounding financial accounting of the Dreamliner. In short, I have thus far largely argued in articles on SA that long term trends in growing global per capita income and the growth in air travel it tends to engender are strong enough to offset more near term execution and accounting issues currently plaguing the company. After a number of recent developments over the first half of 2016, however, I now believe that investors in this iconic American company would be wise to take profits and await a lower entry point in the stock over the next 12-18 months.
My conclusion is based on a number of negative developments for the company that likely have no near term resolution including the government's investigation of Dreamliner accounting, the likelihood of the need for further production cuts in the current generation 777 program, continued execution issues in the Air Force's next generation tanker program that could further pressure earnings, and concern over the company's cash flow, despite the company's strong cash generation in Q1 of 2016, that could impact growth in capital returns.
Dreamliner Accounting: Is Profitability Truly Just a Dream?
Questions have swirled for some time around the profitability of Boeing's 787 Dreamliner program. Most investors are well versed in the trials of the program, but a brief summary still seems appropriate. The Boeing 787 Dreamliner is a truly remarkable aircraft that incorporates many innovative features to deliver a superior passenger experience, reliability, and fuel efficiency. Yet a number of execution blunders by Boeing significantly delayed the delivery of the first Dreamliner and the continuing consequence of those early execution issues is that Boeing still loses money on every Dreamliner it sells. This is not particularly unusual for an engineering program as large and complex as the development of a new commercial aircraft and in fact the tendency of such programs to be profitable only in the later stages of production is accounted for with a well recognized accounting method that allows the company to defer the realization of upfront costs until the program becomes profitable.
Source: The Boeing Company
It is becoming increasingly clear, however, that Boeing's projections of Dreamliner profitability were at best overly optimistic and at worst misleading. As of April of this year, Boeing counts 1,154 orders for the three variants of the Dreamliner family. It has delivered 403 of the ordered aircraft or about 35% of its order book. To this point, the company has not yet generated a profit on its Dreamliner sales and has deferred over $28 billion in costs to be covered by future profits from later sales. The company's projections for profitability assumed the sale of 1,300 aircraft, requiring the company to sell and deliver another 146 aircraft over its current backlog. This profitability would only be achievable if the program realizes significant margin expansion in coming years.
The company's accounting of the deferred costs of the Dreamliner program have been viewed skeptically for several years as the company continually pushed back the aircraft's profitability. In February of this year the questions of Boeing's accounting of the program made front page news when it was announced that the SEC was investigating the company's accounting around the program due to information from several company whistle blowers who allegedly provided internal documents to substantiate their claims. The company is making progress towards profitability on a per plane basis, and is very likely to reach it soon due to ramping production and a shift in mix to more profitable 787-9 models. But the uncertainty of both the outcome of the investigation and the degree to which Boeing will be able to expand the Dreamliner's margins hang over the program.
Source: Bloomberg News
Investors should understand that if improving profitability in the 787 program were unable to offset the current deferred losses, the company would be required to realize a potentially significant loss on future earnings. One analysis by Robert Spingarn of Credit Suisse Group estimated the company would likely face a $7.5 billion loss from the Dreamliner program. For comparison, the company reported net income of approximately $1.7 billion in the first quarter of 2016 on a GAAP basis.
The 777 Production Gap and the 777X Risk
Most analysts agree that a significant portion of Boeing's operating income is derived from the company's highly profitable 777 program. One estimate by Goldman Sachs last Fall put the figure as high as 30% of operating income. The current generation 777-300 is set to be replaced by the 777X, a futuristic iteration of the classic wide body, by 2020. Analysts have long pointed out that Boeing will exhaust the backlog of the current 777 program well in advance of 2020, which led to the first announced production cut in the program starting in 2017. The company plans to cut production of the highly profitable aircraft by 16% or from 8.3 to 7 aircraft per month starting next year.
A simple "back of the envelope" analysis of Boeing's projections should leave investors skeptical that this cut will be sufficient. Including a few recent orders for the 777-300, the company will exhaust its backlog for the plane by September of 2018 or more than a year before the first 777X is scheduled to be delivered. This has led Goldman Sachs' analyst Noah Poponak to project far deeper cuts to the program will be necessary. He suggests a 28% production cut in 2018 followed by a further cut of 20% in 2019. If this holds true, Boeing will face a significant hit to earnings and cash flow that may not be fully offset by plans to ramp production of the 737 Max during those years.
A further risk to the company's 777 program for investors comes from the coming transition from the current generation 777-300 to the next generation 777X. The company is currently planning for the first deliveries of the 777X to occur in 2020. Any projections nearly four years out on a major engineering project such as the launch of the 777X is subject to enormous uncertainty and investors would be wise to be cautious about the company's ability to deliver on-time as promised considering the company's and industry's track record. The 777X is not a brand new platform, but it does promise the incorporation of many innovations including composite materials, new engines, and folding wingtips that could potentially lead to delays.
In addition to potential engineering or production the delays, the company's order book for the 777X presents risk as well as it is heavily concentrated in a handful of Middle Eastern airliners. Emirates and Qatar Airways account for over 2/3rds of the orders for the 777X. While this is a minor point, it should bear notice from investors.
The New Tanker Continues to Tank
While Boeing's Defense segment has taken a backseat to its Commercial operations in recent years, one bright spot was seen as the contract for the next generation aerial tanker based on the company's existing 767 platform. The nearly $50 billion contract for the Air Force's next generation tanker has been a growing headache for the company as the aircraft has been dogged by technical issues related mostly to the fueling system. Thus far the KC-46A cost over runs have hit Boeing's earnings to the tune of $1.4 billion including a $425 million hit in 2014, last Summer's large $835 million charge, and this year's first quarter $162 million charge. The tanker's problems are not yet resolved and it is likely that the program will have additional near term impact on earnings.
Source: The Boeing Company
Will the Cash Spigots Remain Open?
Underpinning much of the company's share performance over the past two years was the belief that ramping orders and production in the company's commercial business coupled with improved execution by the company would lead to growing free cash flow and rising capital returns to shareholders. Through 2014 and 2015 Boeing largely delivered on those promises, hiking the company's dividend and share repurchase programs significantly. In the first quarter of 2016 the company repurchased $3.5 billion in shares and has pledged to continue aggressively repurchasing throughout 2016.
Yet some noted company analysts have grown increasingly skeptical about the company's ability to grow its capital returns in coming years due to the factors detailed above and the generally softening order flow in 2016. Earlier this month Goldman Sachs noted that many of the drivers of Boeing's recent free cash flow, including sales volume, advance payments from customers, and pricing on high margin wide body aircraft (777 and 787), are under increasing pressure. Other analysts disagree, noting that the company's first quarter of 2016 still generated nearly $500 million of free cash despite the many headwinds facing the company at the start of 2016. While Boeing has thus far proven its skeptics wrong, Investors should be wary of any potential deterioration in the company's cash flow as it would likely have the greatest of any single event on company's share price.
Summary-The Balance of Risk to the Downside
Boeing is a wonderful company and one of the crown jewels of the American economy. Yet the prospects for the company's near term share price seem poor considering the many headwinds facing Boeing over the next 18 to 24 months. The company's current valuation seems fair at 17x ttm while yielding over 3%, but the major concern for investors should be the identification of major catalysts to move the share price one way or the other. I believe the balance of risk is to the downside considering the factors detailed above and the potential of any one of those factors to catalyze a significant fall in the company's share price. Negative developments in the SEC investigation of Dreamliner accounting, admission of the likely need for further 777 production cuts, delays in the development of the 777X, further write downs or delays in the KC-46A, or evidence supporting the Goldman Sach's view of deteriorating cash flow in coming quarters could each tip the stock lower and present a better entry point in Boeing shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.