Prior to reporting its Q2 2016 earnings Boeing (NYSE:BA) has announced it will be recognizing almost $3B in charges. Almost $850 million of the $2.1B after-tax charge is related to the Boeing 787 program, where the company will be reclassifying 2 unsellable aircraft from 787 inventory to R&D expenses. I will await the earnings report to see whether Boeing will actually lower their accumulated deferred costs.
Prior to Boeing announcing the write-off of the 2 airframes, I penned an article on Boeing's ability or better said Boeing's inability to recoup the accumulated deferred costs within the current accounting quantity of 1,300 units. A reader, however, pointed out that the assumed order mix is not reflective of reality. In this article I will present the results of the reworked model to accommodate for different profit margins and implementing a more realistic delivery schedule.
The method behind the calculations remains the same. The 1,300 accounting quantity can be sliced in 3 (almost) equal sub-blocks. The first block has been used by Boeing to accumulate the deferred costs, the second block will be used to ramp up profits and the third block will see full profit production.
Changes to revenue assumption
For the first 436 units, I initially assumed an average sales price of $128.4 million. After analyzing the delivery schedule this has been increased to $129.8 million. For the 436 units that follow after that the average sales price has increased to 1 linear part of $135.6 million and a second linear part of $134.2 million, up from $132.5 million.
Figure 1: Development deferred costs using various profit margins (Source)
Figure 1 shows the development of deferred costs using various profit margins. What can be seen is that you can make things as good or bad looking as you want. Using a profit margin of 15% it can be seen that Boeing will have $15.7B left in deferred costs after the 1,300 th delivery, for a 20% margin this will be $11.3B and $7B for a profit margin of 25%. Ron Epstein, analyst for Bank of America, thinks that Boeing will not be able to make more than $16 mln per airframe on the remaining deliveries. The AeroAnalysis model shows that this coincides with a profit margin of roughly 15%-16%, which is probably not the profit margin that Boeing has hoped for and one can also question whether this really is a realistic estimate given that end of life pricing of the Boeing 777 gives margins of 16%.
The Golden scenario
There is one scenario which I dubbed the 'Golden scenario'. This scenario follows the high profit margin that the Boeing 777 program once was. A Boeing 777 sold for close to $150 million not too long ago with production costs close to $100 million. This is equivalent to a profit margin of 33.33%. If we feed this into the model and let it do the math for us, things start to make a bit more sense.
Figure 2: Development deferred costs using Boeing 777 profit margin (Source)
What can be seen is that when using the profit margin of the Boeing 777, the math finally seems to add up. I also think that Boeing is aiming to achieve margins closer to 33% than to the 15%-20% analysts are expecting.
Boeing is still a long way from being anywhere close to the required profit margin, but with a lot of deliveries left in the accounting quantity and some leverages that can be utilized I think Boeing is actually aiming for the Dreamliner to follow the path of the Boeing 777: A highly profitable cash cow.
While some readers will be skeptical about this outcome, it needs to be pointed out that the Boeing 777 of which over 1,500 have been ordered was not Boeing's cash cow from the start. The aircraft found its sweet spot in the market, while Boeing simultaneously increased profitability on the airframe. A similar thing is likely to happen with the Boeing 787. Whether the Boeing 787 will fully recoup the deferred costs within the accounting block is a question that nobody can answer with certainty today. What is certain is that the deferred costs of the Boeing 777 where much lower than on the Dreamliner program. This, however, does not mean that the Dreamliner cannot grow into the role the Boeing 777 has fulfilled for years in terms of profits and cash.
At this point I think the scenario where Boeing increases the accounting quantity is the most realistic one. Additionally, charges that Boeing might need to take are no more than $7B if it does not increase the quantity.
In the end ramping up profitability on the Dreamliner program remains a challenge and I am curious to see whether the charge Boeing has taken will actually lower the deferred costs at all.
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Disclosure: I am/we are long BA.
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.