Boeing: Did This Bearish Analyst Really Pay Attention?

| About: The Boeing (BA)

Summary

Deferred production costs cover more than the name suggests.

Deferred can rise while production is profitable.

Epstein's questions show that he either did not do his homework or did not understand deferred production costs, at least not in the way Boeing uses it.

During the Q&A session, analysts and media are able to ask some detailed questions. Due to time constraints, each analyst is allowed to ask 1 question, and if you are lucky you are able to squeeze in a follow up question.

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In the Q&A session following Boeing's (NYSE:BA) Q2 earnings report, analyst Ronald Epstein from Bank of America Merrill Lynch almost completely wasted his question.

His question can be split in 2 questions, and I will be using question 1 to make a remark and question 2 to clarify a few things that seem to be unclear to not only investors but also to at least one seasoned analyst.

Question 1:

So I guess maybe a question for both of you just to see if we're thinking about this right. Does the roughly $1 billion of deferred that was moved pre-tax to R&D, does that imply if you take that $1 billion and divide it by what's left in the block that the profitability per airplane goes up by about $1 million on a program basis?

This question seems very reasonable. However, if you look closer into the question, it really does not make a lot of sense. With over 400 units delivered, Epstein links the reduction in deferred balance to profitability going up on a program basis by roughly $1 million for undelivered units. This does not make sense since the reduction in deferred production has to do with the cost incurred for the 2 test airframes being reclassified to R&D. Dividing the reduction in deferred balance by the undelivered units in the accounting quantity is a per unit figure that gives you no information whatsoever on possible changes in Boeing's assumption for the program profits per unit. It only tells you that Boeing will have to recoup $1 billion or $1 million per unit less in the remainder of the accounting block.

Question 2:

And then I guess the second part of that question is, when do you expect the program on a unit basis to be cash flow breakeven for 78?

This question is one that amazed and confused me at the same time. In this case, cash flow positive simply means that revenues exceed production costs. This is not the same as profitable production, but is very close. In the 4th quarter of 2015, Boeing already went cash positive on a unit basis and it is mind-blowing to see that Epstein seems to have missed this.

That Boeing was close to breaking even could be known from the guidance it provided last year, but also from Boeing's wording in the earnings reports. In Q3 2015, it was still speaking of 'dilutive impact of higher 787 deliveries' while this remark about operating margins being pressured by the 787 was not present in the Q4 report.

I will never know what confused Epstein, but the only thing I could think of is that he saw the deferred balance rising and therefore assumed Boeing did not break even yet. A rising deferred balance, however, does not mean that production is not yet profitable or cash positive. There actually is a simple way to explain rising deferred production costs on profitable production.

Booking insufficient profits

The name 'deferred production costs' suggests that if production costs exceed the average production cost assumed for the entire accounting quantity that the surplus will be added to the deferred balance.

Boeing's method, however, does not only assume a certain cost but also a certain revenue for the airframe. So Boeing actually assumes an average profit per airframe. As long as Boeing's realized profit per airframe does not meet that average profit, the deferred production costs will rise.

This can easily be demonstrated with an example:

Example

Company Alpha expects program unit revenues of $120 million and program costs of $100 million. The program profit per unit therefore is $20 million units.

Actual revenues for a certain delivered airframe are $115 million and the costs to produce this airframe were $110 million. The unit profit is $5 million.

In this case, $15 million, $20 million minus $5 million, will be added to the deferred balance and the production is said to be cash positive.

A second airframe is delivered with a revenue of $90 million and production costs of $100 million. The unit loss is $10 million.

In this case, $30 million, $20 million minus minus (becomes pls) $10 million, will be added to the deferred balance and the production is said to be cash negative.

*Figures from the example do not reflect actual costs, revenues or assumptions for either metric.

The examples clearly show that production can be profitable but that does not mean deferred balance goes down. Additionally, missing on top line has implications for the deferred balance as well, unlike the term 'deferred production costs' suggests.

Conclusion

Epstein's questions did not seem to be well formulated in the best case, leading to less informative answers from Boeing. The informative part that could be extracted was that the average profit margin on the program went up, but that is where it pretty much stopped. In the worst case, Epstein had not paid attention to previous reports and had no clue about what was included in the deferred production costs.

This does not mean that his coverage and analysis of Boeing's programs are incorrect, but from an analyst touting the bearish case for Boeing with a main role for the Dreamliner program accounting, I would expect better formulated questions that show know-how.

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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.