One week prior to reporting its Q2 2016 earnings, Boeing (NYSE:BA) filed an 8-K to inform investors that it would be recognizing charges in its earnings report for three of its aircraft programs. One charge that was surprising was the charge related to Boeing's Dreamliner program.
From some messages I received in my inbox and the comment section, it became clear that not all readers were aware of the production costs for the test aircraft. This subsequently led to some people thinking that Boeing loaded a bunch of other costs into the charge. In this article, I will have an elaborate look at the charge in an effort to sketch a clear picture and give readers an idea of the magnitude of the production costs. To do this in the best way possible, I have also opened a line of communication with Boeing.
Deferred production costs
A good starting point is to understand what the deferred production costs are. Deferred production costs are the costs a manufacturer makes on top of the production costs it uses for its accounting quantity. At least that is what you would think. Boeing, however, uses the term "deferred production costs," but in fact, these are slightly more than just deferred production costs. Boeing expects a certain revenue and cost for each unit in the accounting quantity. So regardless of the actual costs Boeing incurs or the actual revenue, the jet maker uses those figures to calculate earnings. The surplus in costs or difference from the assumed and realized revenue is being added to the deferred balance. So the deferred production costs are not only related to production costs, but also to the average revenue per airframe. A Boeing spokesman also called the term deferred production costs a "misnomer" in an e-mail exchange I had with him.
So Boeing currently has an accounting block of 1,300 units. For all of those units, it expects a certain earnings figure. If the actual production costs are higher than the assumed production costs, the deferred balance rises. If the production costs are lower than the average assumed production costs, the deferred balance decreases. This, however, also counts for the revenue, but inverse. If the revenue is lower than the average program revenue, then the deferred balance goes up. If the revenue is higher, the deferred balance goes down.
This way Boeing is able to pull forward profits. Up until Q1 2016, the deferred production costs were $28,651 million. On a per unit basis, this means Boeing earned $72.9 million less than it anticipated to earn on average for the first 1,300 deliveries. In Q2 2016, deferred costs rose by just $33 million (excluding the impact of the charge) for 38 deliveries. This means, that on these 38 deliveries, Boeing realized a $33 million lower profit than its program accounting method would suggest.
Boeing recognized a charge in its Q2 earnings of $847 million after-tax. However, what needs to be noticed is that the pre-tax figure is more informative. This figure is $1,235 million. The charge is related to a reclassification of two test aircraft from the deferred balance to research & development. Boeing initially intended to refurbish this aircraft in 2017, but now believes it will not be able to find any customer prior to refurbishment. Additionally, refurbishment would come at a price that is too high in combination with the sales prices. A long story short, the two test aircraft that Boeing thought it would be able to sell are not commercially saleable.
The two aircraft that are now deemed unsaleable, once served as test aircraft. The Boeing 787 flight test program consisted of six airframes. One reason for the airframes being unsaleable is the fact that these aircraft are not only heavily overweight, but also modified and have clocked 6,700 testing hours.
The fact that these aircraft were used for testing purposes makes it perfectly acceptable to reclassify them as R&D as at the moment they are unsaleable. So Boeing is not doing anything weird or out of the ordinary by reclassifying these two airframes.
One of the concerns that was raised multiple times is that Boeing could have loaded a lot more into the $1,235 million charge than the production costs. A first step to get a feeling of the numbers is by dividing the $1,235 million by 2 to get the per-unit costs. By doing so, you get a unit cost of $617.5 million.
Jon Ostrower from The Wall Street Journal tweeted that the average development costs of the five test airframes were $740 million each. Comparing this with the $617.5 million that is being recognized as R&D costs now, the charge does make sense. With that I mean, to me, it does not seem Boeing loaded a bunch of other stuff into the charge.
To verify this figure, I have looked into some of Boeing's previous earnings reports. In the Q3 2009 report, I found two things that were useful. The first thing is that Boeing has previously deemed three out of its six test aircraft unsaleable. This shows that Boeing has previously reclassified some of its test aircraft and it is generally accepted. The second thing I found is that a total of $2,619 million was reclassified. On a per-unit basis, this is $873 million. Compensating for $138 million of incurred costs that were made after production of these three airframes, the average cost per test aircraft is $743 million, which is in line with the $740 million quoted by Jon Ostrower.
For five test aircraft, that means $3.85B or $770.8 million each. Additionally, the $1,235 million of costs are confirmed by Boeing to be the production costs of these two unsaleable airframes. The sixth aircraft now serves as the trusted wings of the President of Mexico.
These unit costs in excess of half a billion dollars are high, but this is indeed the order of magnitude you should be thinking about for the production of test aircraft. The earliest aircraft that were saleable also added between $200 million and $600 million each to the deferred balance. Test aircraft are being built with longer flow times, which adds time and thus costs.
Difference between charge and reduction deferred balance
So while the reclassification and magnitude of the charge were questioned by some, to me it seems to be fair. One of the main questions that I had was where the difference between the charged amount and related decrease in deferred costs is coming from. Boeing reclassified a total of $1,235 million while it decreased the deferred balance by $1,011. This leaves a $224 million gap or $112 million per airplane.
I reached out to The Boeing Company to ask for a clarification about the difference between the charge, and spokesman Mr. Doug Alder was kind enough to provide me with a response that perfectly makes sense.
In essence, the dilutive impact on both revenue and production costs, as the program accounting is meant for, was spread over the entire block. This means that when Boeing removed the two test airframes from the accounting, it did not only remove the $1,235 million or $617.5 million per unit in production cost from the accounting quantity, but also their impact on average sales price and revenue used for the accounting method.
Since these airframes were early-builts with quite low market appeal, Boeing had to give steep discounts to potential customers. So the two test airframes negatively impact the average sales price and cost of goods used for Boeing's accounting. By removing these two unsaleable airframes from the accounting quantity, the average sales price went up compared to what it had already booked on the past 431 deliveries and the 869 upcoming deliveries in the accounting block while the average production costs went down. So, in retrospect, Boeing assumed this new average sales prices and production costs and prospectively will apply these to the units left in the accounting quantity.
The result is that the profit margin of the program went up slightly, this was also shared during the Q&A session for Boeing's Q2 earnings:
The program margin did go up slightly in the quarter overall, and but it's still very low single digits.
For airframes that were less profitable than the average earnings over the entire accounting quantity, which has been the case for all units that have been delivered up until now, this gap increased. The result is that Boeing could not only decrease the deferred balance by the $1.235B it needed to produce these two airframes, but also had to correct for the widened gap between the actual unit profit versus program profit per unit.
There are few conclusions that can be drawn from this dive in the charge:
- It makes perfect sense to reclassify the costs incurred for the production of these airframes as R&D expenses
- The charge is reflective of the actual costs Boeing incurred when producing these airframes; Nothing more, nothing less...
- The $224 million gap between the charge and reduction in deferred balance is caused by new assumptions for average revenue and costs and subsequently the program profit on a per-unit basis
Combining all conclusion and elements, one can love or hate program accounting, but Boeing did nothing wrong by reclassifying costs incurred for the production of these two airframes. Ultimately, the charge is a fair financial de-risk.
If you would like to receive updates for my upcoming articles, please click the "Follow" text at the top of this page next to my profile.
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.