With wide body aircraft order inflow drying up, a logic next question that one can ask whether it is wise for Boeing (NYSE:BA) to keep increasing production rates for its narrow body program. These concerns have been amplified somewhat as there are serious concerns on capacity increases in the airline sector (NYSEARCA:JETS) that put pressure on yields. Airlines such as Turkish Airlines have deferred deliveries, same counts for Southwest Airlines (NYSE:LUV)
Backlog and production rate
An important thing to look at when determining whether a production rate is justified or not is by looking at the backlog. Boeing received orders for 10,362 Boeing 737NG and Boeing 737 MAX airframes of which 6,012 units have been delivered. This leaves a backlog of over 4,300 aircraft. With the current production of 42 aircraft a month, this would indicate a backlog stretching 8 years.
It, however, is important to look at the development of the backlog and book-to-bill ratios. Ideally, a jet maker would try to keep backlog stable stretching 3-5 years to have somewhat of a buffer. So in that sense, with a backlog stretching 8 years, further increases do make sense.
Figure 1: Orders and deliveries for the Boeing 737NG and 737 MAX (Source: AeroAnalysis)
Looking at the orders and deliveries it can be seen that deliveries have been growing almost linearly, while order inflow showed a cyclic behavior. The cyclic behavior is to be expected, but it needs to be observed that also this cyclic behavior shows an upward trajectory.
Now to make things better visible it is worth to look at the backlog growth:
Figure 2: Backlog growth and accumulated backlog for the Boeing 737NG and 737 MAX (Source: AeroAnalysis)
On the left axis the backlog growth is shown with the backlog accumulation on the right axis. The backlog growth better makes the cyclic nature of order inflow visible. What can be seen is that there are only a handful of years with backlog declining and the backlog growth cycle lasts 5-7 years. For 2016 we are seeing deliveries slightly outpacing order inflow.
It can be seen that the launch of a new generation of aricraft (1993 and 2011), marks the start of a new cycle. So with that in mind as well as a small interim spike when airlines place follow-up orders combined with demand further hikes seem to be no problem.
The question, however, is how much rates can still be hiked. In the coming 20 years there will be demand for 28,140 narrow body jets. That equals to over 1,400 jets a year. If we assume that the likes of Bombardier (OTCQX:BDRAF) and COMAC will be winning a total market share of 10% there are still 1260 jets to be sold by Boeing and Airbus (OTCPK:EADSF). Airbus has an advantage with its narrow body product, so if we assume a market share of 45%, we get to around 570 orders a year for the Boeing 737. If we assume a 5% market share for COMAC and Bombardier, calling it a flop, there would be 600 order per year for Boeing on average at current market shares.
Boeing already has announced to be increasing output to 57 a month or 684 jets a year. This means that it would be very likely that Boeing would start 'eating' through its backlog. There are further rate hikes planned from the current 42 per month to 47 per month in 2017 and 52 per month in 2018.
By year end I think the backlog will be more or less stable at 4,200-4300 aircraft. In the case of Boeing getting 600 orders per year, Boeing would start eating through its 4,000+ unit backlog at a rate of 84 jets a year.
In the case where Boeing can count on 570 orders a year, this gap would widen to 114 jets a year. With order cycles of about 7 years, running out of backlog at current announced rates is not a threat. Boeing can produce 6-7 years (one full cycle) without getting orders before it runs out of backlog.
Delivering this backlog within 5 years would mean that Boeing should raise production beyond 70 aircraft a month and that is with zero order inflow.
Looking at the graphs, increases of the production rate for the Boeing 737 are justified. Even without order inflow Boeing has years of backlog with room to increase rates to deliver aircraft within a 5-year timeframe. Since 1993 Boeing booked 1.75 orders for every 737 it delivered. Even over the past 10 years, book-to-bill rations have been far above 1. If Boeing's market share declines to 33% of the unfilled market, there is little to worry about for the long term.
At 63 aircraft per month the Renton facility will be maxed out and Boeing's will not even risk strong backlog decline. There is some risk regarding the stress on the supply chain. With the supply chain having to cope with rate increases from Airbus as well as Boeing, there is a significant risk that rate increases might put unbearable stress on the supply chain. A thorough stress test is required before Boeing increases rates even further.
With the 737 being one of Boeing's financial successes, the rate increases towards the maximum output is a logic one as it makes full use of the facility.
Additionally, Boeing should also start looking for a 737 replacement coupled with a new production facility that could push narrow body production beyond 750 aircraft. Most aircraft orders are being placed in the years after the launch of a new generation aircraft. So to Boeing it is key to come up with an all-new concept on the narrow body market that improves its ability to compete and will bring solid growth to the order book.
In absence of such a project launch, rate increases could be short-lived and Boeing could face some challenges if market conditions deteriorate. Most important to further increases is the timing of such rate hikes, increases have to reflect market demand which is almost directly related to economic growth.
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Disclosure: I am/we are long BA.
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