Boeing: Drawing Up The Balance After 500 Dreamliner Deliveries

| About: The Boeing (BA)


Boeing ended 2016 with exactly 500 deliveries.

Boeing is ramping up profits faster than I initially expected.

Chances of block extension or charge are not eliminated.

One of the articles that returns every quarter is the article about Boeing's (NYSE: BA) ability to increase profitability on the Boeing 787 program. Over time, this article has become more forward looking, making it harder for people who are new to the subject to understand all of it.

Therefore, after feedback from a Seeking Alpha editor, I have decided to split the returning analysis into two versions: A basic version that can be read here explains the importance and progress to new readers and a more advanced version that is more suitable for people already familiar with the subject. By doing so, I hope to better assist people who are new to the subject as well as people who know the subject inside out.

The Boeing 787

The Boeing 787 is the airplane that Boeing launched after oil prices increased and the airline industry was coping with a crisis that followed the 9/11 attacks. Competitor Airbus ( OTCPK:EADSF) ( OTCPK:EADSY) bet on the hub-spoke network with airport congestion as its main focus and launched the Airbus A380.

Boeing bet on the point-to-point network that required smaller aircraft such as the Boeing 787. The jet maker aimed to cut costs by 20% compared to the Boeing 767. The aircraft was revolutionary in almost every sense, and to date the jet maker has grossed 1,200 orders for its Dreamliner.

The airframe does meet its promises on fuel burn, but delays in the development have significantly increased development costs. In fact, development costs are so high they are widely considered sunk costs that will never be recovered. A production model, where Boeing transfers risks to its supply chain, has backfired as core elements in the supply chain coped with an inability to scale up production or deliver products from the desired quality standard.

This led to Boeing building up deferred costs at a much faster pace and much higher than it had ever anticipated and teething problems after service entry did not make things better for the Dreamliner program.

Before Boeing even delivered a single airframe, it had built up roughly $10B in deferred costs.

Program accounting

Boeing uses program accounting for its aircraft programs instead of unit accounting. To understand what the deferred costs are, it is important to know how program accounting works. In programs where initial production costs are high, it does make sense to amortize costs over a wider number of productions than just on the few initial productions. In other words, costs are spread out over an accounting block or quantity. For the Boeing 787 program, the accounting block currently stands at 1,300 units up from 1,100 units.

Boeing says that the units in the accounting block are units of which it can credibly estimate costs and revenues, but should not be considered an indication for a breakeven point. Analysts, however, tend to use this accounting quantity as a sort of breakeven aim. The reason being, that it is likely Boeing needs to take a charge or extend its accounting quantity if it has not zeroed out the deferred costs by the 1,300th delivery (the number of units in the accounting quantity).

Simultaneously, one should be aware of the fact that if Boeing zeroes out its deferred balance by the 1,300th delivery, it will actually have made the profits that it estimated for the accounting block and that the profits it has been reporting for the program were valid after all.

The assumption for costs and revenues means that Boeing assumes an average profit figure for each of the aircraft it currently delivers. If the actual profit figure is lower than the assumed profit, the deferred balance rises. If the profit is higher than the assumed profit, the deferred balance declines. So the deferred balance tells you how profitable or unprofitable the program has been to date versus the assumed program profits.

Contrary to what one of my readers claimed, the deferred production costs balance is related to the difference between realized profits and estimated profits rather than just the difference between average and realized production costs. Before writing the article on which the reader commented, I have been in touch with Boeing on the subject. It is everybody's interest that I do provide accurate information and that this information is verified where possible to avoid confusions.

Deferred balance for the Boeing 787

Per Boeing's data, the deferred balance for the Dreamliner program topped at $28.65B in Q1 2016 and our data shows that this happened at the 393rd delivery. On average, each delivery was roughly $73 million less profitable than the average assumed profit for the accounting block.

In the second quarter, Boeing removed two test aircraft from the accounting block and reclassified them as R&D costs. As a result, the deferred balance dropped by roughly $1B. In an e-mail exchange with Boeing spokesman Doug Alder, I understood that the removal of the test aircraft from the accounting block led to the underlying assumed average profit per airframe to go up slightly.

The removal of the test aircraft, which are considered unsuitable for placement with customers, is a welcome de-risk. However, in order to get an accurate view of actual progress in zeroing out the deferred costs, which is the obvious target for Boeing here, it is needed to correct for the removal of the test aircraft from the accounting quantity.

In Table 1 you see what I expected Boeing to report and what Boeing reported.

What can be seen is that Boeing's progress in zeroing out the deferred balance has been significantly better than I did expect before. Even when compensating for the top of the deferred balance that was $14 million lower than expected, the gap is still $100 million in Q3 2016.

While I only have two data points to better match the model, it is worth it to start an iterative process that will be verified with data Boeing releases each quarter. By doing so we obtain a model that can estimate the deferred balance per quarter more accurately.

Since the gap is quite significant I have reason to believe that not only the delivery mix is playing a role here, but the ramp up towards full profitability is going significantly faster than I assumed earlier.

The renewed model is not a perfect fit but does assume a faster ramp up pattern towards full profits. Whereas I first assumed a deferred balance of $27.5B for Q4 2016, I now expect the deferred balance to drop by $168 million to $27.35B.

The renewed model assumptions better fit past performance, but it is main purpose is to look at the 1,300 th delivery and see how the balance looks at that point. Previously I expected the deferred balance to be roughly $7B. The new model, however, suggest that the deferred balance will be roughly $2.5B plus the unamortized non-recurring costs.

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Although there still is need for a charge or accounting block extension, Boeing has been ramping up profits at a significantly faster pace than I expected. Not only does this make the case for a block extension more realistic, it also means that its cash performance will improve faster than I initially anticipated.

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Disclosure: I am/we are long BA.

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