An article that I write every quarter is one 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, I've decided to split the returning analysis into three parts. Two parts will focus on forecasting the deferred balance in the upcoming quarter using two different methods, while the third article will look at the in-quarter performance to see how accurate the model is and how Boeing's profit ramp up is coming along. 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.
In this article, I will look at the performance of the Boeing 787 during the second quarter for the Boeing 787 program.
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 1,275 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.
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. 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 break-even point. Analysts, however, tend to use this accounting quantity as a sort of break-even aim. The reason being that it is likely Boeing needs to take a charge 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.
Deferred Balance for the Boeing 787
According to 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, for the first 393 deliveries, each delivery was roughly $73 million less profitable than the average assumed profit for the accounting block.
In the second quarter of 2016, 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 email 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.
By doing so, we obtain the following graph:
Figure 1: Accumulated deferred costs per quarter (Source: AeroAnalysis)
Figure 1 shows how the deferred balance has increased over time but has been flattening over the past few quarters. Also, figure 1 already is a pretty good visualization, and one can imagine how the trend would continue in the future. What can be seen is that although the deferred balance clearly decreased for the third quarter in a row, the decline was somewhat less steep compared to what you might expect given from the shape of the graph (past performance).
The deferred balance after 565 deliveries is $26.461B versus $26.992B last quarter or $46.8 million per airframe compared to $50.7 million per delivered airframe in the last quarter. To make things more visible, one could plot the differences in the deferred balance per quarter and divide by the number of deliveries.
Figure 2: Boeing 787 Deferred Balance Decrease Per Delivery (Source: AeroAnalysis)
Figure 2 shows that the decrease in deferred balance changed from minus $83.5 million per airframe in Q1 2014 to $16.1 million in Q2 2017. Quarter over quarter, the deferred balance decrease per airframe improved by 62.6%, significantly better than the 52.3% improvement in the previous quarter. The absolute figure, however, better reflects the robustness of the improvement. In Q2, the deferred balance built off improved $6.2 million per airframe compared to an improvement of $3.4 million per airframe in the previous quarter.
Figure 2: Accounting block Boeing 787 (Source: AeroAnalysis)
Boeing has set an accounting block of 1,300 units. It took the company 393 deliveries to halt the rise in deferred balance. In the quarter after reaching this top, the company recognized a charge that led to a lower deferred balance. If we add back this charge or deduct it over the entire range, which is more suitable, the actual top was at 431 deliveries with a deferred balance of $27.68B. Boeing has 735 units left to recoup the costs. Not all units that are already sold fall within the accounting quantity, but for simplicity's sake, we can say that Boeing will still need 25 sales to reach the 1,300 aircraft, which is the size of the accounting quantity.
With the 735 units that are yet to be delivered, Boeing needs to recoup $36 million per airframe plus $4.6 million per airframe in amortized tooling costs. Given that Boeing currently recoups around $16.1 million per airframe, the road toward zeroing out the deferred balance is a long one. The Boeing 787 family's discounted price label is in the $117-150 million range, which means that Boeing will need profit margins in excess of 30% to make things work for it. Given that Boeing's best-selling widebody jet, which operated in an almost unrivaled market space, the Boeing 777, had margins of 35%, and now, with heavier discounts, around 25%, the task at hand for Boeing is extremely challenging.
In-Quarter Performance Vs. Expectations
Each quarter, AeroAnalysis provides some projections, and those projections are very interesting to make, but it is important to have a look at whether they are anywhere close to the actual performance. Using the linear improvement trend for the deferred balance decrease per delivery, I expected the decrease to be between $13.25 million and $16.15 million. I took the low end of the range as the minimum, but Boeing managed to actually hit the high end of the range just $0.06 million lower than my high-end estimate.
What is important to note here is the accuracy of the model. While predicting or trying to predict the deferred balance by some is labeled as "guesswork" or even "unreliable," it is important to see that the difference between the realized deferred balance and the actual reported figure has been within 0.15% in the last quarter with the biggest difference being .14%, and the model with the lowest difference only had a 0.06% error. Even the cumulated differences are less than 1% of the highest reported deferred balance figure, which is a pretty neat accuracy thus far.
In the latest quarter, the difference between what I expected and what Boeing achieved was only $16 million or half a million dollars per airframe. So, statements about trying to predict the deferred balance being nothing more than guesswork are not supported by simple calculations of the accuracy of the model. Saying that the model is validated would be a bit too much, but the model does seem to do a good job projecting the deferred balance for upcoming quarters.
Despite a relatively big improvement from going from below average profits to above average profits, the road for Boeing is still a long one, and it is safe to conclude that Boeing is at the start of a steep ramp-up in margins. The jet maker should increase margins to the mid-30s in order to avoid charges or the need to increase its accounting block. Currently, I think the most likely scenario is that Boeing will extend its accounting block once again, but I am slightly more positive about Boeing's ability to execute a fast ramp-up. In the upcoming two to three quarters, we will likely see whether that increased positive sentiment is justified.
Currently, I view the Dreamliner program as one of the main programs to drive Boeing's cash flow growth. In the long term, Boeing still has to de-risk the program in some way or form.
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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.
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