The Boeing (BA) 787 program is likely one of the most-watched commercial aircraft programs from a cost perspective for the company… or well, it used to be until the Boeing 737 MAX took over that questionable honor. Boeing uses program accounting to report average profits for an accounting block of 1,500 units, while any excess or shortfall in profits is added to a deferred production balance, which should be zeroed by the last delivery in the accounting quantity.
In this report, we will have a look at what our expectations are for the performance in the third quarter of 2020 and the deferred production balance at the 1,500th delivery. We think it’s very useful to do so because it gives an idea of Boeing’s ability to generate certain profits on production and of the ramp-up pattern of those profits and possibly indicates whether there’s a need for charges in the future based on current expectations.
This report is in addition to the report that we already wrote on our expectations for the third quarter based on past performance. While this report also does include a projection for the second quarter, the calculation method is significantly different. Whereas the method from the previous report merely projects one quarter ahead based on past performance, the method used for this report is more elaborate as it uses a combination of margins and sale price estimates for the variants of the Boeing 787 aircraft as well as delivery mix and reduction in the deferred production balance during previous quarters. This allows us to estimate the deferred production balance decline on a per unit basis instead of a per quarter basis, which enables us to project the deferred balance for the entire accounting quantity.
Investors also should note that this is one of the few moments where you get a “peek in the kitchen.” Once the balance is zeroed out, it’s unlikely that Boeing will quantify anything on the Dreamliner program other than accounting quantity increases, backlog, deliveries, and production, and you will not be given a clue about cash and profit generation on the program because it would reveal the profitability of the aircraft program.
During 2017, the program saw some key events with the first flight of the Boeing 787-10, the biggest variant of the Dreamliner program, orders from key customers, and a long-awaited extension of the accounting block.
Changes to the accounting block were made in the third quarter of 2017 and the second and fourth quarter of 2018. Boeing’s next step up in efficiency followed with the addition of the Boeing 787-10 to the delivery mix in 2018 and the increased production rate from 12 aircraft per month to 14 aircraft per month in 2019. Over the past few quarters, AeroAnalysis contacted Boeing several times to exchange thoughts and views, and that has allowed us to quite accurately model the deferred balance development. In the third quarter of 2017, Boeing extended the accounting block by 100 aircraft. A block extension is what we have been expecting for a while. Another extension followed in Q2 2018, again a 100-unit extension. In the first quarter of 2020, Boeing announced a 100-unit reduction in the block size, while production is now anticipated to decline to seven units per month in 2022.
Source: Economy Traveller
Gaining understanding of program accounting and the development of the deferred balance is very important. An example demonstrating this: At the start of 2016, Boeing shares sank on the announcement of an SEC probe that would focus on the program accounting method on the Boeing 747 and Boeing 787 programs. Although this potentially could harm Boeing, we viewed the drop in share prices overdone, and it likely was the result of investors being unfamiliar with program accounting and alternatives to recognizing charges. Any investor who bought on “the dip,” which almost was a no brainer, has seen their investment pay off well with a ~100% return (300% if it weren’t for the Boeing 737 MAX crisis to hit Boeing fair and hard). Aerospace isn’t “sexy” to invest in compared with tech and certain other areas, and it might not be as rewarding as biotech, but if you know what you are investing in and are able to put certain subjects in a bigger context, then it can be very rewarding.
Since not all my readers are familiar with the program accounting method and program accounting on the Dreamliner program, we have provided a brief overview below.
Boeing uses program accounting for its commercial aircraft programs instead of unit cost accounting. To understand what the deferred costs are, it’s important to know how program accounting works. On programs where initial production costs are high, such as aircraft programs, 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 and are not only the costs that are spread out but also the revenues. For the Boeing 787 program, the accounting block currently stands at 1,500 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. Unless the company has set an average program margin of 0% – which it has not – a zero deferred balance indeed is no indication of a breakeven point and should not be considered as such. Analysts pay close attention to the deferred balance, and so should investors. The reason is that it’s likely Boeing needs to recognize a charge if it has not zeroed out the deferred costs by the 1,500th delivery (the number of units in the accounting quantity) or announce another block extension, which we deem more likely.
Simultaneously, one should be aware of the fact that, if Boeing zeroes out its deferred balance by the 1,500th delivery, it will have realized the profits that it estimated for the accounting block and the profits it has been reporting for the program valid after all. So, the 1,500-unit accounting block is far from a breakeven point. Even if Boeing does not zero out the balance by the last delivery and has to recognize a charge, it can still have booked a profit if the recognized charge is lower than the realized program profit.
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 vs. the assumed program profits.
Changes To The Model
The model that AeroAnalysis developed has been used for the past few years to monitor the development of the deferred production balance. As we have gained more insight and as the matter also has become more complex, we have started to expand the depth of the modeling. In the end, our modeling depends on assumptions of sales prices, production costs, delivery mix, ramp-up, and cost-cutting measures. We think it’s important that readers know when we make changes to the model to achieve desired accuracy. Therefore, these changes since Q1 2018 are discussed below.
Q1 2018: The model has been completely rebuilt to allow for more dynamic inputs.
Q2 2018: The total balance that Boeing needs to recoup on the Boeing 787 program consists of two sub balances. The first one is the deferred production balance, and the second one is unamortized tooling costs and other non-recurring costs. In previous modeling attempts, we always considered the deferred production balance only, assuming that Boeing would first build off the deferred balance and, after that, start reducing the unamortized tooling costs. This assumption was nothing more than an assumption to simplify the calculation process. We have lumped both balances since it’s more important to be able to assess the overall improvement rather than being able to attribute performance to either of the balances. Additionally, the ramp-up pattern has been flattened somewhat since we previously overstated the improvement by $153 million to $367 million. This is just 1.5% of the deferred production balance. But, in absolute figures, we are talking about several millions per airframe, and previously, the model estimated the balance within a 1% margin and often within a 0.5% margin. In light of that, we deem a 1.5% deviation to be too high, and it could even make the difference between having to recognize charges and extending the accounting block – or not. The delivery mix has been adjusted, and additional cost-cutting measures have been estimated in a separate column.
Q3 2018: Additional margin improvement has been implemented in the automated calculation model as Boeing saves money on titanium and steps up its production in 2019, and considering that earlier statements from Boeing on initial margins have been implemented more accurately. Savings from aft-redesign work on the Boeing 787-8 have not been implemented, as the scale of savings and implementation point are not known. Additionally, the model now includes the adjusted delivery mix accounting for 1,500 units in the accounting block as well as two ways to minimize the three pricing schemes.
Q4 2018: Pricing adjustment for the Boeing 787-10 and final delivery mix for 2018 implemented. Pricing scenarios have been eliminated and a possible deviation on the balance has been implemented. The delivery mix for 2019, according to NYC787, has been implemented.
Q1 2019: Block extension to 1,600 units and new estimate on transition point toward higher production this year has been implemented.
Q4 2019: Pricing adjustment for the Boeing 787-10 and final delivery mix for 2019 implemented.
Q1 2020: Block extension to 1,700 units anticipated as well as production decline to 8 units per month.
Q2 2020: Block size has been reduced to 1,500 units consistent with Boeing’s current accounting quantity.
Third Quarter Estimate And Full-Block Estimate
Our third quarter estimate includes some assumptions that impact the deferred production balance going forward. If those assumptions do not reflect what Boeing will announce, we will likely be far off in our assessment of the in-quarter burn off of the deferred production balance. Currently, I’m expecting that the deferred balance decrease to be in the $1.2B-$1.3B range. However, what should be noted is that currently there are several layers of added complexity as there are longer, but also near-term, phenomena that can significantly alter the deferred production balance burn off profile.
Quite important to note is that, currently, the model shows that the production balance will not be zeroed by the 1,500th delivery. Driven by expectations on lower production rates and a block extension, I now expect the balance to be zeroed at 1,600 deliveries, which is a shift of 56 units in the negative direction. This in part is driven by uncertainty on how the deferred production balance will be reduced because there’s an unusual big difference between the delivery numbers and actual produced aircraft during the quarter. We believe that if Boeing decreases the assumed margins for some subblocks, then as odd as it may seem that could increase the deferred production balance because Boeing previously classified some of those potential burn offs as program margin profits.
In previous quarters, I saw no reason for investors to worry about the Dreamliner program. Obviously, with the current environment in which COVID-19 and air travel recovery are new dynamics, that has changed, introducing production pressures that could significantly erode the stellar financial execution on the Boeing 787 program. It will be interesting to see whether Boeing can post anything that comes even close to our low expectations in a quarter where delivery numbers have been dented. If that does not happen, then I’m slightly more positive (than I have portrayed in this analysis) about the financial prospects. With Boeing already facing multiple cash pressures, having to slice Dreamliner production is going to increase pressure on Boeing, but certainly something that could be part of the new normal for Boeing. The new rates and accounting quantity push out the point at which the Boeing 787 production balance would be zeroed, and that is definitely dissatisfying as the way in which the Dreamliner project has been managed financially but also in terms of engineering and supply chain management is a fiasco that has put Boeing in a position where, in aggregate, it has been booking profits higher than actually realized for quite some time, and that is now set to continue showing that, while the theory behind the method works… the execution is so poor it shouldn’t be applied without setting a set of constraints.
Either way, I believe that the decision to consolidate production should positively impact the prospects of the Dreamliner program in a low-production rate environment avoiding a reach-forward loss.
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Disclosure: I am/we are long BA, EADSF. 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.