The subject of Boeing’s (BA) deferred production balance on the Dreamliner program is a highly interesting one, especially as we have recently seen Boeing 787 profits flattening. The free cash flow always will be more interesting to assess Boeing’s overall performance. However, the quarterly burn-off in deferred production costs and unamortized tooling costs for the Boeing 787 is important and interesting for two reasons. The first one is that if Boeing does not zero out costs, it might have to recognize a charge, though we do not see this as a plausible scenario as long as Boeing is successful in securing sales. Secondly, if you have somewhat of a grasp on the burn-off of the balance, you can get an idea of the aircraft’s profitability relative to the program margin. With the Boeing 787 being one of the main drivers of Boeing’s cash flow profile, having the ability to see how the deferred balance develops is very nice. Those two things make the deferred balance extremely interesting to consider each quarter.
Every three months, exclusively on Seeking Alpha, readers receive three articles as part of regular coverage on the Boeing 787, which probably is among the most in-depth coverage available for this particular program:
- In one article we look at forecasts from a rather in-depth model using multiple inputs such as base values for the Dreamliner and the margins.
- In a second article we look at a forecast using a simple trendline fit model.
- In a third report, we look at the actual in-quarter performance relative to the estimates deal with in the previous two reports.
It should be noted that there’s quite a big difference between the in-depth model and the trendline model.
In the in-depth model, assumptions are being made on delivery mix, revenues, and margins, and these inputs are processed in a proprietary model, giving an estimate on what the deferred balance looks like in the next quarter as well as on the last delivery within the accounting block. The trendline model doesn’t go any further than providing a pointer on the unit improvement in costs based on past performance and does this only for the next quarter. It’s very important to comprehend the difference between the approaches used in both models and their purposes, even if the results that both methods give are the same.
So, two out of the three reports deal with estimating the deferred balance in the subsequent quarter and one even does this all the way through the last delivery in the block. A third report looks at how cost did actually develop and how that compares to the models and whether cost burn-off was satisfying during the quarter or not. This report looks at what progress Boeing actually did book on the program during the second quarter of 2019 and how it differs from our estimates
In order to understand the challenge Boeing faces on the Dreamliner program, it’s of the utmost importance that readers understand the method of program accounting and why costs on the Boeing 787 have risen to levels that were not expected before.
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 1,450 orders for its Dreamliner.
The aircraft does meet (and even exceeds) 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 system, 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 in time. 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. Meanwhile, Airbus has come up with the Airbus A350, an aircraft that can be seen as an alternative to the Boeing 777 and Boeing 787. So, the market space is not reserved to Boeing or Boeing’s Dreamliner only.
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 the higher initial production costs over a wider number of production than just on the few initial productions. In other words, costs are spread out over an accounting block, and it’s not only the costs that are spread out but also the revenues. For the Boeing 787 program, the accounting block currently stands at 1,600 units, up from 1,500, 1,400, 1,300 and 1,100 units previously.
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 1,600th 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 1,600th 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 1,600-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 that Boeing uses in their program accounting reporting (per subblock of 100 aircraft).
Deferred Balance For The Boeing 787
According to Boeing’s data, the deferred balance for the Dreamliner program topped at $28.65B in Q2 2016 and our data shows that this happened at the 431st delivery. On average, for the first 431 deliveries, each delivery was roughly $66.5 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. From an email exchange with Boeing spokesman Doug Alder, we 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, while the production costs of these aircraft were completely removed from the deferred production balance.
The removal of the test aircraft, which are considered unsuitable for placement with customers, was 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’s needed to correct for the removal of the test aircraft from the accounting quantity.
By doing so, we obtain the following graph:
Figure 1 shows how the sum of the deferred balance and unamortized tooling and other non-recurring costs has increased over time but has started decreasing since 2016. Figure 1 already gives a pretty good visualization, and one can imagine how the trend would continue in the future. What can be seen is that the deferred balance clearly decreased for the 14th consecutive quarter and that trend will not be reversed. The deferred balance after 939 deliveries is $20.8B vs. $22B last quarter or $22.15 million per airframe compared to $24.65 million per delivered airframe in the last quarter. This marks a $1.232B improvement. To make things better visible, the differences in the total deferred balance per quarter divided by the number of deliveries can be plotted.
Figure 2 shows that the decrease in deferred balance per unit changed from minus $87.7 million per airframe in Q1 2014 to $36.7 million in Q3 2019. Quarter over quarter, the deferred balance decrease per airframe deteriorated by nearly $9.3 million per unit. In Q3 2017 and Q2 2018, unit cost improvement has been offset by Boeing’s decision to extend the accounting block by 100 units during the quarter. The result is that Boeing has added 100 highly-profitable aircraft to the accounting block. This results in the average profit per aircraft within the block to go up and means that on previous deliveries the gap between the average profit and the realized profit widened. The same thing happened in Q4 2018.
After the block extension in Q3 2017, we asked Boeing to provide particular figures as they did when the company removed aircraft from the accounting block, but a Boeing spokesman refused to provide any further clarification on the matter, which, of course, is disappointing given the importance of the Dreamliner program to Boeing’s earnings going forward as well as its free cash flow profile. Keeping in mind that the realized Dreamliner profits per unit are the decrease per unit plus a program margin, which has been hiked two times in 2018 and likely will see more accretive measures in the coming quarters, the Dreamliner program is looking extremely strong for Boeing.
Boeing has set an accounting block of 1,600 units. It took the company 393 deliveries to halt the rise in deferred balance. In the quarter after reaching this top, the company reclassified the costs incurred on early test frames that were later deemed unmarketable. This 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 $25.498B. Boeing has 706 units left to recoup the balance of $20.8B. Boeing still needs 115 sales to reach the 1,600 aircraft, which is the size of the accounting quantity. Boeing has sold more than 1,400 Dreamliners, exceeding the numbers of 1,300 units initially in the accounting block, which is important since there have been some rumors each time Boeing extended the block that Boeing would never sell that many aircraft. They are doing that now. Despite near-term cooling, long-term market demand is robust to support 1,600-plus Dreamliner deliveries at a reduced production rate. This is important to keep in mind. Orders can be cancelled, but the people who were claiming Boeing wouldn’t sell even 1,100 units are proven wrong.
Currently, it does seem that each time the remaining units left in the block will fall below 100 units, the block is being extended. So, we’d be expecting a blog extension in the first quarter of 2020.
With the 661 aircraft that are yet to be delivered, Boeing needs to recoup $31.5 million per airframe on average on top of the average program margin to totally zero out the balance. Given that Boeing currently generates profits of ~30 million per airframe, the road toward zeroing out the deferred balance remains difficult, especially because the production rate is set to come down from late 2020. The Boeing 787 family’s discounted price label is in the $120-$160 million range, which means that Boeing will need profit margins north of 20% on top of average assumed margins for the balance to zero out completely. Given that Boeing’s best-selling widebody jet, which operated in an almost unrivalled market space, the Boeing 777, has margins of 25%, the task at hand for Boeing seems to have become more manageable after implementing three block extensions of 100 units each time totaling 300 units since 2017, but I expect that more sales are required. Beyond the point of 1,600-1,700 aircraft deliveries, the balance should be zeroed out and Boeing will still continue extending the block as it’s common practice, but investors and analysts will go mute on those extensions as they will merely be “business as usual” extensions and Boeing will no longer disclose further details on the balance.
In-Quarter Performance Vs. Expectations
Each quarter, AeroAnalysis provides some projections and those projections are very interesting to make, but it’s important to have a look at whether they are anywhere close to the actual performance. Using the trend for the deferred balance decrease per delivery, AeroAnalysis expected the decrease to be around ~$38 million per unit.
For the detailed model, a unit decrease of $38 million was expected based on assumptions that part of the stellar performance of the previous quarter would be maintained. The reported decrease per delivery during the quarter was $26.7 million per airframe. So, it seems that assumption was false.
In previous quarters, we observed that the curve was flattening around $30 million per airframe which I believe is close to matured profits. So, I saw little improvement in the unit costs except those driven by the delivery mix. In Q3, Boeing surprised with a unit cost improvement of $36.7 million and that invited the thought that Boeing’s unit costs were approximately $7.5 million better than what we would initially anticipate. Back in Q3, I wasn’t certain whether this was a one-off uptick in the unit cost improvement and I insufficiently emphasized that in my forecasts for Q4. That’s something I regret. In Q4 2019, Boeing showed a burn off in the deferred production balance of $27.4 million supporting my initial expectations that profits are close to being matured.
I reached out to Boeing to get some clarification on whether Q3 was an exceptionally good quarter for the Dreamliner program or Q4 included any impact on renewed block assumptions.
Boeing provided the following comment to AeroAnalysis:
…we included the (impact of the) rate reduction in the 4Q closing position. The deferred production balance decreased by $1.1B in 4Q19. This is a similar reduction to what we saw in 3Q19. Stabilizing at 12/mo versus our prior assumption of 14/mo will introduce a slight headwind for the long-term unit margin trajectory. However, many of the underlying profitability drivers remain in place (mix, pricing, supplier step-down and internal productivity). We also continue to look for ways to make our production system as flexible as possible to avoid a significant impact on unit profitability. Note, these are productions rates we’ve operated at in the past with solid productivity levels.
Conclusion: Boeing 787 profits have flattened
The fourth quarter performance on the Dreamliner program showed a reduction in the unit profits. Despite a decision to step down in production starting in late 2020, Boeing reduced the deferred production balance by nearly $5B in 2019. It will still take years to zero the balance, but I think that beyond the accounting block quantity set for now Boeing can make hundreds of additional sales with the Dreamliner on the condition that the company keeps production levels at realistic levels supporting demand. With exception for the uptick during the previous quarter, Boeing’s quarterly improvements on the Dreamliner program started to flatten. I can say that during the last quarter I was slightly more positive than I am now. During the next quarter we will likely find out whether Boeing can still make the profits rise further at a rate assumption of 10-12 aircraft per month in the coming years or whether we have reached a point of mature profits. For now, I do expect that the lower burn off in deferred production costs per unit was primarily caused by one-off pressure as Boeing reduced the production rate and lowered its assumption on some of the gains achieved by the scale of production and only slightly impacted by the headwind on the margin trajectory.
For investors, we see no reason to worry about the Dreamliner long-term challenge to zero out the deferred balance, I believe that will still happen even though production is set to be dialed back significantly, potentially leading to lower accounting block profits. We currently believe the Dreamliner is going to be one of the main supporters of Boeing’s cash profile going forward, but the growth prospects for the Dreamliner cash profile is gone.
What’s important to note is that, as long as the balance isn’t zeroed out, block extensions are regarded by some investors as a bad thing. We can partially understand that, since it seems to suggest that the profit ramp up is coming along more slowly. On the other hand, block extensions are executed as the expected number of sales grows. Boeing is starting to sell more and more slots within the accounting quantity. As the number of “unordered” units in the total block decreases, Boeing will start adding more subblocks. As sales continue growing and profits mature, they might start doing that more regularly, thereby increasing the program margins. At this stage the big question is how much of the supplier step down pricing and efficiency gains Boeing is going to be able to preserve as it dials back production on the Boeing 787 program. 2020 will likely be another strong year for the Dreamliner deferred production balance burn off, but starting 2021 we have moderated our expectations.
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