The subject of Boeing’s deferred production balance on the Dreamliner program is an interesting one. The free cash flow will always be more interesting to assess Boeing’s overall performance. However, the Boeing 787 burnoff in deferred production costs and other costs is important and interesting for two reasons. The first one is that if Boeing does not zero at costs, it might possibly have to recognize a charge. Secondly, if you have somewhat of a grasp on the burnoff of the balance, you can get an idea of the aircraft’s profitability relative to a low-single-digit 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 and assess each quarter.
Every three months, readers receive three articles as part of regular coverage on the Boeing 787. The quarterly coverage based on in-house developed tools and data collection is uniquely covered on Seeking Alpha and probably the most in-depth and accurate coverage you’ll find. One article looks at forecasts from a rather in-depth model and the second method looks at a forecast using a linear model. It should be noted that there is quite a big difference between the in-depth model and the linear 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 linear 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 is very important to comprehend the difference between the approaches used in both models and their purposes, even if the results that both methods give might be the same.
So two out of the three articles 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 article looks at how costs did actually develop and how that compares to the models and whether cost burnoff was satisfying during the quarter or not.
In order to understand the challenge Boeing faces on the Dreamliner program, it’s of 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.
In this report, we focus on the burnoff during the first quarter of 2018 and look where it differed from our expectations and we will attempt to explain those differences if possible.
The Boeing 787 is the airplane that Boeing launched after oil prices increased and the airline industry was coping with a crisis that followed after the 9/11 attacks. Competitor Airbus 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 1,355 orders for its Dreamliner.
The aircraft does meet 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 suppliers failed to 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 only.
Boeing uses program accounting for its aircraft programs instead of unit-cost 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 and it is not only the costs that are spread out. Boeing makes assumptions on the revenues as well. For the Boeing 787 program, the accounting block currently stands at 1,400 units, up from 1,300 and 1,100 units earlier.
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 for the total deferred balance. If Boeing zeroes out its deferred balance by the 1,400th 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. So, the 1,400-unit accounting block is not a breakeven point in the sense of profits.
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. The method allows for high initial costs and low initial revenues to be spread over a certain block size resulting in smoother profit recognition.
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. Our data shows that this happened at the 431stdelivery. 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. In 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, 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:
The deferred balance after 670 deliveries is $27.7B vs. $29.5B last quarter or $41.4 million per airframe compared to $46.4 million per delivered airframe in the last quarter. 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 $83.5 million per airframe in Q1 2014 to $23.5 million in Q1 2018. Quarter over quarter, the deferred balance decrease per airframe improved by roughly 12.6%.
In Q3 2017, 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.
We have asked Boeing to provide more specific figures as they did when the company removed aircraft from the accounting block, but a Boeing spokesman denied 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.
Boeing has set an accounting block of 1,400 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 production balance of $25.498B. As of the end of Q1, Boeing has 730 units left to recoup the costs of $27.7B. Not all units that are already sold fall within the accounting quantity, but for the sake of simplicity we can say that Boeing will still need 45 sales to reach the 1,400 aircraft, which is the size of the accounting quantity. So Boeing has almost sold the numbers of units in the accounting block, which is an important step especially 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. Market demand is robust to support 1,400-plus Dreamliner deliveries.
With the 730 units that are yet to be delivered, Boeing needs to recoup $38 million per airframe on average to totally zero out the balance. Given that Boeing currently recoups >$23.5 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 $115-150 million range, which means that Boeing will need profit margins higher than 25% 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 unrivaled market space, the Boeing 777, has margins of 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, AeroAnalysis expected the decrease to be around $25 million to $26 million for our linear model.
Using the detailed model, a unit decrease of $29.6 million was expected. The reported decrease per delivery during the quarter, however, was $23.5 million per airframe or $206 million lower than we expected. Over the past few quarters our model has overestimated the improvement and we expect that this is related to the block extension, which we estimated to have a $215 million negative impact going forward. The second scenario, which we didn’t present in our preview of the deferred production costs for the Dreamliner program, takes the estimate from scenario 1 (an estimate that gets aligned quarterly) and applies what we believe is the pressure from the block extension. We believe that each quarter, Boeing’s reported balance should at least be around the lower point and in steeper cost cutting achievement around the higher point.
During the first quarter, Boeing reduced its deferred production balance by $799 million. This is roughly $206 million lower than the decrease AeroAnalysis has modeled. Looking at the accuracy of the model in the past, this is quite a big difference, but the error is still within 1%, which is quite good considering that Boeing does not supply any pricing data or info to make the model more accurate. We also continue to see that the correction to the model has produced more consistent results since the block extension producing an error of less than half a percent.
For investors, it is important to continue assessing the cash profile of the company as a whole, since this also includes the cash improvement of the Boeing 787 program. Overall, improvements in pricing, delivery mix, production and continued efforts to reduce the risk of having to recognize a charge have somewhat taken the eyes away from the Boeing 787 cash profile but that shouldn’t be considered a bad thing. Despite a gap between the projections by AeroAnalysis and the actual decrease realized by Boeing, the conclusion does not change, and that conclusion is that Boeing is heading in the right direction and is using the Boeing 787 sales success to increase value to shareholders while the delivery mix is becoming more favorable. Ultimately, Boeing’s ability to zero out the deferred costs hinges on a more favorable delivery mix, further pricing stepdown with suppliers, lower costs associated to higher production rates and additional efforts to reduce costs. If any of these elements does not fully materialize or does not materialize timely, Boeing might have to extend the block once again or recognize a charge. So, Boeing is on the right track but the way we view it there is little room for error, as additional costs-cutting measures on top of the ongoing improvement barely zero out the deferred balance.