10 minutes read

During the presentation of second quarter financial results, Boeing (BA) hinted that it might temporarily halt production of the Boeing 737 or further decrease the production rate from the current rate of 42 aircraft per month. By some, this rate of 42 aircraft per month has been regarded as sign of strength and sustainability. In this report we explain why this is not necessarily the case, we have a look at why Boeing kept the rate of 42 per month, and why the jet maker has contemplated a production rate decrease or temporary shutdown. In 2-3 separate reports we will look at why Boeing is keeping the production rates at 42 single aisles per month but from a different perspective.

In total, there will be three general reports on the MAX production rate:

  1. This report to look at the importance of the Boeing 737 on a factory level and to research whether there’s any connection between the Boeing 737 delivery payments and backlog on one hand and the Boeing 737 MAX production rate on the other.
  2. A report to research whether there’s any connection between pre-delivery payments on the Boeing 737 MAX and the production rate as well as a return-to-service schedule.
  3. A report to research whether there’s any connection between unit profits on wide body production and Boeing’s ability to keep producing the Boeing 737 MAX at the current level without hurting the overall business too much.

Deliveries and backlog

Figure 1: Boeing 737 deliveries per quarter (Source: AeroAnalysis)

What we see is that since the third quarter of 2017, Boeing has started producing more Boeing 737 MAX aircraft in favor of the Boeing 737NG. From Q3 2017 to Q3 2018, MAX deliveries were up 33 units or 116% while NG deliveries were down 40 units or 33%.

Up until July, Boeing has delivered 114 Boeing 737 aircraft including 57 Boeing 737 MAX aircraft. Those aircraft have a value of $6.5B which (in a rough calculation) would allow Boeing to produce 157 Boeing 737 MAX. However, it should be taken into account that delivery payments are lower than the actual value as milestone payments occur months and years prior to delivery. Taking this into account, the deliveries up until July pay for the production of just 94 Boeing 737 MAX aircraft. 94 aircraft is equivalent to less than 2.5 months of production. So there’s no cash balance between the Boeing 737 aircraft delivered year-to-date and the production rate of 42 aircraft per month for the Boeing 737 program. In fact, I suspect that Boeing pays a significant portion of supplier costs after deliveries, meaning that with the Boeing 737 deliveries occurred to date, significantly less than 94 aircraft productions can be financed.

Afbeeldingsresultaat voor 737 p-8

Source: Boeing

The decline in deliveries of the NG aircraft is not a surprise. It’s what Boeing had planned and the supply chain as well as sales efforts were brought in line with that planning. As a result, Boeing currently has an extremely slim backlog for the Boeing 737 Next Generation aircraft. The last Boeing 737-900ER was delivered in June 2019 and the most popular member of the NG family, the -800, has just nine aircraft that are yet to be delivered. Additionally, there are 38 P-8A Poseidons in backlog as well as five Boeing Business Jets.

So, in total there were 52 aircraft in backlog as of the end of July. It might seem like a lot, but given that Boeing was producing 52 aircraft in a single month, 52 aircraft to keep deliveries running is pretty bad. These 52 aircraft have a market value of around $5.7B. On delivery, Boeing would likely get $3.4B as a final delivery payment which pays for roughly 80 Boeing 737 MAX that Boeing currently builds and stores. Year to date, $6.5B worth of Boeing 737 have been delivered which on delivery pays for roughly 90 Boeing 737 MAX aircraft. So, a quick calculation shows that the backlog and deliveries would pay for the delivery of roughly 170 aircraft.

To date, over 250 aircraft Boeing 737 MAX aircraft have been brought in storage, and even if we reduce that number by the 50 aircraft Boeing planned to deliver in the last days of March, we get to 210 units. So the 42 aircraft per month as a production rate does not have any near- or long-term connection to any backlog (there are just a few units left) or to the cost of producing the MAX in the sense that the jet maker could fully plug the cost of Boeing 737 MAX production by the Boeing 737 delivery payments. In fact, we should be removing a significant portion of the existing backlog as most of the backlog are Boeing 737-800A Poseidon aircraft for which deliveries span multiple years. So, while I have received multiple messages claiming that Boeing can finance Boeing 737 MAX production with the remaining backlog for the Boeing 737NG, this is simply not the case. It’s also not true that the NG backlog would warrant a production rate of 42 aircraft per month since there are 52 NG aircraft in a backlog of which 33 (30 P-8s and 3 Wedgetails) are to be built in later years and eight aircraft already have been built. In fact, were it not for a production error on a fuselage intended for KLM, the last civil Boeing 737NG would already have been produced earlier this year. So the build-rate of 42 aircraft per month cannot be connected to any final delivery payment that has occurred this year or has yet to occur and can also not be connected to any backlog, since Boeing has built all civil Boeing 737NG aircraft (there still are two aircraft in backlog that are not built, but it’s likely an order that will be cancelled).

To understand where the rate of 42 aircraft per month comes, we have a look inside the Renton facility where the Boeing 737 is produced.

Inside the Renton facility

Afbeeldingsresultaat voor renton facility

Source: Airline Reporter

The Boeing 737 is exclusively assembled in Renton. There are a total of three assembly lines and the P-8A Poseidon production runs at a separate line. At the time Boeing stopped delivering the Boeing 737 MAX it was running the Boeing 737 facility at a combined rate of 52 aircraft per month. That means 50 Boeing 737NG and Boeing 737 MAX aircraft per month and two (actually 1.5) P-8A Poseidons per month were built. If you keep in mind that the P-8A Poseidon production capacity is around 18 aircraft per year, you will quickly notice that $5.7B figure I mentioned above is an optimistic one as it puts the entire backlog of all 737 variants together and divides by the production rate. If we take into consideration that the P-8A backlog spans multiple years, the backlog that could see delivery this year is valued closer to $2B. We also should take into account that we know that three out of five BBJ for the UK wedgetail program will be delivered in 2021-2022 and the two remaining unidentified orders are unlikely to be built. So the near-term value of the 737NG backlog reduces to $1.5B and $0.9B in delivery payments, which pays for the production of just 20-25 Boeing 737 MAX aircraft. So, in total, final delivery payments for the near-term backlog and year-to-date deliveries provide cash for the production of 115 aircraft or just three months of MAX production.

So, you could ask yourself the following:

“If there is no real cash balance between NG deliveries and MAX production, why keep on producing at 42 aircraft per month?”

The answer to that question might be as simple as unsatisfying:

It’s the rate that Boeing comfortably produced on before the Boeing 737 MAX was brought into line production. I believe that the other reason is that on the level of Boeing Commercial Airplanes and company finances, this is production rate that does make sense as we will portray in two separate pieces.

Back in 2015, Boeing was running its single aisle production at a rate of 42 aircraft per month on two commercial assembly lines for the Boeing 737NG and one separate line for the P-8A Poseidons. Each commercial line has a maximum rate of 20 aircraft per month. Driven by the sales success of the Boeing 737 MAX, Boeing added a third assembly line. That line would ramp up the total Boeing 737 output as well as the Boeing 737 MAX output while the two other NG lines would be converted to produce the MAX over time.

The production rate of 42 aircraft means nothing else than having the P-8A Poseidon line running as usual, while the other lines are running at reduced rate equivalent to two commercial aircraft lines and the P-8 line. The rate of 42 aircraft per month is equivalent to the maximum use of two assembly lines and allows Boeing to maintain current staffing levels. On top of that, it allows the supply chain to keep producing at a rate of 52 aircraft per month, giving suppliers more than enough space to reduce the schedule delay of several weeks they were running at prior the Boeing 737 MAX grounding. We understood from sources at Renton that currently all three lines are running and that likely has to do with maintaining staffing as well as costs associated to completely halting a line.

Halting production or decreasing production

Afbeeldingsresultaat voor 737 max production

Source: The Times of Israel

During the Q2 earnings call, CFO Greg Smith and CEO Dennis Muilenburg said that further rate reductions and even a temporary halt of the Boeing 737 production lines were possible. Earlier there were rumors about a short shutdown in September, but at this point there are no rate reductions announced or planned nor are there any plans for layoffs according to a source at the Renton facility.

So, Boeing aims to continue producing 40 Boeing 737 MAX aircraft per month, but the schedule plays a crucial role here. In Q1 Boeing added roughly $1B in costs to the accounting quantity for the Boeing 737 followed by additional cost accumulation of $1.7B as the lower production rate will continue well into late 2019. The reason to consider halting production is simple: Every aircraft that Boeing builds now is one that burns cash as no delivery takes place and no delivery payment takes place as a result… so no cash changes hands. Instead the airframer makes additional costs to fly the aircraft into storage and produce the Boeing 737 MAX at a lower rate. So somewhere there’s a cross-over point where it makes sense to cut production. Currently I expect that if the grounding lasts beyond December 2019, Boeing will consider adjusting the production rate. What will be decisive on how much the rate is adjusted is the timing at which Boeing becomes aware of any schedule slip for the Boeing 737 MAX certification.

As mentioned, the production rate reduction to 42 aircraft per month is equivalent to having two out of three commercial lines running allows for a trade-off between costs and staffing, but it also means that since staffing levels at present aren’t reduced, it allows Boeing to increase production rate quickly when the Boeing 737 MAX is cleared to return to service. The rate of 42 aircraft per month also means that there’s no shock in the supply chain.

Afbeeldingsresultaat voor 737 max

Source: Cnet

42 is not the answer to life for Boeing or the Boeing 737 program, but the rate of 42 a month is a comfortable spot for Boeing in bad times. What obviously plays a role for Boeing is their cash position. We estimated that each quarter of continued production increases Boeing’s inventory by $5B. You could say that with $9B in cash and cash equivalents there’s not a lot of room to continue doing this for a long time. Obviously, Boeing has access to the debt market but globally speaking Boeing can continue the current production rate for another two quarters until the end of 2019 before it “runs out of cash.” Cash from other programs will continue to come in, so Boeing will continue to see some cash flowing in (and some cash flowing out) hence I don’t think the cash pile divided by inventory build-up per quarter is a good measure, though that method yields results comparable to a method where we look at the pre-delivery payments used to continue building the aircraft, which we discuss exclusively on Seeking Alpha in an upcoming piece.

Cutting rates further will increase cost even more and every aircraft that Boeing doesn’t build now is one that they will not be able to receive delivery payments for or be able to use in negotiations with airlines and also will pay penalty fees for. So, Boeing has to walk a fine line and additional delays in the recertification of the Boeing 737 MAX will almost certainly cause Boeing to tip over, triggering further rate cuts. Until somewhere in December, we believe Boeing can produce the Boeing 737 MAX using customer payments that already have occurred and have not been returned. Given that Boeing aims for an early-Q4 return to service for the Boeing 737 MAX, the jet maker is operating in a tight space.

Conclusion

As we showed, there’s no balance between the program rate and program backlog and cash, as some suggested. What’s worrisome is that Boeing’s current costs estimates are based on their own insight in storage capacity, engineering and timeline, and even if Boeing might be completely right with all their estimates, their history of failing to balance costs, schedule and engineering isn’t working in their advantage.

Boeing aims for a return in service in Q4 2019, but to date there has not been any public announcement on how Boeing envisions that return. We know there have been 500 test flights supervised by the FAA, but we have no insight in Boeing’s schedule assumptions going from submission of the software package that should fix the Boeing 737 MAX in September to regulators approving the fix and how long it will take from that point on to start pushing out aircraft to customers. On top of that, regulators haven’t put a date on a return on service… since they have learned the hard way that you don’t put a date on safety. At the time of writing, it’s the 20th of September and we haven’t heard anything that convinces us that Boeing is on track to have the MAX back in the air by October.

Boeing made their estimates, but at the point where clarity is needed, namely in Q4, the schedule remains vague while changes and costs related to Boeing 737 production are closely tied to that Q4 schedule. Currently it seems that in the case of a schedule slip storage capacity at Moses Lake and time needed to staff other storage airfields is going to play a big role in the production rate of the Boeing 737, next to the continued balancing of cash. What Boeing has not provided any clarity on is what would trigger a rate reduction and what would trigger a full line shutdown, but I’d think that if Boeing can’t balance their cash and their schedule a line stoppage or further rate reduction will occur. It’s continued act of balancing various schedules.

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