Aug. 22, 2016, © Leeham Co.: Boeing’s deferred production and tooling costs for the 787 program continue to be a focus-item by some
aerospace analysts, media and observers: will the company be able to recover these costs, or will it inevitably have to take a write down.
Some Wall Street aerospace analysts believe Boeing can’t recover all the costs.
For example, Ron Epstein of Bank of America Merrill Lynch concluded Boeing will only recover about $14bn of the $29bn in deferred production costs.
Rob Spingarn of Credit Suisse pegs the recovery number at about $22bn.
These figures are before Boeing took a $1bn pre-tax “reallocation” to research and development for costs related to two more of the first six test airplanes last month in advance of the July 27 earnings call.
Boeing officials are confident they will recover the costs. LNC spoke with Wall Street analysts and Boeing to paint a picture of how Boeing expects to accomplish this.
Let’s start with the language in Boeing’s 2Q2016 10Q Securities and Exchange Commission filing. The dollar figures are in millions.
At June 30, 2016 and December 31, 2015, commercial aircraft programs inventory included the following amounts related to the 787 program: $34,123 and $34,656 of work in process (including deferred production costs of $27,673 and $28,510), $2,412 and $2,551 of supplier advances, and $3,707 and $3,890 of unamortized tooling and other non-recurring costs. At June 30, 2016, $22,966 of 787 deferred production costs, unamortized tooling and other non-recurring costs are expected to be recovered from units included in the program accounting quantity that have firm orders and $8,414 is expected to be recovered from units included in the program accounting quantity that represent expected future orders.
This language is incomplete insofar as it doesn’t include some important data.
Many believe Boeing has to extend the accounting block, perhaps by several hundred airplanes, to recover the costs. LNC has been among those believing this.
But extending the accounting block, if it happens, for the 787 may turn out to be more of a routine business practice rather than an admission that more airplanes have to be sold to cover the deferred production and tooling costs.
Boeing routinely extends the accounting block on its mature 7-Series programs. The accounting block on the 737 was extended by some 200 in the most recent quarter. Over the decades, this program has seen many block extensions. The same is true for the other 7-Series programs, including the 777 Classic.
The accounting block can also be contracted, as was recently the case for the 747 program after a write off for the 747-8.
Boeing extends the block when it is confident the sales support the move. This includes, as described above, firm orders, reasonable confidence options will be converted to firm orders and new sales campaigns will yield orders.
The reason those 88 787s mentioned above are not in the current accounting block is because the delivery dates are too far into the future. As these dates come closer in—and this trigger point remains unclear to outsiders—some of those 88 may still remain outside a reset accounting block because those delivery dates are still too far in the future.
It is fair to say that the closer Boeing gets to reaching the current 1,300 accounting block number, the more likely a new figure will be issued. The company reported 1,161 sales through July 31.
How does Boeing recover its deferred costs?
Simple math, based on the 10Q, would paint the following picture.
We already know the assumption in #2 is flawed because Boeing told LNC there are aircraft outside the block. Profits on these sales will go toward the deferred costs.
In an article by Dominic Gates of The Seattle Times on this topic after the first quarter results, Boeing told Gates that an average over the entire program should be used, not a segmentation as inferred by the 10Q language. In this, the 10Q language would appear to be misleading in a literal reading and certainly by omission of the complex factors that are behind the language.
Whatever the per-airplane profit number is, Boeing won’t disclose it because the margins are considered commercial proprietary.
Wall Street analysts, and others, try to “engineer” the margins. Doing so with accuracy is impossible from the outside. Doing so within “shouting distance” may or may not be possible. In any case, Boeing won’t confirm any margin estimate by analysts or anyone else.
Boeing has said it expects that eventually the 787 program will produce margins similar to previous wide-body programs. Analysts believe these margins have been in the 17%-19% range.
Boeing has also said the 787-8 margin is single digits. But this, too, is a wide range: 1% to 9.9%.
It also comes down to if unit cost accounting or program accounting is being assigned to the margin and whether research and development and SG&A allocations are included when discussing margin, say analysts.
Boeing officials gave guidance to analysts and said on earnings calls and elsewhere repeatedly that reducing costs combined with increasing margins is the path toward recovering the deferred costs.
At the Boeing investors day in May, corporate CFO Greg Smith addressed the issue. The following is a transcript, worth repeating verbatim.
Greg Smith: So, while we expect earnings to grow over the remainder of the decade, we expect cash flow to grow even at a faster pace, largely driven by the
improvements and the production increases, 787 cash, and just overall disciplined cash management efforts.
We’re covering 787 deferred production over the remainder of the decade [and] will be a driver of cash flows going forward. And our confidence in that recovery really comes from four major areas.
So, first, the largest benefit comes from shifting the delivery mix from more -9s and -10s and remember we designed these airplanes to be more producible and there’s significant commonality between these models. So, our overall expectations around mix in the cost base going forward, is already sold.
And second point is improving pricing, on the remaining 900 aircrafts in the accounting block, which is another key driver. We’ve previously had – again, think about early on in the program, early pricing disruption, customer settlements clearly impacting on profitability and cash all in that deferred production, that will not be the case going forward.
And again, our expectations around pricing are essentially already sold within that cost base. These two elements of mix and pricing will account for approximately 70% of the 787 deferred production recovery.
The third point, we’ve also benefited from supply chain step down, remaining 900 airplanes compared to the initial 400 delivered. Once again, this is largely based on existing firm supplier contracts and this will account for approximately 25% of the recovery of the initial $29bn of deferred.
And last, but not least, internal productivity is expected based on similar learning curves, we’ve captured on other programs, as well as projects in work that you’ve seen some of them yesterday for step-down function and efficiencies.
But with that said, this is the smallest piece of the equation around deferred. So, the path to recover 787 deferred production balance of the $29bn is clearly grounded on existing contracts with customers and suppliers. Another driver of cash flow is higher production rates I discussed.
We do plan to increase rate on 787, 737 and 767 and have modest growth in the Defense business. Specifically, for 2016, we continue to expect operating cash would be approximately $10bn. With the continued expected further growth in operating cash flow in 2017, we expect backlog growing deliveries and capture additional productivity as well as the 787 cash improvements I talked about all helping us in 2017.
Smith said about 80% to 85% of the supply chain’s 25% contribution to cost reduction is already under contract.
Since this May conference and answer, Boeing last month said increasing the production rate of the 787 from 12 to 14/mo is unlikely, based on current demand projections. This will delay recovering the deferred costs by 4-6 months, Boeing said.
Robert Spingarn, the aerospace analyst for Credit Suisse, told LNC that maintaining rate 12 has about a 10%-15% impact on cost reduction.
Spingarn last December issued a note in which he concluded Boeing will recover only about 75% if the deferred costs. In reaching this conclusion, Spingarn used an average production cost among the three family members of $105m, eventually declining to +/- $80m.
He also used current sales prices of about $115m for the 787-8, $125m for the 787-9 and $145m for the 787-10. (These are numbers for the December 2015 note, remember.) These are similar to the sales price figures LNC was hearing from our market sources as well.
Because of the deferred costs, which included three years of delays and customer penalties on the early deliveries, Boeing had a cash loss on every delivery. Boeing said the cash break-even point was in the fourth quarter of last year, roughly five years after the entry-into-service of the first 787-8.
Boeing booked profits on the program from the first delivery. This is through its use of program accounting, about which LNC has written many articles.