July 19, 2019, © Leeham News: Boeing yesterday announced a $4.9bn charge connected to customer compensation for the 737 MAX grounding. It also announced a $1.7bn additional cost associated with the accounting block and forecast a 4q2019 return to service.
Wall Street analysts overall were positive with the new. Aftermarket stock trading was up; pre-market trading today is slightly down from the aftermarket high.
Below are excerpts of research notes issued last night and this morning.
We expect BA shares to trade higher today after BA announced a 2Q19 charge and new planning assumptions regarding the MAX. Specifically, BA has finalized some penalty payment discussions with MAX customers and is taking a roughly $5B or $8.74 charge in 2Q19. BA now is planning for the MAX to return to service in 4Q19 and to ramp up MAX production to 57/mo in 2020. We think BA’s announcement somewhat reinforces our tactical buy call – with any number of investors looking to get bullish, we think BA’s announcement will be interpreted favorably and act as a positive catalyst for the stock.
|BA announced a near $5B after tax charge or $8.74 in 2Q related to customer concessions and settlements over recent MAX issues. BA decided to take the charge as a period expense rather than a charge against the block. In addition to the charge, MAX accounting block margins will be negatively impacted by an incremental $1.74B. The margin impact will affect all aircraft in the accounting block that haven’t been delivered.
That BA and its MAX customers came to a settlement, in our view, indicates that all parties (BA, MAX customers, and global regulators) have some visibility into when MAX flight operations and deliveries start. Penalties are generally based on an operators lost revenue over the amount of time a delivery is late or an airplane is grounded. Certainly the charge was much larger than expected and much sooner than expected, but we think investors will likely view the announcement of a charge as a lot of the bad news is now in the stock.
Boeing (BA) announced yesterday that it is taking a $4.9B after-tax charge ($8.74/share) associated with potential customer concessions and delivery delays due to the 737 MAX grounding. The charge equates to a $5.6B hit to pre-tax revenues and pre-tax profits. We believe this charge is substantially more than had been expected. We are adjusting our 2019 and 2020 estimates to reflect the charge and the additional delays in the 737 MAX return to service (RTS). We are maintaining our HOLD rating and our $380 price target.
The announcement implies BA expects the FAA (and likely Canada) to authorize a RTS in Q4/19, but there is a risk that other regulatory agencies may take longer. We do not believe we will have a coordinated RTS between the regulatory agencies, and some regions, such as Europe or China, will likely move after the FAA has lifted the grounding. We believe there is still risk associated with the timing of the RTS globally as other factors such as trade, geopolitics, and customer concerns can still impact the RTS schedule.
|Key takeaway from yesterday’s Q2 preannounce was that BA assumes “return to service early in Q4” in line with our estimates and plans to reach 57/month in 2020 vs. our assumption of a 52/month peak. While timing of return to service obviously is in the hands of the regulators, we assume that BA’s timing comments are based on its extensive interactions with regulators. Furthermore, its willingness to publicly target reaching 57/month next year presumably reflects discussions with customers indicating sufficient demand to warrant taking the rate up to that level.|
The $5.6B pretax customer compensation reserve also isn’t a huge surprise although until now it was hard to quantify. Furthermore, BA will have a $1.2B tax offset and the compensation outlays will spread over a number of years, mitigating the impact on any one year.
Numbers appear more favorable than expected: We believe these cost figures are below Street expectations, as we think buyside consensus for BA’s impact from Max is between $10B and $20B, including all incurred and future costs for re-engineering and production enhancements, absorption impact from the delay itself, and for compensation to the various parties involved, from accident victims to the customers affected by the delays. Within this context, $4.9B for customer comp., plus the ~$2.2B in after tax cost increases to the 737 accounting block (our est. of the after-tax combination of the $1.0B disclosed in Q1, plus the $1.7B disclosed today) would come in below the low end of the range, though this appears to still exclude accident victim related comp. Of course, the recovery for the program remains uncertain, and so these costs could continue to rise, and any uninsured comp to accident victims would be additive. To be clear, we model a slower recovery, and so costs would be somewhat higher on our assumptions, but probably still within the est. cons. range above.
Share correction seems overdone: With 2,999 aircraft remaining in the accounting block (as of Q1), the higher accounting block costs equate to around $900k per aircraft or about 165bps in margin. The $4.9B in customer concessions and other considerations is around $1.6M (or 300bps) for each undelivered and grounded MAX. Though this hits the P&L now, the cash portion will impact as future aircraft are built and delivered. In sum, we highlight that the ~$48B contraction in market value from the high of $446 per share far outweighs the impact projected here, either based on BA’s recovery plan or our more conservative one. Regardless, we think it’s helpful that BA has provided some framework to gauge the financial impact.
No change to production likely a relief, especially for suppliers. We expect investors will be relieved that Boeing maintained a production rate of 42/mo, which looked to be at risk after the most recent delay, and a target date of early 4Q19 for a return to service. Major US carriers have removed the MAX from their schedules through early Nov and so this looks consistent with Boeing’s press release since it would require regulatory approval in early Q4 to fly in early Nov. Obviously though, there is significant risk of slipping to the right, as we have seen a few times since the grounding started in March. We believe Boeing is reluctant to cut rate to avoid inefficiencies and disruption in the supply chain that would increase risk around future rate increases. Another few months of slippage seems unlikely to tip the scales here but production rate risk doesn’t go away entirely until there is a clear path to regulatory approval. With no change in production, yesterday’s announcement is a Boeing-specific one for now, not one that affects suppliers. We believe the market was highly concerned about the impact of a production cut at suppliers (especially Spirit), with many of them still producing at 52/month.
the numbers are a bit larger than we anticipated. BA’s estimate for compensatory damages of $5.6Bn (pre-tax) is almost double the $3Bn we outlined earlier in this week. For reference, it’s ~20-25% larger than the penalty amounts observed for the 787 (which covered ~800 airplanes that were ~4 years late). We think this means that 1) there are other elements outside of pure delivery delays in BA’s figure, and 2) one can/should conclude that the estimate is conservatively set to a large amount. As we highlighted earlier this week, we would expect BA to attempt to work these amounts down and shift to other forms of payment in kind where possible in the coming quarters/years. Furthermore, pulling these items out in a single charge rather than applying them to ongoing manufacturing margins is a cleaner way for investors to understand and isolate their transitory impact (something we worried about and called out in our earlier work).
Aside from the compensatory figures, the bigger surprise for us was the revelation of an incremental $1.7Bn in production-related costs to be included in the 737 accounting block. This is ~3x what we estimated, and indicates that the incorrect assumption that we made is that cost impacts should grow linearly as the recertification date slips rightward. The actual impact is non-linear and is based on all of the extra costs that result from piling up hundreds of airplanes and cascading disruption into the supply chain. This represents just over a 100bps headwind to 737 program margins (which we assume are ~30%), which isn’t huge, but continues to cut against some of the margin upside that we hoped for to fuel very attractive earnings/FCF compounding in future years.
There is a tentative return to service target of “early” 4Q19, which compares well to concerns of as late as 1H20. In recent weeks and months, we have seen multiple push-outs on the timeline for a submission of 737 MAX upgrades to the FAA given additional identified risk factors. And as a result, investor expectations for a grounding removal have been drifting towards year-end 2019 or even late 1H20. However, in its release Boeing noted that its “best estimate at this time” is for a return to service in “early” 4Q19. While we approach this target with a degree of skepticism due to numerous false starts to-date and uncertainties ahead (e.g. a new FAA head), we note it is the first time the company has proactively put forth a date, creating a level of confidence when key regulators such as EASA and TCCA are closely coordinating with the FAA to reverse the grounding. Finally, the 4Q19 objective is consistent with the updated forecast from our 2Q19 earnings preview and implies a formal submission of fixes later in the quarter (i.e. September).