Jan. 22, 2020, © Leeham News: Boeing’s announcement yesterday that it does not expect recertification of the 737 MAX until mid-year drew generally negative responses from Wall Street aerospace analysts.
More charges and costs to Boeing and the supply chain are expected beyond what was anticipated in next Wednesday’s 2019 earnings call.
Below are the initial reports from analysts in notes received by LNA. The bold face type is in the original.
Boeing said that it expected ungrounding of the MAX to occur during “mid-2020”. The timing was also reported by the media as June or July. Boeing stressed that timing of the MAX return will ultimately be set by the FAA and other regulators. An FAA statement said there is no set timeline for the MAX’s return, and that safety is its number one priority.
We were surprised by Boeing’s statement because it pushes back the certification date at a time when we saw the process as moving forward. It is also unclear to us what led to mid-2020 timing – was this due to new FAA information or new issues Boeing has identified? After many delays and missed timelines, we want to know why Boeing selected mid-2020 timing and what prompted the statement at this time – just after airlines said they moved their MAX schedules back to June. Our understanding is that Boeing saw the need to give customers and suppliers a rough picture of timing. Boeing said it will provide more detail on the MAX return on January 29, when it reports Q4 earnings. Does the announcement stem from a new issue with new uncertainty (i.e. could go longer) or is Boeing’s new leadership taking a cautious approach to the MAX outlook (i.e. could well come sooner)?
Boeing’s projections have lost credibility. Should the delay go to mid-summer, costs will rise related to customer compensation, supplier support, maintenance of stored airplanes, and debt financing.
Boeing (BA) today announced that it now expects the ungrounding of the 737 MAX in mid-2020 (June-July). While BA had not previously provided specific guidance for the timing of the ungrounding, consensus estimates were that the return to service (RTS) for the MAX would start in early Q2/20. This ~3-month push to the right is incrementally negative for Boeing and the 737 MAX supply chain. We expect the next major data point will come when Boeing reports its Q4/19 results next week and provides the first look at its 2020 outlook.
After the perception that BA has been too aggressive in its public pronouncements on the timing of the MAX return to service, we believe the communication today should provide a buffer concerning the time for regulators to satisfy their recertification requirements. We believe new CEO Calhoun is taking a much more cautious approach with the regulators and is actively working to improve communications with regulators and others. We would expect that this announcement today provides some buffer for Boeing and the regulators, but considering the timing and nature of the announcement, we do not necessarily believe this announcement was planned by Boeing for today. The company highlighted that this push on the MAX RTS reflected the operational planning and the company’s communication with its customers and suppliers.
We continue to see risk for the 737 MAX in two distinct buckets. First, the eventual resumption of 737 MAX production and expectations for the eventual production rate increase. It now appears that the production pause will stretch at least into Q2/20, and when it does resume, the pull from suppliers will be depressed as BA works to reduce MAX inventory levels. We now believe a pull between 20-30/month initially from Boeing is realistic, which likely persists for much of 2020. It is theoretically possible for BA to lift its production pause on the MAX before the ungrounding; but, this is highly unlikely. Boeing indicates it needs a very high degree of confidence on the timing of the RTS before it will re-start production. However, BA is also cognizant of the supply chain stress the production pause is creating, so it will also look to balance this concern as well. The bottom line, however, is that this further delay on the MAX RTS adds increased risk to the supply chain and further raises questions on the timing of the production increase and eventual production levels.
Second, the eventual timing of airline MAX reintegration into fleets will likely take longer than expected. This is due to the increased certification requirement (such as pilot training, international review) as well as the fact that deliveries are likely to ramp just after the summer flying season. Finally, the public reception to the MAX, and potential impact on the current MAX backlog represents another substantial question. We believe BA will increase its customer concession set-aside substantially with its Q4/19 results, and the $3.6B charge taken already on the 737 block is also expected to increase.
We expect estimates to come down across the sector as a result of the expected extension in the 737 MAX production pause. However, the impact will vary by supplier, and the inventory overhang at both Boeing, Spirit AeroSystems and in the supply chain will limit initial production volumes. The ongoing MAX grounding is a positive for the commercial aftermarket, but we do believe some firms with large MAX initial provisioning (IP) exposure saw some uptick in sales in Q4/19 as a result of airlines deploying budgets ahead of 2020, even with the ongoing grounding.
BA’s indicated current best estimate that MAX ungrounding will occur in mid-2020 is based on the slower than expected pace of regulatory progress to date and not on any new unexpected delays. Furthermore, in addition to keeping its customers and suppliers informed of its latest thinking on MAX, BA will have to make an assumption of when MAX deliveries and production begin in order to close its Q4 books for its Q4 report on 1/29. We suspect that the current updated estimate also reflects a more cautious posture by new CEO Dave Calhoun to avoid prior CEO Dennis Muilenberg’s multiple outward revisions.
The new estimated schedule will have two specific impacts on BA’s Q4 report. First, it’s likely to increase BA’s estimate of customer compensation for the delays. Assuming a mid-March ungrounding, we had assumed that BA would increase its compensation reserve by ~$6B. This number now looks low, and the entire increment will be taken as a charge against Q4 earnings but with likely little impact on Q4 cash flow. Second, the pushout will also increase BA’s costs to produce the 2,965 MAXes in the 737 production accounting block. We had assumed that estimated costs would rise by $4B. This number now looks low, particularly if BA assumes a modest ramp in production and deliveries. Because there were no MAX deliveries in the Q, the impact on Q4 itself should be minor with the additional costs hitting future deliveries.
Updating model for MAX production pause, push-out to our RTS assumption to 8/1/20, slower expected production/delivery ramp, additional Q4 charges and increases to MAX program costs, higher ’20-‘22 MAX-related cash costs, lower long-term BCA profitability (on reduced MAX and 777X gross margins), higher interest expense, and reduced buyback: We model production at rate zero for all of Q1’20, rate 27/27/32 for Q2/Q3/Q4’20, rate 32/37/37/42 for Q1-Q4’21, and rate 47/47/52/52 for Q1-Q4’22. This corresponds to ’20-’22 cumulative 737 production (including NGs) of 1,296 units vs 1,872 prior (a 31% cut). Additional model updates include: (1) Delays in delivery restart (to late Q3’20, vs Q1’20 prior) and a slower delivery ramp vs prior (with far fewer deliveries in ’20 vs prior, moderately more in ’21 vs prior); (2) Q4’19 charges of $16.3B, and a $3.9B increase in MAX program costs; (3) Higher ’20-’22 cash concessions; (4) Lower BCA margins (11.7% in ’22 vs 14.2% prior); (5) Higher interest expense to reflect expected near-term debt issuances to cover cash shortfalls and fund the dividend; (6) Higher share count to reflect pressure on the repurchase operation due to lower FCF. As a result of the above changes, our cumulative ’20-’22 FCF estimate is now $37.2B vs $48.3B prior, a 23% reduction. Our ‘22 FCF/share est. is now $27.29 (vs $29.20 prior). On valuation, we are reducing our applied FCF yield on ’22 FCF/share to 8.5% (vs 9.0% prior) as our modeling now captures some of the downside risk that our prior higher FCF yield was intended to reflect. Our TP declines to $321 (from $324). ’19-’21 EPS estimates. update to $(26.28)/9.45/22.69.
…The competiveness of BCA’s product portfolio vis-à-vis Airbus—[is] a position of weakness that if not resolved impairs the long-term investment story, and if it is resolved impairs the short-medium term investment story (entering a cash heavy investment cycle). This, layered in with broader cultural issues at the company, execution missteps at BDS, 777X EIS risk, and other items keep us firmly on the sidelines.
Boeing’s midday announcement of its new best estimate that regulators may allow the MAX to re-enter service in mid-2020 is a negative, in that it points to a base case that is a few months beyond ours. It is not a complete surprise though, given developments the past month. We believe the new timeline for “ungrounding” includes both FAA certification of Boeing’s software updates as well as approval of pilot training requirements. There may be some buffer too, but experience suggests no reason to take the under on timing. Today’s release provides more context for earnings on Jan 28, where we expect major charges for customer compensation and new costs in the 737 accounting quantity. We also hope for insight on plans to manage the balance sheet this year. As ever, the most important potentially positive developments for the stock relate to tangible progress toward returning the MAX to service.
Our best guess is that revenue service slips ~3 months in base case. While “ungrounding” might refer to when airlines can place the MAX back in service, the release refers to beginning the ungrounding and we believe that 1) preparing stored aircraft for service, 2) completing training for the first crews, and 3) flying the aircraft in non-revenue service, which press reports suggest that US carriers anticipate, should all contribute to an interval between beginning an “ungrounding” and actual revenue service. Working backwards, we had assumed that the early June return to revenue service that Southwest, United, and American are targeting might mean March-April approval for the aircraft and training. It seems the new base case might push the whole timeline out a few months, though Boeing’s release encompasses a range of outcomes, both better and worse.
Ungrounding timeline includes establishing training requirements. Boeing’s mid-2020 forecast includes time for the JOEB to determine updated pilot training requirements, which will include simulator time. In its November update, Boeing made a bigger distinction between FAA approval of the software updates following certification flights and additional weeks needed for global regulators to determine training. “Ungrounding” now seems more comprehensive, incorporating this training element, and this is appropriate, in our view, as devising new training with simulator time is now part of the process.
New schedule is NOT “conservative” but may contain some buffer. Experience shows the potential for the timeline to slip further and we would not discount this possibility. However, the release notes that the process thus far has informed Boeing’s estimate, along with the potential to address items that may arise, not just those that are known. Hopefully, this makes today’s timeline more realistic than previous ones. With regard to the known outstanding items, the new software issue reported Friday is likely one source of pressure, as is the potential need to address wiring in the tail. Despite these setbacks, there does appear to be a process in motion here, with the Wall Street Journal reporting Friday that the FAA and Boeing had planned for a “key certification flight” in late Jan, though that has slipped as a result of the latest software issue.
Delays add to airline compensation; magnitude TBD. We have heard concerns that this announcement may push a return to service beyond the peak summer travel season, perhaps increasing significantly the compensation Boeing will have to pay airlines for grounded planes. On some level, this seems right and it is among the reasons that we believe investors should be bracing for a significant compensation-related charge when Boeing reports Q4 . . . we have been thinking about something in the high-single-digit billions. (A pre-announcement this week seems less likely following today’s release but we can’t rule it out entirely.) The degree to which this latest news changes the number is unclear, however. With pilots requiring simulator training and the FAA presiding over final checkout, it has been clear for a few weeks now that it would be far more difficult to get many aircraft into revenue service for the full summer season, especially beyond a handful of major operators like the US carriers and Ryanair.
Boeing should raise debt soon. Addressing the airline compensation requirements noted above is among the reasons Boeing will need to raise more debt soon, in addition to supporting its supply chain while the 737 production line is down and supporting its own workforce. CNBC reported yesterday that Boeing is talking to banks about a two-year, delayed-draw loan that could total $10b or more. Our model has Boeing borrowing $9b this year. We assume that the 737 MAX outlook Boeing contemplated in today’s release is consistent with what it has been discussing with potential lenders. Once MAX deliveries bring FCF back to positive—potentially later this year—we expect Boeing’s capital deployment priority to be de-leveraging through at least 2022.
Suppliers aren’t spared the pain but should get some BA support. Suppliers should continue suffering along with Boeing as they weigh retaining their 737 employees against the ongoing production halt. Suppliers do not bear the same liabilities to airline customers as Boeing but remain in uncertain territory with the MAX halt weighing on financial and operational performance. SPR has the most 737 MAX exposure among suppliers and we see a very difficult 2020 as the company grapples with the line shutdown and a slow production ramp. However, it is in Boeing’s interest to maintain a healthy supply chain and so we expect Boeing to make some kind of payment to Spirit that would at a minimum go toward supporting Spirit’s suppliers in Tiers 2-3 and below so they will be available when production resumes.