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Investing, Stocks  | February 24, 2019

The subject of Boeing's (BA) deferred production balance on the Dreamliner program is a highly interesting one. The free cash flow will always be more interesting to assess Boeing's overall performance. However, the Boeing 787 burn-off in deferred production costs and unamortized tooling costs is important and interesting for two reasons. The first one is that if Boeing does not zero out costs, it might possibly have to recognize a charge though we do not see this as a plausible scenario. Secondly, because if you have somewhat of a grasp on the burn-off of the balance, you can get an idea of the aircraft's profitability relative to the program 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 each quarter.

Every three months, exclusively on Seeking Alpha, readers receive three articles as part of regular coverage on the Boeing 787 which probably is one of the most in-depth coverages available for this particular program. One article looks at forecasts from a rather in-depth model and the second method looks at a forecast using a simple trendline fit model. It should be noted that there's quite a big difference between the in-depth model and the trendline 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 trendline 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's very important to comprehend the difference between the approaches used in both models and their purposes, even if the results that both methods give are the same.

So, two out of the three reports 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 report looks at how cost did actually develop and how that compares to the models and whether cost burn-off was satisfying during the quarter or not. This report looks at what progress Boeing actually did book on the program during the 4th quarter of 2018 and how it differs from our elaborate model and whether these differences can be explained.

In order to understand the challenge Boeing faces on the Dreamliner program, it's of the 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.

The Boeing 787 is the airplane that Boeing launched after oil prices increased and the airline industry was coping with a crisis that followed the 9/11 attacks. Competitor Airbus (OTCPK:EADSF) (OTCPK:EADSY) 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 1,421 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 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 or Boeing's Dreamliner only.

Program Accounting

Boeing uses program accounting for its aircraft programs instead of unit-cost accounting. To understand what the deferred costs are, it's 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 but also Boeing making assumptions on the revenues as well. For the Boeing 787 program, the accounting block currently stands at 1,600 units, up from 1,500, 1,400, 1,300, and 1,100 units earlier.

Boeing says the units in the accounting block is the quantity of units it expects to deliver based on firm contract, letters of intent, and ongoing sales campaigns. This quantity is limited by the company's ability to 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. If Boeing zeroes out its deferred balance by the 1,600th 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 1,600-unit accounting block is not a breakeven point and also is not a measure of the long-term sales potential that Boeing sees for the aircraft.

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 against the assumed program profits.

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 and our data shows that this happened at the 431st delivery. 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. From 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:

Figure 1 shows how the sum of the deferred balance and unamortized tooling and other non-recurring costs has increased over time but has started decreasing over the past few quarters. Figure 1 already gives a pretty good visualization and one can imagine how the trend would continue in the future. What can be seen is that the deferred balance clearly decreased for the ninth consecutive quarter and that trend will not be reversed.

The deferred balance after 781 deliveries is $25.6B vs. $26.4B last quarter or $32.8 million per airframe compared to $35.5 million per delivered airframe in the last quarter. This marks a $753 million improvement. 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 $87.7 million per airframe in Q1 2014 to $23 million in Q3 2018. Quarter-over-quarter, the deferred balance decrease per airframe deteriorated by nearly $4 million per unit. This slight deterioration, however, does include the impact of a block extension. The extent of this impact will be discussed later. What happened during the quarter is actually the same thing as happened in Q2 2018 and Q3 2017.

In Q3 2017 and Q2 2018, 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. The same thing happened in Q4 2018.

After the block extension in Q3 2017, we asked Boeing to provide particular figures as they did when the company removed aircraft from the accounting block, but a Boeing spokesman refused 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. Keeping in mind that the realized Dreamliner profits per unit are the decrease per unit plus a program margin, which has been hiked two times in a year and likely will see more accretive measures in the coming quarters, the Dreamliner program is looking extremely strong for Boeing.

What is important to take note of is that this apparent deterioration in the decrease per unit is in fact not a deterioration at all but merely stems from an increase in the overall program profit.

Boeing has set an accounting block of 1,600 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 balance of $25.498B. Boeing has 811 units left to recoup the balance of $25.6B. 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 179 sales to reach the 1,600 aircraft, which is the size of the accounting quantity. Boeing has sold over 1,300 Dreamliners, exceeding the numbers of units in the accounting block, which is an important given there have been some rumours 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 1,600-plus Dreamliner deliveries. This is important to keep in mind, orders can be cancelled, but the people who were claiming Boeing wouldn't sell even 1,100 units are proven wrong.

Currently, it does seem that each time the remaining units left in the block will fall below 100 units, the block is being extended.

With the 811 that are yet to be delivered, Boeing needs to recoup $31.6 million per airframe on average on top of the average program margin to totally zero out the balance. Given that Boeing currently generates profits of >$25.0 million per airframe, the road toward zeroing out the deferred balance is still 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 north of 20% 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 unrivalled market space, the Boeing 777, has margins of 25%, the task at hand for Boeing seems to have become more manageable after implementing 3 block extensions of 100 units each time totalling 300 units since 2017, but we anticipate at least one and possibly 3 more block extensions to zero out the balance. Beyond that point, the balance should be zeroed out and Boeing will still continue extending the block as it's common practice, but investors and analysts will go mute on those extensions as they will merely be "business as usual" extensions and Boeing will no longer disclose further details on the balance.

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 quadratic improvement trend for the deferred balance decrease per delivery, AeroAnalysis expected the decrease to be around $23.5 million to $24.5 million.

For the detailed model, a unit decrease of $23 million to $26.5 million was expected. The reported decrease per delivery during the quarter, however, was $19.3 million per airframe. There is no shame in admitting that my numbers were off quite a bit, this is caused by the block extension during the quarter fully supporting what we have said several times, namely that our estimates will materially differ from the realized results in quarters where the block is being extended. That is also what happened during the 4th quarter of 2018.

The nice thing about having your own calculation models and understanding on this subject is that you can look beyond the tables into the model and the wide spectrum of inputs and intermediate results to see where these differences are coming from. What we did find is that the block extension and its associated margin impact according to our model would have an impact of around $160 million. So that would mean that the corrected expected decrease would have been $740 million, which is reasonably close to the realized $753 million. How the margin expansion impact during the quarter exactly is not fully clear at this point, I have a general idea on how it is calculated and it matches reasonably well with differences in previous quarters in which a block extension was executed but it remains an area of study for me.

Conclusion

We continue to believe that Boeing will need 1 and possibly up to 2-3 more extensions to zero out the total deferred balance.

For investors, we see no reason to worry about the Dreamliner long-term challenge to zero out the deferred balance, we currently believe the Dreamliner is nicely boosting Boeing's free cash flow and we expect the Dreamliner program to be a major booster going forward.

We believe that Boeing is currently nearing the stage where its actual realized profits are nearing the mature point. Going forward, the mix, as well as the upcoming rate increase, should be providing the next step up in margins.

What's important to note is that, as long as the balance isn't zeroed out, block extensions are regarded by some investors as a bad thing. We can partially understand that, since it seems to suggest that the profit ramp up is coming along more slowly. On the other hand, block extensions are executed as the expected number of sales grows. Boeing is starting to sell more and more slots within the accounting quantity and as the number of "unordered" units in the total block decreases, Boeing will start adding more subblocks. As sales continue growing and profits mature, they might start doing that more regularly, thereby increasing the program margins. So there's a huge positive spin to it that is often underappreciated by investors, and we think the Boeing 787 will be one of the main cash and profit drivers in the years to come. We expect that if Boeing keeps sales momentum high for the Boeing 787, block extensions could start occurring regularly.


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