Dreamliner 787 Still Boeing's Nightmare Aircraft

Boeing (BA) insists the latest production glitch with the troubled 787 Dreamliner won't negatively affect its financial performance. But the company's continued inability to hit contracted shipment dates may well conspire against that optimistic guidance.

Engine availability issues forced Boeing to postpone already planned, in-flight aircraft safety trials. Nonetheless, chief financial officer James Bell did his best to reassure attendees at a Morgan Stanley (MS) "Global Industrials Conference" last month that customer delivery schedules would be delayed by no more than a few months, with little material impact to the aerospace and defense contractor's 2011 financials.

Boeing's spending through 2012 is modeled on a reduction in cash outflows, save for cash dividends of approximately $1.2 billion annually. In particular, current 2011 guidance is for R&D expenses to decline about $500 million from 2010 estimates of between $3.9 billion to $4.1 billion, according to CFO Bell. Assuming first launch deliveries of Dreamliner passenger jets in first-half 2011, Bell has projected a sustainable turnaround in operating cash flow, from near neutral this year to more than $5.0 billion next year -- as forecasted commercial demand has rebounded along with air traffic trends, particularly for the world's best-selling, narrow-body passenger jet, its single-aisle, Boeing 737.
Despite more than 2 ½ years of scheduling delays for its flagship B787, analysts seem to believe that cycle lows are behind Boeing, too, according to a survey by Bloomberg Businessweek: Consensus revenue and share-net growth are anticipated to grow by 11.4 percent and 22.3 percent to $72 billion and $4.77 per share next year, driven by lower R&D spending, expanded monthly production for its Next Generation 737s, and initial shipments to customers of the 787 Dreamliner and its other oft-delayed, new series of intercontinental, passenger and freighter carriers, the 747-8 family of jumbo jets.

Look things in the face and know them for what they are. ~ Roman Emperor Marcus Aurelius (AD, 121- 180)

Near-term, Boeing is facing a challenge from Montreal-based Bombadier -- the world's third largest civil aircraft manufacturer -- and its CSeries jet, currently being marketed as a single-aisle aircraft with "wide-bodied passenger comfort." Beyond 2012, a growing availability of substitutes that will become available to existing customers of its popular Boeing 737, such as narrow-body passenger jets from regional plane makers in China and Russia, pose even graver threats -- with plans to aggressively discount the B737 by a reported 20 percent to 30 percent.

Saj Ahmad, a London-based aerospace and airline analyst at FBE Aerospace, said many regional carriers, especially in fast-growing Middle Eastern markets are growing impatient with ongoing delays with the B787 saga -- even more so since traffic numbers began rising amid a demand for new, fuel-efficient planes.

With workmanship issues still a major issue for the 787, production capability is being stifled with almost frequent occurrences of work stoppages to verify build quality, said Ahmad.

Contrary to consensus estimates, righting the 787 program will require Boeing's scaling back its initial ambitious strategy:

• The much heralded global supply chain modeled on outsourcing more than 60 percent of design and production, where suppliers shared in the construction risks. Unfortunately, supply chain and design problems early on signaled that learning curve costs didn't follow historical slopes -- reduction in production costs didn't deliver predictable unit gains usually observed in aircraft construction.

Three days to assemble a B787 looks great on paper; but, despite years of development, unit costs have yet to decline on the B787 program. Fortunately, Boeing has slowly retreated from its initial goal to profitably produce the world's first major airliner using lightweight, carbon-fiber composite materials, rather than aluminum, for most of the plane's framework. Though the new specs haven't been officially disclosed, engineers in-house recognized -- and finally convinced senior management -- that stress cracks repeatedly showing up in the wing-fuselage joints required a return to aluminum and other traditional, weightier materials, making it unlikely the goal of 20 per cent improvement in fuel economy and 30 per cent lower maintenance costs will be realized.

No surprise to aviation watchers, Boeing's R&D expenses in 2009 soared to $6.5 billion, from $3.8 billion in the prior year, precipitated by $2.7 billion in (non-cash) asset impairments related to the first three 787 flight test aircraft. Management admitted in its annual earnings filing with the SEC for 2009 that none of the three planes could be sold "due to the inordinate amount of rework and unique and extensive modifications made to the aircraft."

Though disputed by chairman and chief executive W. James McNerney, Jr., engine refits and structural flaws with the carbon-composite wing frames on at least two of the three additional 787 test aircraft built to speed up in-flight FAA certification suggests additional "one-time" write-offs are coming -- again!

Contrary to McNerney's best efforts to contain costs, planes built for "to the limit" integrity testing, including wing stress and repeated braking, among other structural framework testing (equivalent to 10,000 cycle flights) are unlikely to be sold for anything close to list price. Investors should brace themselves for another non-cash write-down of unsellable planes: another $3 billion in production costs to be relisted as R&D expenses. Though a non-cash charge-off, this accounting sleight of hand still serves to lower shareholder equity -- the "sunken costs" that are always justified as part of the learning curve equation.

Boeing will also face additional challenges in reaching stated operational profits given expected increases in production costs: plans to increase in-house use of engineers to address other serious design flaws ostensibly blamed on shoddy workmanship by subcontractors, such as problems identified during the second quarter regarding shims and fasteners on the 787s horizontal stabilizers.

Boeing's purchase of the 787 rear fuselage plant in Charleston, S.C. from Texas-based Vought Aircraft Industries for $1 billion last year and taking control of the operation was a dramatic admission that a sizeable part of Boeing's strategic plan to outsource much of the B787 production work has now been reversed, too.

The company's commitment to invest at least $750 million in plant & property -- and promise to create 3,800 new jobs by 2016 as part of a multi-million tax-incentive deal tied to Boeing's construction of a second 787 assembly line in North Charleston, near its fuselage plant in South Carolina, has already been built into operational cash flow guidance of $5 billion.

By 2013, Boeing expects to deliver seven B787s a month in Everett, Wash. and three a month in Charleston.

Boeing's penalties to all customers will probably reach about $5 billion, said Mike Walton, an analyst at Deutsche Bank AG in New York said. The company will probably seek to satisfy those claims through a variety of concessions, including discounts, maintenance agreements, options, purchase rights, delivery-slot availability and other means instead of cash payments, he said.

Admittedly, Walton's guidance is probably a close calculation of charges pending, but his conclusion is oxymoronic: Sales discounts and maintenance agreements do have cash value, and can negatively impact Boeing's cash flows.

With respect to Wall Street forecasts on Boeing's cash flow for the next year or two -- in the spirit of Deutsche's Walton, "I disagree with unanimity."