Mismanagement at Boeing Crashes Replacement B737 Jet
Boeing (BA) believes finances are sufficient to support production ramp-up of its long-delayed 787 Dreamliner and jumbo-jet 747-8 programs next year. To the contrary, continued mismanagement will result in serious cash drain in 2011 from further schedule problems -- and cripple replacement timelines for its flagship B737 passenger jet
Recent trading in Boeing bonds suggests credit analysts have bought into Boeing's claims that the worst of production and FAA certification delays are behind the company: A late summer rally in Boeing's CDS spreads -- insurance costs against bond default -- has narrowed in recent months, from being wide of its comparable 'A' industrial CDS benchmark to moving within a recent range of 3 to 10 basis points, according to sources at Standard & Poor. The cost to insure $10 million of Boeing bonds recently fell to $65,000 for five years; as compared to a CDS spread of 105 basis points ($105,000) -- a 0.46 percent premium over comparable 'A' industrial CDS benchmark quoted on Nov. 11, 2009.
In my view, rebounding from 52-week trading lows speaks more to Boeing's reputation and pricing sway over prospective customers than to R&D and fundamental business prospects. For many years, Boeing and Airbus, a subsidiary of Europe's largest aerospace and defense contractor EADS, have enjoyed a virtual duopoly in wide-body, medium or long-range passenger aircraft, resulting in lack of demand elasticity (substitutes) that keeps customers from cancelling contracts: there's been just a seven percent falloff in 787 orders -- either cancellation or shift to other models -- from a peak high of 910 units sold at the end of 2008 to a recent order flow of 847. 
At quarter-ended September 30, Boeing increased its 2010 cash flow guidance from zero to more than $1.5 billion, reflecting continued strong performance in core commercial businesses: Airliner revenue jumped $866 million year-over-year, or almost 11 percent, due to higher new airplane deliveries -- resulting from an easing of 737 and 777 supplier production challenges (specifically, shortages in seats related to supplier Koito Industries' admitted falsification of safety data) -- and healthy demand for aviation services, driven by spares and freighter conversions .
On the quarterly earnings call, chairman and chief executive officer Jim McNerney expressed optimism that contractual commercial backlog of $255 billion, more than seven times the business segment's projected 2010 sales, demonstrated the company's financial capacity to manage core operations and defined next-generation aircraft programs.
Understated, however, was that the surprising windfall in operating cash flow won't actually contribute any fresh working capital needed for continued 787 and 747-8 inventory build or plant equipment (announced volume increases for B737-NG (next generation) planes, from 31.5 to 38 aircraft per month by 2013). The unexpected positive swing in quarterly cash flow came from dollars to be generated next year: advanced payments received on orders and receipt timing in the defense business. Anticipated two-year operating cash flow results (2010-2011) remain unchanged at roughly $5.5 billion.
In early August, the 787 Dreamliner Test Program suffered further schedule slippage due to engine-related failure issues from supplier Rolls-Royce. Chairman McNerney said Trent 1000 engine problems wouldn't hinder delivery dates, and reaffirmed first launch in February 2011 to Japan's All Nippon Airways (ANA), originally promised delivery of the first 787 back in May 2008 :
Rolls is confident that they can support our schedule with hardware and a software fix. It is not going to require that they recertify the engine, rather just submit some data to, in essence, sustain certification.Meanwhile, supplier issues keep cropping up. A Boeing 787 supplier has halted delivery of tail sections for two weeks. The pause was meant to give the supplier, Alenia, time to fix gaps in horizontal stabilizers it makes. That's the part of the plane's tail that looks like a wing. Boeing spokeswoman Lori Gunter says Alenia is adding shims to fix a gap in the stabilizer.
When the first 787s roll off the production line, there is still a long way to go until it earns money. Production costs are unlikely to decline until the third or fourth year -- which chairman McNerney has admitted to in past conference calls- - due to two effects: the learning curve and the production rate (economy of scale). Additionally, no analysts have bothered to inquire how much price discounting will affect margins. 
Nonetheless, Boeing chief financial officer James Bell continues to insist that calculated costs of the 787 program do not exceed projected revenue for these aircraft. His declaration, however, is founded on accounting sleight of hand -- as Boeing "buries" 787 pre-production costs over its entire eight years of output (847 airplanes, capacity by year 3 of 120 units per year).
Barclay Capital warned back in July 2009 that Boeing was dangerously close to forward operating losses on the 787 program -- even before the additional scheduling delays of 2010:
We believe the company, shareholders, and suppliers would all be much better served to have Boeing 787 financials based on estimates of costs and revenues over the tried and true traditional 400 aircraft block size, which is a quantity for which cost estimates can clearly be made with more confidence. Given that the very large block sizes are apparently getting close to a loss position, choosing a smaller block size would in all likelihood mean an even larger loss taken over a smaller quantity of aircraft, but this would leave open the possibility of large profits on aircraft after the first 400.Boeing is standing firm that forward cost overruns will be immaterial. In my opinion, the company is being less than forthright, given other rumblings that could impact production cost liabilities:
- About 33 percent of the company's employees are associated with certain labor associations like Society of Professional Engineering Employees in Aerospace (SPEEA), International Association of Machinists (IAM) and United Auto Workers (UAW). In my opinion, work stoppages are likely come 2012, when contracts expire with both IAM and SPEEA. In particular, machinists in the Boeing Everett plant are "pissed" the second 787 assembly plant in Charleston, South Carolina is a non-union shop.
- There is a material lack of clarity when it comes to customer claims for the 787 program. As of September 30, 787 inventory accounted for about 59 percent of the $21.7 billion in commercial aircraft inventories, which included "deferred production costs" (recognized future year expenses). Bell's "recognized" 787 expenditures do not include likely penalty payments for late deliveries -- up to $5 billion, according to Myles Walton, a Deutsche Bank AG analyst in New York.
- The lack of visibility extends to supplier contracts, too. Boeing has obligations to purchase more than $30 billion in goods and services that are off-book, meaning they are undisclosed liabilities not reflected on its balance sheet! Delays or not -- the company owes these monies to its subcontractors.
- Airlines still need to negotiate with their unions before they'll fly. For example, American Airline and Southwest Airlines cannot accept deliveries until their respective pilot and flight attendant unions sign contracts addressing work conditions for these new planes.
We are all born ignorant, but one must work hard to remain stupid. ~ Benjamin FranklinProgram risks are building with the 747-8, too. Gerson Lehrman Group recently opined further delays to the wide-body 747-8 passenger and freight aircraft project will cost Boeing an additional $250 million per quarter.
Originally intended to take share back from Airbus' intercontinental 500 (+) passenger-capacity A380 jumbo jet (introduced in 2007), first orders are proving lackluster for the 747-8 program: 76 of the 747-8 freighter and just 33 of the Intercontinental passenger series, at listed prices of $301.5 million - $304.4 million and $293 million - $308 million, respectively. 
In my view, mounting development costs threatens not only profitability but distract and delay needed R&D for either enhancements to -- or replacement of -- its best-selling, single-aisle (narrow-body) 737. Asset growth will require more than the $10 billion in liquidity on the balance sheet. Ergo, expect 737 development to be financed not from earnings but from illusionary inventory build ("deferred production costs") and borrowings (more debt).
McNerney told analysts on its earnings call that Boeing was "studying the market" to determine whether to build a new version of its 737 (looking out to a 2020 timeframe) or put a new engine in the current design to improve fuel efficiency:
I think once we complete the 787 and the 747-8 programs, which represent a relatively high watermark of R&D spending as you can imagine. There will be adequate capacity to deal with both the 777 improvements that we need to make and the narrow body 737 replacement.Say what he may, management incompetence is compromising the company's inability to financially address -- in the here and now -- the company's decision not to address 737 or 777 developments. Until Boeing's 787s and 747s are flying in skies the world over, Boeing's longer-term profitability will remain grounded.
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