Boeing 787 update and forward looking

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Boeing 787 Problems Loom Large (NYSE:BA) | Seeking Alpha

Boeing 787 Problems Loom Large

Jan. 04, 2021 9:30 AM ETThe Boeing Company (BA)38 Comments19 Likes

Summary

• Boeing 787 margins to be eroded further.
• Ingredients for a reach-forward loss have been added over the past year.
• Boeing is currently facing extra costs as Boeing 787 in inventory undergo inspections.
• Reach forward loss is disappointing and may require more stringent control if the method is utilized in the future.
• Alternative view confirms that the biggest shock in aviation history was needed to derail the program.
• I do much more than just articles at The Aerospace Forum: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

While Boeing (BA) reached a major milestone in 2020 with the recertification of the Boeing 737 MAX, the company is facing its next challenge as problems on the Boeing 787 problem are mounting. Currently there are several things that are known about the current issues, but a lot – including connections to the financials – remain unknown. In 2019, while the Boeing 737 MAX was providing significant cash headwinds to Boeing I outlined for The Wall Street Journal that the Boeing 787 was providing an important cash inflow for Boeing.

 

Source: Airlive

In this report, I explain how the role of the Boeing 787 is fully reversed now and we have a look at why financially things can get more challenging for the Boeing 787.

Production reduction

Prior to the outbreak of the pandemic, Boeing already was facing significant challenges to maintain a production rate of 14 aircraft per month and that should not come as a surprise because a rate of 14 a month is unprecedented for a wide body program. In late 2019, absent of some expected order inflow Boeing already had to announce its decision to lower the production rate from 14 to 12 and later 10 per month in 2021 and the pandemic immediately reduced that rate to 10 per month and forward rates were incrementally reduced to five aircraft per month with the decision to consolidate production in South Carolina.

While the consolidation will likely reduce the cost overhang of the huge Everett facility carried by the Boeing 787, part of that cost overhang reduction is offset by the losses of production gains in the system. Going from 14 to five aircraft per month means that in the forward projections part of the gains are lost and while mostly those losses will be limited to the labor cost front for which there exists significant difference between Washington and South Carolina workers, the projections are very likely to be a lot less rosy than previous projects for the accounting block.

Long story short: While there are gains in the system stemming from consolidations, reduction in production has significantly decreased the program margins for the Dreamliner.

Tooling costs

Previously, there were some concerns among my readers that Boeing would be facing reach forward losses on the Boeing 787 program due to impairment of the Everett based tooling. However, in a separate analysis I noted that while I initially believed the possibility of impairment was there a deeper dive did not provide supportive evidence as the Boeing 787 tooling can be stored and while that does not completely eliminate the chances of impairment since the value of the tools to operations is zeroed, the absence of a program termination means that the main tooling required for production still has prospective value as long as it's stored and storing the tooling could also mean that the portion of the deferred production balance associated with the unamortized tooling is pulled out of the Dreamliner program. The costs that Boeing would face when putting the tooling in storage is mainly related to the actual costs of disassembly, clean up, transport and storage activities.

 

Inventory accumulation

Recently, driven by significantly-reduced demand, Boeing reduced its production rate for the Boeing 787 to five aircraft per month starting in 2021. Of course that puts further pressure on margins, but the bigger problem is now becoming inventory accumulation that is not solely driven by the lack of demand for wide body aircraft but primarily by the need for inspections on the Boeing 787.

Earlier in 2020, a flurry of issues was detected and the most notable was a combination of two issues, namely improper shimming and insufficient skin smoothness could result in loading and load paths scenarios in which the aircraft would not meet limit load criteria. It's a potential unsafe condition, but limit load is still the extreme loading that an aircraft experiences only once or very few times in its service life. So, chances of those loads occurring is statistically small but the aircraft needs to be built to sustain those loads and in fact it needs to be built to sustain ultimate load, which is 1.5 times limit load.

Boeing identified eight aircraft for which those limit load criteria were not met and that sparked inspections on all aircraft including the ones that Boeing currently has in inventory. Those aircraft are not delivered until the inspections are completed and that delays deliveries and likely is costing the jet maker a lot of money and recently those inspections have been expanded significantly including more or all fuselage joins whereas previously the inspections were limited to the 47 and 48 section of the fuselage.

The expansion of the inspections shows that the issues are wider and more uncomfortable than initially thought. From several readers I have received a question whether the inventory of Dreamliners undergoing inspection is indeed 70 aircraft as they have read. In September, AeroAnalysis contacted Boeing to inquire about the scale of the inspections but apart from a separate issue on the stabilizers we received no numbers.

 

Using numbers from Uresh Seth from All things 787, there have been 96 aircraft rolled out in the first 10 months of October and Boeing reported 53 deliveries. That leaves 43 aircraft in inventory and at a rate of 10 aircraft per month over November and December that would increase to 63 aircraft. However, other numbers do suggest that production has significantly slowed down and there are 31 aircraft in storage and 46 aircraft undergoing testing and flight testing, which already brings the total to 77 aircraft. So, we are indeed talking about tens of Dreamliners representing billions in revenues as well as costs of goods. Inspections will continue into 2021 as the final assembly of the Dreamliner in Everett comes to a conclusion, so we are looking at an inspection effort that's taking months and I can only imagine those inspections to be costly.

Impact to program and forward losses

When contacting Boeing in September, AeroAnalysis asked for was whether there was any guidance on the financial impact of the inspections but at the time Boeing was unable to provide any information. However, the Q2 2020 and Q3 2020 filings do contain the following statement:

During 2020, we experienced significant reductions in deliveries due to the impacts of COVID-19 on our customers as well as quality issues and associated rework. The 787 program has a large number of undelivered airplanes in inventory at September 30, 2020. Pre-COVID-19, we were producing at a rate of 14 per month and had planned to adjust the 787 production rate to 12 per month in late 2020 and to 10 per month in early 2021. Due to the impacts of COVID-19 on customer demand, we are currently producing at a rate of 10 per month and plan to reduce to 6 per month in 2021. As a result of the planned production rate changes, we reduced the accounting quantity for the 787 program by 100 units during the first quarter of 2020. The 787 program has near breakeven gross margins due to the reductions in the production rates and the reduction in the program accounting quantity. If we are required to further reduce the accounting quantity and/or production rates or experience other factors that could result in lower margins, the program could record a reach-forward loss in future periods. We made the decision during the third quarter of 2020 to consolidate 787 production in South Carolina in 2021, which did not have a significant financial impact on the program.

Important to note is that Boeing provided a cautionary statement on further reductions on the production program potentially triggering a reach forward loss position for the Boeing 787 program meaning that Boeing will not be able to cover costs on the current accounting quantity and Boeing has actually reduced its forward production rate to five aircraft per month while the program was already expected to have near break-even margins at a rate of six aircraft per month and to that come the extra costs of inspections which Boeing has not quantified but are likely adding up significantly.

 

Boeing currently has costs in the amount of $17.3B in excess of what it recognized so while on unit basis production is still profitable, the company could see significant book-keeping impact if the company heads for a reach forward loss position (a reach forward loss position is when the aircraft program costs more than it generates in profits).

Conclusion

For a long time, I have been keeping track of the deferred production balance on the Boeing 787 program and for a long time my projections have shown that Boeing would be able to reduce its deferred production balance (a measure between what Boeing recognized as profits and the actual profits realized) within the accounting quantity. The margins were improving as Boeing added units to the accounting quantity and production went up and on those conditions there certainly was a strong base for Boeing to assume the balance would be zeroed. However, the current market realities that include a pandemic and reduced demand in certain regions prior to the pandemic have resulted in the program to shrink significantly in a year leading to lower efficiencies and on top of that come additional costs for inspections that have significantly expanded on global supply chain scale. All of those elements could result in a reach forward loss for Boeing on the Boeing 787 position, though there's no certainty on that because Boeing does not provide detail to determine with certainty when a loss is triggered but the ingredients for a reach-forward loss have been added in 2020.

A reach-forward loss would be disappointing, because it demonstrates that while the system works in theory, in reality the accounting method to streamline profits is not suited for multi-year applications. At the same time, I also believe that we should keep our eyes on cash generation because a reach forward loss would mean that while production is profitable (bringing in cash), the entire program might not be profitable (near cash break-even) but the earlier costs exceeding cash inflows already have been recognized in the company’s cash flow statements. We also should consider that a pandemic was needed to get Boeing’s 787 program to its knees. So, it took the biggest shock in aviation to derail the program. I think that does say something about the program. What remains is that Boeing needed a strong execution and dwindling demand for aircraft is not allowing that. For Boeing, it's also time to break with the past and get focus back on engineering first and finances later. The current expansion of the inspections do show that the issues, partially, could be going beyond manufacturing issues and head into the design space coupled to association production method. It also does show that, right now, Boeing is doing what it needs to do and that is put safety first. I wouldn’t go as far as complimenting the company for this but we might be seeing that Boeing is slowly turning a page from the dark past, but the road ahead is long.

What remains to be seen now is whether Boeing will actually have to announce a reach-forward loss for the program... the ingredients for it are there.