Boeing posts stellar 2011 third-quarter profit amid 787 & 747-8 concerns

– Boeing cash flow plummets as 787 inventory builds up
– Boeing 787 block size in line with analysts’ forecasts
– Boeing says 787 has a steeper learning curve than consensus
– 787-10X to be launched in 2012: sources
– 747-8I Intercontinental completes all flight tests
– Boeing leans towards 68 inches for 737 MAX engine fan size: sources 

Chicago-based Boeing, the world’s largest integrated aerospace company, has posted a better-than-anticipated 2011 third-quarter net profit of US$1.1 billion, versus US$837 million recorded in the same period last year. The 31% surge in the aerospace giant’s third-quarter net profit is backed by a significantly less growth in its revenues, which grew a marginally 4% from US$17 billion a year ago to US$17.7 billion in the third-quarter of this year. Operating margin improved from 8.2% in the third-quarter of 2010 to 9.7%.

Earnings in the first nine months of this year grew by 22% from last year’s US$2.1 billion to US$2.6 billion on a 3% increase in revenue from US$47.8 billion to US$49.2 billion.

As a result of its strong core performance, Boeing increased its 2011 earnings per share (EPS) forecast to US$4.30 and US$4.40, with an anticipated US$68 and $70 billion in revenues.

“Strong operational performance drove double-digit margins in both of our major businesses and produced an outstanding quarter,” Boeing chairman, president and chief executive Jim McNerney said.

“We also strengthened our foundation for accelerated growth by completing development and certification of the 787-8 Dreamliner and 747-8F Freighter, launching the new 737 MAX, and continuing our disciplined ramp-up in commercial airplane production rates. Our improved outlook for earnings reflects confidence in our market positions, and our team’s relentless focus on productivity and disciplined execution,” McNerney conceded.

Interestingly, despite the US Department of Defense’s drive in cutting spending in its weapons programmes, which have seen bottoming defence budgets in order to trim the ballooning US$14.9 billion national debt of the world’s largest economy, Boeing’s defence devision posted a remarkable improvement in its results, with a 20% hike in Boeing Defense, Space & Security (BDS)’s earnings from operations from US$684 million in the third-quarter of last year to US$824 million earned in 2011 third-quarter.

Operating margin for Boeing’s defence unit, the Pentagon’s second-largest defence contractor, also improved by 1.6 percentage points from 8.4% to 10% this quarter, on a zero-growth in BDS’s total revenues at US$8.2 billion for the quarter.

The company cited “strong operating performance” and “improved delivery mix” for the 27% increase in earnings in the Boeing Military Aircraft (BMA) unit from a US$312 million profit in 2010’s third-quarter to a profit of US$397 million recorded in the same period this year.

Meanwhile, on the commercial side, Boeing has delivered its first 787 Dreamliner to its launch customer All Nippon Airways (ANA) in Japan during the quarter, which operated the game-changing aircraft on the world’s maiden 787 flight from Tokyo Narita International Airport to Hong Kong on 26th October (“Photo blog: Boeing 787’s maiden flight lands at Hong Kong“, 27th Oct, 11).

Notwithstanding the stable results posted by the Boeing Commercial Airplanes (BCA) plane-making unit, which saw a 7% rise in its earnings from US$1.017 billion in the third-quarter of last year to US$1.085 billion this year on a 9% rise in BCA’s revenues from US$8.7 billion the same period a year ago to US$9.5 billion, the increasing gross inventory for both the 787 and 747-8 programmes, for which the former stands at a staggering US$18 billion at the quarter-end, does have a material impact on the company’s results.

For instance, the operating cash flow of Boeing declined by an unprecedented 76% from from US$1.86 billion in 2010’s third-quarter to just US$449 million in the same period of this year, whereas the operating cash flow for the first nine months of the financial year plummeted significantly by 41% from 2010’s US$1.8 billion to this year’s US$1.1 billion.

Moreover, the Chicago-based aircraft manufacturer reduced the number of deliveries of the 787 and 747-8 for 2011 from its original target of 25 to 30 deliveries to 15 to 20 deliveries, with two-third of the deliveries being the 747-8F freighter ones.

This highlighted the still significant risk facing the world’s second-largest manufacturer of commercial jetliners in the foreseeable future, with the significant amount of rework on both the early-built 787 and 747-8 examples carrying the highest risk on the airframer’s production ramp-up plan to produce 10 787s per month by the end of 2013, as well as the overall operating margin of the company which will come under downward pressure in the next few years as the early-built, low-margin 787 and 747-8 airplanes are delivered.

Image Courtesy of Boeing

A silver lining for the Dreamliner
Having delivered the first two 787-8 Dreamliners to Japan’s All Nippon Airways (ANA) during the third-quarter, significant challenges still persist for the revolutionary aircraft programme albeit the milestone symbolised the dawn of a new era in commercial aviation. Profitability and execution risks on its ambitious production ramp-up plan, are namely the biggest headwinds facing the game-changing aircraft.

In announcing its third-quarter 2011 results, Boeing has disclosed that it has chosen 1,100 as the initial programme accounting block for the 787 Dreamliner programme which provides a rare glimpse of the profitability of an aircraft programme over its lifespan in addition to providing a supposedly reliable guidance on the production cost and realistic sales prospects for the aircraft in the near to medium term.

“Over the next 20 years, we estimate the addressable market for the 787 class of airplanes at 5,000 units. At current plan production rates, the initial quantity of 1,100 units represents approximately 10 years of production. This time horizon is in line with previous initial quantities for new programmes. The programme method of accounting amortises unit production cost and tooling over the accounting quantity. A fundamental principle in applying program accounting is the ability to reliably estimate the revenues and associated costs for the defined programme quantity,” Boeing corporate president and chief financial officer (CFO) James Bell explained on reaching the initial accounting block size on the 787 programme.

“Our initial gross margin booking rate on the 787 is in the low single digits, which takes in consideration the cumulative impacts of delays and near-term production challenges. Programme profitability will be assessed quarterly as part of our disciplined EAC [equivalent annual cost] process,” Bell conceded.

However, achieving profitability on the 787 programme is a challenging task, given the US$18 billion of gross inventory on the 787 in addition to another US$9.7 billion of deferred production cost, which spreads the high production cost on early-built examples on the number of airplanes that will be produced in the entire programme.

“Gross inventory for the company now includes $18 billion related to the 787 work-in-process, supplier advances, tooling and other non-recurring costs, an increase of approximately $1.8 billion during the quarter. Included in work-in-process are deferred production costs, which represents the difference between the higher production costs experienced on earlier units, principally driven by learning, and average programme costs over the accounting quantity for both airplanes delivered and in work-in-process,” Bell elaborated.

“At the end of the third quarter, the deferred balance was $9.7 billion and included over 40 units still in process. The deferred production balance will continue to grow as we increase production rates and introduce the 787-9 derivative. When the programme achieves and stabilises at the rate of 10 airplanes per month, we expect deferred production costs to begin to decline and over time, unit margins will exceed programme margins,” Bell added.

Meanwhile, in a sign that the tremendous amount of rework on the early-built 787s is taking considerably longer than expected to complete, Boeing has delayed the entry into service (EIS) date of the 787-9 variant to early-2014, consistent with the previously reported 3-6 month delay in the 787-9’s EIS.

“We continue to monitor and address challenges associated with aircraft assembly, including management of our extended global supply chain, incorporation of design changes into aircraft in various stages of assembly, completion and integration of travelled work as well as weight and systems integration. For example, in 2011 we delayed production rate increases and some 787 component deliveries to reduce out-of-sequence work moving into final assembly at our Everett factory and improve supply chain efficiency. In addition, a number of engineering and other design changes identified during flight testing are being incorporated on aircraft completed prior to certification,” Boeing said in its Q-10 filing with the US Securities and Exchange Commission (SEC) following the release of its third-quarter results.

“We remain focused on achieving planned increases in 787 production rates while continuing to satisfy customer mission and performance requirements. We currently expect to increase production of 787 aircraft to 10 aircraft per month by late 2013. Our efforts to achieve planned production rate targets include improving the production system, co-ordinating rate increases with suppliers, the start-up of the second assembly line in North Charleston, South Carolina and establishing transitional surge capacity at our Everett location. With successful completion of the 787-9 critical design review we have assessed the schedule and first delivery is now expected in early 2014, although we continue to look for opportunities to regain schedule. In addition, we continue to work with our customers and suppliers to assess the specific impacts of prior schedule changes, including requests for contractual relief related to delivery delays and supplier assertions,” Boeing emphasised in its Q-10 filing.

Now that the 787-9’s entry into service (EIS) has been delayed to 2014, Aspire Aviation thinks there is a reasonably high possibility that the production ramp-up plan will also be further delayed to 2014, along with yet another delay for the 787-9 to at least mid-2014 should the number of rework required to make the 787s built deliverable do not decline satisfactorily.

Nevertheless there is a silver lining through the dark clouds shining on the 787 programme, from both the financial and commercial outlook standpoints.

First of all, Boeing has indicated a considerably steeper learning curve on the 787 programme than the 777 programme which is understood to be at a 16% learning rate, according to a UBS research dated October 11 to its clients.

“There are significantly more costs associated with these first 40 airplanes as we build them out of sequence. And so that is why we believe once we digest those, the learning curve will go down sharply to traditional learning curve levels earlier than you would normally see on a traditionally ran programme where you did not have concurrent production with development,” Boeing chief financial officer (CFO) James Bell asserted.

A noteworthy point is, the reactions from the Wall Street analysts on the 787 programme’s initial accounting block size as well as on the learning curve have been generally positive.

“We think consensus underestimates the profitability of the 787 programme and we think that is evident given the positive reaction to the 787 accounting quantity and gross margin,” New York-based Buckingham Research wrote in a note to its clients.

“Ahead of earnings, we saw the 787 accounting quantity and any incremental information on the 787 production ramp as investors’ primary concerns. In our view, buy-side expectations were that an accounting quantity of ≤1,100 would be a positive, 1,100-1,200 a neutral, and >1,200 a negative (we thought the accounting quantity would be 1,200 units). We think investors viewed the 787 accounting quantity of 1,100 units (~10 years or production) favourably as we think investors believed a meaningfully higher block size would mask higher programme costs. Boeing commented that the gross margin for the first block would be in the low single-digits. We estimate the programme gross margin will be 3%,” Buckingham said in the October 28 note.

Though Boeing’s plan to ramp up the 787 production to 10 per month by the end of 2013 remains the major concern for Wall Street analysts, with Credit Suisse predicting the 787 production will not be ramped up until the first-quarter of 2015.

“We view this as challenging given 40% of the supply chain is still outsourced and our model assumes a 10 per month rate is not achieved until Q1 2015. Management did say that if the timing in which mature ramp is reached slips a quarter (from Q4 2013 into 2014), it did not believe there would be a significant implication on accounting quantity or profitability assumption,” Credit Suisse said in an October 26 note to its clients.

Image Courtesy of Getty Images

Looking ahead, the underlying demand for the fuel efficient 787 Dreamliner remains fundamentally strong, despite a faltering global economy could bring more order cancellations in the short-term.

With the possible launch of the stretched 787-10X variant in 2012 which could accommodate 320 passengers with a range of 6,800 nautical miles (nm) powered by two 74,000 lbs (329 kN) engines, burn 20% less fuel than an Airbus A330-300 with a 10% and 5% lower operating cost than the A350-900 XWB and A350-1000 XWB, respectively, this could bring a renewed momentum in new 787 orders beginning as soon as 2013 as Boeing burns down its strong 787 backlog.

“We are thinking about a 787-10 as we see the market for intra-Asia flights is huge,” Boeing 787 programme vice president (VP) and general manager (GM) Scott Fancher told Hong Kong’s South China Morning Post onboard the inaugural ANA 787 flight.

“We are not making a decision about what happens in one or two years. Building an airplane you need to plan for 30 years,” Fancher was quoted as saying.

Furthermore, the 787-10X would require a minimal amount of research and development (R&D) and engineering resources at a time when Boeing works on the re-engined 737 MAX with a 2017 service entry and mulls on the revamped 777-8X/-9X as a response to the potential threat arising from Airbus’ A350-1000 XWB.

In addition, the risk facing the 787 programme’s future remains largely an execution one, with the completion rate of parts arriving in Everett continues to improve steadily with no new major issues dubbed “show-stoppers”, according to Aspire Aviation‘s sources, and once the 787’s fractured global supply chain is permanently fixed, there is a bright potential lying ahead of the 787.

“It is all the rework on the early airplanes. We are just methodically going through the rework that was driven by flight test discoveries and other engineering changes that we needed to get through, and it is just a matter of walking through it. No real change in the configuration of the airplane. As we mentioned earlier, we are breaking to a higher rate on productions. So I think it is simply a matter of timing,” Boeing chairman, president and chief executive Jim McNerney commented.

“Change incorporation on early production airplanes is being tackled methodically in Everett and San Antonio now that certification is behind us and the production configuration has been finalised. While our updated guidance reflects a few less deliveries by year end, the work to be done during change incorporation is well defined and planned for each airplane. Now it is all about burning down the work while ensuring the quality our customers expect at the time of delivery.

“This week, we are completing a production rate increase from 2 airplanes per month to 2.5 per month, with implementation and ever final assembly. And elements of the supply chain are already moving toward subsequent rate breaks in the future.

“Boeing South Carolina is progressing to plan as production on the first 787 continues in our new final assembly building. First delivery out of Charleston is on track for next year. Across the board, we are applying a disciplined approach to ensure the health of the 787 production system as we progress through a series of planned upcoming rate increases to achieve 10 airplanes per month by the end of 2013,” McNerney emphasised.

“Flight testing on the 787-8 powered by GE engines is approximately 95% complete, with ETOPS (extended twin engine operations) and function and reliability testing now underway and progressing well. We are also seeing improvements to the quality, productivity and overall condition of the assembly within the production system,” McNerney stressed.

Boeing 737 MAX & 747-8
As the 747-8F freighter entered into service in the beginning of the fourth-quarter after resolving a month-long dispute centred on the performance shortfall on the aircraft’s General Electric GEnx-2B engines, the global freight market frets again and is in a conundrum as the Geneva-based industry body International Air Transport Association (IATA) showed a 2.7% decrease in September 2011’s freight traffic versus the same period a year ago.

Despite the global economy continues to be a major challenge for any new 747-8I Intercontinental and -8F freighter sale, the aircraft’s business case remains sound with a significantly larger revenue cargo volume when compared to the A380 and bodes well for carriers that place an emphasis on frequency to grow without undermining the frequency-based business model.

“We do not have a changed view. The last couple of months, there has been some softening, but the path on these growth curves often up and down quarter-by-quarter. But the facts are we are still – when you sum up the year so far, we are still ahead of last year even though it is low single digits. So it is a watch item, as I  said in my remarks, but not ready to conclude that there is a fundamental change in our market assumption at all,” Boeing chief executive Jim McNerney commented on the faltering global economic recovery.

Image Courtesy of Boeing

Though as the 747-8I Intercontinental has completed its flight testing programme required for certification today, the entry into service (EIS) of the 747-8I has slipped into early-2012, owing to the incorporation of design changes, according to the company’s Q-10 regulatory filing with the US Securities and Exchange Commission (SEC).

“The 747-8 Intercontinental remains on track for certification in the fourth quarter. First delivery is now scheduled for first quarter 2012 due to a delay in flight testing and the time required to incorporate all flight test driven changes,” Boeing revealed in the regulatory filing.

“In addition to continuing flight testing and certification efforts on the 747-8 Intercontinental, we remain focused on incorporating engineering and design changes identified during flight testing into aircraft completed prior to certification, achieving a planned increase in 747 production rate from 1.5 to 2 airplanes per month in mid-2012, reducing out-of-sequence work and improving supply chain efficiency. If risks associated with these activities cannot be mitigated it could result in customer claims and/or supplier assertions and/or result in an additional reach-forward loss. We continue to implement mitigation plans and cost-reduction efforts to improve programme profitability and address programme risks,” Boeing cautioned.

In commenting on the 747-8’s business case and its performance shortfall, Boeing president, chairman and chief executive Jim McNerney said “we are working through weight and fuel burn issues. Every confidence of getting there. Full visibility with our customers. GE is very close to our customers as they are working to deliver the airplanes against the performance that they have promised. So I think none of that changes our view of the programme” while adding, “the 747-8 will give cargo operators the lowest operating cost and best economics of any freighter in its class while providing enhanced environmental performance”.

In the meantime, Boeing is progressing on the configuration of the re-engined 737 MAX which has proven to be popular with 496 orders and commitments following a programme launch in August.

“We have got pretty good fidelity on what the offering is, and we are finalising that. We have obviously had enough confidence in the performance of the airplane to have preliminary agreements with a number of airlines and deep discussions with others,” Boeing chief executive Jim McNerney asserted.

“It is settling down quickly in terms of the details and so on. I am happy with the progress on the design and the reaction of our customers to the design. [Though] we are still thinking through where we would produce it,” McNerney added.

According to Aspire Aviation‘s multiple sources at the Chicago-based airframer, Boeing is leaning towards choosing the option of a 68 inches engine fan size on the 737 MAX in order to have more flexibility in terms of future growth and better fuel burn, with the configuration to be finalised as early as late-November.

Aspire Aviation understands that the 10%-12% fuel burn reduction on the 737 MAX 8 when compared to the existing 737-800 NG (next-generation) might have already factored in the fuel burn savings brought by aerodynamic changes such as revised trailing edge design, straightened vertical stabiliser, 787-styled tail cone as well as the laminar flow concept.

While the 10%-12% fuel burn reduction delivered by a 737 MAX 8 is less than the 15% figure touted by Airbus on its A320neo (new engine option), an AirInsight analysis finds that the 737 MAX 8 has a 4% lower cash operating cost (COC) per seat-mile than the A320neo which has confirmed the 737 MAX 8 being 4% more fuel efficient than the A320neo per seat whereas the 737 MAX 9 has a 2% higher fuel burn than an A321neo.

Aspire Aviation believes this puts the 737 MAX at least on par with the A320neo aircraft family while the 737 MAX 9 could potentially become more competitive by utilising the 737 MAX’s partial fly-by-wire system to redistribute wing loads inwards and thereby increasing the aircraft’s maximum take-off weight (MTOW) in order to become a closer 757 replacement.

All in all, the 737 MAX is the correct approach which enables Boeing to maintain a sizeable market share in the narrowbody marketplace while maintaining the duopoly with its arch-rival Airbus, at the same time freeing up financial and engineering resources for a potential 777 revamp (“New Boeing 777X to be a highly efficient derivative“, 14th Sep, 11).

Given the second-generation composite technologies such as the carbon nanotube reinforced polymer (CNRP), out-of-autoclave (OoA) composite production skills need time to find their places in wider uses in the aerospace industry and mature before a composite narrowbody could be profitably produced en masse at 50 to 60 units a month, the 737 MAX would serve this intermediate role well until the eventual replacement, new small airplane (NSA), comes (“Boeing 737 MAX to help recover sales momentum“, 5th Sep, 11).

In conclusion, Boeing’s third-quarter 2011 is a stellar and robust one, which lays the groundwork for future growth in earnings. With the 787 and 747-8 being delivered, the engineering resources freed up as well as the modestly declining research and development (R&D) in the next few years will enable Boeing to focus on the longer term such as the 787-10X and 777X developments and ultimately, a revolutionary new small airplane (NSA).

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