While The Boeing Company's Production Rates Rise Its Margins Could Stumble

Boeing's (NYSE: BA  ) share price soared 77% in 2013, but the company must execute on its promise to improve production rates on its commercial aircraft if it plans to impress investors with a strong financial performance in 2014. Unfortunately, ramping up its production rate doesn't guarantee that Boeing's operating margins -- and thus its profits -- will improve as many investors would like to believe. A recent bottleneck in 787 production provides us with a perfect example of why investors could see lower operating margins for Boeing's most important commercial aircraft business.

Starting from the top
Boeing's massive backlog of orders was one of the company's biggest stories last year as it hit a record high of $441 billion in the fourth quarter. That's an incredible amount of revenue visibility and security that few companies can match. In fact, Boeing's backlog of orders is valued at nearly five times its 2014 estimated sales total -- a mind-boggling amount, in my opinion.

That sets Boeing up for an interesting year, as it won't be launching any new airplanes to drive orders; rather, it will be gearing up to improve production rates to take advantage of the record backlog and drive revenues and profits higher.

The First 787 to roll out at a higher production rate. Source: Boeing

So far, Boeing's production rate seems to be a on a strong path. Looking at two of Boeing's most important airplanes, management has improved the production rate of its next-generation 737 by 33% since 2010 -- from 31.5 planes per month to 42. That 737 production rate is the highest attained and is merely a stepping stone to the planned rate of 47 airplanes per month in 2017. Production of the 787 Dreamliner reached 10 units per month at the end of last year, which is also a record.

As the company ramps up production, it should help support or improve margins in a couple of ways. In addition to minimizing overhead costs per airplane, many of Boeing's suppliers are on volume-based contracts. That essentially means that the more parts that Boeing purchases, the less it pays a supplier per part -- thus improving margins.

However, as in life, nothing is quite that simple, and the road to better margins could hit some speed bumps.

Unfortunately, due to delays and budget overruns prior to the 787 Dreamliner's launch, its ramped-up production will actually lower the company's overall margins for now. Just as the 787 had jumped over previous hurdles surrounding its initial launch, a bottleneck in production recently reminded us that plenty more hurdles exist before operating margins improve.

It appears that Boeing's plant in South Carolina is having troubles keeping up with the 787 Dreamliner's increased production rate of 10 per month. That's causing the plant to send thousands of work orders to its larger plant in Everett, Wash., for parts of production to be completed so the overall company can stay on its increased pace. That, in turn, brings up more issues. First, the influx of work orders to the Everett plant caused Boeing to create special teams to inspect all wiring to make sure no errors or discrepancies exist. Second, the company has now hired hundreds of additional contract workers in South Carolina to help fix the production bottleneck. Both will likely put pressure on Boeing's commercial operating margins as production is initially ramped up.

Bottom line
Boeing's operating margins in its commercial airplane division have been a bright spot for investors recently. For the full-year 2013, its commercial airplane operating margin increased 130 basis points to nearly 11%. This is a great development, as Boeing's commercial business is needed to offset revenue declines in its defense business. Investors would be wise to keep an eye on Boeing's commercial operating margins over the next couple of quarters to see how much downward pressure the increased 787 production will create. In time Boeing's margins should bottom out as the production rate on its airplanes normalizes and becomes more efficient, and that will help improve Boeing's financial performance -- it's just a matter of how quickly the company can make this happen.

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