Exclusive Update
The Boeing Company put in a good third quarter, with Wednesday's earnings report showing the company had beaten analyst expectations on earnings and revenue, and that management raised guidance for the full year. Boeing grew revenue from $17.7 billion in the third quarter of 2011 to $20 billion this year, though lower margins in the commercial aircraft segment as well as significantly higher pension expenses saw profit decline somewhat from $1.1 billion in 2011 to $1 billion in 2012. Boeing is now guiding for $80.5 billion-$82 billion in earnings for the full year, with per-share earnings of $4.80-$4.95, a marked increase from previous projections.
Wednesday's earnings also provided some good information on the company's progress in handling three key areas: pivoting earnings away from defense and toward commercial planes, holding development costs down, and ramping up production capacity to meet demand.
Swords into plowshares: Boeing's move toward commercial sales
Boeing is showing good progress in generating a higher proportion of revenue from commercial sales, as military contracts look vulnerable in the face of falling defense budgets in the West. While Boeing was able to grow military and space sales in international markets, this performance was not enough to prevent a 4% decline in total defense, space, and security revenue. However, a strong performance in the commercial segment more than offset this loss, leaving Boeing even less exposed to future defense cuts with about 60% of revenue now coming from the commercial segment:
| 3Q, 2012 | 3Q, 2011 | YTD, 2012 | YTD, 2011 | |
|---|---|---|---|---|
| Commercial | 60% / $12,186 | 53% / $9,515 | 58% / $34,966 | 52% / $25,476 |
| Defense, Space and Security | 39% / $7,839 | 46% / $8,200 | 41% / $24,264 | 48% / $23,505 |
On the other hand, while Boeing did a good job in pivoting revenue toward commercial sales, earnings remained more firmly dependent on the defense segment due to higher operating margins. Boeing's defense operations achieved a 10.5% operating margin, up from 10% last year, while commercial operations saw a sharp margin decline, from 11.4% to 9.5%. This trend of lower margins will continue in the near future as Boeing steps up delivery of its newest jet models, the 787 Dreamliner and the latest 747 model, the 747-8. Even though these are Boeing's highest-value jets, paradoxically, the more of them Boeing delivers, the lower earnings will appear to be, at least initially.
Due to Boeing's use of program accounting, which is a method to spread out development costs among a block of jet orders, as Boeing delivers new planes it must recognize more and more of the full costs of the development program. Between the spectacular sums spent on the modern programs and the contract fees and expenses Boeing incurred by delivering the 787 three years late, the early stage of 787 and 747 sales will not contribute to earnings at all, instead going toward defraying program costs. Depending on how one tallies the costs of the program, and how successful Boeing becomes at bringing production costs down, the 787 program could break even and begin to contribute to earnings as soon as some time this decade, or as late as never.
Hold the line: Boeing's battle with development cost
Even should the 787 program never turn a profit, on the earnings call with analysts Wednesday, CEO Jim McNerney stated his belief that technologies developed for the Dreamliner could be "spiraled in" to other airframes, allowing the company to field modernized products at all points in its portfolio without incurring similarly budget-busting research and development costs. McNerney projected that the next decade or two would be a "de-risked" environment, meaning that the coming years will be a period of applying known technologies to known products, rather than a period of expensive innovation.
As an example, McNerney noted that Boeing was in consultation with major customers to upgrade the company's popular 777 jet model. Rather than embark on a full redesign, McNerney claimed that simply adding a new engine and a composite wing to the existing airframe could result in dramatic performance improvements. McNerney went on to explain how carbon composite wing technology developed for the 787 could be harvested for the 777, saying "building a composite wing of this size would not have been thinkable a decade ago... We now know how to do that and I can't think of anyone else who does."
In the most optimistic case, technologies proven for the 787 can be combined with proven fuselages and airframes to make highly competitive models that are both affordable for Boeing to produce while being out of reach for less-advanced competitors. One danger, however, is that integrating 787 technologies with older airframes like the 777, utilizing older control systems, may be more difficult than McNerney lets on, resulting in higher-than-expected development costs and late deliveries.
That fear is compounded by the fact that it wasn't Boeing that built the carbon composite wing, but rather third-party suppliers, primarily Japanese manufacturer Mitsubishi Heavy Industries as well as other suppliers from Japan, South Korea, and Australia. Delays and compatibility issues in integrating Japanese wing sub-assemblies with the 787 fuselage were part of what made the Dreamliner project three years late and billions over budget in the first place.
Even more worrisome, it may prove challenging for Boeing to keep this technology out of the hands of its competitors since the design and manufacturing is not done by Boeing itself. Perhaps the most potent example is that Mitsubishi Heavy Industries, the designer of the carbon composite wing box, created the Mitsubishi Aircraft Corporation subsidiary in 2008 to begin design of Japan's first domestic modern passenger jet. Though the Mitsubishi Regional Jet only seats 70-96 passengers, if Mitsubishi pushed forward into making larger planes, the company's know-how might force Boeing back into the research and development game well before two decades have passed if Boeing wants to keep a technological lead.
Selling jets like hotcakes: Boeing's push to meet demand
Of course, any competitors are still a long way off, and Boeing already has more orders than it can fill. Despite a 17% increase in order delivery compared to 2011, Boeing's order backlog actually increased in the third quarter from $374 billion to $378 billion. That's because while Boeing appears to be on track to hit its increased production targets, new orders for planes are growing even faster.
First, Boeing deserves credit for executing strongly on its planned production ramp-up. Despite some weakness in producing 747-8s, management advised that production increases for the 737 and 777 remain on track. Particularly commendable, Boeing appears ahead of schedule on its objective to increase 787 production from 3.5 per month last quarter to 10 per month by the end of 2013. So far in 2012, 28 Dreamliners have been delivered, five of them in the last month alone, and the third quarter also saw the first Dreamliner from Boeing's newly built South Carolina assembly plant delivered, an important milestone.
What investors did not hear was any indication that production quotas would be raised again on the back of this strong performance. McNerney noted that "we did the easier-to-do airplanes first and now we're moving into some airplanes that require a little more work," indicating that capacity increases may top out over the next few years as the company begins to tackle the 787-9 variant of the Dreamliner, which is still in the engineering phase. If the Dreamliner is stuck at the rate of 10 per month after 2013, it would take Boeing until 2020 just to deliver the planes currently on order, never mind fulfilling any additional orders over the next decade.
At other production lines, Boeing looks much more stable. The current backlog for the 737, Boeing's most popular plane, will take the company under two years to work through at current production levels. However, while the 838 orders for Dreamliners make up only about a fifth of Boeing's 4,100 order backlog, because of their large sticker price the 787s account for over 60% of the total value of the backlog. With smaller competitors like Embraer, Bombardier, COMAC, UAC, and the Mitsubishi Aircraft Corporation edging in on the 100-200 seat market the 737 serves, Boeing's future growth opportunity relies strongly on the 787 and other larger, technologically advanced planes that it cannot yet produce quickly enough to meet customer needs.
The Bottom Line
Boeing put in a strong quarter, and a faster delivery timetable is all to the good. However, to realize fully the $4.5 trillion market opportunity Boeing sees over the next two decades, it's simply not enough to execute well on the relatively modest production ramp-up that management has indicated will be in place into 2014. Boeing has noted before that production could accelerate rapidly in 2015 after undergoing a "learning curve," but the company still has some daunting design challenges ahead of it, including the 787-9, a redesign of the 777, and a potential 787-10 that the company has called a question of "when, not if." Lessons learned during the production of the 787-8 will have to be applicable for these other airframes if Boeing is actually going to be able to meet customer requirements on a cash-positive basis over the next decade.
