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Boeing 737 MAX Debacle Forces a Temporary Production Cut

By Adam Levine-Weinberg - Apr 9, 2019 at 7:25AM

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With 737 MAX deliveries halted indefinitely, Boeing will reduce production of its 737 aircraft family by nearly 20%.

Last month, Boeing's (BA 1.28%) 737 MAX 8, a brand-new version of its workhorse aircraft family, suffered a fatal crash for the second time in less than five months. The preliminary investigation findings for both accidents point to problems with a software system that Boeing calls the Maneuvering Characteristics Augmentation System (MCAS).

As a result, all Boeing 737 MAXes around the world were grounded by mid-March, forcing the company to halt deliveries of the new aircraft type. And with dozens of 737 MAX aircraft rolling off Boeing's assembly lines every month, storing all those planes is quickly becoming a big problem for the aircraft manufacturing giant. Boeing has accordingly been forced to reduce its 737-family production by nearly 20% for an indefinite period, beginning in mid-April.

A solution is coming, but not immediately

Boeing has developed updated MCAS software, new pilot training procedures, and enhanced cockpit displays for the 737 MAX to prevent a repeat of the recent tragedies. However, it could take months to submit those fixes to the FAA and other safety regulators around the world, receive certification for those changes, make any necessary aircraft modifications, and complete the extra pilot training.

Indeed, the Lion Air and Ethiopian Airlines accidents have called into question the rigor of the FAA's certification process for the Boeing 737 MAX. There's a good chance the FAA and aviation safety regulators in other countries will compensate by being especially thorough and cautious before clearing the 737 MAX for takeoff again.

A Boeing 737 MAX in the China Southern Airlines livery

The global Boeing 737 MAX fleet is likely to be grounded for several months. Image source: Boeing.

There's no way to be sure how long Boeing will have to wait to resume 737 MAX deliveries, but a good guess is that at least some countries will lift the grounding by June or July. Still, based on Boeing's current production rate, a lot of unusable jets will pile up between now and then.

Production will come down

Before the Ethiopian Airlines crash last month, Boeing had planned to boost 737 family output, which includes a small number of older-generation aircraft in addition to the 737 MAX, from 52 per month to 57 in June. The company was also trying to line up supplier commitments to support a future increase in the production rate to 63 per month.

That calculus has changed dramatically over the past month. In the long term, it would be virtually impossible for airlines to desert the 737 MAX en masse. But in the short run, Boeing can't deliver any 737 MAXes because of the type's global grounding. Even looking out a little further, some airlines want to delay their Boeing 737 MAX deliveries until the recent design changes are shown to be effective -- and air travelers' fears about the 737 MAX start to fade.

On the flip side, halting 737 MAX output entirely would snarl Boeing's supply chain, making it hard for the company to ramp up production again. Furthermore, many airlines still want to get the 737 MAXes they have ordered as soon as possible.

As a compromise, Boeing announced on Friday that it will reduce its 737 production rate from 52 per month to 42 as of mid-April. Once the 737 MAX grounding is lifted, Boeing will be able to ramp up output again. However, it could take months from when the 737 MAX gets back in the air for Boeing to reach the planned production rate of 57 per month.

One-time costs could be substantial, too

The 737 program is extremely profitable for Boeing, so the reduction in output this year will hurt the company's earnings and cash flow. Boeing could also face billions of dollars of liabilities related to lawsuits from victims' families. Customers and suppliers will probably clamor for compensation as well, to make up for lost revenue or additional costs that they're incurring from the grounding of the 737 MAX and the planned production slowdown.

Coming up with the money to pay these claims won't be hard. Boeing generated $13.6 billion of free cash flow last year, up from $11.6 billion a year earlier. Its initial guidance for 2019 called for free cash flow to rise again to a range of $14.7 billion to $15.2 billion.

Nevertheless, Boeing will have to cut its 2019 cash flow target because of the lost production and various other liabilities related to the 737 MAX crashes. Some of the costs will probably spill into 2020, limiting the potential for a quick rebound in cash flow.

Considering the risks, Boeing stock seems pricey

Boeing stock had fallen about 15% since peaking in early March, before the Ethiopian Airlines crash. Yet the stock has still gained about 15% over the past year.

BA Chart

Boeing stock performance data by YCharts.

Despite the turmoil it faces, Boeing's market cap remains above $200 billion, more than 15 times the company's 2018 free cash flow. While Boeing previously seemed poised for solid free cash flow growth in 2019 and 2020, the various costs related to slowing production, compensating victims' families, and making suppliers and airline customers whole has disrupted that trajectory.

Furthermore, Boeing is relying on increased production of its 787 Dreamliner to drive part of its expected free cash flow growth in 2019 and 2020. However, the new production rate of 14 per month isn't sustainable in the long run. Boeing will probably need to start reducing output four or five years from now, offsetting some of the cash flow growth from getting the 737 MAX program back on track.

Thus, Boeing stock is currently priced for substantial increases in the company's free cash flow over the next five years. Yet Boeing faces too many headwinds to be confident in this growth outlook. As a result, investors should probably avoid the stock for now.

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