The highly fuel-efficient 787 Dreamliner is enormously popular with airlines, but it has still been a huge money-pit for Boeing (NYSE:BA) over the past decade due to massive cost overruns. This has led to Boeing booking Dreamliner sales at very low profit margins.
As low-margin Dreamliner revenue has become a larger percentage of the company total, it has weighed on Boeing's overall margins. Fortunately, Dreamliner profitability could improve radically later this year, as Boeing may be ready to raise the 787's program accounting block at some point in 2016.
Understanding Dreamliner profitability
The cost of building 787s has exceeded revenue by about $30 billion since production began, and cumulative losses are expected to peak around $33 billion this year.
Boeing's "program accounting" system hides these losses from plain view. Under program accounting, for each aircraft family, Boeing estimates the average cost and profit margin for each plane over an "accounting block": a set of planes that the company expects to produce.
Typically, production costs fall steeply over the first handful of deliveries and then continue to decline as processes become more efficient. Program accounting smooths overall profitability by offsetting the big losses incurred during the first few years of production with the profits expected later.
Boeing initially set the 787 accounting block at 1,100 units when it began deliveries in 2011. It increased the accounting block to 1,300 in late 2013. Essentially, this means that after 787 production becomes cash positive later this year, Boeing expects to recoup the $33 billion in deferred costs over the rest of the 1,300 unit 787 accounting block. That will be roughly 850 planes.
Thus, Boeing expects an average cash profit of nearly $40 million on the last 850 Dreamliners in the accounting block. And since production costs will be declining steadily, the last few hundred could be even more profitable, bringing in perhaps $50 million each.
Larger accounting block means more profit
The upshot of this is that extending the program accounting block adds highly profitable sales from later in the production run. Another 200 Dreamliner sales producing average cash profits of $50 million would increase total program earnings by $10 billion, all else equal.
Given the way that program accounting works, these profits would be spread across the entire remaining accounting block. This means that it would have an immediate positive impact on the profit margin reported for each Dreamliner sale.
In a best-case scenario, that could increase the profit margin on Boeing's 787 deliveries by 6-7 percentage points. A more likely scenario is that some of the expected future profits would be needed to cover higher-than-expected costs incurred up until now. (Many analysts think that Boeing's current accounting model for the 787 program is too aggressive.)
Even that latter scenario would have the benefit of dispelling fears that Boeing will need to take a "reach-forward loss" to write down deferred production costs.
Time to raise the accounting block again?
To extend the accounting block, Boeing first needs to be reasonably confident that it will sell the additional airplanes. It also needs to be able to estimate revenue and costs for the additional airplanes in the accounting block in order to calculate a profit margin.
Boeing is likely to produce far more than 1,300 787s over the life of the program. The company estimates total demand for small widebodies at 4,770 units between 2015 and 2034. The Dreamliner will be Boeing's main weapon in that segment for most (if not all) of that period, and Boeing expects to maintain more than 50% market share.
Even incorporating some conservatism into that forecast, Boeing is likely to sell at least 2,000 Dreamliners before the last one rolls off the line. The company already had 1,142 firm orders as of the end of November, and the biggest impediment to sales in recent years has been that the 787 is virtually sold out until 2020.
On the expense side, Boeing has significantly reduced costs on the 787-8 in the two-plus years since the last accounting block increase. The larger 787-9 also had a smooth entry into service and production costs for that model are falling, too. Thus, the company should be able to estimate costs well beyond the first 1,300 units by now.
The biggest question mark is probably revenue -- i.e. how much Boeing will be able to charge for the Dreamliners it will build seven or eight years from now. Still, Boeing added at least 71 net firm orders to its 787 backlog in 2015 after capturing 41 net firm orders in 2014.
If Boeing can continue selling 787s at a steady pace in 2016, it should gain more confidence in pricing for the 2022-2023 period that a program accounting quantity increase would cover. That would give it a green light to raise the accounting block, perhaps to 1,500 units.
It's virtually inevitable that Boeing will raise the 787 accounting block again sooner or later. If it's not during 2016, it will almost certainly be during 2017. Whenever the increase occurs, it could drive a step-change in Boeing's profitability -- and investor sentiment.