Boeing's Battle with Development Costs
Boeing (NYS: BA) released third quarter results on Wednesday, demonstrating a good performance that beat analyst expectations on both revenue and profit. On the back of a strong increase in commercial jet deliveries, Boeing raised its revenue guidance for the year.
Based on third quarter results, it appears that Boeing is doing a great job at growing its commercial sales, and depending less on military revenue, which is important as the defense budget in the United States contracts. However, upon digging deeper into Boeing's progress in pivoting away from defense, we can see that increased deliveries of Boeing's most modern planes actually hurt profit margins.
That's because, with each delivery of a 787 Dreamliner, for example, Boeing has to recognize not only the revenue from the sale of the plane, but also a portion of the development costs for the entire 787 program. Due to big budget overruns and delivery delays, those costs are so high that the first block of 787s delivered will actually enter at a 0% profit margin. The payback period for the 787, in particular, has been estimated at 1,100 deliveries; though with several design variants of the 787 yet to be produced, that schedule might be pushed even further into the future.
Even should the 787 program itself never turn a profit, CEO Jim McNerney stated on the earnings call with analysts Wednesday his belief that technologies developed for the Dreamliner could be "spiraled in" to other airframes. This would allow 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 air frames like the 777, which utilizes 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 worrying, it may prove challenging for Boeing to keep this technology out of the hands of its competitors, because 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 to 96 passengers, if Mitsubishi pushed forward into making larger planes, the company's know-how might force Boeing back into the R&D game well before two decades have passed, if Boeing wants to keep a technological lead.
For Boeing, "competition" has traditionally only referred to the European aerospace giant Airbus, as the two have operated in a stable duopoly for over a decade. However, regional jet manufacturers like Embraer (NYS: ERJ) , Bombardier, COMAC, UAC and, last but certainly not least, Mitsubishi, may be able to take advantage of the global diffusion of aerospace technology to break into the 100- to 200-seat market currently served by the Boeing 737.
In order to maintain its top-dog status, Boeing is going to have to be able to meet customer orders for its planes before competitors can mount serious challenges. Boeing has faced serious problems with ramping up production capacity in the past and, if that happens again, it will give newcomers the market opportunity they need to establish themselves. Tomorrow, we'll look at what Boeing's earnings tell us about the company's long-term plan to increase capacity at its assembly lines.
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The article Boeing's Battle with Development Costs originally appeared on Fool.com.Fool contributor Daniel Ferry has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Embraer-Empresa Brasileira. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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