Boeing Earnings Conference Call Notes and Position Strategy

Notes from the 10/23/19 Boeing Earnings Conference Call

On The Max 8 Return

"As we have shared, we completed the MCAS software update earlier this year which addresses concerns found following the two MAX accidents and provides three additional layers of protection to prevent accident like these from ever happening again."

To-date we have conducted more than 800 tests and production flights totaling more than 1,500 hours with the updated software which incorporates feedback from across global regulators and MAX operators.

We are making steady progress on the second software update announced in June for additional flight control computer redundancy to eliminate the possibility of even extremely unlikely risks that are unrelated to the accidents.

In the upcoming days, Boeing will complete additional testing of this software update and conduct multiple simulator evaluations and reviews leading up to a certification flight with the FAA onboard.

We target regulatory approval for the 737 MAX return to service to begin this quarter. As we've said before, however, it's the FAA and other regulatory authorities who will ultimately determine the timing and conditions of return to service in each relevant jurisdiction. This may include a phased approach and timing may vary by jurisdiction.

Based upon this estimate and other factors, we expect to maintain our current production rate of 42 deliveries per month with a focus on supply chain and production systems stability. This will be followed by incremental rate increases that would bring our production rate to 57 by late 2020.

After return to service, we expect the 737 MAX airplanes produced during the grounding and included within inventory will be delivered over several quarters with the majority of them delivering in the first year.

Should our estimate of the anticipated return to service change, we might need to consider possible further rate reductions or other options including a temporary shutdown of the MAX production line."

On The Next Steps Towards Re-Certification

"In the near term, we're marching through the technical steps if you will and that includes finalizing the software. That will go into a series of simulation -- evaluations. There's a near-term milestone that we referred to as the line pilot evaluation that will take that final software and with external line pilots from airlines come in and evaluate the handling quality of the airplane.

We'll also have a external set of pilots coming in, again authorized by the regulators that will conduct what we call a Joint Operation Evaluation Board. And that set of pilots will evaluate the training materials. So over the near term those are two key milestones for us. One that evaluates the software update to the airplane; and the second that evaluates the training products.

In that same time frame, as those two milestones are completed, we'll roll into the certification flight that I mentioned earlier. That will be another key milestone for us. And then after all of the assessments are completed, those evaluations are done, that will roll into the Airworthiness Directive decision that the FAA will make and that other regulators will make.

Subsequent to the issuance of the Airworthiness Directive and the ungrounding of the airplane, then we would move into the phase of ungrounding the aircraft and incrementally bringing up fleet operations for our airline customers. And the reference points that you're seeing out there from our customers are perfectly aligned with the detailed technical plan that I just walked you through.

So they're very aware of that plan. And there is a time period between the airworthiness directive and when they can resume full operations, revenue-bearing operations. And that includes bringing each individual airplane up, making sure that each airplane is safe and ready to perform.

We've been working, as we've been storing airplanes to ensure the health of those vehicles, but we'll be working tail number by tail number with our customers to ensure they can bring the fleet up back successfully and then get back to full revenue-bearing operations.

And that's why you see a bit of a time lag between the Airworthiness Directive and what our customers are now quoting as going operational dates."

On Management Changes

"With our first and foremost priority the safe return to the service of the MAX, we announced a change earlier this month that separates the Chairman and CEO roles to further enable me to center my attention on running the company as Boeing's President and CEO.

Dave Calhoun, our Board's Independent Lead Director is now serving as our Non-Executive Chairman.

With the committee's input, we established a new product and services safety organization that will review all aspects of product safety and maintain oversight of our accident investigation team and the company's safety review boards. Additionally, we're strengthening and elevating our engineering function through a direct reporting line to Boeing's Chief Engineer, who reports to me.

We're also establishing a formal design requirements program, enhancing our continued operation safety program, partnering with our airline customers on flight deck designs that continue to anticipate the needs of future pilot populations, and we're expanding the reach of our Boeing safety promotion center.

These actions are on top of the steps our Board already has taken to reaffirm its commitment to and oversight of safety, including establishing a permanent aerospace safety committee and adding safety-related experience as one of the criteria for future directors.

In addition to implementing the Board's recommendations, we are committed to reaching even higher. We're concurrently expanding our efforts to strengthen the way we manage safety across Boeing and our supply chain, for example, by broadening the use of a comprehensive safety management system and safety review boards. We're already driving a company-wide approach to safety, quality and integrity that strengthens our vision and serves to reinforce and improve our operational performance.

Additionally, investments in enhanced flight simulation and computing capabilities have increased our company's ability to proactively test a wide range of scenarios resulting in improved product safety. Advanced research and development efforts in future flight decks are also underway, leveraging leading-edge work in human factors, science and design.

As we announced yesterday, we made several leadership changes that will further strengthen our company during a challenging time. Stan Deal has succeeded Kevin McAllister as President and CEO of Boeing Commercial Airplanes and Ted Colbert has succeeded Stan Deal as President and CEO of Boeing Global Services effective immediately."

On Quarterly Performance

"During the quarter, we generated revenue of $20 billion and core earnings per share of $1.45, reflecting lower 737 deliveries partially offset by higher defense and services volume. We recorded negative $2.4 billion of operating cash due to the 737 impact. We paid $1.2 billion of dividends in the quarter.

Commercial Airplanes generated revenue of $8.2 billion reflecting 62 deliveries. BCA ended the quarter with our backlog of nearly 5,500 airplanes worth $387 billion. As we discussed before, global trade tension is putting near-term pressure on our widebody production rates, especially the 787. I will discuss that in more detail later.

Now over to Defense Space & Security, BDS reported third quarter revenue of $7 billion and booked $5 billion of new orders, demonstrating the continued value we bring to our customers across our Defense Space & Security portfolio. Those orders included contracts for our fifth KC-46 Tanker production lot for the U.S. Air Force and nine AH-64E Apaches for the U.S. Army.

Turning to Global Services. BGS reported revenue of $4.7 billion, representing 14% growth year-on-year. BGS continues to win new business, highlighting the value we bring to our commercial and government customers and the strength of our One Boeing offerings.

Revenue for the quarter was $20 billion with core earnings per share of $1.45 reflecting lower 737 deliveries, partially offset by higher defense and services volume.

For the purpose of our third quarter financial results, we have assumed the regulatory approval for the MAX return to service begins in the fourth quarter this year. While this assumption reflects our best estimate at this time, I just want to reiterate that the actual timing and condition of return to service will be determined by the regulatory authorities and could differ from this assumption and our estimate.

Our third quarter financial results also assume a gradual increase in the 737 production rate from the current 42 per month to 57 per month by late 2020. We also assume that after return to service of the MAX airplanes produced during the grounding and including within inventory will be delivered over several quarters with the majority of them being delivered within the first year. Any changes to these assumptions could require us to recognize additional financial impact.

We added $872 million of program costs on the 737 in the third quarter. This is primarily to reflect current assumptions regarding timing of return to service and the timing of planned production rate increases. These additional costs will be spread across the undelivered aircraft in the accounting block of approximately 3,100 units and therefore reduce the 737 program margin.

During the quarter, we reassessed our estimate of potential considerations and other in concessions for customers for disruptions related to the 737 MAX grounding and associated delivery delays. This reassessment included updated -- updating estimates to reflect revised return to service and production rate assumptions as well as latest information based on engagements with 737 MAX customers.

We have made no significant adjustments to the recorded liability in the quarter.

As we've mentioned, we're also addressing the impact individually customer-by-customer and we will look at various forms of economic value that we can provide. We expect any concessions or other considerations to be provided over a number of years. And therefore, you can expect the impact to our cash flow to affect 2019 and beyond. We continue to see this impact to be more front-end loaded in the first few years but of course will be dependent upon individual conversations with customers.

We will continue to assess our current production plans and incorporate any new insights, such as return-to-service time line, storage capacity, and supply chain all in our analysis to help inform us on whether further rate reductions or other options including a temporary shutdown of the MAX production are needed. We've also taken actions to prudently manage our liquidity, increasing our balance sheet flexibility in managing our spending and laser-focused on productivity. We will continue to diligently review all levers available to minimize the financial impact."

BCA Quarterly Highlights

"Our Commercial Airplanes business revenue decreased to $8.2 billion during the quarter reflecting lower 737 deliveries. BCA operating margin declined to negative 0.5%, reflecting lower 737 delivery partially offset by higher 787 margin. BCA backlog includes nearly 5,500 airplanes valued at $387 billion equating to more than six years of production."

BDS Quarterly Highlights

"Third quarter revenue increased to $7 billion reflecting higher volume on satellites, weapons and new franchise programs T-7A in particular, partially offset by lower F-15 volume. BDS booked operating margin of 10.7% in the quarter reflecting improved performance. During the quarter BDS won key contract awards worth $5 billion and our backlog stands at $62 billion with 30% from outside the U.S."

BGS Quarterly Highlights

"In the third quarter, Global Services revenue increased to $4.7 billion reflecting the acquisition of KLX and higher government services volume. Year-over-year growth of 14% for the quarter continues to outpace the average services market growth rate of 3.5%. BGS booked operating margins of 14.4%. And as I mentioned before BGS margins quarter-to-quarter are subject to fluctuations due to factors such as mix, products and services as well as performance on individual contracts. During the quarter BGS won key contract awards worth approximately $6 billion bringing its backlog now to $21 billion."

On Financial Conditions

"Let's now turn to cash flow on slide 10. Operating cash flow for the third quarter was negative $2.4 billion driven by lower 737 deliveries, lower advance payments and timing of receipts and expenditures. We expect continued working capital pressure to adversely affect cash flow until MAX deliveries resume. Strong operating cash from other parts of the business, a strong balance sheet and further balance sheet levers will help provide adequate liquidity during this period. In the third quarter we paid $1.2 billion in dividends. And as I previously mentioned, we have temporarily paused our share repurchase program."

"We ended the quarter with $10.9 billion of cash and marketable securities. We raised additional debt in the quarter increasing the balance by $5.5 billion, primarily to fund the Embraer acquisition and also to help shore up liquidity position as we work through the current MAX challenges. Our strategy of maintaining a strong balance sheet provides us with substantial borrowing capacity through capital markets access and unused credit facility of $6.6 billion."

"We ended the quarter with $10.9 billion of cash and marketable securities. We raised additional debt in the quarter increasing the balance by $5.5 billion, primarily to fund the Embraer acquisition and also to help shore up liquidity position as we work through the current MAX challenges. Our strategy of maintaining a strong balance sheet provides us with substantial borrowing capacity through capital markets access and unused credit facility of $6.6 billion."

On Embraer Partnership

"Progress continues towards our planned strategic partnership with Embraer. We're actively engaged with authorities and relevant jurisdictions and have obtained a number of regulatory approvals including clearance to close in the U.S. and Japan.

The European Commission earlier this month opened a Phase 2 assessment in its review of the transaction. We now expect the transaction to close in early 2020."

On Business Environment

"We continue to see healthy global demand for our offerings in Commercial Defense Space & Services. These are sizable sectors that are growing and backed by strong fundamentals with a combined market opportunity of $8.7 trillion over the next 10 years.

In commercial aviation, while we have seen some moderation of traffic growth, global passenger volume continues to be resilient, building on nine straight years of above-trend growth. Passenger traffic this year is growing at a solid 4.5% through August, again outpacing global GDP and tracking with long-term growth rates.

Meanwhile, the air cargo sector is facing more headwinds, as overall volumes have contracted year-to-date amid a challenging trade environment. That said, we continue to see steady utilization of the global freighter fleet while carriers are placing incremental orders to support their fleet replacement needs.

Additionally, traffic data points to solid growth in air cargo intensive sectors, such as pharma, technology and express shipments. Improvements in industrial production and global trade will be key to a rebound in air cargo in 2020.

With an industry outlook for approximately 44,000 new airplanes over the next 20 years and an ecosystem of life cycle solutions needed to maintain and supported, we continue to see sustainable, long-term growth in commercial aviation. This is powered by mature and emerging economies, the growing middle class and continued innovations in business models and products.

We believe the evolution in key market dynamics in aggregate, continues to drive less cyclicality for our industry. These long-term demand fundamentals provide a solid foundation for our commercial business. We are well positioned in this market with a strong portfolio of airplanes, a large and diverse order backlog and a strong One Boeing team.

The narrowbody segment will command a larger share of new deliveries with expected demand for more than 32,000 single-aisle airplanes in the next 20 years. These new airplanes will continue to stimulate growth and provide required replacements for older, less-efficient airplanes. Our 737 program has a backlog of more than 4400 aircraft."

On Backlog & Production

"In the quarter, Korean Air and Air New Zealand placed follow-on orders for the 787 to replace aging aircraft, reflecting the start of the widebody replacement cycle that we expect to accelerate early next decade. We see the need for more than 1000 small to medium widebody aircraft to be replaced over the next decade.

We believe it is appropriate to make a production rate adjustment to balance the supply and demand. So beginning in late 2020, we plan to transition the 787 production rate from 14 per month to 12 per month, for approximately two years.

At our planned rates, our 787 backlog of nearly 530 orders, provides a solid foundation and represents more than 3.5 years of production.

Moving to the 777 program. The current generation 777 continued its steady sales momentum with 14 new orders in the quarter. These provide further support for the 777 bridge.

On 777X development, we continue to progress in our preflight testing, focusing on final systems propulsion and airplane-level test. On the static airplane test results, our detailed analysis of the data is progressing well. What we've seen to-date reinforces our prior assessment that this will not have a significant impact on the design or on the preparations for first flight.

The GE9X engine remains the pacing item, as we work towards first flight of the 777X. GE our engine supplier has made good progress to address the durability challenges. GE has installed retrofit components in the certification test engines and testing has restarted. Once the engines become available, GE and Boeing will need to successfully complete additional testing before we are ready to fly.

We still expect first flight to take place in early 2020.

That said, as we further assess the impact to the GE9X engine and associated risk, we now expect first delivery of the 777-9 to be in early 2021. The combined 777, 777X production rate is five per month. We continue to expect the 777 delivery rate to be approximately 3.5 aircraft per month in 2019. The delivery rate is expected to be at approximately three per month in 2020, as we mitigate some of the impact of the slide in 777X time line by producing more 777 current generation aircraft.

On the 767 program, we added 16 new orders in the quarter including 15 for the KC-46 production lot 5. As previously announced, we plan to increase the 767 production rate from 2.5 to three per month in 2020.

Looking at the defense and space market for the next 10 years, we see $2.5 trillion of opportunities for our business with 40% of that from outside the U.S. The BDS portfolio remains well positioned with proven world-class platforms to address current needs and innovative capable and affordable new franchise programs to build the future.

We see the $3.1 trillion services market over the next 10 years as a significant opportunity for our company. We continue to see growth with expanded service offerings, across the supply chain portfolio and our global digital solutions."

On Valuation

BA is expected to earn adjusted EPS of $18.28 in the coming twelve months. We’re expecting 8.8% compounded annual growth over the next three to five years (down from 15% earlier this month reflecting a negative impact to margins due to the MAX grounding).

This puts us near $23.50 in earnings within the next three years. BA has held firm with a three to five earnings multiple of 18x to 21x. We’re looking for a total return of 44% over the next three years or an IRR of 15%.

On Techincals

Even prior to the MAX tragedies, the stock has been in a lengthy consolidation period between $320 and $390. We anticipate the return of the MAX will provide enough positive sentiment to drive the stock through the upper resistance level.

We are long Boeing and will continue to add once there is greater clarity on the MAX return and a breakout to the upside of its trading channel.

Joseph S. Kalinowski, CFA