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Morningstar | 3Q Boeing Commercial Airplane Margins Surprise to the Upside but We Continue to Watch Cash Flow

Wide-moat Boeing reported third-quarter results that featured core EPS of $3.58, beating consensus expectations. Management also raised 2018 guidance for revenue and EPS, which now stands at a $15 per share midpoint. There was a 71-cent-per-share tax benefit in the quarter, which helped results but commercial airplane margins of 13.2% (14% excluding charges) also pushed earnings higher. Working against these positive elements was 93 cents of defense program charges (T-X trainer and MQ-25).

Despite all the focus on earnings, we're still concentrating on cash and operating cash flow came in ahead of our expectations this quarter at $4.6 billion . However, Boeing kept 2018 cash flow guidance unchanged at $15 billion-$15.5 billion. Nothing in the results changed our view that while Boeing continues to execute and generate prodigious amounts of cash, its shares look slightly overvalued. That said, we're moving up our fair value by 2% to $330 due to the 2018 operating cash flow beat we're anticipating. We estimate $15.8 billion versus $15.5 billion for management's upper end of guidance.

Although Boeing expanded commercial airplane margins a whopping 340 basis points, GAAP consolidated operating margins contracted about 200 basis points coming in at 8.9% this quarter. Operating margins in the defense business came in at negative 4.3% compared due to initial investments (non-cash charges this quarter) on the T-X and MQ-25 programs, as well as a small KC-46 tanker charge of $64 million. Even after backing out these charges, defense margins contracted sequentially, and margins also fell about 70 basis points year over year. We're also not convinced that these are the last charges we'll see on T-X or MQ-25 given the fixed priced development contracts Boeing is under on each program and its history of taking charges on the similarly structured KC-46 contract.

Operationally, it looks as if the supplier issues are abating on the 737 line and that Boeing will hit its full-year delivery target of 810-815 aircraft. Management confirmed that fuselages from Spirit Aerosystems are now arriving on time, which is crucial given the limited sequencing flexibility Boeing has for the fuselages in its final assembly lines. The CFM engine delays should be resolved by year end, but if not, we don’t think this will lead to significant 737 delivery delays. The next milestone on the 737 will be the step up to 57 aircraft per month. Boeing typically steps up the rate at midyear but we think the company may push this rate increase to a bit later in 2019, as management will be eager to avoid the recent production hiccups it experienced on the last rate break. At the 57 rate break next year, management targets production of nearly 100% 737 MAX variants.

On the 787, Boeing burned off $657 million of deferred production, indicating sequential improvement in cash margins given a static block size. Order intake during the quarter was solid with book/bill in the quarter at about 0.8 times for commercial airplanes and just above 2.0 times for defense, while services was around 1.0 times book/bill. Within the 5,800 plus aircraft order book we're still monitoring 777X closely. We note that the program has struggled to pick up new orders and that 70% of the backlog sits with the three major Middle Eastern carriers.