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Morningstar | Boeing Investor Day Alleviates Concerns of a Production Meltdown, but Challenges Remain

We attended Boeing's investor day on Sept 5. The 737's production challenges loomed large and while we came away from our 737 Renton facility visit thinking management was beginning to burn down its 737 inventories, some traveled work continues to arrive. We also toured Boeing’s widebody aircraft production and noted significant increases in automation, particularly on the 777/777X line. We think management can recover on the 737 and we're maintaining our $320 fair value estimate, wide moat rating, and 2018 estimates.

Due primarily to delays in Spirit Aerosystems' fuselages--but also in part to the CFM LEAP engine--Boeing's 737 program piled up nearly 70 aircraft in inventory (per various plane spotters). Although this sounds significant, typically 25 737s are outside of assembly going through final checks, which means only 45 aircraft represent abnormal inventory. Boeing management believes inventory has peaked and while it will take the remainder of 2018 to get back on-track, the situation is improving.

We're anticipating light 737 deliveries in third quarter and higher program costs over the remainder of 2018. Customers took 298 737s through end of July, which means that to hit its 2018 guidance calling for 810-815 total deliveries (737s plus other models), we calculate that Boeing must deliver nearly 300 737s from August to December of this year. Management believes this is possible and we're keeping our 2018 estimates for deliveries, earnings, and cash flow unchanged.

We also came away impressed with the automation on the 777/777X and 737 lines. Management touted benefits of automation, which include higher quality (improvements of 50%), improved throughput (2 times faster on 737 wings), lower amounts of manual labor (80% manual on wings to 80% automated), and improved safety. Despite these benefits, we think further automation isn't planned as Boeing grapples with its existing automation and rate increases.

Our sense is that an aging skilled workforce and management's double-digit margin targets are also driving the company’s automation push. Management did not mention it, but we think automation should begin to give Boeing the ability to conduct rate insensitive production by keeping its workforce and recurring costs more stable through delivery rate changes. Boeing uses a variety of contractors to automate its final assembly lines, but Electroimpact and KUKA were the most conspicuous brands on the manufacturing lines we saw.

The 777X static test aircraft just recently finished production and assuming these tests take roughly 12 months, we place 777X first flight well into next year. This and the various test articles we saw coming down the assembly lines give us confidence that the program continues to track to its schedule but as we've pointed out previously, our main concerns are around the order book, which is heavily dependent on Middle Eastern carriers and Boeing continues to face a soft large widebody market. Wing join worked well on the first test aircraft but given the complicated drilling of three different materials--aluminum, titanium, and composites--Boeing will likely still need to fully industrialize this task. The existing 777/777X fuselage assembly line continues to weave in automation. In this manner Boeing can introduce automation in a more controlled way and better predict where challenges may occur since the processes around 777/777X fuselages are nearly 100% common. However, the 777 and 777X wings are quite different with the legacy 777 wing remaining entirely metallic versus an all composite wing for the 777X, which is manufactured at Boeing’s new composite wing center. The wing center currently operates one autoclave but it will house three autoclaves eventually and its configuration supports a monthly rate of 10 777X aircraft. We note that on an annual basis the highest production rate Boeing achieved on the legacy 777 was just over eight aircraft per month.

On the 787, management continues to address unit costs through its supply chain and anticipates better mix thanks to a higher proportion of pricier dash 10 variants. Process improvement continue on the 787 line with Boeing dropping the final assembly line down to four stations from five by combining the fuselage and wing join tasks. Boeing recently unveiled plans for a common aft fuselage between the dash 8 and other variants of the 787; management will also make the horizontal stabilizers common. These efforts should lower unit costs on the dash 8, which has been a problem child in terms of cost. Management confirmed its plan to move to 14 aircraft per month early next year on the 787 and based on conversations with management, we think the recent rumors swirling around inventory buildup on the 787 line are overblown.

Automation on 737 wing manufacturing and on the 737 assembly lines has managed to keep staffing nearly stable in the face of increasing production cadence. We think this trend will continue and that the step-up to 57 aircraft per month next year will not require a permanent increase in labor. On the three 737 lines, one is solely producing NG variants, another is a mix of NG and MAX variants, and one is already entirely dedicated to the MAX. Loading into the 737 assembly has improved but isn't consistent yet, particularly on the fuselages from Spirit Aerosystems. The 737 line operates like a Swiss watch and the fuselage issues combined with delays to the LEAP engine caused a ripple effect that quickly led to a build-up in inventory, requiring the use of 600 additional employees on the line plus overtime for many more employees.

Mark Jenks, the program manager for the mid-market airplane, attended the investor event and management reiterated that a decision on whether to launch the program will be made next year with an entry into service by 2025. All of this indicates that Boeing remains serious about the program, but we think the probability of Boeing launching its first clean sheet program since the 787 is becoming more remote. We think the business case remains difficult for Boeing to close because of competing customer requirements and the need to develop and field a small widebody with narrowbody economics. Airbus' floating an extra long range version of the A321neo certainly isn't helping either. Engine manufacturers also remain skeptical over the market size--Boeing places it at around 4,500 aircraft but we think it's closer to 2,000. Moreover, the current pressures on the supply chain due to Boeing’s partnering for success initiatives and its vertical integration push combined with rate ramps on the 737, 767, and 787 isn’t making it easy for suppliers to close their business cases. Lastly, we'd be shocked if Boeing went with an entry into service of 2025 should the company launch the program any later than early 2019, since this would represent a very tight development schedule.