Boeing Earnings Preview: Q3 To Bring Upside Surprise?

Boeing Co. (NYSE: BA), the largest U.S. airplane and defense manufacturer, is projected to report lower third-quarter profit despite higher anticipated revenue due to lower margin on jets, loss of defense revenue and pension funding costs.

Some analysts think Boeing will beat consensus estimates for the quarter and raise its 2012 guidance once more. Depending on the production speed of the aircraft maker's new 787s and possible defense cuts, Boeing’s profits could take big swings in either direction.

The Boeing Company (NYSE:BA), which reports earnings Wednesday before markets open, is likely to post earnings per share of $1.12 for the quarter ended September 30, based on the average estimate of analysts surveyed by Thomson Reuters. That’s 23 percent less than a year ago, when the company reported earnings of $1.46 per share. The figure has risen from $1.1 over the past three months.

Boeing is expected to beat last year's reported revenue of $17.73 billion and come in at $20.03 billion for the quarter. For the fiscal year, analysts are expecting earnings of $4.71 per share on revenue of $80.64 billion.

Chicago-based Boeing has consistently topped earnings estimates in the last four quarters. The company recorded a maximum positive surprise of 31.53 percent in the third quarter of 2011. On average, the earnings surprise rate was 22.8 percent.

Some think there’s a good chance that Boeing might beat Wall Street’s estimates when it reports earnings results on Wednesday.

“The setup for Q3 resembles what we’ve seen in several recent Boeing quarters over the past few years, with consensus EPS once again looking ‘beatable,’” Carter Copeland, an aerospace analyst at Barclays Capital, wrote in an Oct. 15 note.

Boeing’s revenue exposure is spread across more than 90 countries around the globe. In its 2012 Current Market Outlook, Boeing estimates a $4.5 trillion market for 34,000 new commercial airplanes over the next 20 years. Boeing’s projection of growth is based on the strength of the commercial aviation market, recovery witnessed in world economies and strong demand for fleet addition and replacement. Airline traffic is forecast to grow at a 5 percent annual rate over the next two decades, with cargo traffic projected to grow at an annual rate of 5.2 percent.

“Despite slower global economic growth and a range of uncertainties, including the European sovereign debt crisis, we continue to see positive worldwide expansion in air traffic,” Boeing’s Chief Executive Officer Jim McNerney told analysts on the company’s second-quarter earnings conference call.

“Customer demand for our commercial airplanes is being driven roughly equally by a strong replacement cycle and worldwide fleet growth,” McNerney said. “Overall, we are positioned exceptionally well in the growing commercial airplane market.”

Inspired by such strong projections, Boeing raised its fiscal 2012 EPS guidance in July to between $4.4 and $4.6, compared with its earlier guidance range of $4.15 to $4.35. The company also raised its revenue guidance for 2012 to the range of $79.5 billion to $81.5 billion, compared with the earlier range of $78 billion to $80 billion.

“We expect Boeing to raise 2012 guidance once more with Q3 results,” Credit Suisse analyst Robert Spingarn wrote in an Oct. 15 note. “However, we also think the company will talk down 2013, given that pension will likely be a greater headwind in 2013 than in 2012.”

Commercial Aircrafts

Boeing said it delivered 149 commercial planes in the third quarter, up from 127 aircraft in the same period last year. The bulk of the orders were 102 of its Boeing 737 aircraft, a mid-size plane with a high profit margin, which the company has been selling since 1967.

For the year, Boeing expects to deliver between 585 and 600 commercial airplanes. This includes an expected 70 to 85 787 and 747-8 deliveries. Full-year revenue for the Boeing Commercial Airplanes (BCA) division, which generates half of the company’s total revenue, is expected to come in at between $47.5 billion and $49.5 billion with operating margin hovering around 9 percent.

Boeing is staking its future on the innovative 787, a new design that uses carbon fiber rather than aluminum and innovative new jet engines to produce a plane that will be able to fly farther on less fuel.

With stability now achieved at 3.5 airplanes per month, Boeing plans to boost production of the 787 to 5 per month by the end of this year, and 10 a month by the end of 2013. At that rate, the company will need less than ten years to deliver the full accounting block.

The “accounting block,” as it’s called, will be the number of planes that it will take to at least break even on the manufacturing costs. Last October, Boeing set the initial 787 accounting block at 1,100 units.

The plane maker uses this practice to determine average profitability of a new model rather than posting a loss on early output because of high startup expenses. The quantity of jets over which 787 costs are spread is based on the number of initial sales, airlines’ options, orders Boeing is confident of winning in the near term and the planned production rate.

Putting more jets in the initial block would lower profit margins for a longer period of time, while starting with a smaller block and expanding it later would boost margins for the additional planes more quickly.

Delivering planes means Boeing gets paid, and can start booking profits from them. More delays, or a failure to make the plane as quickly as hoped, will push that revenue farther out. The 247-seat aircraft has a list price of $206.8 million to $243.6 million, depending on the model.

Boeing has started a third assembly line for the 787 Dreamliner to increase the production rate under the program, which is running well behind its original delivery schedule. The current firm orders for 787 stands at 838 while the cumulative 787 deliveries stood at a mere 26 at the end of September.

This third assembly line for the 787 is located at Boeing’s main jet plant facility at Everett, Washington, adding to an already existing 787 assembly line at the same facility and another one at North Charleston, South Carolina, which rolled out its first plane in April earlier this year.

These delays in delivery have forced the company to pay compensation to its customers who are receiving orders post their original delivery dates. Thus, the new assembly line will not only increase deliveries of 787, adding to growth in top-line over the coming quarters, but also reduce the impact on margins through lower delay compensations.

Copeland of Barclays expects Boeing to extend the 737 accounting quantity in the third quarter to include initial 737 MAX units (possibly a 400-unit extension), similar to other recent increases on the program.

The 737 MAX is a new-engine variant of the world's best-selling single-aisle airplane. This extension will have a negative impact on margins for the 737 program, but should be relatively small.

“Our forecasts include roughly 200 basis points of cumulative compression to 737 program margins but we would argue that some of this has already been provided for in the pricing assumptions laid into prior block extensions,” Copeland said. “We think language which suggests that the extension had a ‘small downward impact on 737 margins but little impact to BCA in total’ is to be expected.”

Sterne Agee analyst Peter Arment pointed out in an Oct. 10 note that margin dilution is expected at BCA from higher mix 787 and 747-8 deliveries. “With the 747-8 operating as a zero margin program and the 787 initial accounting block at 1,100 aircraft with gross margin estimate at only 2 percent, BCA operating margins will see significant dilution as these programs ramp in the 2012-2014 period,” he said.

Meanwhile, R&D spending will remain higher than expected over the 2012-14 period given the 737-MAX and 787-9 efforts.

Defense Cuts

In the defense space, however, the threat of cutbacks will loom over the company going forward.

Boeing and other defense contractors are faced with the potential for severe, automatic military spending cuts in January unless Congress agrees to an alternative for cutting the deficit.

If the planned cuts take place, about $500 billion will be cut from defense spending over the next 10 years. To put this in perspective for investors, Boeing gets about 50 percent of its revenue from its defense business.

“It’s no secret that given Boeing’s large defense exposure, estimates could see pressure from sequestration,” Copeland said. “Our top-down Department of Defense budget model would imply a 6 percent to 7 percent cut to calendar year 2013 hardware outlays in the event of sequestration.”

However, given Boeing’s large international exposures and strong funded backlog status, Copeland thinks any sequestration-oriented revision would be smaller than the 6 percent to 7 percent implied by a simple DoD outlay approach.

“While the threat of budget sequestration and further U.S. defense cuts continues to create uncertainty, international markets continue to offer a broad range of new sales opportunities,” Boeing CEO McNerney said in July.

Overall, Boeing expects defense revenue for 2012 to be between $31.5 billion and $32 billion with operating margin greater than 9 percent.

The Boeing Defense, Space & Security (BDS) division beat expectations in the first two quarters of the year, and JPMorgan analyst Joseph B. Nadol III sees potential for further upside in the third quarter -- this time from helicopters.

Boeing delivered 18 Chinooks and 10 Apaches during the July-September period, compared with 22 and three in the first half of 2012, respectively. A decline in F-15 deliveries to zero in the third quarter from three in the prior quarter partially offset rotorcraft strength.

Military aircraft sales guidance for 2012 is about $16 billion, implying an 8.5 percent sequential decline if second-half sales are split evenly between the third quarter and the fourth quarter.

Pension Overhang

As we’ve seen in prior years, another year-over-year decline in discount rates has prompted investors to ask whether Boeing would consider adopting mark-to-market pension accounting which would significantly raise EPS in a non-cash adjustment, making shares look much cheaper on a P/E basis.

“Although we would argue that such accounting treatment would in fact cause cash to more appropriately match reported EPS, our read of the Boeing management team is that this is not something that they are likely to implement,” Copeland said.

Accordin to Sterne Agee analyst Peter Arment, pension expense overhang for 2012 is estimated to hit $2.6 billion, up $1 billion versus 2011, given the falling discount rate to 4.5 percent versus planned assumptions at 5.3 percent. This will cause weaker 2012 GAAP earnings growth.

Credit Suisse analyst Robert Spingarn said he has reduced his 2013 EPS figure in September in anticipation of higher pension expense as a result of lower discount rates. “Specifically, we raised our 2013 pension expense forecast from $2.9 billion to $3.1 billion,” he added.

Boeing is expected to provide details of 2013 pension expense on the Wednesday’s earnings conference call.

Stock Performance

Even though Boeing has posted solid profits, its shares are turning in their worst performance in 40 years, both in absolute terms and relative to the market.

As we enter the third-quarter results season, Boeing shares have done essentially nothing all year, and are up only 0.5 percent, compared with the broader S&P 500 index, which is up 14 percent year-to-date. The performance gap started to widen since the July airshow.

Investors are still worried about delays in Boeing's 787 program, even though production is rising. Recent reports that General Electric GEnx engines failed on 787s and a 747, and a possible strike by Boeing engineers weighed on the stock, too.

Analysts don’t expect Boeing to announce a major share buyback program on Wednesday.

“While we believe that management is close to solidifying its cash deployment plans, and will favor a $1.5 billion to $2 billion per annum buyback, we do not expect any announcement with the third-quarter results, Credit Suisse analyst Robert Spingarn said in an Oct. 15 note. “More likely, we think Boeing will make an announcement in either later in the fourth quarter or the first quarter of 2013.”

The company's closest rival in the aerospace and defense industry, Lockheed Martin Corporation (NYSE: LMT), will report earnings on Oct. 24, 2012.

Boeing’s other main competitors include: Honeywell International Inc. (NYSE: HON), General Dynamics Corporation (NYSE: GD), Embraer SA (NYSE: ERJ), Raytheon Company (NYSE: RTN), Northrop Grumman Corporation (NYSE: NOC), EADS NV (EPA: EAD) and BAE Systems plc (LON: BA).

Shares of The Boeing Company (NYSE:BA) closed down 31 cents, or 0.42 percent, to $73.7 apiece in Monday’s trading.