Boeing Compensation Update - Ungrounding Mid-2020Boeing issued its 2019 full year earnings on January 29
th, 2019 and added some additional colour around compensation to airlines. With better clarity on how this is unfolding let’s revisit what Air Canada is likely to negotiate, or has negotiated.
Here are excerpts from Boeing’s earnings call concerning expected return-to-service date and compensation:
- As we mentioned last week, we're currently estimating that the ungrounding of the 737 MAX will begin mid-2020. This estimate is informed by our experience to-date with the certification process.
- During the quarter, we also reassessed our estimate of potential concessions and other considerations to customers for disruptions related to the 737 MAX grounding and associated delivery delays. This reassessment included updating estimates to reflect our most recent assumptions, as well as latest information based on engagement with 737 customers. Based on our assessment, we added $2.6 billion to the recorded liability in the quarter. This brings the total cumulative impacts to $8.3 billion net of insurance.
- As we've mentioned, we're addressing the impact individually, customer-by-customer. We expect any concessions or other considerations to be provided over a number of years. And we continue to see the cash impact to be more front-end-loaded in the first few years, but of course, will be dependent upon individual conversations with customers. In 2019, we reduced the liability balance by $1.4 billion through cash payments but also other in-kind considerations.
- Our financials this year will continue to be negatively impacted by the MAX. Cash flow, in particular, will be more significantly impacted in 2020 than 2019. We expect the use of cash flow in 2020 to be greater than 2019, primarily due to – 737 MAX advanced payments will be lower in 2019 based on our latest 737 delivery assumptions. As I mentioned previously, we're increasing our customer consideration liability and expect the cash impact to be higher this year.
From the above, Boeing now has better clarity on when the aircraft will be re-certified. The manufacturer has met with airlines, reached a settlement with some for 2019 damages, and increased its compensation to $8.3 billion. It appears that this $8.3 billion is for the cash component only. Boeing wants to spread its total compensation costs over years and wants to see the cash content front-end loaded while concessions or in-kind considerations are spread out over a number of years.
As stated earlier, Boeing has already reached an agreement with a handful of airlines on compensation related to 2019 financial damages due to the MAX grounding. Assuming the Reuters’ article on Turkish Airlines is accurate (see link below), it appears that the ratio of cash compensation to other in-kind considerations is 2:1. In other words, 66.67 percent of the total compensation will likely be cash and the remaining 33.3 percent in future concessions.
https://www.reuters.com/article/us-boeing-737-max-thy/turkish-airlines-says-reaches-compensation-deal-over-boeing-737-max-idUSKBN1YZ0A4 Cross-check Let’s look at the 2019 settlement for Turkish Airlines and compare it to what was calculated for Air Canada in an earlier post.
Turkish Airlines’ reported settlement is $225 million (USD) comprising $150 million in cash, and $75 million in ‘other in-kind considerations.’ The article (dated Dec 31, 2019) does not state if Turkish’s settlement is for 2019 only, but it most likely is, as Southwest, American and other airlines reported they had reached agreements with Boeing in December for 2019 damages.
Turkish was to have 24 MAX aircraft
operating in 2019. On average, the actual impairment works out to be $8.33 million USD per aircraft. Air Canada was to have 36 MAX aircraft operating in 2019. If we use $8.33 million per fin
as a proxy, then Air Canada’s 2019 compensation should be at least $300 million USD ($390 CAD). In the January 6
th post, the estimated impact on Air Canada’s operating income resulting from the MAX grounding was $395 million.
Air Canada’s Revised Estimate Air Canada did not report a 2019 settlement, so it is either still negotiating with Boeing, or has recently reached a settlement. A likely outcome is that Air Canada agrees to something similar to Southwest’s 2019 agreement.
Here is an excerpt from Southwest’s FY 2019 earnings report on January 23, 2020 indicating that with respect to 2019 damages resulting from the MAX grounding:
“substantially all of the compensation will be accounted for as a reduction in the cost basis of both owned MAX aircraft and future purchased MAX aircraft, which is expected to reduce depreciation expense in future years.”
In order to incentivize airlines to agree to a longer-term, non-cash payout, Boeing will likely pay a ‘premium’ on any non-cash consideration. In Air Canada’s case, there is also jeopardy for Boeing as the Airline is considering reducing its
firm MAX orders, for reasons discussed in the January 26
th post.
Analysts who cover Boeing report the profit margin on the 737 Max is at least 25 percent while profit margins on parts, training, and warranties are higher, at least 50 percent, and typically much, much higher. Both Boeing and Airbus have begun building more parts in-house, as well as offering integrative support services (managing maintenance, material and engineering) in an effort to capture more aftermarket profits. All this to say Boeing has considerable flexibility on non-cash concessions.
Air Canada will likely take the majority of in-kind consideration as a reduction in cost on future purchased MAX aircraft in the next couple of years, with a much smaller percentage on other cost savings (parts, etc.), spread out over several years. In view of the additional leverage (possible cancellations of firm orders), it would not be unreasonable for Calin to negotiate at least a 20 percent premium on other in-kind considerations.
Using the 2:1 breakdown (two-thirds cash, one-third ‘other’), then the estimated compensation for a mid-year recertification is $850 million (see Jan 26 post) would be increased by $57 million:
Cash: $567 ($850 m x .666)
Other:
$340 ($850 m x .333) (20% premium) = $283 m x 1.2 = $340 m
Total: $907 million
In summary, based on a mid-year re-certification for the MAX aircraft, Air Canada should receive approximately $567 million in cash compensation in 2020 and an additional $340 million in discounts, mostly on aircraft but also on parts, etc., beginning in 2021.