While most of the company’s attention is focused on commercial aircraft, its defense business is also worthy of attention.
Boeing’s (BA 2.03%) most important business is Boeing Commercial Airplanes (BCA) and will likely remain that way for the time being. But in an election year, investors will understand the concept of variables. In Boeing’s case, its defense division, Boeing Defense, Space & Security (BDS), is crucial. Here’s why.
BDS should generate big cash
To fully understand the significance of BDS, it is essential to look back at the company’s November 2022 investor presentation, where management set a target of $10 billion in free cash flow (FCF) within the 2025/2026 timeframe. At the time, management projected FCF of $3 billion to $5 billion in 2023 (the actual figure was $4.4 billion), with the expectation that this would grow to $10 billion.
Boeing has outlined the following goals to increase FCF to $10 billion in 2025/2026 (see table below):
The issue of BCA’s production ramp has already been covered elsewhere so I won’t go into detail here. There has been some positive news recently. Focusing on BDS, it is clear that management’s plans include a significant transformation of the business, which unfortunately has not yet materialized.
Boeing Division
Boeing targets free cash flow growth from 2023 to 2025/2026
Key Drivers
Boeing Commercial Aircraft
$6 billion
Increased production (737 & 787), productivity
Boeing Defense, Space & Security
$2.7 billion
Program migration, productivity
Boeing Global Services
$300 million
volume
Data source: Boeing presentation.
Boeing’s Defense Business
The November 2022 guidance made the following assumptions:
Margins should return to high single digits and cash flows should be strong. Boeing will achieve key milestones (program de-risking) in three of its four troubled fixed-price development programs in 2024.
Boeing executives like to talk about its defense business in terms of three segments. The first, which accounts for 60% of revenue, is the core business, which is already seeing mid- to high-single-digit margins. The second, which accounts for 25% of revenue, is primarily fighter and satellite programs, and is improving, with CFO Brian West saying on the company’s second-quarter earnings call that the company “continued to see improving margin trends in the quarter.”
Image source: Getty Images.
But 15% of business in fixed-price development programs is costing companies billions of dollars in losses. Four programs are particularly problematic:
T-7 Red Hawk trainer. MQ-25 Stingray tanker. KC-46 Pegasus tanker. VC-25B Air Force One.
The original plan was for the MQ-25, KC-46 and VC-25B to hit key de-risking milestones in 2024. Management maintains it is working toward hitting those milestones, and “our game plan remains to return BDS to high single-digit margins over the mid-to-long term,” West said on the company’s last earnings call.
But recently retired CEO Dave Calhoun said he was “cautiously optimistic about the long-term prospects for our defense business,” and given the recent history of BDS, his caution is justified.
As the chart below shows, BDS hasn’t come anywhere close to high single-digit profit margins in recent years and is reporting expenses and losses on all of these troubled programs: Losses so far for 2024 include $519 million for the KC-46, as well as losses for the T-7 and VC-25B.
Data source: Boeing presentation.
Is it a structural issue?
The BDS issue might not be as worrisome if other defense companies didn’t have similar problems. Lockheed Martin CEO Jim Taiclet has previously argued on the issue that “we’re in a monopoly purchasing environment,” meaning there is a “single buyer” for “almost every product” the major defense companies make, and “they use their monopoly buying power, so to speak, over the industry.”
RTX also continues to experience margin pressure in its defense business and recently took steps to terminate fixed-price development programs and programs with international customers, which will result in a charge of $600 million in the second quarter and a negative impact of $500 million to 2024 FCF.
Image source: Getty Images.
What’s next for Boeing’s defense business?
The optimistic view sees Boeing coming to terms with the problems of recent years and struggling to de-risk these programs as it moves toward high single-digit profit margins on BDS, but is encouraged by the fact that 85% of BDS revenues are in place.
Optimistically, the profitability issues of fixed-price development programs are likely structural issues that will never go away, especially in light of the rising national debt. As such, long-term expectations for profitability and revenues of major defense contractors, including BDS, may need to be adjusted downward.
