On Friday, new evidence emerged in the Boeing 737 Max saga. Specifically, news broke regarding instant messages from 2016 between Boeing’s chief technical pilot at the time and another pilot. These messages indicated flaws with the
Maneuvering Characteristics Augmentation System (MCAS) during test sessions in the flight simulator – highlighting the fact that Boeing was well aware of issues with the aircraft (although the company contests this claim). Needless to say, this doesn’t bode well. A terrible 2019 for Boeing just got worse. The company now faces a huge strategic challenge because the issues may essentially spill over to more than just the 737 Max. Authorities may revisit the entire certification process not just limited to the 737Max
Boeings 737Max has now been grounded for eight months with the company waiting anxiously for approval to fly again. For the 80+ customers of the 737Max product, the uncertainty and costs have kept escalating.
With the latest unflattering evidence, it is a fair to infer that the return to service of the Boeing 737 Max just got extended. Indeed, American Airlines has removed the 737Max from its schedules until late January, and Southwest Airlines and Air Canada until mid-February. Industry experts indicate that these dates are based on “optimistic scenarios”.
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With repeated negative news on Boeing that suggests the company glossed over concerns, the entire certification process has been bought into question. The FAA released a statement over the weekend and the tone of the statement is very telling: “
… The FAA is also disappointed that Boeing did not bring this document to our attention immediately upon its discovery. The FAA is reviewing this information to determine what action is appropriate.” (read the full statement at https://www.faa.gov/news/updates/?newsId=93206)
And then there is the question of multiple regulators around the globe conducting their own inquiry into the approval process. Indications are that this could be the case especially after Joint Authorities Technical Review (JATR). The final report of the JATR concluded,
“…the MCAS was not evaluated as a complete and integrated function in the certification documents that were submitted to the FAA.”
As a consequence, Boeing likely is descending into the scenario that it has been trying to avoid. The process is gradually devolving from approval for the 737Max return to service towards one akin to a re-certification depending on the extent of the regulators’ inquiry. This could transcend to future product lines impacting timelines and costs.
Cash flow will likely continue to be depressed – the first such instance in many years
In the second quarter of 2019, Boeing took a charge of $4.9 billion and reported a loss of $2.9 billion. This is against an estimated order backlog of 5,900+ orders with more than three-fourths being that for the 737Max units. The aircraft orders are critical to the cash-flow for Boeing and even for suppliers. The cash flow accrues both from pre-delivery payments (PDPs) and the final purchase.
As long as delivery rates kept increasing and more orders were booked, cash flows kept increasing (with some adjustments). And Boeing continued to beat expectations on Wall Street, quarter after quarter. This has now been reversed. With the Max grounding, that cash-flow stream has been significantly impacted for the time being.
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The share price for Boeing is down by roughly 3 percent on a one-year rolling average basis. But what is more telling are the shifts in revenue and earnings. Boeing’s second-quarter revenue was down by 34.9 percent from a year ago; earnings (loss) per share was (5.82) vs 3.33, and operating cash flow entered negative territory compared with $4.6 billion. Boeing is still flush with $9.6 billion of cash on the balance sheet but given the number of items it has to cater for, this is no longer a cushy amount.
Cash flow may also suffer due to Boeing’s revenue mix. In 2018, 31 percent of revenues were via US government contracts. Additionally, 56 percent of revenues were on non-US sales.
The strength of the dollar here coupled with geo-political challenges may be detrimental in this regard. There is also the cost of new aircraft programs and to remain competitive it is almost certain that Boeing will need to launch a new aircraft with a clean-sheet design.
All eyes are on the middle-of-the market (MOM) segment — one that is wanting for a new aircraft. It is estimated that there are nearly 1,500 Boeing aircraft (757s and 767s) currently flying this segment and will require replacement in the next 5-7 years.
Combined with new customers that such an aircraft will attract, the opportunity it represents is in excess of a trillion dollars. Using prior clean-sheet design programs as proxies, the development cost of the 787 is estimated worth of $25 billion, the A380 program cost S25-$30 billion, while the Boeing New Middle of the Market Airplane program (NMA) is pegged upwards of $15 billion. Boeing will also need to provision for the payouts that will need to be made to the airlines for the late deliveries in addition to possible lawsuits.
It may be a while before the cash flow recovers.
To restore credibility Boeing needs a drastic measure
With a credibility crisis on its hands, Boeing needs some drastic measures. Until now, the stock price has not been severely impacted but investors at some point will start getting impatient. Clear, deliberate and decisive action – one that signals confidence to regulators and customers alike – is the need of the hour.
Yet the narrative from Boeing has not quite highlighted this. The focus seems to be on mitigating bad press rather than attacking the heart of the issue. Take for instance the most recent press-release (Read: https://boeing.mediaroom.com/news-releases-statements?item=130533 ) which comes across as a carefully crafted PR document with the sole purpose of minimising liability which otherwise could have highlighted clear, decisive steps being undertaken to alleviate the challenges at Boeing.
Given Boeing’s critical position in the US manufacturing base, it is likely that the situation is being looked at from several angles. Aerospace, after all, is a sector that has a net positive trade balance for the United States and Boeing continues to be a key player in that. Indeed, the impact of the 737Max has been felt in the US GDP itself.
So what if any actions can Boeing take? Two that come to mind and hold potential (while completely speculative) are the return of Alan Mulally and/or investment by Warren Buffett.
Alan Mulally is well known in aviation circles and was denied the top job at Boeing in 2006. He left for Ford Motor Company and engineered one of the most successful turnarounds in the corporate world.
His appointment would bode well as he knows Boeing inside out and is widely admired as an engineer’s engineer. Further, he is a turnaround man, is well versed with dealing with regulators during challenging times, and has successfully led complex manufacturing operations and ably proven himself– at two of America’s leading iconic firms.
The second scenario includes investment by a firm like Berkshire Hathaway. An investment by Buffett would help with strengthening the balance-sheet lend immediate credibility.
One can also speculate that such an investment is not out of the question as Buffett repeatedly expounds on his faith in American business and would not be averse to an investment at the right price and structured in the right manner which may include preferred shares, warrants, and other provisions.
In fact, looking at his prior investments in Goldman Sachs and Salomon Brothers investments one could draw parallels. Interestingly, Buffett has been an ardent Boeing user via his business jet (a modified Boeing 737) which he named “
the indefensible” and has lately been less averse to investments in the aviation sector.
To reiterate – both above scenarios are speculative but are included to highlight the nature of decisions Boeing will need to take.
Costs of the NMA and other aircraft programs have to be factored
Boeing issues spill over to liquidity on the current aircraft types as well as new product development. It has to balance these delicately. The current strategy of not discounting the 737 or 777 models is important for liquidity on existing types and the ability of the aircraft to carry their value. But to ensure customers are not lost Boeing needs to offer its customer something. Industry watchers indicate that Boeing is offering discounts on the 787 and other models. The only challenge: this is not quite working.
On the new product development, the middle of the market airplane known as Boeing NMA (New midsize airplane) is awaiting a decision. This airplane addresses a market that requires a range of 4500- 5000 nautical miles and a capacity of 200 – 275 seats with better economics (read: lower costs). Namely, a range-capacity combination ahead of that offered by the B737 and A320/A321 but less than what is offered by the Boeing 787s and the Airbus 330 and 350. There has been a buzz about a re-engined 767 and converting it into a single-aisle but no official confirmation on this. All this while, Airbus is moving ahead with A321 XLR.
Other programs such as the Boeing 777 and Boeing 787 also have challenges of their own. For the 787, the order stream after 2022 falls off drastically.
On the 777 programs, the new generation aircraft namely the 777X is delayed. The 777X is positioned as the successor to the extremely successful Boeing 777-300/200 series but is facing roadblock after roadblock.
Powered by the largest turbofan engine ever built by far – the GE9X — issues have cropped up with the engine’s durability. Most recently, there were issues in the final phases of load testing which will have to be resolved. Key customers like Emirates have already indicated that they do not expect the 777X delivery in 2020 and are adjusting plans accordingly.
Most recently, Qatar Airways is also mulling changes to its 60 aircraft order. Finally, there is also the ultra-long-haul segment where Airbus is being aggressive in positioning its A350 aircraft.
For Boeing, this presents a strategic challenge as they have to look at market dynamics, how they will adapt over time and perhaps even take a decision on segments they want to give up.
The China tensions could not have come at a worse time
Finally, there is China. The largest foreign market for U.S. aerospace products, China currently imports half of its aerospace products from the US.
In 2018, U.S. firms exported $17.7 billion in products to China. This number was expected to grow but then the trade-wars hit. And for companies like Boeing that presents a challenge.
China is also on its way to becoming an aviation giant and of the current global fleet, ~14 percent is positioned in China. Boeing's own market forecasts indicate that China will require 7,000+ airplanes by 2036.
These represent a trillion-dollar opportunity. The only challenge is that this assumes that the duopoly of Airbus and Boeing will continue and seems to dismiss the fact that the Chinese government considers the development of its aviation system a national priority. As evidence, one only has to visit Chinese airports, MROs or even a manufacturing facility to personally experience the scope and size of the ambition. And China’s entry into the airplane wars as a formidable threat cannot be underestimated (even though their aircraft have lots of distance to cover to be at par with Boeing and Airbus offerings)
Till now, Boeing has resisted calls to set up a factory in China (Airbus set up in 2009). This is driven by decisions that have far-reaching strategic consequences including technology transfer, patent infringement, and pure commerce.
At the same time, the Commercial Aircraft Corporation of China (COMAC) produced an aircraft that resembles Airbus320 in many ways other than core technology offerings such as use of composites. As China gets access to technology or develops its own, the change could be exponential.
As far as aircraft manufacturing goes, China is marching on and as its aircraft improves - if its airlines are able to convert even 15% of orders to COMAC (which they could also be mandated to do). If this happens, Boeing will need course correction and it will need it fairy fast. This is a scenario that has to be planned for. In terms of cost, cash-flow, and contingency.
In flying training there is a concept called controlled flight into terrain (CFIT). The term, coined by Boeing in 1970s, refers to an accident in which an airworthy aircraft under pilot control is unintentionally flown into terrain. Ironically this is a situation where pilots are aware of the impending terrain have ample inputs but read the situation incorrectly with negative consequences.
One can only hope this is not the case with Boeing.
Satyendra Pandey has held a variety of assignments in aviation. He is the former head of strategy at a fast-growing airline. Previously he was with the Centre for Aviation (CAPA) where he led the advisory and research teams. Satyendra has been involved in restructuring, scaling, and turnarounds.