Premium #213 – How Boeing Lost the Chess Game with Airbus

Last week Boeing announced more than 4,000 layoffs at a time that it is generating record orders, has turned around the 787 program, and return on equity is rebounding, as shown in the table below: Revenues continue to grow to all time highs, and earning are strengthening. While operating margins have slipped slightly, return on equity has improved, albeit not yet to levels seen in 2011. But these numbers don’t appear to be alarming enough for layoffs. What’s really going on behind the scenes? Let’s examine what’s happening today at Boeing, and how that situation arose. 10% Staff Reduction by Year-End 2016 is planned. Several reports indicate that Boeing plans to reduce employment in Commercial Aircraft by about 10%, or 8,000 jobs by year end. The first round of about 4,000 jobs will be completed by June, primarily through voluntary retirements and buy-outs. Whether the 8,000 job total can be achieved without forced layoffs by year-end is another question. It seems odd that during a period in which Boeing is raising production to record levels, it would be cutting workforce. A situation that has occurred in the past at Boeing is that the most experienced employees tend to be those agreeing to be "bought out". Boeing may be forced to reject some requests from employees with seniority because their experience cannot be replaced. Even so, it may lose key elements of its experience base and "depth." Boeing is raising production rate on the 737 to 57 per month and the 787 to 14 per month this year, while reducing rates on its 747 and 777 lines. Boeing still expects to deliver a record number of airplanes this year - which makes job cuts in a growth environment seem even more strange. The logic isn’t there, unless people are to be replaced by automation. But that’s a longer-term solution that doesn’t appear to justify the job cuts sought in 2016. Airbus has Won the Narrow-Body Market Boeing management has cited Airbus pricing and lower margins as the driving force for layoffs. But they are masking market realities. The simple fact is that Airbus is today building a better narrow-body airplane. Boeing has a competitive problem vis-a-vis Airbus, and the company’s cash cow, the 737, is being significantly challenged. With the inability to incorporate today’s larger fans under the wing of the 737 without a major redesign, the new MAXs are at a disadvantage when compared with Airbus A320neo family. The initial 737 was introduced in 1967, when engines were cigar shaped instead of the large fans we have today, and lacks the ground clearance necessary to accommodate the larger engines. The A320, introduced 21 years later, has adequate ground clearance, and is a more efficient aircraft. After 49 years, it is finally time for a 737 replacement? Boeing has clearly lost the battle for the 180 seat market, where the A321neo is outselling the 737MAX9 by a 5:1 margin. The small end of the market is moribund, due to the Bombardier CSeries and Embraer E2 offerings being more efficient, and neither the A319neo nor 737MAX7 have sold well. Boeing does not report MAX sales by model for that reason - they are embarrassed by the poor performance of the -7 and -9. The net result is that what was once a narrow-body family is essentially down to one product at Boeing, the 737MAX8. This is why Boeing has been studying a Middle of the Market replacement for the 757. But recent reports leaking from Seattle indicate that Boeing’s study indicates that they may be too late, with much of the market already taken by A321neo, and inadequate demand remaining for a new program solely for that market. Advantage Airbus. While the MAX8 is a good product, it is a 162 seat aircraft in typical 2 class configuration competing with 150 and 185 seat models from Airbus. Boeing has lost its advantage in the narrow-body market, which is its major cash generator, as the MAX7 cannot compete with Bombardier and Embraer and the MAX9 lacks the performance to compete with the A321. Airbus has been aggressive in discounting its aircraft, and is building market share. While Boeing delivered more aircraft last year than Airbus, the latter won the order battle and is slowly and steadily raising its production capacity, including opening an assembly line in Alabama. Airbus now assembles narrow-bodies in four countries while Boeing produces all its 737s in Seattle. With Airbus winning the order battles consistently, it is only a matter of time until those orders reach production, and Airbus takes the lead in aircraft deliveries. What Boeing needs is a leapfrog - an all new aircraft that will beat Airbus. But with the 787 program losing $6 million per aircraft in the fourth quarter of 2015, they can't afford it yet. The Wide Body Market is More Competitive In wide-body aircraft, the 787 is selling well. The problem is that the 787 programs needs to pay for the massive overrun during its development, and isn’t generating nearly the profitability that Boeing counted on. Each aircraft delivered is still losing money, and Boeing will need to bite the bullet and write off the massive development cost overrun on the program. While this will be painful for shareholders and management, it needs to be done. The 787 is a bright spot in terms of orders, and recent orders have shifted to the larger and higher priced -9 and -10 models. We would expect the program to generate positive cash flow at this point - but the nearly $30 billion hole Boeing dug will be too deep for this program to ever turn profitable. While Boeing now has a great airplane and learned lessons on how to build a high technology aircraft with an international supply chain, the bottom line is negative. Current management appears to be trying to put off the inevitable write-down, but can't mask reality forever. The current 777 isn’t selling well as the market is waiting for the 777X models that enter service in 2020, and may require an additional production cut before the new products arrive. While the 777X had major orders at its launch, sales of late have been sparse, and the long gestation for entry to market will enable Airbus to launch its A350-8000 stretched version to directly compete and close a market advantage that Boeing has. While Boeing will likely remain in the lead in this category, Airbus has been pricing its A350 models aggressively (as Ray Conner candidly indicated in a recent discussion of a campaign at EVA Air in Taiwan) and could extend that aggressiveness against the 777X. The good news is that the 777X will be a proven aircraft with strong performance and a large customer base who could easily acquire the aircraft. This will be a strong market for Boeing, who also Boeing have a great freighter aircraft in the 777F, a market in which Airbus doesn't compete. The bad news is that Airbus will continue to price aggressively, which will likely decrease Boeing's margins. The 747-8 has been a market failure; even the freighter market has dried-up. The 767 line remains alive with freighter and tanker orders, but has a limited future. Boeing remains strong in wide-body aircraft, and has the current market advantage. But Airbus is catching up with both new technology A350 models and older-technology A330neo models that it can discount massively to thwart 787 orders. Having won the narrow-body battle, Airbus is now looking at the wide body market. The bottom line is although Boeing is building a record number of aircraft, Airbus has ensured that the planes it builds come with limited margins. The A330neo, which competes with the 787, is a example of this two-front competition. Being a derivative model with low development costs, Airbus can afford to massively discount this aircraft. While it is an older generation airframe with new engines and not as efficient as the 787, the capital cost differential is putting pressure on Boeing to further reduce margins on the 787, which can no longer recover its development costs. A Decade Ago, Boeing was Poised for Strategic Success If we go back more than a decade, Boeing was well positioned to enhance its industry leadership position against Airbus and had a strong strategy to do so. Their Yellowstone strategy of Y1, Y2 and Y3 new development programs was underway with the new 787 and Airbus was struggling with the A380. If the Boeing strategy could have been executed, with a new model every 5 years, a new 737 replacement (797) would be in service today, with new 777 replacement (808) nearing market entry. This would have provided Boeing three new products in a sequence that Airbus, after suffering from A380 losses, could not match, and provide Boeing a lead in all three segments. But the 787 failure was a bet the company gamble that they lost, and it has cost the company market leadership. Competitively, Airbus was then proposing an initial A350 that was essentially what we now see as the A330neo. That program was not well received by the industry and forced Airbus to scrap that design and come up with an all-new high-tech airplane to compete with the 787, which it did with the A350XWB. Airbus was relying on the A320 and A330 as its cash cows, as their A340 and A380 program struggled. Things were well set-up for Boeing to force Airbus into massive re-investment after leapfrogging their offerings in every segment. Today, those tables have been turned in the other direction. Unfortunately, the 787 program turned into a major debacle with cost overruns. Development costs exploded to more than $25 billion. This meant that Boeing could not financially undertake the next plane on the plan, which would have been the 737/757 replacement, nor replace the existing 777 with an all-new technology program as well. This was the backdrop to CEO McNerney's famous line about no more moon shots. Boeing had to compromise and re-engine both 737 and 777 rather than introduce game-changing models, and is still paying the price of the 787 development difficulties and financial losses. Losing Strategic Advantage The 787 was the first of three steps to gain competitive advantage in all segments. But the failure to execute on the 787 stalled the game of leapfrog. Boeing could no longer take the first leap and was forced to play catch-up because poor execution and arrogance cost Boeing their first mover advantage. The 787 delays enabled Airbus to rework their initial A350 design into the A350XWB, which has been well received by the market, and will likely add a new model later this year that will enable that family to compete effectively with 787 and 777X models, closing a market gap that only Boeing filled. Airbus losses on the A380 were not as large as Boeing’s losses on the 787. Airbus learned its lessons, and has become much more sensitive to development issues and technology risks, and can leverage the fact that it has always had a more multinational supply chain. Boeing was combining both new technology and an expanded supply chain with the 787, and bit off more than it could chew. Boeing underestimated the requirements to develop an effective international supply chain, and the resulting difficulties and delays in producing the 787 continue to haunt the company, as it cost them the opportunity to introduce needed new products. Regaining Competitive Advantage for Boeing In the short-term, Boeing still remains competitive in the narrow-body marketplace, with its 737 MAX8 selling well against the A320. While Airbus is approaching a 60/40 advantage in new orders, there are more than enough orders to go around and both companies plan to increase production rates to record levels. Expectations, however, are for cash flow and margins to be down as Airbus and Boeing continue an aggressive campaign against Bombardier, which neither company wants to allow a market foothold. The CSeries is already outselling the A319neo and MAX7 combined, and given the potential to stretch the CSeries, it would be a threat to the big two’s cash cows if Bombardier is successful. Without an all new model, which neither Airbus nor Boeing can afford to do until the neo and MAX have a 10 year production run to recoup their costs (2026/27 respectively), the status quo in narrow-bodies is likely to remain. Boeing has an advantage in the mid-sized wide-body market with the 787, but the A350-900 is proving popular and will provide strong competition. In addition, the A330neo is putting price pressure on the 787, as Airbus attempts to thwart what should have been a cash cow for Boeing and keep the aircraft unprofitable. The Super Twin market, over 350 seats, is currently an advantage for Boeing, as the 777-9, with 400 plus seats, will be larger than the A350-1000. But Airbus is looking at a stretch, and an A350-8000 could put a dent in future 777-9 sales if, as we expect, it will be launched at Farnborough this year. The 777X program won’t enter service until 2020, which seems longer than normal for an upgrade of an existing model. Airbus has an opportunity to offer its new model well in advance of the 777-9 EIS, providing a competitive alternative with newer technology and potentially better economics. That will introduce competition into a segment (350-400 seat twin) that Boeing currently holds alone. To regain leadership, Boeing needs to leapfrog Airbus in either the narrow-body or Super Twin wide-body markets. Today, their derivative models aren’t providing sufficient differentiation, and it appears Airbus is in the driver’s seat for the next decade, when the strength of new models from each company will tell the tale. The Bottom Line The initial failure of the 787 set Boeing back because it could no longer afford to execute its strategy of three new technology airplane programs, and resulted in two derivative programs that, quite frankly, don’t fully stack up against the competition. While Boeing can celebrate the 787 as a program that has turned around and become successful, its initial delays, grounding, and negative cash flow precluded the development of other programs Boeing needed to leap frog over Airbus offerings. Airbus is in a position to put financial pressure on Boeing through aggressive pricing, and have been doing so. The recent win for Boeing at United is generally accepted to have been won at record low pricing, with pricing reported at $22 to $24 million per aircraft. The net result is lower margins and the resultant pressure on Boeing management to improve their bottom line through cost-cutting. Layoffs will be the first step (it is unlikely that Boeing can voluntarily reduce their work force by 10%) and will even more pressure on the supply chain be next? Will we see another round of “partnering for success” or as suppliers call it, a Boeing demand for a 10-15% price cut? With no viable options in product strategy, given two sub-optimal development programs in 737 MAX and 777-X, Boeing has no other choice than cut costs if it wants to meet its financial targets. But cutting costs and employees at the same time one is increasing production rates doesn’t seem either feasible or to innately make sense. Boeing’s labor relations have a volatile history, and this move will likely exacerbate tensions between labor and management. Layoffs may also jeopardize state aid from Washington, as the quid pro quo for such aid is employment and jobs. To win, Boeing needs to resist the pressures from Wall Street, write off the 787 development costs, let Airbus win unprofitable contracts, and maintain margins as best as possible. But Boeing’s strategic failure on the 787, and the cash flow issues that followed that failure, have placed it in a strategic position from which it cannot regain market leadership in the near term. This 10 year cycle will belong to Airbus.

No results