This post is another business overview. Unlike ones I’ve done in the past, this piece focuses less on valuing the stock and more on discussing Boeing and the challenges they face.
Author’s Note: On January 5th, a door plug on an Alaska Airlines 737 MAX 9 came off during flight, exposing passengers to open air at 16,000 feet. There were no fatalities. The Federal Aviation Administration (FAA) ordered the domestic fleet of MAX 9’s grounded. Since then, other airlines have found similar quality lapses in their MAX 9 fleet. Boeing and its suppliers have again come under harsh criticism, including this article in the WSJ.
Growing up in the Pacific Northwest, I had a basic familiarity with Boeing—it was a major reason Washington was the only state with a positive trade balance with China (as of 2019). I saw Boeing the way so many others did: a peerless aviation titan, with its only viable competitor—Airbus—requiring massive government subsidies just to compete. In 2017 I accepted an internship at Boeing, and spent the following summer at one of their defense sites in Philadelphia. After school, I spent about three years with Boeing back in the Seattle area. Although my experience there was a mixed bag, it’s something I remain grateful for, and I’ve often said that those years were a lot better for me than they were for Boeing.
From the 737 MAX crashes (one in October 2018, another in March 2019) and the subsequent grounding, to the COVID pandemic that hit the aerospace industry particularly hard, Boeing has been through the wringer since 2019. Indeed, making any normalized valuation has become difficult, since the last “normal” year was 2018, and dozens of factors have emerged suggesting that the new normal will be different from the old.
Indeed, the company seemed to impatiently chase a sense of normalcy that it just couldn’t quite catch. Here are two examples:
- I started full-time at Boeing in July 2019, at which point the MAX had been grounded for about four months. The company’s stated goal was to return the plane to service by the end of the third quarter…soon restated to end of the year, etc. etc. When 2020 came around, the company suddenly had many more problems, and the Federal Aviation Administration didn’t approve the 737 MAX to fly until the end of 2020.
- Along with New York, Seattle was one of the first American cities to respond to COVID in 2020. Our team began working from home the first week of March—all employees in the region were doing the same within two weeks, and the policy spread across the country quickly. The original plan was to have everyone back in the office by May. This turned to June, then September, then year-end. One thing led to another, and after March 2020, I went into my office only twice—once as a false start in July 2021 prior to the Delta variant, and once in April 2022 to turn in my badge on my last day.
I don’t bring this up to criticize the company for their handling of these issues, but rather to illustrate the difference between Boeing and some tech companies which were quick to announce remote work policies, and didn’t rush to change them prematurely. Unlike many tech companies, Boeing was severely threatened by the pandemic, and management had every reason to wish it away and return to the good old days. Further, Boeing makes a tangible product, and there was significant value in having engineers and other support staff as close to the manufacturing process as possible.
But we’re getting ahead of ourselves: let’s back up with a brief background of what Boeing does and the world they’re facing.
The 30,000-Foot View
The Business Breakdowns podcast did a great overview on Boeing a few months ago, which I would recommend to any interested reader.
Prior to the MAX/COVID double whammy, Boeing did roughly $100 billion in annual sales, split roughly 60/30/10 between their three main business lines—the splits are very different today given a weak commercial jet market during COVID. The largest was Boeing Commercial Airplanes (known as BCA—like many big companies, Boeing has an acronym library worthy of its own dictionary), which makes passenger aircraft from the workhorse 737 to the larger 777, 777X, and 787 lines (the largest of all, the 747, is no longer in production). Most assembly work is done in the Seattle area at two separate locations—one for the 737, another for the “wide-body” models—except for the 787, which is now produced in Charleston, South Carolina. BCA’s customers are major airlines all over the world, and they primarily compete with Airbus, a European company heavily owned and subsidized by a handful of European countries.
The second segment is Boeing Defense, Space, & Security (or BDS, rather than BDS&S). They make attack fighters like the F-15, helicopters like the Apache, H-47 Chinook, and V-22 Osprey, Air Force One, and an assortment of rocket and missile components. Their main customers are the U.S. government and America’s allies, and BDS competes with other defense contractors like Lockheed Martin and Northrop Grumman.
Boeing Global Services (BGS) is technically two businesses in one, given that it serves both the defense and commercial product portfolios. Boeing put these businesses together in 2017, possibly to provide direct illustrate of the potential to capture value from aftermarket services, spares, and support throughout a product’s lifecycle. Given that Boeing’s key products are long-lived assets, it makes sense that a lot of the value is captured after the aircraft go into use. Indeed, in their defense business, Boeing has often been aggressive on pricing in order to win contracts, with the hope of eking out a tiny margin on production while capturing the lucrative aftermarket value in the long run.
Boeing vs. The World: Nationalized Competitors
In the long run, Boeing’s chief opportunity is that the “normal” that eludes them is a good one: the company has often cited 4% long-term growth in their annual Commercial Market Outlook. Fuel is a key cost item for many airlines, and jet makers like Boeing continue to provide more fuel-efficient aircraft that airlines are willing to pay for to keep their fleets up to date and their fares competitive.
However, this long run may not matter if Boeing can’t get back to cruising altitude, and there are significant challenges. Airbus has evolved from providing a cheaper product to providing a more innovative and cheaper product, and has consistently gained market share from Boeing in recent decades. Yet Airbus may be a tame threat compared to what’s on the horizon: Comac. The Commercial Aviation Company of China may be Airbus on steroids: a state-owned behemoth that can rely on subsidies and industrial policy to compete. Granted, this is years away from a viable reality, as Comac only has two C919’s (their equivalent of the 737 or the Airbus A320) currently in service. However, the overlap between commercial and defense applications for aerospace manufacturing means that large manufacturers like Boeing are huge national assets—and it appears to be in China’s interest to have one of their own. Indeed, Boeing’s value to the United States essentially affords it a “too important to fail” status.
The emergence of Comac places Boeing in a catch-22. China is the largest growth market for new aircraft, and Boeing hasn’t been willing to pass up this opportunity. But certain countries (like China) require a certain amount of Boeing’s supply chains to pass through China in an indirect quid pro quo to facilitate Chinese airlines purchasing Boeing aircraft. This makes sense as a unified industrial policy from China’s standpoint: to sell to the state-owned airlines, Boeing must contract out some work to state-owned companies under China’s AVIC umbrella (AVIC is a collection of Chinese aerospace manufacturers). Every blueprint shared with AVIC and every assembly shipped to Boeing is part of a slow intellectual property/manufacturing know-how drip that’s helping Comac strengthen its own future supply chains, which are likely to be of China, by China, and for China.
These arrangements are necessary for Boeing to sell to Chinese customers, but I’m worried it’s a losing proposition in the long run. I can see a future where China mandates all domestic airlines to buy domestic aircraft, freezing Boeing and Airbus both out of the largest growth market for aircraft. I could also see China peddling its planes overseas, likely in other emerging aviation sectors like Africa and Southeast Asia. In my recollections, the threat from Comac was something Boeing was loath to mention or address directly.
Postponing Normal?
It’s a further risk that the long run “normal” state of 4% growth will be more and more difficult to reach—and that Boeing may be structurally less profitable when those good days finally do return.
This starts with the balance sheet. Boeing increased their debt burden from ~$10 billion to ~$60 billion during COVID. While the company was fortunate in hindsight to avoid financing such debt at higher rates in 2022, it still represents a massive increase in leverage for a company that rides cyclical waves of demand. A large chunk of Boeing’s future profits will go toward paying down this debt.
Of course, it doesn’t help that in recessionary scenarios where Boeing’s profitability is most harmed, airlines can defer their own capex and reschedule orders, and it’s easy to imagine a world in which Boeing is forced to add even more leverage to an already strained balance sheet. The best way to prevent such a tailspin? A speedy return to high production rates without nagging quality issues.
Boeing, Supply Chains, and Inflation
But even quality production—something Boeing stakes their entire culture on—has been difficult to come by. Part of this is simply carelessness: things like tools and debris left behind in the factory. A bigger part takes place within Boeing’s supply chain. About two-thirds of unit cost for each airplane flows through the supply chain—indeed, Boeing is more of a general contractor and integrator than a manufacturer, representing a key strategic change from the past.
Boeing’s suppliers range from massive captive suppliers like Spirit AeroSystems (formerly owned by Boeing, Spirit makes the entire fuselage for the 737) to small machine shops all around the world. The universe spans thousands of suppliers in all, many of which have complex supply chains of their own. In 2020, as the entire industry suffered from vanishing demand, large companies like Boeing could afford to borrow cash—but many small companies could not. Some of the projects I worked on at Boeing included dealing with suppliers in both real and alleged financial peril—which always made for fraught negotiations. Given the current environment of cost inflation, I think it’s worth digressing in more detail on Boeing’s supply chain.
The largest supplier work packages (with partners like Spirit and the Japanese “heavies” of Mitsubishi, Kawasaki, and Subaru) are often for the duration of an airplane program. But smaller assemblies and parts are often signed to 4- or 5-year contracts. These often roll over at updated pricing, as the work transfer process requires a lot of internal stakeholders to buy in.
When negotiating this pricing, Boeing has often preached the “learning curve”, that a supplier should be more efficient at Unit 1000 than at Unit 1, and thus falling average cost should result in lower pricing. Yet certain profit/overhead markups are often baked into the contracts, at which point Boeing and the supplier simply quibble over an appropriate labor/material cost level. Some of these discussions can get mired in detail, but Boeing has teams of experts who analyze optimal manufacturing costs to support these negotiations.
Where things have changed since 2021 is on the inflation front. As labor and material costs skyrocketed, many suppliers were simply unwilling to keep bearing the risk, and demanded not just higher pricing, but escalation clauses which would increase pricing automatically in line with some measure of cost inflation. Such a pricing arrangement shifts substantial amounts of risk back to Boeing—risk that the supply chain was always intended to bear and was compensated for bearing. Yet many suppliers took such positions out of necessity for their own survival, making negotiations that much more intractable. As a result, Boeing will end up bearing more risk for a supply chain reeling from low production rates and higher cost inflation.
Supply chain management ultimately depends on relationships, and there’s often a temptation for Boeing procurement teams to advocate more for the interests of their counterparts than those of their employers. Boeing even has a term for this: “vendor defender”. From my perspective, the debate between the “vendor defenders” and the “supplier deniers” (my own term) intensified in early 2022. My last six weeks at the company were by far the most intense and enjoyable of my time there, and I felt I got a few glimpses into a new world of skittish suppliers and a Boeing being reluctantly forced to concede ground.
Normal Starts with a Quality Culture
Old-timers (of which Boeing has a quite a few) are quick to point out that the Boeing-McDonnell Douglas merger in the 1990s significantly changed the culture of the surviving company. McDonnell Douglas was primarily a defense firm with a more structured corporate culture, while Boeing was primarily a commercial business at the time. As the old-timers tell it, the McDonnell Douglas culture captured Boeing’s management, applying defense contractor bureaucracy throughout the entire combined company. The result of this was an army of poorly-paid, poorly-motivated, paper pushers with little to incentivize individual performance.
To new management’s credit, they are taking some actions that appear to recognize these issues, like sweeping reorganizations of non-core functions like finance. Yet the challenge will be to execute such changes without demoralizing those the company needs to retain and further damaging the company’s culture. The company has a long way to go to achieve these goals. Some articles have compared the current CEO (Dave Calhoun) to GE’s legendary Jack Welch. But the most relentless fat-trimming won’t be enough to restore vitality to Boeing.
The 737 MAX crashes shattered perceptions and have left Boeing with a permanently damaged reputation—Boeing essentially admitted to this by subtly beginning to refer to the MAX aircraft as 737-8 (in the case of a MAX 8) planes, as opposed to the previous generation denoted as 737-800. From a public relations standpoint, distancing itself from the MAX moniker that has garnered a bad rap makes sense.
Nor is the MAX an isolated incident. Further quality issues on the 787 and throughout supply chains have led to further delays, rework, and losses. For Boeing to put all this behind them, the emphasis must remain world-class engineering and manufacturing. These factors, which made Boeing great in the past, will make the company great in the future.
Avoiding false starts and self-inflicted wounds will be enough for Boeing to right the ship and likely return to profitability. But whether it’s enough for Boeing to return to “normal” is a slippery question. It’s difficult to assess what this even means given Airbus is facing similar quality issues (notably on the engines of the A320neo), and that Comac will eventually start producing at scale. Adding in the high leverage, my estimation is that Boeing’s position is structurally worse than it was prior to the 2019—and is likely to remain so. The long-term industry attractiveness remains, but Boeing looks to be left with a smaller piece of the pie.
Normal just isn’t what it used to be.