Changing Market Environment
The numerous ways to describe the changing commercial aerospace landscape can be articulated around several elements. Some are technology heavy, such as new materials, connected aircraft, more electric aircraft, while others are by definition industrial: automation transformation, IoT, blockchain, and global supply chain.
However, one dominant element of the changing landscape is often the least discussed in the shifting strategic environment. A significant shift is resulting from a major redistribution of roles and responsibilities between OEMs and suppliers. Over the next two decades, the market environment will be characterized by a diminishing emphasis on ownership of the production elements and a greater emphasis on life cycle ownership for OEMs and suppliers alike.
When observing the current Boeing and Airbus market situation, it is noticeable that the two organizations are at very different stages of their historical market presence and thus, their respective product development and strategy cycles. Yet they continue to be evaluated equally, without reference or analysis of their market cycles. All are not created equal, and while some analysts are producing independent or objective assessments, others find outlets such as “Seeking Alpha-bet” useful to communicate one sided opinions, often regurgitated from interested parties and thus devoid of any analysis worth considering.
Boeing is transforming radically
Let’s revisit a few of Boeing’s transformation efforts over the past decade or so. Under Jim McNerney, the company initiated a much needed and timely reexamination of its operations, and at the same time, launched its most ambitious programme to date, the 787. As we know, the 787 did not happen as planned, the programme was and still is to a limited extent, plagued by supply chain, technical and financial issues.
While McNerney was often the target of critics in the Puget Sound region, it remains clear that his decisions and that of his team contributed to laying the foundation for Boeing’s current strong financial and operating performance. McNerney initiated the “financialization” of the Boeing company, knowing full well that business cycles needed to be dampened somehow in order to ensure continued market leadership in an increasingly challenging competitive environment. Some could argue however, that what precipitated this transformation had its roots in the 787’s initial debacle, which forced an intense reexamination of Boeing’s product and corporate strategies. There is some truth in that argument but the decision was clearly not a result of this crisis, however much it accelerated the process.
This was the first major strategic shift from Boeing in a long time, as previous strategies were primarily product driven, echoing how the company understood its market participation. We could also argue that the 1997 acquisition of McDonnell Douglas was also strategic. It was, but for reasons more closely associated with Boeing enhancing its military portfolio business after the cold war and a strategic objective to win the lucrative JSF contract away from competitor Lockheed Martin. This acquisition significantly helped alleviate commercial market cyclicality and substantially enhanced Boeing’s defense portfolio.
Rebooting relationships ahead of transformative events
Boeing will not be the same company by 2035, an obvious statement, but why?
First, the competitive environment will fragment further. Our recently published forecast to 2032 suggests over 36,000 new aircraft produced. Let us examine the evolution of Boeing production market shares from 2008 to 2032 at selected intervals:
This chart illustrates how Boeing’s overall market shares in the narrowbody and widebody market segments will continue to progressively decline over time and settle to around 35 to 40 percent by the mid 2030s. Worth noticing, these four OEMs produced 1,472 aircraft in 2017 while our forecast suggests production of 1,700 aircraft in 2032. Boeing share is declining in a market environment that will witness production growth, and this is to the benefit of Airbus and COMAC in that order. While Boeing production volumes may decline in the face of increased competition, the company’s production revenues will be stimulated by new higher value products such as NMA and the new single aisle which will contribute to significantly higher services revenues and better margins than 737MAX. The in-service fleets will also contribute to an increase in services revenues which we expect will increase to over 33% percent of Boeing’s revenues by 2032.
Reducing production associated risks & globalization of the company footprint to support sale strategy
Another goal that Boeing will likely aim for in the course of the next decade is to ensure that the company is less and less perceived as an element of US government policy. While it may not be possible to avoid direct connection with US interests, particularly in an increasingly fragmented competitive environment and rising Chinese influence, Boeing will increasingly seek to participate more actively as a regional economic agent to support sales and leverage local industrial assets and partnerships if possible.
Boeing’s revenues and overall market growth are also going to be instrumental at stimulating free cash flow (FCF), likely to jump 25-30% by 2023. This will place Boeing in a very strong position with shareholders and support IRAD in the early 2020s. The Trump tax break has also benefited Boeing substantially, something that Airbus does not benefit from at this juncture. While Airbus may be behind with its cash position, there again, the market cycle and product portfolio maturity are significant negative differentiators working against Airbus. This further validates Boeing’s careful decision to serve the narrow-body market with a 737MAX as opposed to a new aircraft. It is however important to note that the decision to launch MAX was primarily driven by American Airlines. Had Boeing not launched MAX then, we might have 500+ Airbus CEOs and NEOs on order from that airline.
This decision was essential to stabilize the organization, reduce programmatic risks and ensure Boeing’s financial growth post its 787 crisis. In short, Boeing may not have the better aircraft for narrow-body customers, but it has a product that delivers quite decently on performance, operations, and significantly contributing to maintaining market share and strengthening the organization ahead of the NMA and future narrow-body decisions, which will be significantly more capital intensive.
For Boeing, the resulting strategy will be to minimize the gap between the introduction of these two new aircraft to accelerate the transition to new products, leverage technology R&D, industrialization plans, and grow their associated services portfolio. The period 2027-2030 will therefore be particularly critical and disruptive for Boeing, with decisions pertaining to workforce, location and industrialization likely to dominate the agenda. As shown below, one of several scenarios suggest that Boeing is likely to have a more balanced revenue distribution between its three major 2018 production sites. While other production site may emerge, to include them in this note would be entirely speculative.
Services-more services, increased risk-sharing & production and the advent of selective partnerships.
Boeing has learned a tremendous amount from the 787 “visionary” model and initial debacle. Some of these (obvious) lessons are:
- Know the supply chain
- Incremental is better than revolutionary technology in a risk adverse industry
- Avoid a “boom-bust” vulnerable portfolio of product and services
- Don’t put all your eggs in one (Puget Sound) basket
- Take care of your shareholders
- Internalize what you can do best
- Externalize what your organization is not structured to handle
The transformation of the competitive environment will drive Boeing to further relationships with a limited number of Tier 1 suppliers. While Boeing will drive more design and engineering in house, it cannot swing the pendulum too far and will need to perhaps consider looking at risks sharing partnerships that provide financial incentives to suppliers that have been largely critical of the PFS programme over the past few years.
Globalization, trade and disruption
Boeing will also target Airbus on its home turf. With the massive uncertainty affecting the UK aerospace industry post-Brexit, it is possible that Boeing may attempt to grow its base in the UK to leverage available resources and UK government subsidies to avoid a dwindling aerospace industry. Another area of growth for Boeing is likely to be Brazil in the event that the negotiations currently in progress to firm up a partnership with Embraer are successful. It is possible that Boeing may chose to assign limited production work to Embraer as well as some engineering taskings.
As part of the trade spat with China, the US administration stated goal is to reduce the US trade deficit with China. It currently stands at $375.2 billion for 2017 up from $347 billion in 2016 despite a seasonal deficit for China of $4.98 billion in March of this year. As part of the negotiating strategy, it is possible that the US delegation suggests to China to narrow the trade gap via the acquisition of more Boeing planes at the expense of Airbus. This indirect strategy has already been affected in the past by the US administration in South Korea, Saudi Arabia and Singapore to support US military and commercial sales. This will be a significant test for the China-US relationship. While we agree that the Chinese economic growth demands stable aircraft delivery, this may also turn out to be a crossing of the Rubicon for China. President Xi Jinping (習近平) inner circle weighs considerably in the decision to respond to tariffs from the US, as indicated by the less conciliatory Vice-Finance Minister Zhu Guangyao (朱光耀) :”Looking at it another way, external pressure is the driving force for innovation and development”, another way to say that time is on China’s side.
Will organic growth be enough?
While we generally believe that Boeing commercial will be driven by a favorable market environment, we have reservations about BDS’ ability to grow organically. While T-X and MQ-25 are not awarded yet, we view Lockheed Martin as the likely winner of that competition on the basis of risk reduction for the government customer and the ability of Lockheed Martin to price aggressively an highly effective solution. MQ-25 is a big question mark and certainly not as clear-cut perhaps as T-X. While the E-3 recapitalization is going to be high on the agenda from the late 2020s, we do not view Boeing as a strong potential prime for this competition, even if it may supply green aircraft for the yet undefined replacement of USAF aircraft. This leaves BDS with little other than KC-46, tranche 2 of the KC-135/KC-10 recapitalization, and perhaps one or two additional export customers. While this is good from a cash-flow standpoint, it does nothing to position BDS for growth into the 2030s. For that to happen, Chicago is going to have to spend some cash on a strategic acquisition.
We view three prime candidates for Boeing: Northrop Grumman, Raytheon and L3 Technologies. Of all three, we view Northrop Grumman as the least likely to materialize due to likely US government objections. L3 is the one that possible could serve Boeing’s strategic interest best. The company has a good mix of systems and services portfolio and is a key supplier to the US government. L3 is particularly attractive as it continues to expand its global footprint, moves up the value chain as a as a prime, expands its defence and commercial services, and captures longer term programmes. This is exactly what BDS could benefit from as well.
Boeing will continue to disrupt the status quo through a combination of services and product innovation. Emphasis near term will remain on cost reduction and margin improvement plans, driving the organization to further rebalance its industrial footprint domestically and globally, while doing so in controlled manner to minimize current production surge risks.