Boeing: Turbulent Times - [Business Breakdowns, EP.129]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Zach Ross, an investor at Irentic Capital. And today, we're breaking down Boeing. Founded in Seattle in 1916 by William Boeing, the company has produced thousands of commercial and military aircraft over the past century. It is an important national and global asset, and one half of arguably the most famous duopoly in business alongside Airbus. To break down Boeing, I'm joined by John Ostrower, founder and editor -in -chief of The Air Current. You can split Boeing's business into three segments, commercial, defense, and services.

1:26For this discussion, we focus primarily on Boeing's commercial business, which accounted for nearly 40 % of its revenues last year. We talk about the cost and complexity of building new airplanes, how the 737 max disaster changed the business, and why the future of commercial planes will look radically different. Please enjoy this business breakdown of Boeing. All right, John, thank you for joining us to break down the heralded Boeing Corp. I think maybe to set the stage, it would be helpful from my perspective, from the audience's perspective, to provide some context on the commercial side of the business, the defense side of the business, how big the industry is, what secular trends or tailwinds support businesses' growth, and where Boeing fits into the equation.

2:11Yeah, absolutely. So the best way to think about Boeing and Airbus too is really they're both publicly traded companies, but it's really important to think of both of these aerospace giants, not necessarily as individual discrete companies, but as extensions of their national patrons. Yes, they're publicly traded. Yes, they operate with the same type of commercial considerations as other companies, but fundamentally they are extensions of both commercial dominance that the EU and the US want to wield around the world. These are instruments of soft power. And so they play a very, very, very specific role in fabric of the nations which they're associated.

2:58So with respect to Boeing, I mean, you look at history over a hundred years where they evolved from the earliest fabric airplanes all the way to carbon fiber composite jet liners that can do an 8 ,000 mile hop in one complete flight. You can fly Perth to London right now nonstop in a Boeing 787. That's an amazing thing. I mean, just to watch that progression over the last 100 plus years. So looking at that, this is a company that from the commercial side of the business really had an important inflection point right around the start of the jet age. As we transitioned into the 707s and the DC -8s and the early jet age for hopping around the world on jet airplanes, what ended up happening was the entire ethos of the industry shifted gears and sort of the macro picture for airplane operations went from higher, faster, farther to faster, better, cheaper.

3:54And so you look at that evolution and really largely explains why we've been flying around between 30 and 40 ,000 feet and somewhere between eight and nine tenths of the speed of sound. Because the most durable single trend in all of aerospace, predominantly on the commercial side, is to deliver products that have a lower operating cost, whether it's lower fuel burn, lower maintenance. Airlines don't generally want more performance because there's a whole ecosystem designed around the structure that we have right now. And fitting within that and optimizing that has been predominantly the vehicle for how they become profitable.

4:38And so Boeing has served their customers to that end. And so that's the commercial side of the business. On the defense side of the business, thinking of it as a national asset, these are strategic capabilities of the United States of America. There aren't a lot of teams that can design a transport aircraft or a fighter jet or a bomber in this country. You're in the world, really. So protecting those capabilities and cultivating them is a strategic goal of the US. That's a super helpful summary. I guess if I were going to take a white piece of paper, what exactly is the business model for Boeing today?

5:15There are two big pieces that drive the model on the commercial side. One is growth and one is replacement. And so you've got an environment in say North America and Europe, which is more geared toward replacing the existing fleet with new, more fuel efficient airplanes that might be larger or have new engines that provide a performance benefit. And then you have the emerging markets. You have China, you have India, you have Asia Pacific at large, you have the Middle East and Latin America that have not traditionally been the big drivers in the first chunk of the jet age. It was very much watching US and European economies grow to the scale that they have.

5:56Now we see China with a significant demand for airplanes. There's a whole geopolitical element around that today about who they're willing to take airplanes from and why and when. But if you look at where India is today, as they aspire to be an economy and a global powerhouse alongside the US and China. So that's driving a lot of the trends. In the background of all of this, the environmental side, where there are a lot of people in this industry wondering whether or not either of those growth models are fundamentally sustainable. But getting back to the business model question, traditionally, the airplane business, as it's been practiced by Boeing, on the commercial side, has been to ride the demand waves up and down.

6:39And so as demand accelerates, Boeing will accelerate production to meet that demand. and they have always seen it as a benefit to be most closely aligned to those waves. The problem with that is that any up wave also creates a down wave. So managing that ends up creating large numbers of people being potentially laid off on the opposite side of a boom. And so what that has meant is that they have made their money on building and delivering airplanes. So the way you deliver an airplane at about two thirds of the final price of the airplane is actually paid on delivery. The first third or half or so is working capital to buy engines, interiors, fuselages, wings, build all that on the way there to building the airplane, also pre -delivery payments as well.

7:25And so that is the primary driver of revenue within Boeing's commercial business. On the opposite side of that is the services business, where the long tail of an airplane as it enters service will need maintenance and upgrades and new tools for its life that either make it more efficient or keep it operating. I've seen estimates that that's like 70 % of the total cost, lifecycle cost of an airplane. Boeing and Airbus also have tried to increase their share of the services business, the commercial side of the world, because it ultimately is more stable than the ups and downs of the market where you've got airlines that are growing too fast and then coming down and hard on the other side, which results in changing production rates and all that.

8:12It's really interesting. Pre -COVID, there was really a sense that things had stabilized in terms of growth. And I would actually probably put that to about the point of 2017. Heading into 2018 and 19, there was an absolute oversupply in the market for the largest twin aisle airplanes, Boeing and Airbus. Boeing in particular had been building at an incredible, incredible pace. 787s after their initial development of the airplane to deliver financial return on that airplane. And frankly, the demand for it was there for several years as airlines waited for that airplane. However, what we really saw financially in the years leading up to the pandemic, there was a glut of twin aisle airplanes.

8:50So this is an industry that particularly Boeing, I would say, and there's plenty of evidence to support this, that they have chased the ups and downs in a way that has left them at the mercy of overproduction and then the consequences of that on the opposite side. So we have a business that's effectively settled into a duopoly, at least on the commercial side and on the aerospace and defense side, obviously a bit more competitive. Presumably they have their own kind of niches that they dominate there. It's a business that's been around for a hundred years. How is the industry structure settled in the way that it has?

9:26Form follows function in a lot of ways. And so the barriers to entry that come along with that require a particular form factor. And that's one of the things that we're in the process of seeing challenged now, which I think makes the next five to 10 years probably the most exciting time in aerospace in the last 50. But coming back to the core of your question, Boeing is a global company. Airbus is a global company. These are super tankers of economic activity. I mean, just an incredible, incredible number of jobs that are closely tied to the social fabric of both the US and European economies.

9:59So there's absolutely a political element that comes along with this in terms of the staying power and their influence within all of that. When an industry matures in the way that it has like commercial aircraft, where you see the rise of low -cost carriers, ultra low -cost carriers, we can get from Seattle to Dallas for 45 bucks. I mean, what that does is it even more biases you toward less disruption. And so again, maintaining that form factor and holding on to the existing designs, because once you have them and the infrastructure that comes with them. I mean, you're talking about when you're buying an airplane, you're talking about a 20 to 30 year relationship between the airline and the aircraft manufacturer.

10:37So it just doesn't change that easily. You've got simulators and you've got pilots and you've got maintenance organizations and you've got the understanding that comes along with how you build these things and take care of them. And it just isn't a thing that changes very quickly. And what we've seen, I think on multiple occasions in this industry is that when you do try to change it really quickly, things break and they break really painfully. We saw that with the 787 development. I mean, when Boeing went from high bypass engines and long range performance with a really highly optimized aluminum airplane and fly -by -wire on the 777 to just less than a decade later with majority carbon fiber composite design, more electric architecture, and a totally new production system to do all of this.

11:27Boeing ended up spending, estimates have ranged from anywhere between 300 and like 900 % of what they had originally planned, depending on how you measure it. I mean, they thought they were going to be able to get away with this for an investment of under $5 billion in $2 ,003. Again, I've seen estimates from 14 to 60, depending on how you measure. How much does it cost to produce an airplane between the cost associated with establish your own program. And then once that program is established, the associated R &D, the sunk costs, incremental aircraft expenses. I just want to give the audience an appreciation for the scale that we're working with here.

12:04Yeah, absolutely. So the new aircraft program, the estimates are around 15 to $20 billion. And so you're talking about a single aisle airplane, Boeing will tout or Airbus will tout $110 to $130 million in list price. For the sake of this discussion and the sake of understanding of the aerospace industry, no one ever pays less price, generally speaking. Typically, discounts of 40 % to 60 % are very, very common and typical, I would say, across what an airline actually pays for an airplane. When you think about the maturity of an airplane program like the A320 or the 737, you're talking about a, again, this is very rough, but an all -in cost to build of probably anywhere between $25 to $35 million an airplane.

12:52Very rough numbers. And they'll end up selling for about $50 to $55. And so again, there are so many different factors that go into establishing a price, how you measure it, maintenance contracts, lifecycle deals, all the different items that in terms of what goes to Boeing, what goes to suppliers that you purchase equipment that then gets shipped to Boeing. It's a very, very, very squishing number in terms of what that actually is. But generally, Boeing has sought profit margins anywhere between 5 % and 15 % for a commercial airplane. And sometimes, as an airplane matures, that gets a lot better, which is why it's such a long -term business.

13:32And then how long would you expect an aircraft to be in service for? An airplane delivers today, typically the economic useful life of an airplane is measured in roughly 25 to 30 years. So an airplane that goes today will probably cease service till 2050, which is an amazing thing when you really think about it. You think about going backwards from the jet age, beginning of the jet age, or beginning from the Wright brothers in 1903 to 1953. I mean, that was fabric covered airplanes at Kitty Hawk all the way to the very start of the jet age. And that's how long an airplane is going to be in service for that delivers today.

14:10And so thinking through the coordination problem, how many suppliers, vendors, third parties are you coordinating to get an aircraft manufactured and delivered to its customer? So what I always like to say is that if the flying public understood how complex it is to get an airplane off the ground from building it to delivering it to flying it, they would either never complain or never fly. I'm not sure which one, because fundamentally the complexity of managing that process from making sure that all the parts arrive in the proper sequence, are installed in the proper sequence, are installed correctly, the QA, all of the engineering that goes along with that.

14:51I mean, you think of aerospace as an incredibly precise manufacturing process. And it is. I mean, we're talking about thousandths of an inch tolerances or even ten thousandths of an inch in some cases. What you're fundamentally talking about is the single most challenging industrial task humans do. This is no knock on SpaceX and commercial space business. That is incredibly, incredibly challenging. They do not have the tempos and volumes that commercial aerospace does. And they also do not have an environment which is anywhere near as inhospitable to the product. So a rocket will wait for good weather, perfect, pristine weather, and an airplane will fly in terrible weather and be serviced by people whose salaries range anywhere from minimum wage all the way through three or $400 ,000 a year.

15:44That's just the normal process of having an airplane in service. So what it does, it requires just so much more robustness in how it's taken through its operation. And so to coordinate all of the suppliers, you're talking about thousands of suppliers. Those suppliers have suppliers, and those suppliers have suppliers, and those suppliers have suppliers. I mean, you're talking about a chain that in some cases is four, five, six levels deep, especially when you talk about raw materials like titanium and the specialized metals that are required for jet engines. I mean, it's really an amazing process to manage all of that.

16:17And by the way, every single step has to work. There's no fudging it. And so the amount of coordination that's required there is truly one of the arts of this business to then build it, have it meet your specifications across millions of parts. By the way, then you're doing it several hundred times a year, maybe as many five or six, 700 times a year. That is an incredibly, incredibly challenging thing. And it requires an unbelievable amount of institutional knowledge for how you do that and how you do that in a way that is repeatable, safe, and oh, by the way, did I mention profitable? To do all these things together is just unbelievably challenging when you're talking about a margin in the single digits.

16:58Before we get to some more recent history, it seems that Boeing's merger with McDonnell Douglas in the late 1990s is worth spending a bit more time on. Why was that important from your perspective in explaining how the business situated today? The merger between Boeing and McDonnell Douglas in 1997 was a huge moment. And number one, it represented the exit of McDonnell Douglas from the commercial world and the absorption of its defense business into Boeing for the most part. And that was a function of both the end of the Cold War, but also the result of different corporate strategies that both companies had.

17:35And Boeing had been a much more stable company than McDonnell Douglas going to that point. Its commercial business had struggled for years. They had a terrible accident also in the late 1970s with the DC -10, which had by many similarities bore striking resemblances to what happened with the Max decades later and what it set the trajectory that it set the company upon. But fundamentally what it did at the time was it changed a lot of the corporate culture about how Boeing thought about its role as an aircraft manufacturer. And going from McDonnell Douglas' leadership was primarily running the company at that point.

18:13And in doing so, brought a lot of very Jack Welch GE -centric approaches to how the company was run in terms of thinking about the company as a financial instrument. And so in the early 2000s, there was a huge push to divest a lot of the key pieces of the company that the leadership viewed as non -core. So which is to say Boeing wanted to be an aircraft integrator. They pull all the pieces together and they wanted to have that design capability. And that was going to be their expertise, an aircraft assembler. And so in the case of the 787, they divested their Wichita unit and their Tulsa unit to create Spirit Arrow Systems, which is now their biggest supplier, a company that they've had enormous challenges with as a supplier, which is now facing significant financial troubles because of the sum total of the strategies that created it.

19:02And so that has guided a lot of how the company has behaved over the last 20 years. And so thinking about the role of the merger here, there were ultimately markers along the way that saw Boeing prioritizing different things over time at a corporate level that just massively accelerated that. And so a lot of the criticisms that have been levied against the company, a lot of folks who were internally of the belief that that was the major turning point. Again, after that, it was, again, the sum total of each misstep sort of compounding the issue, getting farther away from solving the core problem, which is how do you take this incredibly complex integrated product and have an enterprise that is equally complex, equally integrated, and responsive to the needs of your customers and ultimately the needs of everyone in your ecosystem.

19:52And so that has been Boeing's singular challenge. And it's manifested in a lot of different ways over the years with respect to program performance, financial performance, and how that's ultimately unfolded until today. And so perhaps an appropriate segue, for a long period of time, Boeing was this darling of the equity markets. I believe the equity value per share nearly tripled from 2016 to 2018, and then it made national news for the wrong reasons. And so I'd like you to kind of help us to better appreciate the turbulence that Boeing has faced here over the past, call it five years or so. It's been an interesting century for Boeing.

20:27I mean, you got to go back pretty much to the beginning of the 2000s for explaining how it got to where it got. So when they launched the 787 in 2003, 2004, they undertook that process over what ended up being two, three years longer than they expected because of the technology wasn't ready, the supply chain wasn't ready. And certification just took way longer. Because of that astronomical cost, it caused them to prioritize the speed to deliver a single aisle airplane. The 77 is a twin aisle airplane with greater fuel efficiency as quickly as airlines could get it. But the cost of developing a new single aisle airplane at a time when Airbus was coming out with the A320neo drove them to put new engines and create the 737 MAX.

21:12And so during those years, between 2011, when they launched the airplane and entry to service in 2017, those years were transition years for Boeing. While they were starting to deliver 787s, which by the way, we're losing a lot of money per delivery at that point, but over time generating significant cash, Boeing does accounting. It is not on a unit basis, it's on a program basis, which we could probably spend an entire program on just that. But during the interim years when they were building a bridge to the 737 MAX transition and also the 777X, which was an updated version of their long -haul 777, which would have new carbon fiber wings and also new GE engines for significantly improved fuel efficiency and capacity.

21:55During that time, Boeing significantly ramped up production of its metal -winged 777 and the 737 Next Gen, which ironically enough was the generation that preceded the MAX. And based on a lot of moves that they made in the early 2000s to really optimize those programs under a certain set of really legendary leaders inside Boeing, they became the cash cows. They generated tremendous, tremendous, tremendous cash for Boeing at a time when the 787 was getting on its feet. And so that's where Boeing was able to earn that reputation you spoke about in terms of the darling of the equity markets, which drove its stock price to record levels at one point, pushing $500 a share.

22:36And then in October of 2018, a 737 MAX leaving Jakarta crashed with 189 people aboard, all were killed. And it was the first accident with a MAX and kicked off an investigation into what potentially had happened. And five months later, there was another crash. And Ethiopian 302 crashed, killing all aboard another 737 MAX, two brand new airplanes. And you think about the history and the safety of the industry. I mean, we talked about the incredible complexity of this business. One of the most amazing accomplishments of this business is how safe aviation and commercial aviation has become. We just don't even think about it anymore for the most part.

23:15But what we had in this case after literally one of the safest years in commercial aviation history, you had two airplanes crashing within months of each other, and that just doesn't happen. So pretty quickly after, it kicked off a series of groundings. started with the Chinese and went around the world regulator by regulator. And a couple days later, the Canadians in the US were the last to ground the airplane. And investigation really centered on a few different things. Number one, the flight control system of the airplane and a system called MCAS, called the Maneuver Characteristics Augmentation System.

23:49And that was designed to meet certification requirements for how the airplane handled when it was at a high angle of attack. Let's just say the nose was really high up and certain conditions were met, like the flaps were up and the autopilot was off and was being hand flown, and how the airplane would respond as it slowed and approached a stall. And so that had the system that would automatically swivel the tailplane of the airplane to lower the nose. And in the case of both incidents, the system was erroneously activated because of bad angle of attack data that caused the system, which was at that point driven by a single sensor and a single data input, to activate.

24:27and activated repeatedly and ultimately caused both crews flying those airplanes to lose control. There has been numerable pieces written over the last several years about exploring all the different causes. Certainly, there's been a lot of discussion about the pilot reaction to both systems. I think one of the things that the aerospace safety community has looked at with respect to both incidents is that neither of those accidents happen if MCAS doesn't exist. And so when you look at the sequence of events, that was what ultimately triggered the airplane being grounded for 20 months when it finally went back to service in the US in December of 2020.

25:04Given those circumstances, there's been leadership turnover. How is that permeated through the culture and the strategic direction of what the company is today and what it potentially becomes as we kind of look into the future? The Max crisis did set off a leadership transition. Boeing was under siege during that entire process from this harrowing tragedy in October 2018, all the way through the end of 2019 for the leadership side of it. And then CEO Dennis Mullenberg was ultimately ousted at the end of 2019 and David Calhoun took over shortly thereafter. And Calhoun had been on the board for years.

25:40I think it's really important to note that as all of this is happening and all of this chaos is swirling around Boeing and this horrible tragedy, which is just unthinkable on a scale that I don't even think Boeing could have fathomed. Fundamentally, the strategy of Boeing at a high level has not changed. Culturally, there are elements that they're emphasizing more. They've a chief safety officer, they've stood up new programs for safety promotion and an ombudsman for the organization and really additional checks and balances. But fundamentally, the corporate strategy of Boeing has not changed.

26:10Building airplanes for the world's airlines for growth and replacement. That continues to be the metric by which they're measured on Wall Street, which is cash generation. And so they're at a point where having gone from continuing to build airplanes at almost 42 per month for 737s to stopping the line completely and then restarting it and sort of running headlong into the factors that drove its performance to that point. So its relationship with suppliers, getting its supply chain back up and running while you're dealing with, by the way, all this is happening as a global pandemic is running roughshod over the global economy.

26:43and supply chain fragility was the concern du jour. And so all of the macro forces are colliding with the local forces and it makes it really, really hard to get back on footing. And right now, Boeing absolutely demonstrably has gotten more stable than it was before in terms of the number of airplanes that they're producing, but they're still running into supply chain issues. Getting back up to a rate and a regular tempo is still really challenging. But I would say that largely speaking, they are building airplanes at a much more regular pace than they certainly had been over the last 18 months.