Demand Is Not Boeing's Problem, but Execution and Supply Risks Persist

Equity Analyst

Nicolas Owens

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Boeing is a major aerospace and defense firm that makes money mostly by manufacturing large commercial airplanes. Its narrow-bodied planes are ideal for high-frequency, short-haul routes, and its wide-bodied ones are used for long-haul and transcontinental flights. Worldwide sales of narrow-bodies have increased over the past 20 years with the rise of low-cost carriers and middle-class consumers in emerging markets.

Boeing's narrow-body business was battered by the extended grounding of its 737 MAX due to two fatal crashes of the plane before the COVID-19 pandemic. The pandemic cut air travel by two thirds between 2019 and 2020. Boeing's primary competitor, Airbus, saw a one-third drop in airplane deliveries while Boeing had to cease deliveries of its workhorse plane entirely for 20 months to rework the navigation and other systems on hundreds of jets. We see pent-up demand for air travel adding to the long-term increase in demand for air travel in emerging-market economies. Boeing plans to expand 737 MAX production to meet that demand. Critical to our thesis is at least some normalization of U.S.-China trade relations, as our forecast anticipates Chinese carriers will take up to a quarter of new airplanes in the next decade.

We expect wide-body demand to take longer to recover from the pandemic than narrow-body demand because wide-bodies are used for longer and international trips, which are bouncing back slower than domestic routes. We think Boeing's 787 Dreamliner is a fantastic aircraft for long-haul travel, but it, too, experienced a months-long halt of production as manufacturing quality issues got ironed out and planes refurbished. Deliveries recommenced in August 2022, but we don't expect them to return to 2019 levels until 2029.

Boeing also supplies military products to governments and aftermarket services to its commercial customers. These businesses together generate just over a third of its operating income over a cycle. We are broadly assuming GDP-like growth in the defense business and expect the services business will regain profitability faster than Boeing as a whole because aftermarket revenue increases directly with flight activity.

Business Strategy & Outlook

We think Boeing merits a wide moat rating because it benefits from durable intangible assets and switching costs. Although we think that Boeing has taken some competitive hits in the commercial aerospace duopoly, the commercial airplane market is large enough and so difficult to break into that it supports two wide-moat aircraft manufacturers. We think Boeing's defense business is more exposed to operational risk than peers due to its higher exposure to fixed-price contracts, but we think the firm is turning a corner operationally and benefits from intangible assets stemming from the technical complexity of its products as well as switching costs from the time and effort the military faces to switch suppliers as well as a lack of viable alternative suppliers. We think Boeing global services possesses intangible assets from proprietary access to aftermarket part designs as the Federal Aviation Administration and other regulators require that spare parts be identical to the original design, as well as benefiting from switching costs stemming from a lack of alternative suppliers for such parts.

In the commercial aircraft manufacturing segment, we believe the technical complexity of aircraft manufacturing and the extensive regulatory barriers to entering the market constitute wide-moat-caliber intangible assets. Both Boeing and Airbus benefit from these barriers to entry and it means they operate in a duopoly in the global large-frame jet aircraft market; we expect virtually all global revenue associated with air travel growth will continue to flow through the two incumbent manufacturers' top lines. What's more, we estimate demand from airlines for their products will remain high enough, long enough, that we expect both firms to generate economic profits for decades.

Further, we see the lack of alternative aircraft suppliers, the criticality of their products to the customer, and very long product cycles as presenting powerful switching costs. These three factors usually reinforce each other to allow for long-term economic profits to persist at both Boeing and Airbus. The intersection of airplanes' long service life, the economics of operating them, and that there are only two global suppliers is the arena in which long-term competition between Boeing and Airbus takes place. At present, Boeing has a superior product in the wide-body or long-haul category, and Airbus is enjoying the advantage at the long-range end of the narrow-body, also referred to as the midmarket category.

Boeing and Airbus supplied more than 99% of the commercial aircraft deliveries for aircraft with more than 130 seats between 2000 and 2022. Going forward, we don't see the process of designing new commercial aircraft as having gotten any easier. And though there were two serious attempts at entering this market in the past two decades, both faced considerable delays and difficulty marketing the aircraft, which we think demonstrates the barriers to entry in action.

The first was Bombardier, an experienced regional jet manufacturer based in Canada and an ideally qualified new entrant. In 2005, it targeted a relatively untouched market segment between regional jets and narrow bodies with its aircraft design, the CSeries, launched relatively quickly by 2013. The firm had significant engineering talent and experience designing aircraft, but in 2014, roughly a year after the CSeries first flight, one of the test aircraft experienced an uncontained engine failure, which extended development time by two years. The aircraft was certified in mid-2016, and Swiss International Air Lines became the first operator. At that point, the expensive process of aircraft development had bloated Bombardier's balance sheet considerably as the firm borrowed cash to fund it, and Bombardier did not have substantial orders for the aircraft. Bombardier secured a large order for 75 aircraft and 50 additional options from Delta in early 2017, but because customers are highly skeptical of new suppliers (another barrier to entry), Delta demanded a price discount considerably deeper than the industry standard of 50% to close the sale (some industry reports suggested the discount was somewhere between 66% and 75%). Boeing used this knowledge to accuse Bombardier of dumping, or selling the aircraft below production cost to gain market share. The U.S. Department of Commerce agreed with Boeing and placed a preliminary 300% tariff on the transaction, which effectively killed Bombardier's U.S. marketing efforts, and entering the large U.S. market was critical for the aircraft to succeed.

As Bombardier was in a difficult strategic and financial situation, it reacted by giving away a 50.01% majority stake to Airbus (and later sold its remaining 31% stake in the program to Airbus for $591 million, a small fraction of the program's development cost) so that Airbus could complete final assembly of the aircraft in Mobile, Alabama, and avoid the tariffs. In short, Bombardier used every resource at its disposal to break into the commercial aviation market and was able to design a capable aircraft but still was unable to set up a maintainable business. We think the result was a win for the duopoly, even if it was a relative loss for Boeing because the firm effectively forced a small competitor to sell valuable intangible assets at fire-sale prices to its only other competitor.

Today, the most serious potential new entrant is Comac, which is based in China. It has been designing its C919 since 2008 and has successfully introduced the ARJ21, a regional aircraft, after extended development. The C919's development has been the longest in history. The aircraft completed its first flight in 2017 but had not received type certification from any aviation regulator until late September 2022, when the Chinese civil aviation administration approved the plane for commercial use in China. We assume deliveries will start at a low rate in 2023 and production will accelerate, but we still don't think that the C919 will be able to ramp up quickly enough to satisfy demand in the massive Chinese market. The ARJ21 was certified in late 2014 and was still delivering at a rate around four aircraft per month in 2022, which we think shows the difficulty of ramping aircraft production. For context, we estimate that between 2015 and 2019, Chinese air carriers took delivery of almost 30 aircraft per month, on average. We have no reason to believe that ramping the larger and more complex C919 will be an easier process than ramping ARJ production.

While we think that the C919 will be supported by Chinese demand, we don't anticipate meaningful international demand for the aircraft. Comac's C919 is inferior in almost every way to modern narrow-body aircraft—the 737 MAX 7, for instance, can travel roughly 75% more nautical miles than Comac's similarly sized C919, and economics drive airline purchase decisions.

In sum, the technical complexity of aircraft manufacturing is a material barrier to entry, which we believe constitutes intangible assets. Boeing and Airbus are the only two capable suppliers of globally competitive aircraft larger than 130 seats, and we don't see any globally competitive new entrants entering the market any time soon. Therefore, we believe it's reasonable to assume that almost all global demand for new aircraft will flow through the income statement of incumbents, though we concede that some Chinese demand will likely move toward Comac.

To address the second premise, that the market is large enough and undersupplied enough to support two wide moats, we built a 20-year aviation forecast for deliveries. We believe more than one producer can generate economic profits if the industry is structurally undersupplied. This was the case in aviation sales prior to the pandemic, as both manufacturers had backlogs that covered more than five years of production for narrow-body aircraft. We see additional evidence that customers face switching costs from a lack of alternative suppliers as aircraft purchase contracts always allowed for manufacturer-friendly clauses such as the requirement that airlines put down large deposits at signing and make additional predelivery payments for aircraft for years leading up to delivery. We think customers would only accept such terms if the industry were structurally undersupplied. Our long-term aircraft demand forecast supports our assertion that the market will return to an undersupplied state such that both manufacturers would continue to benefit from barriers to entry and switching costs from a lack of alternative suppliers.

To build our forecast, we begin with global GDP estimates and assume that global air travel fully recovers from the COVID-19 downturn in 2024. We assume one year of excess growth, as pent-up demand for travel, measured in revenue passenger kilometers, or RPKs, partially catch up to GDP growth that occurred during the COVID-19 aerospace depression. Although we forecast travel reaching 2019 levels by 2024, in this forecast RPKs do not return to the prepandemic trendline: there will be a permanent two- to three-year gap between the prepandemic trend and our forecast. To get there, we assume air travel elasticity to GDP in line with long-term global historical rates, and we assume global load factors follow recent trends and cap at about 88%, leading to a 3.2% available seat kilometer compound growth rate, which implies available seat kilometers will eventually be around double 2019 levels.We then examine aircraft per available seat kilometers globally and in the U.S. to determine a normalized level of aircraft per available seat kilometer and determine that there will need to be a global fleet of about 50,000 aircraft to support this level of travel and we expect about 82% of that fleet will be narrow-bodies. We assume about 80% of the current fleet of about 23,000 aircraft will be retired in our 20-year forecast.

When we split the relevant markets between Boeing and Airbus, we assume Boeing will have a 40% delivery share of the narrow-body market (after excluding Comac, Embraer, and United Aircraft deliveries), primarily due to competition from Airbus. Airbus' A321LR and A321XLR are the only viable midmarket aircraft today, and Airbus' impressive backlog share at the top end of the market shows its attractiveness to airlines. We think Boeing's 737 MAX 8 is a capable aircraft for the traditional narrow-body market but that Boeing missed the opportunity to build a "light" middle-of-the-market aircraft and is paying the price by ceding a sizable portion of the narrow-body market to Airbus. Even though Boeing now lags in the narrow-body market, we think the market is large enough that the firm will ramp up 737 MAX production well above previous peak production.

We assume Boeing will retain its advantage in wide-bodies as we expect the 787 will remain the dominant small wide-body, the 777X will be launched successfully, and the cargo market remains mostly in Boeing's hands. We expect Boeing will achieve a 60% share in wide-bodies.

Finally, we think we should address the long-term impact of Boeing's recent operational failures on our moat rating, namely, the 737 MAX grounding and the 787 production problems that led to its the delivery halt in July 2021. Ultimately, we think that it will be difficult to assess the extent to which these changes have improved Boeing's design process for several years because the problems with both the 737 MAX and the 787 predate the changes, so we think the first real test for the company will be the rollout of the 777X by 2025. That noted, we think a significant portion of the portfolio has been heavily scrutinized by regulators and re-worked by Boeing, and we don't think investors should expect incremental failures on the 737 MAX or the 787 after the intense scrutiny these programs have received. These two programs alone compose over half our estimated long-term operating income for the firm, so incremental failures on other programs would be less material.

Qualitatively, we don't think Boeing's intangible assets have deteriorated. And while Boeing has a gap in its product lineup in the workhorse narrow-body market, the firm still has the know-how to develop and deliver aircraft, which is ultimately the valuable intangible asset. Switching costs can be shown more empirically through the backlog. Boeing only lost about 30% of its ASC 606 adjusted unit orders from the 737 MAX crisis, which is meaningful as airlines could leave orders without penalty during the crisis. Further, ASC 606 adjustments required Boeing to remove some order from its book from distressed airlines, and we expect some of these airlines to emerge from distress in the aviation upswing, which would bring their orders back onto the books. While Boeing likely had to renegotiate a sizable chunk of the order book, we think this is a temporary condition rather than a permanent change of its relationship to customers, and we believe this is supported by the fact that Boeing has been able to continue to increase the 737 MAX backlog even while clearing existing inventory. 

We think Boeing's defense segment possesses intangible assets due to the complexity of manufacturing defense products and from the sole-source contract structure of defense production. Boeing's defense unit primarily produces crewed and uncrewed aircraft and missile products. Military product development costs billions, so the government typically has a competitive contract bidding process and then gives a sole-source contract to the winner to avoid cost redundancy. We think this puts a nearly unshakeable barrier to entry on the firm's existing portfolio, which has years-long contracts to fulfill, as the military does not switch providers after a contract is won. Typically, development programs are granted in a manner that is beneficial to the contractor, as well. During the early stages of development and production, the government generally purchases using cost-plus contracts that shift the financial burden of cost overruns to the customer, but the potential profit to the contractor is generally lower. Given the immense risk of cost overruns in designing complex products such as fighter aircraft, this dynamic works in the contractor's favor. When the costs of the product are better understood, the contract typically switches to a fixed-price contract. While Boeing is more exposed than peers to highly risky fixed-price development programs, we estimate these programs account for only about 15% of the portfolio and some fixed-price development programs have not taken material charges. We think the effects of the most problematic fixed-price development program, the KC-46A tanker, have been taken care of as the military is accepting delivery of the aircraft, but we estimate Boeing spent roughly twice the contract value on product development.

We see switching costs from a lack of viable alternative suppliers for a product as well as the significant time and monetary investment required to switch. Since military products are purchased on a sole-source basis, the military cannot shop around for a new contractor after a product is developed. The military would instead need to cancel the program and invest time and billions of dollars into a new contractor to recreate the capability, which could take several years. During that time, the military would face a capability gap that could be exploited by a military adversary, and military platforms and weapons systems are mission critical for military operations. Due to the immense difficulty of switching and the mission criticality of the product, the military almost always chooses to work with the contractor to fix whatever problem arises rather than to switch to a new military platform. This can lead to cash-cow platforms such as the F-15, a product that was originally developed in the 1970s and is still delivered in significant quantities, though Boeing has made numerous upgrades to the platform.

Boeing global services provides aftermarket parts and services and acts as a manufacturer and distributor of a wide variety of consumable and expendable aftermarket parts. We believe this segment benefits from wide-moat-caliber regulatory intangible assets as airlines must maintain aircraft to type certificate standards, which require aftermarket parts to be identical to the original parts built into the aircraft. Typically, the original equipment manufacturer of the part, which could be a variety of aviation suppliers, is the only source that has access to the original schematics for the part, which gives the manufacturer a monopoly on the aftermarket. We see switching costs from the lack of alternative suppliers and from the mission criticality of aircraft to airlines. Since the manufacturer possesses a monopoly on the market for aftermarket spare parts and airlines need to have functional aircraft to run their business, the airlines have little choice but to accept the prices charged by the manufacturer.

Wide

Economic Moat

Boeing

Jeppesen is a company that delivers products that integrate navigation, operations, and logistics information into one end-to-end solution.

Jeppesen

The Boeing Co. is an aerospace company, which engages in the manufacture of commercial jetliners and defense, space, and security systems. It operates through the following segments: Commercial Airplanes (BCA), Defense, Space and Security (BDS), Global Services (BGS), and Boeing Capital (BCC). The Commercial Airplanes segment includes the development, production, and market of commercial jet aircraft and provides fleet support services, principally to the commercial airline industry worldwide. The Defense, Space and Security segment refers to the research, development, production and modification of manned and unmanned military aircraft and weapons systems for global strike, including fighter and combat rotorcraft aircraft and missile systems, global mobility, including tanker, rotorcraft and tilt-rotor aircraft, and airborne surveillance and reconnaissance, including command and control, battle management and airborne anti-submarine aircraft. The Global Services segment provides services to commercial and defense customers. The Boeing Capital segment seeks to ensure that Boeing customers have the financing they need to buy and take delivery of their Boeing product and manages overall financing exposure. The company was founded by William Edward Boeing on July 15, 1916, and is headquartered in Arlington, VA.

Earnings data Q1 2024

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