Suspended MAX Production Dings Boeing Valuation

Boeing BA has announced that it will suspend 737 MAX production in January 2020 until further notice, probably until the aircraft is recertified by the Federal Aviation Administration. As the rate of 737 production increases drives a large chunk of our valuation for the company, this decision reduced our fair value estimate to $349 per share from $357.

We’re now pricing in lower production volume in 2020 and 2021 to account for the forgone production in January-March as well as a slower reramping of production in 2020, which shaves $3.50 per share from our fair value estimate. We believe that Boeing’s goal of producing 57 737 MAXs per month is unlikely to occur in 2020 and instead expect this rate to be achieved in mid-2021, as we believe the supply chain will be unable to easily increase production to its highest-ever levels after a total shutdown. We’re also lowering our margin assumptions on the MAX in 2020-23 to reflect concessions to protect vulnerable parts of Boeing’s 12,000 suppliers, which takes off about $2 of value per share. Finally, we’ve increased our grounding timeline slightly, which removes another $2.50 per share, but we recognize that there is a wider band of uncertainty on this issue. We do not believe that investors have a compelling opportunity to buy the stock.

While the bad news dominates the headlines, we continue to believe that Boeing’s wide economic moat structurally protects the company. We think that the 737 MAX’s remarkably stable backlog, which covers several years of production, demonstrates that the entrenched customer processes with Boeing aircraft and a lack of viable alternatives continue to drive demand for the aircraft. While the continued grounding presents a meaningful challenge for Boeing, we expect that the company will be able to move past this scandal over the next few years.

Economic Profits for the Long Haul In our view, Boeing possesses a wide moat that will allow it to generate economic profits for the long haul. Morningstar's definition of a wide-moat company requires a high degree of confidence that a company can achieve a normalized excess return over the next 10 years, and more likely than not over the next 20. Despite the current troubles with the grounded 737 MAX, we believe that structural barriers to entry in the aircraft manufacturing market and the substantial expense and difficulty required for customers to switch suppliers provide incumbents with intangible assets and switching costs that solidify their place at the top of the commercial aerospace value chain.

Boeing’s commercial aircraft manufacturing segment assembles and sells airframes, generally with 130 seats or more. Many of Boeing’s advantages in this segment, such as an extensive backlog that reduces revenue cyclicality and a large installed product base that generates sustainable aftermarket sales, can be attributed to intangible assets surrounding the regulatory and manufacturing environment for airframes, which constitutes a steep barrier to entry. These barriers to entry have prevented all but two global companies, Airbus and Boeing, from entering the aircraft manufacturing market. We think the most important sources of intangible assets in airframe manufacturing are the stiff regulatory burdens imposed on manufacturers and the long, complex, and capital-intensive product cycles.

Civil aviation authorities have arduous requirements for new aircraft certifications, involving a thorough review of proposed designs, flight tests, and an evaluation of the aircraft’s maintenance procedures. The FAA estimates that this process can take five to nine years for a new aircraft. Incumbents have several advantages with regard to regulation. Existing manufacturers have a substantial amount of specialized knowledge on the regulatory process that would be costly to replicate; the 2019 Joint Authorities Technical Review report on the Boeing 737 MAX estimates that Boeing has 1,500 people on staff working to ensure that the company complies with the regulatory process and that the FAA delegates a substantial portion of the compliance process to Boeing. While controversies surrounding the fatal accidents that caused global regulators to ground the 737 MAX may challenge some of Boeing’s authority on the matter, we believe that the continued cost-efficiency of certification delegation will allow Boeing to retain an advantaged position within the regulatory framework.

Also, Boeing has a large array of existing aircraft certified for flight; the FAA’s regulatory framework allows for an expedited certification for derivative aircraft and estimates that this requires only three to five years to complete. In addition, the most likely contenders to enter the market, COMAC and UAC, are Chinese and Russian companies, respectively. The FAA does not have reciprocal acceptance of aircraft design approval with these nations, so we anticipate material frictions in the international approval process. Indeed, COMAC’s regional jet, the ARJ-21, has been in service in China since 2016 but is still not certified by the FAA or its European counterpart.

The long, expensive, and capital-intensive process of designing and manufacturing an aircraft is a second major barrier to entry in commercial aviation manufacturing. Aircraft design takes years, and many would-be competitors have faced development cost overruns and extended development cycles. It is quite difficult and expensive to replicate Boeing’s 13,000-company supply chain, build a skilled workforce, and develop the knowledge base required to properly assemble an airframe. Firm data on the exact cost of developing an aircraft program is rare, but there have been notable examples of well-capitalized competitors failing to develop a suitable product on budget. The most prominent was Bombardiers’ C Series, which suffered from chronic delays resulting from issues with suppliers that extended development for years and program cost overruns that caused the company to take a quarterly charge in 2015 that was roughly Bombardier’s market capitalization at the time. Further, the government of Quebec, Bombardier’s native province, took a stake in the program to protect the company’s workforce. Even after governmental support, Bombardier was unable to secure crucial U.S. customers without deep discounts and gave control of the program to Airbus following a subsequent trade dispute. Other aspiring competitors such as COMAC and UAC have faced similar problems over their development cycle and have thus far generally failed to secure orders outside their home countries. This illustrates the key problem with breaking into aircraft manufacturing: If a competitor goes through the arduous process of developing an aircraft, potential customers face massive switching costs and are thus quite conservative in their purchasing habits.

Massive Switching Costs Switching costs for airlines are predicated on the high cost of switching, conservative customer purchasing habits, and a lack of viable alternative suppliers. Pilots and crew must be certified for each family of aircraft that they fly; retraining large blocks of pilots would be costly and time-consuming. Further, many pilots in the developed world are unionized, which would probably complicate the matter. Airlines hold a sizable inventory of spare parts for aircraft, which would need to be liquidated and repurchased for the comparable aircraft, a process that would require time and potentially a discount for liquidity. Maintenance procedures are also designed for each aircraft product.

While exact customer terms are opaque, there are several tangible ways of estimating switching costs. One example is low-cost carriers. Since the savings from consolidating processes onto a single aircraft are so significant, many low-cost carriers, such as Southwest, Ryanair, and Spirit Airlines, base their entire fleet on a single aircraft family. We used data from the Bureau of Transportation Statistics to estimate the cost savings on a per seat mile basis. This form allows us to examine specific costs per available seat mile by single-aisle and twin-aisle aircraft for each carrier. We found that Southwest, which bases its fleet entirely on Boeing 737s, has saved a fraction of a penny per available narrow-body seat mile in maintenance and pilot training expense from 2014-2018 relative to large U.S. network carriers. Since Southwest has capacity of over a hundred billion available seat miles, our estimated savings per available seat mile add up to the hundreds of millions of dollars. We recognize that there are other factors beyond the choice of aircraft contributing to this efficiency, but we think these savings demonstrate that aircraft consolidation is a viable cost-saving strategy.

A second major factor preventing customers from switching is the long product cycle for aircraft. Airplanes generally have useful lives of about 20-30 years, depending on how they are used, and airlines expect the manufacturer to service the aircraft over the life of the aircraft. Given this long product cycle, airlines tend to be conservative purchasers because they want to be reasonably certain that the manufacturer will be operating and able to service the aircraft over its useful life. Finally, since there are steep barriers to entry and thus only two viable aircraft manufacturers, customers would have difficulty switching even if they wanted to. The backlogs for the most popular narrow-body products at both major aircraft manufacturers are over five years, and the manufacturers actively manage their production to maintain these backlogs. An airline that wanted to switch would need to wait years for a new aircraft or to pay hefty fees to cut in line. Because of these massive switching costs, a potential competitor would have difficulty garnering customers even if it brought a competitive product to market.

Defense Has a Wide Moat Too We believe the defense side of Boeing's business possesses a wide moat based on intangible assets and switching costs. Boeing's intangible assets are deep knowledge of the esoteric contracting rules governing defense contracting and strong relationships with U.S. defense contractors. Military contracting is highly concentrated and regulated, and we do not envision much disruption here. Given the mission-critical nature of these products, customers tend to be conservative purchasers.

Boeing’s long-standing relationships should not be underestimated; the company has been a primary manufacturer of presidential aircraft since Franklin D. Roosevelt’s administration, which we think demonstrates the immense trust by the government. And given that Boeing employs people and supports suppliers in all 50 states and has spent at least $10 million a year lobbying since 2007, according to the Senate Lobbying Disclosure Act database, we believe the company has developed lasting relationships with congresspeople.

On the switching cost side, Boeing benefits from a large installed base of product and conservative customer purchasing tendencies. Just under half of Boeing’s $16 billion in annual servicing revenue comes from governments, and much of this is earned from the military, which demonstrates the size of the current installed product base. The government would need to update its fleet considerably to unseat Boeing, and we see no pressing reason for it to do so. The U.S. Department of Defense typically funds much of the nonrecurring costs on major programs, so it would take a long time before a new competitor could be built from the ground up.