Thursday, October 27, 2016

As Airlines Throttle Back On Wide-Body Orders, Investors Face Choice On Boeing And Airbus

Combined they have an order book filled with 10,000-undelivered airplanes worth something in the neighborhood of $1.5 trillion – yes, you read that right, ‘trillion” with a “t,” not “billion.”

That’s a very nice neighborhood.

So why are some analysts and investors turning sour on Boeing and Airbus, the duopoly with near-total control over the global market for commercial aircraft?

The easy answer is that they – and we all – have become spoiled by Airbus’ and Boeing’s outrageously large sales performance in recent years. And the recent sales slow-down should have been – but wasn’t – anticipated by analysts and investors who follow this chronically cyclical industry. Still, Boeing and Airbus are doing just fine by all historical measures.

But the more nuanced answer is that there’s been a big drop in sales of their biggest – and most profitable – wide-body planes, and the global slowdown in economic activity that’s behind the wide-body sales slowdown could be an indicator of much tougher times still ahead.

Pick which view you want to believe – and act upon it. Plenty of supposedly sophisticated and expert analysts and investors can be found on both sides of the argument – with more than a few others still trying to decide which way to bet.

Boeing shares shot up nearly 4.7 percent Wednesday after the company announced an unexpectedly large $2.28 billion third quarter profit. Clearly many investors were happily surprised. But the company’s revenue actually fell 7.5 percent in the quarter, to $23.9 billion, giving the bears a bit of confirmation that their worries are not misplaced.

Surprisingly, Airbus shares were up Wednesday, though “only” by 3.8 percent, to the dollar-equivalent of $60.43 after the company reported an 87 percent year-over-year drop in its third quarter earnings. In dollars, the European company showed a profit of about $54.5 million in the quarter, down from $797.3 billion a year earlier. Analysts attributed the big stock price increase to Airbus CEO Tom Enders’ declaration that the company will ship 670 total jetliners this year, at least 20 more than previously disclosed.

To reach that goal Airbus will have to deliver an unusually large number of planes in the fourth quarter to make up for delivery shortfalls earlier this year. Those shortfalls have been attributed to the delays in getting interior fixtures for A350s and A320neo narrow-body jets, but Enders indicated confidence that the company will catch up in the fourth quarter. Doing that would quickly erase a temporary but large hole in the company’s cash position. That’s because airplanes makers don’t recognize purchase payments until their planes are delivered to customers.

But the heart of the Boeing/Airbus story has little to do with the third quarter financial reports and production announcements issued Wednesday.

The real issue is that global demand for wide-body jets is sagging, even with Thursday morning’s news of a UPS order for 14 Boeing 747-8 cargo planes. That slowdown in demand important because those big planes are Boeing’s and Airbus’s primary profit drivers. Though each sells far more narrow-body planes than wide-bodies, intense competition between them keeps profit margins slim on narrow-body planes. Selling the big planes is where the big money is for both companies.

Boeing’s goal, for example, is to boost its corporate profit margin from around 10 percent today to around 15 percent by 2019. The only way it can get there is to sell more 777s and 787s, lots more. But the pace of orders for those big planes is slowing. It has sold only 17 777s this year. And its production line, currently cranking 100 777s a year, already is set to be dialed back to just 66 in 2018, and could be further reduced to 42 in 2018 if Boeing fails land another 40 to 50 more very soon. Similarly, plans to up the production rate of the 787 could fall through if a couple of big deals the company currently is working on go south.

UPS’ order for additional 747-8s could keep the dwindling production line for that famous but aged design going a couple more years. Currently Boeing is making just one 747 a month, and even at that low rate it was widely anticipated that production will peter out sometime in 2017 or 2018. Now the UPS order could become he bridge Boeing needs to keep its 747 production line in Everett, Wash., going long enough to win the expected Air Force contract for two new special-purpose 747s that will replace the two 25-year-old 747s that now serve as Air Force One. But after that, 747 production likely will end.

Airbus faces a similar drop in demand for its big, highly profitable wide-bodies (note: its gargantuan A380, which even its best customers have determined to be too big to ever produce profits for them, is all-but un-sellable anymore will never turn a profit for Airbus). The slackening demand for wide-bodies happens to coincide with a time when Airbus is not taking in much cash from the delivery of its new A350. Because of it supply chain issues, Airbus has shipped less than half of those it had planned to ship by this point. And that has created a cash flow short-fall and undermines airlines’ confidence in the plane.

Such production short falls are common early on in the life cycle of brand-new models like the A350. But coming now, as Asian carriers that had driven the airplane buying boom of the last six years are scaling back their ambitions, it has created a painful, albeit temporary, cash problem for Airbus.

Of course, the drop in demand should have been predictable. Since the very early days of commercial aviation there’s been a saying that “airlines order planes when times are great and manufacturers deliver them when times are bad.” That’s because commercial aviation is a chronically cyclical business, subject to the big swings in national, regional and, increasingly, global economies. By the time airlines clean up their balance sheets enough to place lots of airplane orders, travel demand typically is at its pea.

By the time the manufacturers can start delivering those ordered planes, the travel demand and economic cycles are waning. Typically that leads to the cancellation or re-scheduling of the delivery of a third of so of the planes ordered during buying spree.

Boeing and Airbus both have seen much tougher times than they’re currently experiencing as airlines’ throttle back on their demand for new planes, especially big ones. But it’s clear that the party that’s been going on in the airplane-making business the last six years is winding down.

(Dan Reed - Forbes)

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