Up in the air

It is taking a more nuanced approach with Brazilian aerospace conglomerate Embraer (US:ERJ) – the world’s third-largest producer of commercial aircraft – with which it expects to sign a joint-venture deal later this year. Other would-be challengers are simply out of the frame. Lockheed, once a rival commercial airplane manufacturer, now focuses on military aircraft and spacecraft as Lockheed Martin (US:LMT). For now, there is only one aerospace outfit that is capable of taking on the big Chicago-based bruiser.

Airbus (Fra:AIR) could hardly have had a more different start to life than its great rival. Where Boeing is a symbol of American privateer genius, Airbus is the fruit of state-driven, pan-European co-operation. Founded in France in 1970 as Airbus Industrie (and renamed as Airbus in 2001), the world’s second-largest aerospace and defence company was a consolidation of France’s Aerospatiale and Germany’s Deutsche Airbus, bound together by European governments in a bid to take on American prowess. The initiative worked. In 2018, Airbus delivered 800 commercial aircraft, against Boeing’s 806. To put this duopoly’s domination into perspective, Embraer delivered just 90 commercial jets last year.

For now, Boeing and Airbus appear comfortably dominant, with 99 per cent of the large commercial airplane market between them. Aerospace carries a number of unique characteristics. New products are rare, and order backlogs are deliberately long. The barriers to entry to this market are almost insurmountable. But the prize means challengers will keep coming. Chinese manufacturer Comac, which is supported by an unusually high number of (state airline) orders given its recent arrival on the scene, poses a novel threat, while the Russian government is also bidding to revive its aircraft production. This industry could soon descend from duopoly into dogfight.

The global drive to improve the sustainability credentials of business represents a more immediate shake-up to the aviation industry. Travellers are growing ever more conscious of their carbon footprint. The jumbo jet era is coming to a close. Planes are getting smaller. Electric planes are being trialled. These developments pose threats and offer opportunities to the duopoly, the mini-global economy which relies on them, and their investors.

Flight testing

Given its structure, it’s tempting to view the global aviation business through the lens of geopolitics and national industrial policy. But as with every market, customers matter.

Boeing “does what it says on the tin”, a pilot with over 30 years’ experience, who asked to remain anonymous, told us. Having served as both a military and commercial pilot, he witnessed the shift from analogue to automatic flight. The emergence of the so-called ‘glass cockpit’ – characterised by screens instead of manual controls – changed the pilot’s role; now, it is more about “monitoring” than manoeuvring the aircraft, he says. 

In automatic flight, the aircraft tells the pilot what it is doing. It is vital that this is understood, so that it can be overridden if necessary. For this pilot, Boeing is more logical than Airbus – “it looks after you,” he says. Yet such assessments are subjective. Another pilot who has been in the industry for decades finds Airbus jets easier to operate, despite enjoying the Boeing experience more. To him, “a Boeing is a manual airplane that you can attach automatics to, and an Airbus is an automatic airplane that, if you really want to, you can fly manually”. 

Which is easier to operate is up for debate, but both agree that there is less automation and more pilot discretion in a Boeing cockpit.

How’s Boeing doing?

Currently Boeing has a huge problem on its hands, following the grounding of almost 500 Boeing 737 Max planes around the world in the wake of two fatal crashes involving the model. Below we report on the impact of the 737 Max disaster in more detail, but first let’s look at how Boeing has been performing. Last year it generated record revenues of $101bn, an increase of 8 per cent on 2017, with earnings from operations up 16 per cent to nearly $12bn. Earnings per share of $16.01 represented an increase of nearly a third on the prior year. It delivered a record 806 commercial airplanes and won net orders for 893 more, raising the company’s total order backlog to almost 5,900 planes, equal to around seven years’ output. The defence, space and security division also performed well, with $36bn added to the backlog of orders now totalling $57bn, a third of which came from international customers. Aftermarket services have seen annual revenue growth of around 17 per cent. Shareholder returns are keeping pace. Having committed to return 100 per cent of free cash flow to shareholders via share buybacks and dividends, in December the group raised its quarterly dividend by 20 per cent and unveiled a $20bn share repurchase programme. 

Boeing also remains on course with its drive to in-source production. Its radical Boeing 787 supply chain, which was rolled out in the 2000s, became a “symbol for global outsourcing” in the view of Peter Atwater, adjunct lecturer of economics at William & Mary University. Instead of a conventional manufacturer-supplier relationship (as seen with the 737), for the 787 Boeing employed a tiered structure that focused on building relationships with around 50 strategic partners. That strategy is now in reverse. For example, last year, the group began making airplane seating, in a tie-up with automotive specialist Adient. Other examples of insourcing include auxiliary power units and a Sheffield facility that produces actuation systems, which are responsible for extending and retracting a wing’s flaps during flight.

“There was this incredible belief that by outsourcing there were extraordinary benefits in terms of inventory control, pricing and sourcing,” Mr Atwater says. “What you’re seeing now in response is the backlash to that.” There is more scrutiny today on the origins and testing of products, reflected in concerns over “mission-critical technology” on the Max, according to Mr Atwater.

Mad Max

The Max disaster is taking its toll on Boeing’s current financial year. The group took a $5.6bn hit during the first half, which contributed to a decline in revenue of nearly a fifth to $38.7bn and a loss from operations of $1.93bn. An operating cash outflow of $0.6bn was reported during the second quarter, although $1.2bn-worth of dividends were still paid. Boeing delivered less than half the number of planes in the second quarter than it did during the same period the prior year, with a 37 per cent decline to 239 planes delivered and a 38 per cent decline in sales to $16.5bn. Ahead of the announcement, management had indicated a return to service for the Max sometime in the fourth quarter, but analysts at JPMorgan emphasised this is merely an estimate and that downward production risk will not disappear until there is a well-defined path back to service. There is also a possibility that Boeing could shut down the Max line entirely. 

Boeing paid $4.9bn in compensation to affected airlines in the second quarter of its 2019 financial year alone, and this could grow exponentially if a solution to the grounding is not found. The longer it misses scheduled deliveries, coupled with compensation to those airlines that have to find alternative planes over the summer to continue to operate scheduled routes, the more these costs will “snowball”, according to a city analyst, with an end cost that will be “astronomical”. Boeing is also not getting paid for these deliveries, doubling the financial hit. 

Out of the three UK-listed airlines that currently fly or have orders scheduled for delivery for the Max, none have put an exact figure on the amount of compensation they are due. Tui (TUI) says it is in contact with Boeing, although a spokesperson declined to comment on the issue publicly. International Consolidated Airlines (IAG), owner of airlines including British Airways and Iberia, does not currently fly any Max aircraft, and so is not due any compensation. Ryanair (RYA), which was due to receive its first five of 53 ordered Max planes this summer, has not stated how much compensation it is owed. 

The impact of regulation

Boeing may not be entirely in the clear after its planes are approved to resume flying. Pilots who were already flying an earlier version of the 737 model completed 22 or more days of instructor-led academics and simulator training. Those trained to fly the Max variations undertook around three hours’ more education, with computer-based training and a manual review. Once the Max returns, regulators may now require those pilots to be trained in a simulator of the aircraft, according to one analyst. The problem is that few of these simulators exist, although Ryanair would be well-placed for training, as it already has two with another three set for delivery in 2020 and 2021. Boeing’s customers ordered the planes in the belief they would not require pilots to be trained on a simulator, which could add to Boeing’s growing compensation burden.

Environmental regulation may also prove challenging. In 2016, 192 member countries of the International Civil Aviation Organisation (ICAO) Assembly adopted a resolution on the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) to improve fuel efficiency and reduce CO2 emissions. Analysts at Jefferies have noted a change in tone among both airlines and suppliers with regards to the environment. At the Lufthansa annual general meeting in May, its chairman Carsten Spohr said the €10 tickets offered by some of its competitors were “economically, ecologically and politically irresponsible”. Ryanair is best-known for this low-cost approach, yet now calls itself “Europe’s greenest airline” after it began publishing CO2 emissions statistics. The budget airline claims it’s the first to do so, and is aiming to reduce pollution to under 60 grams per passenger kilometre by 2030.

Reputation, reputation

Compensation costs regarding the Max continue to build, but at least one analyst believes Boeing would never consider shutting down the Max entirely, despite the financial hit, due to the reputational risk if it doesn’t get the model safe and flying again. The Max crisis has already begun to negatively impact Boeing’s other airplane models. Engineers have been taken off other projects and put on the Max. A Boeing spokesperson said that “we have ensured that the [Max] program has the resources it needs, however we continue to support all company projects with appropriate staffing levels”.

It was rumoured that Boeing would launch a new, smaller model of the plane at this year’s Paris Air Show, but this didn’t happen. Many airlines already do not accept the first batch of a new model of aircraft while other operators work out the kinks, and so the Max issues could compound this problem. Airlines may be frustrated with the timing of the Max return. If the airlines have limited time to sell seats on the routes that depend on the return of the planes, then this could weigh on ticket prices, especially as the first quarter of the calendar year tends to be a slower time for holiday bookings. 

At this year’s Paris Air Show in June, IAG surprised attendees with the letter of intent to buy 200 Max aircraft in a deal said to be worth around $24bn, with delivery scheduled between 2023 and 2027. A letter of intent can be cancelled at any time, making IAG’s commitment to the order non-binding, leading some to speculate that the benefit of the deal is that it provides Boeing with a vote of confidence, and IAG with a good deal not only on the Max, but also on other Boeing models. 

Teal Group analyst Richard Aboulafia does not foresee a long-term impact on orders from the Max debacle, arguing that airlines’ priorities will always be “requirements and price”. IAG’s letter of intent is testament to this. The deal – securing likely discounts, according to Aboulafia – is expected to be formalised after the summer.

Some suppliers are also beginning to register the impact of the lower Max production rate. Senior (SNR), which makes airframe and engine components for the plane, reported a 150 basis point margin decline at its half-year results against the prior year period – it partly attributed this to the Max. Meggitt (MGGT), which makes seals and composites for the plane, had expected “much greater levels” of spare parts for the Max at the start of the year, but these have been deferred since the grounding. While BAE Systems (BA.) makes flight control systems for the jet, its exposure to the plane as a proportion of its overall activities is minimal. GKN Aerospace, owned by Melrose Industries (MRO), makes winglets, engine lip skins and wiring for the Max. But it only receives around $400,000 for every plane that GKN supports as part of the whole 737 programme, which goes beyond the Max. In contrast, the subsidiary makes $4m per shipset it supplies for the Boeing 787.

How will this impact innovation?

It’s worth considering the extent to which Boeing’s troubles could disrupt its innovation. In January 2019, Boeing’s autonomous passenger air vehicle (PAV) prototype, the Boeing NeXt, completed a controlled takeoff, hover and landing during its first flight test. The aircraft was developed in conjunction with its subsidiary Aurora Flight Sciences, which it acquired in 2017. Acquisitions represent an efficient way for Boeing to tap into innovation trends and push its technologies forward, rather than building everything from the ground up. With electric planes on the horizon, it’s not inconceivable that more businesses could be added to the group in the race to bring the first electric-powered commercial jet to market.

But the current climate may affect aerospace manufacturers’ abilities to innovate. Peter Atwater of William & Mary University has witnessed a mood shift towards the industry from around the end of 2017, when there were grand expectations over demand for Boeing and Airbus aircraft. “There was this sense that everything that could go right, was going to go right,” he says. This overconfidence has since rushed out of the aviation industry, in his view. There are growing headwinds to travel. Consumers are growing more concerned about their carbon footprint. 

These factors could feed into hampering technological development in aerospace. When confidence rises, “new technologies, new world-solving problems become the focus of companies”, Mr Atwater says. “As confidence it falls, it’s all about fixing the problems that they have. So innovation in the aircraft space is likely to go through a considerable decline,” he predicts. 

The carbon footprint problem 

The ICAO already has an online tool that allows environmentally-conscious travellers to see estimated emissions given their journey. The calculation considers the frequency of departure of each equivalent aircraft type that flies the given route, then divides this by the number of economy class passengers to give an average fuel burn per passenger, then is multiplied by 3.16 to find the CO2 footprint per passenger. The tool does not yet allow the user to adjust for which aircraft they will be flying on, but analysts at Jefferies wonder whether customers might favour one flight over another based on their carbon footprint. If customers begin to choose their flights based on the environmental impact of comparable options, then traditional airline yield management systems would then push up the price of that flight. This could potentially make the flight with the higher emissions cheaper, and therefore more tempting. Although, if customers had to pay to offset some of the emissions generated from their flight, then this could balancethe incentives.

Airbus 

The Airbus cockpit is a clean and logical place to be, according to a pilot who currently flies the Airbus A320 and has prior experience in the Boeing 737.

“Not much has changed” in cockpit design since it was conceived, he says, which helps pilots transition between aircraft. He echoes the view that the differences between Boeing and Airbus lie in their use of automation. For example, Airbus employs a ‘dark cockpit’ concept. If a light comes on, a particular button or switch requires the pilot’s attention, “whereas with the Boeing, a light can mean many, many things,” he says. 

“The Airbus is basically automation-galore,” he adds, lauding it as a more ergonomically-designed “pilot’s aircraft”.

Is Airbus ahead?

While Boeing remedies its issues, Airbus would seem to be powering ahead. It has already profited in a small way from the Max grounding. In summer, low-cost Saudi airline flyadeal cancelled its $5.9bn order for 30 Boeing Max jets, which had an option for 20 more. flyadeal went on to agree an identical order with Airbus for its A320 NEO aircraft, with a commitment to “an all-Airbus A320 fleet in the future”.

Airbus has had a good start to its 2019 financial year. The group beat earnings before interest and taxation (Ebit) consensus expectations for its first half by 9 per cent, with its A320 and A350 programmes making strong year-on-year gains in the second quarter. But Airbus has encountered issues in ramping up its production of the A321 jet, owing to its complexity in assembly, now accounting for 40 per cent of the total A320 family backlog of 5,827 aircraft.

Steve Wright, associate professor of aerospace engineering at the University of West of England, and formerly of Airbus, recognises an intriguing development in the European giant’s relationships with its suppliers. “If you want to sell your aircraft to a given country, you better put some work the way of that country,” he says. Perhaps with the threat of Comac in mind, Airbus now has an A320 assembly line in China. It also has one on Boeing’s home turf, in the US, along with facilities in France and Germany.

“This is a huge deal,” he remarks. “It’s the absolute opposite of the original raison d’etre of Airbus, which was to create jobs for Europeans... you cannot ignore the political aspects.”

Politics can also play a role in the selection of companies to supply products to plane manufacturers. In Dr Wright’s experience, as a former avionics and aircraft systems consultant with Airbus, suppliers are often chosen for the sake of maintaining a relationship.

Dr Wright recalls being part of an Airbus selection process for landing gear systems, where Airbus had around five bids. “There were the obvious people you would expect, and there were also some smaller players as well, who quite frankly were unlikely to get the job,” he says. The smaller parties would openly admit that their presence was about communicating their abilities to Airbus. Dr Wright likens this to “a hugely long-term ‘Game of Thrones’ being played out”.

Airbus has not shied away from speaking publicly on its suppliers’ activities, should it deem these a threat to its business. In March 2018, Tom Williams, former chief operating officer of Airbus’s commercial aircraft division told the Financial Times that Melrose’s proposed takeover of GKN could collapse their relationship owing to Airbus’s concerns over Melrose’s perceived short-term outlook, which could come at a cost to research and development. But the parties continue to work together, with GKN unveiling demonstrator wing components for Airbus’s ”Wing of tomorrow” research programme at the 2019 Paris Air Show.

Electric avenue

Airbus has been working on developing electric engines since 2010. It has worked in partnership with Rolls-Royce (RR.) and Siemens’ (Ger:SIE) eAircraft outfit eAircraft on the E-Fan X demonstrator project, which plans test flights in 2021. Rolls announced this summer its agreement to acquire eAircraft, a pioneer of electric and hybrid-electric aerospace propulsion, as the engineer bids to play its part in a ‘third era’ of aviation powered by cleaner and quieter aircraft. In May, Airbus signed a hybrid and electric aircraft research agreement with SAS Scandinavian Airlines. Like Boeing, acquisitions and partnerships will surely play a central role in achieving electric flight.

But not everyone is sold on electric planes, and translating this technology into large-scale commercial aviation could remain science fiction for a while. Richard Aboulafia dismissed it as “absurd”, while one commercial pilot who did not wish to be named said that “the problem is weight and power”. The consensus is that electrification will begin with hybrid engines.

Some experts, including Mr Aboulafia, lament that the industry is prioritising efficiency over innovation. Airbus’s investment of €30bn in research and development (R&D) since 2000 suggests otherwise. The approach to R&D has changed. Start-ups are now dominating. Embracing an ‘Open Innovation’ outlook, Airbus works with prospective partners by providing capital, a Silicon Valley hub, and global contacts. Declaring the future of flight “electric, autonomous, and connected”, Airbus is looking ahead.