Building a large commercial jet is an unbelievable undertaking. While jet orders ebb and flow with the health of the global economy, we believe the long-term demand trajectory is up and to the right, and the jet industry’s competitive dynamics will ensure Boeing remains a key player in the market for decades to come. Despite growing fears over the safety of BA’s backlog in light of heightened global economic uncertainty, BA is a strong company for consideration in our Top 20 Dividend Stocks list.
BA is the world’s largest aerospace company and leading manufacturer of commercial airplanes and defense, space and security systems. As the single biggest exporter and the only large commercial jet manufacturer in the United States, BA supports airlines and U.S. and allied government customers in more than 150 countries (non-US customers = 58% of BA’s revenue). Commercial planes accounted for 66% of sales last year and recorded a 10.7% margin. Defense, Space & Security generated the remaining 34% of sales and reported a 10.1% operating margin.
The large commercial aircraft market (planes with at least 150 seats) is a duopoly, with BA and Airbus each capturing close to 50% of orders (Airbus delivered 629 jets in 2014 compared to BA’s 723). We believe it would take decades for a third meaningful player to emerge given the nature of the large aircraft market. The barriers to entry are just too high.
First, the cost to develop, build, and deliver a new large commercial airplane is tremendous. The Boeing 777 and the Airbus A380 each had development costs in excess of $10 billion, and designing an aircraft generally takes eight to 10 years for a new model and around five years for a variant of an existing model. Development plans are notorious for going over budget and experiencing delays. For example, BA’s 777 was originally budgeted at only $2 billion but ended up costing five times that amount, and Airbus’ A380 went about 40% over its initial budget. Most recently, the 787-8, Boeing’s newest model, was delivered in September 2011, following a more than three-year delay. Given the long time horizon and risk of production delays, financing these massive projects is very difficult.
Due to the high costs and lengthy time frame required to produce a new aircraft model, it’s not surprising that BA has only designed eight planes from scratch since it started building jets in 1955 and Airbus has only designed four since 1969. New entrants to the market need billions of dollars and potentially decades of time to create a competitive aircraft model.
Many investors don’t realize the level of capital spending and subsidies Airbus and BA required over multiple decades to become the companies they are today. Airbus received around $25 billion in subsidies from three European national governments in its first 20 years of operation to keep it afloat and give it a chance at competing against BA and McDonnell-Douglas (later acquired by BA in 1997). BA lost money over its first 20 years of operations and was only able to strengthen itself as a leader in aerospace because of the high volume of production during World War II (BA was able to develop its first commercial jet airliner because of the technology and know how it had developed in the construction of military jets). BA and Airbus also benefit from their massive size today by purchasing materials in bulk on favorable terms. China recently launched a company that plans to build large commercial aircraft and presumably has the financial firepower to subsidize it, but it will likely take many years, if not decades, for it to be competitive and gain trust in the marketplace.
With such massive investment required to commercialize a new airplane and generally hundreds of orders needed to achieve profitability, national and regional markets are too small for a company to turn a profit. In other words, a new entrant would need to be able to take its business globally from day one to be financially viable, creating another barrier to entry.
Money and time aren’t the only challenges of entering the large commercial aircraft market. Figuring out how to design a large aircraft and managing the entire production process might be the biggest challenge. Airplanes generally travel hundreds or even thousands of miles per day year-round and need to last at least 25 years without failing. Proper engineering is of utmost importance. We will not pretend to have a clue as to how a properly functioning airplane is created, but we do know that it takes about one year to produce a big plane and each plane contains hundreds of thousands of parts. Each component needs to be designed, manufactured, and brought together into one plane, introducing an extremely complex supply chain and production process to be managed. BA’s manufacturing space alone exceeds 80 million square feet. With many contracts containing fixed prices, a single slip up or delay can cost hundreds of millions of dollars.
Switching costs also play a role in protecting Airbus and BA from new entrants. Flying two different types of planes adds operating costs to an airline, so low-cost carriers often prefer to stick with a single type of plane. Trust is another big factor given the need for airplanes to maintain their functionality for more than 20 years. BA has a proven track record going back more than 50 years and has built a global distribution network that ensures spare parts are always available for delivery.
Finally, government regulations add another layer of complexity to the market. In the US, commercial aircraft products must comply with Federal Aviation Administration regulations governing production and quality systems, airworthiness and installation approvals, and more. Internationally, similar requirements exist for airworthiness, installation and operational approvals. Since most of the industry’s products are exported around the world, manufacturers mostly comply with these regulations on a global basis. Naturally, government contracts in BA’s defense business are heavily regulated as well.
From a growth perspective, we believe the industry’s long-term prospects are very positive but will see occasional bouts of volatility. Essentially, increased trade, globalization, and air traffic rights between countries will continue improving the wealth of developing countries, which are generally under flown today. With passenger air traffic growing 5-6% in recent years, we believe commercial aircraft demand should roughly track that pace of growth over longer periods of time. Over the next 20 years, factoring in new and replacement airplane demand, the total market value could exceed $5 trillion for more than 35,000 new planes. Strong airline industry profitability, driven by the drop in jet fuel prices, also provides a nice buffer of cash for BA’s main customers, further fueling backlog stability and growth.
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