Answer the following 3 questions after reading the text below.

Case# 17

1. Would the project compensate the shareholders of Boeing for the risks and use of their capital?

2. Were there other considerations that might mitigate the economic analysis? For instance, to what extent might organizational and strategic considerations influence the board?

3. If Boeing did not undertake the 7E7, would it be conceding leadership of the commercial-aircraft business to Airbus?

The Boeing 7E7

We still have a lot to get done as we move toward authority to offer the 7E7 to our customers. The team is making great progressunderstanding what our customer wants, developing an airplane that meets their needs, and defining a case that will demonstrate the value of the program.

Michael Bair, Boeing Senior Vice President1

In early 2003, Boeing announced plans to design and sell a new, super-efficient jet dubbed the 7E7, subsequently called the Dreamliner. However, news over the next six months depressed the market for aircrafts, which were already in sharp con- traction. The United States went to war against Iraq, spasms of global terrorism offered shocking headlines, and a deadly illness called SARS resulted in global travel warnings. For those and other reasons, airline profits were the worst seen in a generation. This seemed like an incredible environment in which to launch a major new airframe project. Nevertheless, on June 16, 2003, at the prestigious Paris Air Show, Michael Bair, the leader of the 7E7 project, announced that Boeing was making excellent progress on the development of the 7E7 and continues to be on track to seek authority to offer the airplane.2 In order to proceed with the project, Bair sought a firm commitment from Boeings board of directors in early 2004. If the board approved the plan, he could start collecting orders from airlines and expect passengers to start flying on the new jets in 2008. Between now and his recommendation to the board, he would need to complete a valuation of the 7E7 project and gain the support of Boeings CEO, Philip Condit, and the other senior man- agers. Would the financial analysis show that this project would be profitable for Boeings shareholders?

Origins of the 7E7 Project

Boeing had not introduced a new commercial aircraft since it rolled out the highly successful 777 in 1994. Later in the 1990s, however, Boeing announced and then can- celled two new commercial-aircraft programs. The most prominent of those was the Sonic Cruiser, which promised to fly 15% to 20% faster than any commercial air- craft and bragged of a sleek and futuristic design. Unfortunately, after two years of developing the Sonic Cruiser, Boeings potential customers were sending the message that passengers were not willing to pay a premium price for a faster ride. Boeing was now long overdue to develop a product that would pull it out of its financial slump, as well as help it regain the commercial-aircraft sales that the company had lost over the years to Airbus, its chief rival.

With the 7E7, an Airbus executive argued that Boeing seemed to be promising a salespersons dream and engineers nightmare.3 The 7E7, while carrying between 200 and 250 passengers, would be capable of both short, domestic flights as well as long, international hauls. It would use 20% less fuel than existing planes of its projected size and be 10% cheaper to operate than Airbuss A330-200. At a time when major airlines were struggling to turn a profit, less fuel, cheaper operating costs, and long or short distance flexibility would be a very attractive package at the right price.

Skeptics of the 7E7 were not in short supply and suggested that the name Dreamliner was appropriate. To make the plane more fuel efficient, the 7E7 would be the first commercial aircraft built primarily with carbon-reinforced material, which was both stronger and lighter than the traditional aluminum. In addition, Boeing promised greater fuel efficiency by using a more efficient engine. Boeing claimed that the use of composites would also reduce its manufacturing costs. The goal would be to design a plane with fewer components that could be assembled in 3 days as opposed to the cur- rent 20 days that it took to rivet together the Boeing 767. The use of composite materials, however, had its risks. Composite materials were suspected as a contributory cause to a 2001 plane crash in New York and, therefore, would have to overcome regulatory scrutiny. Boeing would also have to change its production methods radically. The last time Boeing made a major production change was in 1997 in an effort to cut costs. However, because the process was not smooth, it resulted in two production lines being shut down for 30 days and hundreds of missed airline deliveries.

The ability to produce a short and long distance aircraft would also have to over- come engineering obstructions. Analysts argued that building a plane that would do short hops in Asia and long trans-Atlantic flights would require two versions of the plane with different wingspans.4 Boeing engineers considered the possibility of snap on wing extensions. The question was whether this would be too costly, as well as being technically feasible.

Finally, there was the matter of Boeings board. Two of the most powerful members of the 11-person board, Harry Stonecipher and John McDonnell, were rumored to have raised serious concerns regarding the cost of the 7E7. While the cost of developing the 7E7 project could be as high as $10 billion, there was an imminent veto threat if that number did not shrink by billions. More specifically the board wanted to keep 7E7 development costs down to only 40% of what it took to develop the 777. An additional pressure from the board was to keep the 7E7 per-copy costs to only 60% of the 777 costs. In response, Philip Condit, Boeings CEO and chair, was quoted as saying that Boeing has a responsibility to develop jetliners for less.5 He knew, however, that if Boeing did not take bold risks in the commercial-aircraft industry that their days as a serious competitor to Airbus were numbered.

Commercial-Aircraft Industry

In 2002, two companies, Boeing and Airbus, dominated the large plane (100 seats) commercial-aircraft industry. While Boeing historically held the lead in this market, through a number of measures Airbus became number one. In 2002, Airbus received 233 commercial orders compared to Boeings 176 orders, representing a 57% unit market share and an estimated 53.5% dollar value market share.6

Airbus Industry

Airbus was understandably proud of its growth. Established in 1970, by a consortium of European companies, it took Airbus 23 years to deliver its first 1000 aircrafts, another six years to deliver the next 1000, and only another three years (by 2002) to pass the 3000 aircraft milestone.7 In 1999, for the first time in its history, Airbus recorded more plane orders than its rival, Boeing.

Airbuss large plane commercial-aircraft products included the A300/310, A320, A330/340, and A380 families. Airbus touted the A300/310 family as having the flexibility to serve short-, medium-, and extended-range routes. The widebody, twin-engine aircraft was considered mid-size, with a typical passenger configuration of about 250 passengers. This family first flew passengers in 1983, and it was this aging fleet that provided a replacement opportunity for Boeings 7E7. However, while Boeing was betting on the future demand for mid-size aircraft, Airbus announced its A380, superjumbo four-engine jet in 2000. The A380 was due to fly in 2006 with a 550-passenger configuration and long distance range of up to 8000 miles. It would be the largest passenger aircraft ever built.

The Boeing Company

Boeing was split into two primary segments: commercial airplanes and integrated defense systems. In 2002, it was awarded $16.6 billion in defense contracts, second

only to Lockheed Martin with $17.0 billion. Exhibit 1 shows that in 2002, each segment earned Boeings revenues almost equally. In addition, while commercial-aircraft revenues had been falling, defense revenues had been rising. Analysts believed that Boeing was able to transfer significant amounts of technology from the defense R&D to the commercial-aircraft segment.

The commercial-aircraft segment produced and sold six main airframes designed to meet the needs of the short- to long-range markets: the 717, 737, and 757 standard- body models and the 747, 767, and 777 wide-body models. As of December 31, 2002, Boeing undelivered units under firm order of 1083 commercial aircraft and had a declining backlog of about $68 billion. For 2003, it projected 280 commercial-aircraft deliveries and expected between 275 and 300 in 2004. Boeing estimated that in 2003, the revenues for its commercial-airplane segment would be approximately $22 billion, down from $28 billion in 2002. Recognizing the negative impact of the September 11th attacks on commercial-aircraft demand, Boeing cut the production rates for 2002 in half in order to maintain profitability in that segment.

Exhibits 2 and 3 show Boeings balance sheet and income statement respectively. While Boeings earnings were down significantly from 2001 to 2002, most of this was the result of an accounting change (SFAS No. 142). However, a drop in commercial- airplane deliveries from 527 in 2001 to 381 in 2002 also contributed to the decline.

Demand for Commercial Aircraft

The long-term outlook for aircraft demand seemed positive.8 Boeings Market Out- look said the following:

In the short term, air travel is influenced by business cycles, consumer confidence, and exogenous events. Over the long-term, cycles smooth out, and GDP, international trade, lower fares, and network service improvements become paramount. During the next 20 years, economies will grow annually by 3.2%, and air travel will continue its historic relationship with GDP by growing at an average annual rate of 5.1%.

As shown in Exhibit 4, Boeings 20-year forecast from 2003 to 2022, was for 24,276 new commercial aircraft in 2002, valued at $1.9 trillion. The company predicted a composition of 4,303 smaller regional jets (fewer than 90 seats); 13,647 single-aisle airplanes; 5,437 intermediate twin-aisle airplanes; and 889 747-size or larger airplanes. This prediction reflected a world fleet that would more than double, with one-fourth of the market coming from aircraft replacement and three-fourths from projected passenger and cargo growth.

Exhibit 5 illustrates Airbuss 20-year predictions for the years 20002020. Although the report was dated 2002, because of the September 11 attacks, numbers included the year 2000, to serve as a benchmark year. For that period, Airbus predicted the delivery of 15,887 new commercial aircraft in 2002, with a value of (U.S. dollars) $1.5 trillion. This included 10,201 single-aisle aircraft; 3,842 twin-aisle aircraft; 1,138 very large aircraft, and 706 freighters. The 15,887-unit forecast did not include planes with less than 90 seats.

Although Boeing and Airbuss numbers are not directly comparable due to the slightly different time periods and aircraft classifications, it appeared that Airbus was more optimistic about the market for large aircraft than Boeing was. While Airbus predicted it to be a $270 billion market, including 1138 passenger units, Boeing projected only $214 billion with 653 passenger units. Boeing, however, estimated that the share of intermediate-size planes would increase from 18% to 22%. In its fore- cast, Boeing acknowledged that intermediate-size airplanes would economically allow airlines to fly the increased frequencies, city pairs, and nonstop flights requested by passengers. According to a recent study by Frost & Sullivan, they believed that the Airbus market projection for the A380 was over-optimistic.9

Aircraft Development and Lifecycle

The development of a new airframe was characterized by huge initial cash outflows that might require between one and two decades to recoup. For example, the development costs for the Boeing 777 were rumored to be $7 billion. Any pricing would not only have to recoup the upfront development costs but also the production costs. In addition, pricing would be subject to rigorous, competitive pressures. In short, because of the financial strains a new product line might create, each new aircraft was a bet the ranch proposition. Over time, survival in the industry depended on introducing successful products and having the deep financial pockets with which to survive the initially gushing cash flow.

While aircraft sales were subject to short-term, cyclical deviations, there was some degree of predictability in sales. Sales would typically peak shortly after the introduction of the new aircraft, and then fall. Thereafter, sales would rise and fall as derivatives of the aircraft were offered. Exhibit 6 shows the cycles for the first 20 years of the 757 and 767 sales.

The 7E7

The concept of the Boeing 7E7 was driven by customer requirements. Boeing originally announced in March 2001, its plans to build the Sonic Cruiser, a plane that would fly just below the speed of sound. The success of the Cruiser depended on whether passengers would pay a premium for a faster flight. However, potential airplane customers who had been interested in the Cruiser during a robust, commercial-air travel market were now focusing on survival. The events of September 11 and the bursting of the technology bubble led to a significant decline in airplane orders. As a result, Boeing solicited updated feedback from a number of potential customers who would soon need

to replace their aging fleet of mid-range planes, such as the 757s, 767s, A300s, A310s, A321s, and A330s. Overwhelmingly, the revised message from customers was for a plane with lower operating costs.

Based on discussions with over 40 airlines throughout the world, Bair identified a fresh market to replace mid-size planes, based not only on lower operating costs, but also on the creation of a mid-size plane that could travel long distances, a feat previously viable by only large planes, such as the 747. Such flexibility would allow airlines to offer nonstop service on routes that required long-range planes but did not justify the subsequent larger size. Bair estimated there to be more than 400 city pairs (e.g., AtlantaAthens) that could be served efficiently on a nonstop basis by the 7E7.

Boeing was considering two new members for the 7E7 family, a basic and a stretch version. Exhibit 7 gives Boeings description of the two configurations. Other improvements for passengers included wider aisles, lower cabin altitude, and increased cabin humidity. In addition, the planes would include systems that provided in-flight entertainment, Internet access, real-time airplane systems and structure health monitoring, and crew connectivity. Furthermore, Boeing claimed the 7E7 would have the smallest sound footprint with the quietest takeoff and landing in its class.

Boeing projected a demand for between 2000 and 3000 planes of the 7E7 type within 20 years of each one entering service. A study by Frost & Sullivan predicted the sale of at least 2000 B7E7s.10 However, the demand was highly dependent on whether Boeing could deliver the promised 20% cheaper fuel costs and the range flexibility in a mid-size aircraft. Furthermore, if the range flexibility did require snap-on wings, such a design may significantly increase the building costs of the aircraft. Not only did Boeing face the engineering uncertainty of being able to deliver such an air- craft, but also the risk of its duplication by Airbus. Airbus had already stated that if the fuel efficiency was primarily generated by new engine designs, then it would sim- ply order the more efficient engines for its planes. Any uncertainty in the 7E7 plane specifications and risk of competition clearly put downward pressure on both the price Boeing could demand, as well as the number of units it would be able to sell.

Financial Forecast and Analysis

Exhibit 8 contains a 20-year forecast of free cash flows from the Boeing 7E7 project consistent with public information released by Boeing, Airbus, analysts, and other experts in the field. See the Appendix for detailed forecast assumptions. The primary implication of the forecast is that the 7E7 project would provide an internal rate of return (IRR) close to 16%. This assumes that Boeing would not only deliver the promised plane specifications, but that Airbus would be unable to replicate the 7E7 efficiencies.

Based on both analysts and Boeings expectations, the base case assumes that Boeing could sell 2500 units in the first 20 years of delivery. Pricing was estimated using 2002 prices for Boeings 777 and 767. The 7E7 would be a hybrid of the two planes in terms of the number of passengers and range. By interpolating between the 777 and 767 prices, it was possible to estimate the value placed on the range and number of passengers. Using this methodology, without any premium for the prom- ised lower operating costs, the minimum price for the 7E7 and 7E7 Stretch was esti- mated to be $114.5 million and $144.5 million, respectively, in 2002. The forecast assumed that customers would be willing to pay a 5% price premium for the lower operating costs.

The IRR, which is consistent with base case assumptions, was 15.7%. But, the estimate of IRR was sensitive to variations in different assumptions. In particular, some obvious uncertainties would be the number of units that Boeing would be able to sell and at what price. For example, if Boeing only sold 1,500 units in the first 20 years, then, as shown in Exhibit 9, the IRR would drop to 11%. This might occur if air travel demand worsened, or if Airbus entered this segment with a new compet- ing product.

Additional unknown variables were the development costs and the per-copy costs to build the 7E7. Boeings board was anxious to minimize those costs. The forecast assumes $8 billion for development costs; however, analyst estimates were in the $6 billion to $10 billion range. The cost to manufacture the 7E7 was also subject to great uncertainty. On the one hand, engineers were challenged to build a mid-size air- craft with long-range capabilities. The engineering design to achieve this could push building costs up significantly. Conversely, if Boeing succeeded in using composite materials, which required a fraction of the normal assembly time, then construction costs would be lower. Consistent with Boeings history, the base case assumes 80% as the percentage of cost of goods sold to sales. As shown in Exhibit 9, however, the IRR of the 7E7 was very sensitive to keeping production costs low.

Cost of Capital

Boeings weighted-average cost of capital (WACC) could be estimated using the following well-known formula:

*See first photo for formula*

Exhibit 10 gives information about betas and debt/equity ratios for Boeing and comparable companies. Exhibit 11 provides data about Boeings outstanding debt issues. While Boeings marginal effective tax rate had been smaller in the past, it currently was expected to be 35%. In June 2003, the yield on the three-month U.S. Treasury bill was 0.85%, and the yield on the 30-year Treasury bond was 4.56%. On June 16, 2003, Boeings stock price closed at $36.41.

Analysts pointed out that Boeing actually consisted of two separate businesses: the relatively more stable defense business and the conversely more volatile com- mercial business. Defense corporations were the beneficiaries when the world became unstable due to the terrorist attacks on September 11, 2001. Furthermore, the United States, along with some of its allies, went to war against Iraq on March 20, 2003. While Bush declared an end to major Iraqi combat operations on May 1, 2003, as of June 16, the death toll in Iraq continued to rise on a daily basis. A different type of risk emanated with the outbreak of SARS. On February 1, 2003, China announced the discovery of the deadly and contagious illness that subsequently spread to Canada and Australia. As of June 16, travel warnings were still outstanding. Thus, the question arose of whether one should estimate Boeings cost of capital to serve as a benchmark- required rate of return. Would a required return on a portfolio of those two businesses be appropriate for evaluating the 7E7 project? If necessary, how might it be possible to isolate a required return for commercial aircraft?

Conclusion

Within the aircraft-manufacturing industry, the magnitude of risk posed by the launch- ing of a major new aircraft was accepted as a matter of course. With huge, upfront, capital costs in an environment of intense technology and price competition, there was no guarantee of success or major significant losses if the gamble did not pay off. At a time of great political and economic uncertainty, Michael Bair said:

Clearly, we have to make a compelling business proposition. It could be [that] well still be in a terrible business climate in 2004. But you cant let whats happening today cause you to make bad decisions for this very long business cycle. This plane is very important to our future.1 1

Central to any recommendation that Bair would make to Boeings board of directors was an assessment of the economic profitability of the 7E7 project. Would the project compensate the shareholders of Boeing for the risks and use of their capital? Were there other considerations that might mitigate the economic analysis? For instance, to what extent might organizational and strategic considerations influence the board? If Boeing did not undertake the 7E7, would it be conceding leadership of the commercial-aircraft business to Airbus?