Case Study: Enterprise Risk Management at Boeing

Introduction

Established by William Boeing in 1916, Boeing was the world's largest aerospace and Defense Company with three major business segments: Commercial airplanes, Defense (specializing in military aircraft and missile systems) and Space and Communications. It also had a captive finance company, Boeing Capital Corp ("BCC"). Boeing employed 78,400 people in the Seattle area and was Washington State's largest private employer. At the end of 2001, two-thirds of Boeing's sales were generated in the US. Overseas revenues were generated in Europe (14%), China (3%), Asia excluding China (12%). Boeing's commercial airplanes were sold to airlines all over the world. Despite the severe downturn in demand for commercial jets, this segment still generated roughly half of group revenue and operating profits. The division (59% of revenues, 51% of operating profits and 7.5% profit margins in 2001) made a full line of commercial aircraft, ranging from 100-passenger 717s to giant, 500-seat 747s. Based on recent orders, British Airlines and Airbus each controlled about 50% of the mature, global 100-plus seat passenger jet market.

The worldwide commercial aircraft fleet was expected to grow from 11,300 planes in 2001 to 20,100 planes by year-end 2020, which translated into a compound annual growth rate (CAGR) of 2.9%. Military aircraft and missile systems contributed to over one-third of group sales and operating profits. For this division, the primary customer was the US government. Boeing's military weapons-making segment primarily made the F-18 fighter jets, the C-17 troop and equipment transport planes, helicopters, the AH-64D Apache Longbow, refueling planes, and various precision missiles. The segment was also a major producer of computer-based battle management systems used in missile defense applications. The Space and Communications business generated only modest profits. For this division, the primary customer was again the US government. Boeing was one of the world's largest makers of satellite-carrying rockets and satellites. Both businesses were expected to suffer from industry overcapacity and cut-throat price competition. The Customer and Commercial Financing segment was primarily engaged in the financing of commercial and private aircraft, commercial equipment, and real estate. About 75% and 25% of the segment's revenues were derived from commercial aircraft and non-aerospace leasing and financing activity, respectively. In 2001, total financing/leasing assets jumped to $10.3 billion, up almost 50% from $7.0 billion in 2000. Since the late 1990s, Boeing had been attempting to transform itself from an aerospace manufacturer into a comprehensive aerospace manufacturing and services provider. Over the past decade, volatile yet maturing markets, intensifying competition, and the commoditization of jets, rockets and satellites, had affected the company's profitability. Boeing had attempted to use new equipment sales as a platform for selling high margin, long-term maintenance contracts, to generate more predictable earnings streams and higher returns. Higher margin fixed price production contracts accounted for about 80% of Boeing's defense revenues. Lower margin research & development (R&D) contracts accounted for the balance 20%.

The Commercial Airplanes Business was virtually a duopoly between Boeing and Airbus. It was once dominated by Boeing but was now split roughly 50/50 between the two players. The events of 9/11 combined with the economic slowdown had led to a sharp decline in demand for air travel and prompted US airlines in particular to cut capacity. Whilst demand for air travel had rebounded subsequently, it remained well below FY00 levels. Capacity utilization rates had failed to sustain the recovery seen early in 2002.

Meanwhile, competition remained intense and the US airlines in particular had remained under considerable financial stress, culminating in UAL's (United Airlines) recent filing of chapter-11 protection. Reflecting the above trends, total global jet deliveries were expected to decline from 852 in 2001 to 760 in 2002 and 575/580 in 2003, with Boeing's share expected to be 527, 380 and 275/280 respectively. In the long run, Boeing faced intense competition from Airbus which was aggressively gaining market share. The Airbus A380 super-jumbo which was due to become operational in 1Q06 was in particular a major threat.

The A380 was capable of carrying 555 passengers over long distances and had been heralded by some as the only means of coping with the expected long-term growth in passenger traffic given limited global airport capacity and congested skies. Boeing's plan had been to develop the 747x "sonic cruiser", a faster but smaller long-range rival but this might be scrapped due to weak demand since September 11. Airbus reportedly had 97 orders for its A380. Aircraft programs, particularly new aircraft models such as the 717 program, faced the additional risk of pricing pressures and rising costs inherent in the design and production of complex products. Boeing might also have to provide financing support to airlines, which were unable to obtain other means of financing. The US defense sector was still very competitive although consolidation had resulted in just four prime contractors for defense aerospace systems and electronics; Lockheed Martin, Boeing, Raytheon and Northrop Grumman (which has recently acquired TRW). At a global level, however, the company faced strong competition from major European corporations where consolidation had created a number of formidable competitors such as BAE Systems, EADS (owner of Airbus), Matra BAe Dynamics Alenia (MBDA), Augusta-Westland and Euro copter. Boeing expected launch services to remain highly competitive due to the downturn in demand for non-geo-stationary satellite launches and the human space flight and exploration market. However, it expected solid growth overall through space digital imagery architecture, missile defense, the current Delta IV launch vehicles and the in-progress 737 Airborne Early Warning and Control System programs. The launch services market had some degree of uncertainty since demand depended on the launch customers' access to capital markets. Moreover, some of Boeing's competitors for launch services received direct or indirect government funding. The satellite market included some degree of risk and uncertainty relating to the attainment of technological specifications and performance requirements.

Any war or terrorist event would have a very negative impact on the airline industry. External business environment risks for Boeing included Adverse governmental export and import policies, Factors that resulted in significant and prolonged disruption to air travel worldwide, Other factors that affected the economic viability of the commercial airline industry. Examples included the volatility of aircraft fuel prices, global trade policies, worldwide political stability and economic growth, acts of aggression that had an impact on the perceived safety of commercial flight and competition from Airbus. The Military Aircraft and Missile Systems and the Space and Communications segments were subject to changing priorities and reduction in the US Government defense and space budget. Government contracts could be terminated by unilateral government action (termination for convenience) or failure to perform (termination for default).

Civil, criminal or administrative proceedings involving fines, compensatory and treble damages, restitution, forfeiture and suspension of debarment from government contracts might result due to violation of business rules and other irregularities. Boeing's primary defense customer was the US government. Following September 11 military action in Afghanistan and the ongoing threat of terrorism, near term Department of Defense (DoD) budgets had increased and longer-range defense budget forecasts had been revised upwards. However, Boeing itself did not expect DoD procurement to increase significantly in view of the softer global economy.

Environmental Risks

Boeing's operations were subject to various federal and state environment laws. Areas of concern included discharge of hazardous materials and remediation of contaminated sites. The company had been involved in related legal proceedings, claims and remediation obligations since the 1980s. Boeing routinely assessed its contingencies, obligations and commitments for remediation of contaminated sites, based on in-depth studies, expert analyses and legal reviews. Boeing generally accrued or expensed exposures related to environmental remediation sites immediately, based on estimates of investigation, cleanup and monitoring costs to be incurred. Because of the regulatory complexities and risk of unidentified contaminated sites and circumstances, the potential existed for environmental remediation costs to be materially different from the estimated costs. However, based on all known facts and expert analyses, Boeing believed it was unlikely that environmental contingencies would have a material adverse impact on Boeing's financial position or operating results and cash flow trends.

On October 31,1997, a federal securities lawsuit was filed against Boeing in a US district court in Washington, Seattle. The lawsuit named as defendants the company and three of its then executive officers. Additional lawsuits of a similar nature were filed in the same court. These lawsuits were consolidated on February 24, 1998. The lawsuits generally alleged that the defendants desired to keep Boeing's share price as high as possible in order to ensure that the McDonnell Douglas shareholders would approve the merger. Individual defendants, benefited directly from the sale of Boeing stock during the period from April 7,1997 through October 22,1997. The Court certified two sub-classes of plaintiffs in the action: all persons or entities who purchased Boeing stock or call options or who sold put options during the period July 21, 1997 - October 22, 1997, and all persons or entities who purchased McDonnell Douglas stock on or after April 7, 1997, and who held such stock until it was converted to Boeing stock pursuant to the merger. The plaintiffs sought compensatory damages. On September 17, 2001, Boeing reached an agreement with class counsel to settle the lawsuit for $92.5 million. The settlement would have no impact on Boeing's earnings, cash flow or financial position, as it was within insurance limits.

On February 25,2000, a purported class action lawsuit alleging gender discrimination and harassment was filed against Boeing, Boeing North American, Inc., and McDonnell Douglas Corporation. The complaint, filed with the United States District Court in Seattle, alleged that Boeing had engaged in a pattern and practice of unlawful discrimination, harassment and retaliation against women over the course of many years. The complaint, Beck v. Boeing, named 28 women who had worked for Boeing in the Puget Sound area; Wichita, Kansas; St. Louis, Missouri; and Tulsa, Oklahoma. On March 15, 2000, an amended complaint was filed naming 10 more plaintiffs. The lawsuit attempted to represent all women who worked for Boeing, or who had worked for Boeing in the past several years. Boeing denied the allegation that it was engaged in any unlawful "pattern and practice." Plaintiffs' motion for class certification was filed in May 2001. The class included salaried employees in Puget Sound, Wichita, St. Louis, and Long Beach, and hourly employees in Puget Sound, Wichita, and St. Louis. On October 19, 2001, the court granted class certification to a segment of the population sought by the plaintiffs. The court ruled that the action could proceed on the basis of two limited subclasses: all non-executive salaried women (including engineers) in the Puget Sound area, and all hourly wages women covered by the Machinists' Bargaining Agreement in the Puget Sound area. The claims to be litigated included alleged gender discrimination in compensation and promotion. The court also held that the plaintiffs could not seek back pay. In case of liability, the potential remedies would include some form of injunctive relief as well as punitive damages. The US Ninth Circuit Court of Appeals had accepted Boeing's appeal against the class certification decision, particularly the ruling that left open the possibility of punitive damages. Boeing intended to defend these cases aggressively. But it was not possible to predict the outcome. In August 2002, the US Navy notified Boeing that it wanted $2.4 billion of advance progress payments and overdue interest to be paid or it would refer the matter to the government for collection through offset under current contracts. Boeing's share of any settlement would be 50% or $1.2 billion. This would add to the company's debt burden. Boeing, however, felt its current $350 million loss provision was adequate. Boeing was subject to US government investigations from which civil, criminal or administrative proceedings could result. Such proceedings could involve claims by the government for fines, penalties, compensatory and treble damages, restitution and/or forfeitures. Under government regulations, a company, or one or more of its operating divisions or subdivisions, could also be suspended or debarred from government contracts, or lose its export privileges, based on the results of investigations. Boeing, however, believed that the outcome of any such government disputes and investigations would not have any serious impact on its financial position or continuing operations.

Leverage & Liquidity

Boeing's consolidated net debt had increased over the past five years. In September 2002, net debt was $11.9 billion, compared to $1.7 billion in December 1997. Despite strong growth in group EBITDA through to FY01, consolidated group leverage had continued to rise. The sharp decline in EBITDA at Boeing in FY02 as its commercial aircraft segment had suffered, coupled with additional funding needs at BCC had contributed to the increase in leverage. In 2003, Boeing's EBITDA and cash flows were expected to weaken further as commercial jet deliveries waned. However, Boeing would still remain free cash flow positive. This together with slower growth in business volumes would limit the extent of further weakening in the leverage ratios. In terms of liquidity, Boeing had just $1.6 billion of short-term debt in September 2002 with the remainder having an average maturity of close to 10 years.

Against this, it had $1.7 billion of cash and $4.5 billion in unused bank facilities, consisting of a $3 billion 364-day revolver, a $700 million facility expiring in Sept-05 and an $800 million facility due 2004. There were no ratings triggers that would require a cash call over the near term. Boeing used swaps to adjust the amount of total debt that was subject to variable and fixed interest rates. The company also used forward-starting interest rate swap agreements to fix the cost of funding. This mitigated the changes in fair value of the hedged portion of the firm commitment caused by changes in interest rates. The net change in fair value of the swap and the hedged portion of the firm commitment was reported in earnings. Boeing used foreign currency forward contracts to manage currency risk associated with certain forecasted transactions, specifically sales and purchase commitments made in foreign currencies. Commodity derivatives, such as fixed-price purchase commitments, were used by Boeing to hedge against potentially unfavorable price changes for items used in production. In 2001, Boeing used such commitments to purchase electricity and natural gas at fixed prices over the next three years.

Credit Risk Of the $15,554 million in accounts receivable and customer financing, $7,235 million related to commercial aircraft customers ($366 million of accounts receivable and $6,869 million of customer financing) and $2,597 million related to the US Government. AMR Corporation and UAL Corporation were associated with 23% and 13% of all financial instruments related to customer financing. Financing for aircraft was collateralized by security in the related asset. Historically, Boeing had not experienced a problem in accessing such collateral. Of the $6,869 million of aircraft customer financing, $6,440 million related to customers, which had less than investment-grade credit in Boeing's opinion. Similarly, of the $7,508 million of irrevocable financing commitments related to aircraft on order including options, $7,113 million related to customers which had less than investment-grade credit in Boeing's opinion. Boeing was a party to financial instruments with off-balance-sheet risk, principally relating to customer financing activities. Financial instruments with off-balance-sheet risk included financing commitments, credit guarantees, and participation in customer financing receivables with third-party investors that involved interest rate terms different from the underlying receivables. Irrevocable financing commitments related to aircraft on order, (including options), scheduled for delivery through 2010 totaled $7,508 million and $6,230 million as of December 31, 2001 and 2000. Boeing anticipated that not all of these commitments would be utilized and that it would be able to arrange for third-party investors to assume a portion of the remaining commitments, if necessary. The company had additional commitments to arrange for commercial equipment financing totaling $344 million and $288 million as of December 31, 2001 and 2000. Participations in customer financing receivables with third-party investors that involved interest rate terms different from the underlying receivables totaled $51 million and $54 million as of December 31, 2001 and 2000. Boeing's maximum exposure to credit-related losses associated with credit guarantees, totaled $558 million ($174 million associated with commercial aircraft and collateralized and $373 million associated with the Sea Launch joint venture) as on December 31, 2001 and 2000. Of the $174 million exposure associated with commercial aircraft as of December 31, 2001, the company estimated that the fair value of the underlying collateral, principally commercial aircraft would cover approximately $63 million of the exposure. A substantial portion of the commercial aircraft credit-related guarantees had been extended on behalf of counter parties with less than investment-grade credit.

Give your answers by answering thru this following format:

1. Statement of the problem
2. Facts of the Case
3. Alternative Decisions
4. Plan of Actions