March 14, 2019
As all of you are aware, over the weekend Ethiopian Airlines Flight 302 plunged to the ground shortly after takeoff, killing all 157 people onboard. It was the second crash involving the 737 MAX 8 model in less than five months, following the Lion Air disaster off Indonesia, in which 189 people died.
We are concerned with the loss of lives and our heartfelt sympathies are extended to the families and loved ones of the passengers and crews on board those flights. We understand our investors would welcome our accounting of the situation following these tragic events.
In designing the new 737 MAX and trying to optimize fuel efficiency, Boeing found through analysis and later flight testing that under certain conditions the aircraft’s nose nudged upward creating a higher risk of a stall. The company’s solution was to implement the Maneuvering Characteristics Augmentation Systems (MCAS) control which would automatically bring the nose down to reduce the risk of stalling.
According to the flight data recorder, the pilots of Lion Air Flight 610 struggled to control the aircraft as the automated MCAS system repeatedly pushed the plane’s nose down following takeoff. A preliminary report blamed it in part on a faulty angle of attack (AOA) sensor (believe to be manufactured by United Technologies) that triggered the MCAS system and automatically forced the plane’s nose down.
Following the Lion Air crash, US aviation authorities issued an emergency directive to carriers to update flight manuals with information on what to do when the aircraft’s anti-stall system is triggered by erroneous data from the AOA sensor. Boeing also directed airlines to a checklist in manuals for stabilizing the aircraft and issued a bulletin advising pilots how to override the MCAS system. Despite this, it appears the pilots of the Ethiopian Airlines plane reported similar difficulty based on preliminary information.
In reaction to the second crash, regulatory agencies and governments around the world grounded the approximately 370 737 Max aircraft in service. The grounding of the 737 MAX fleet reflects the regulators, the US President’s and Boeing’s concerns over the perception of safety and its impact on the flying public. Engineering analysis is still required to determine the cause of the Ethiopian crash and whether the causes are systematic and linked to the Lion air crash.
Boeing’s stock has fallen approximately 15% from its highs. Since the president’s announcement Boeing’s share price and those of its airline customers appear to have stabilized.
First, we identified approximately 430 instances (crashes, hijackings, etc.) since 1998 that involved an aircraft.
Over the same period, we identified 35 times where Boeing’s stock dropped 5% more than the market (most in the mid to high single digit range). Of these declines, it took 124 days for the stock to recover (DTR) to its previous levels on average, with a median 29 days. The humps in the chart below represent the distribution of returns over the top and the distribution of DTR across the side.
Exhibit 1. Boeing Drawdown/Days to Recover
Exhibit 1. Boeing Drawdown/Days to Recovery Analysis
Source: Bristol Gate Capital Partners, Wikipedia, FactSet.
The most damaging events in either relative drawdowns or DTR were generally related to production issues and/or market share losses in the 1990s and early 2000s or terrorist attacks such as 9/11. As Boeing’s current troubles were not caused by terrorist attacks, the only risks to be concerned with are production issues/market share losses according to this analysis.
We do not believe Boeing is at risk of losing market share given:
The long backlogs of both Boeing and Airbus. Boeing has a backlog of almost 5,900 airplanes (approximately 80% of which are 737s) and delivered about 800 in 2018. If orders were to be cancelled and moved to Airbus, customers would not be in a position to receive their planes for a number of years potentially damaging their business. Airbus has a backlog of more than 7,500 aircraft, including a five year backlog on the aircraft that directly competes with the 737. Essentially, we believe many of these orders have effectively nowhere to go.
The competitive nature of the market has changed since the late 90s as the companies have settled into a comfortable duopoly that splits the market about evenly and manages their production/competitive aggression to maintain consistent production and the health of the overall industry.
Boeing began developing a flight control software enhancement for the 737 MAX in the aftermath of the Lion Air tragedy that includes updates to the MCAS flight control law, pilot displays, operations manuals and crew training to be deployed to the 737 MAX fleet in the coming weeks. The FAA anticipates mandating this software enhancement no later than April and its acting chief stated flights are expected to resume “within a couple of months”.
Secondly, we identified the last time the FAA grounded an airliner type. That occurred in January 2013 and related to two incidents involving battery failures and fires with the Boeing 787 Dreamliner. Although the battery issue did not result in any fatalities, we believe it is a relevant comparable to today’s situation as it was the first grounding of an aircraft type since 1979 according to Wikipedia, a highly unusual event. In 2013, 50 787s in service were grounded and Boeing halted all deliveries of the model.
The 787 battery issue did not result in any order cancellations (the competitive situation was very similar to today) and the largest financial impact came in the form of working capital draw with inventory building significantly until the 787 was allowed to return to service and deliveries resumed in April 2013.
The chart below highlights the timing of the grounding of the 787 and the subsequent release in April 2013.
Exhibit 2. Boeing Stock Chart
The potential costs to Boeing are unknown and likely to be partially covered by various insurance policies. As well, the company has over $8 billion in cash and, with long term debt at $11 billion and $15 billion in cash from operations generated last year. We believe it has significant financial resources to deal with any potential financial charges and continue operations. We are also confident that it will not affect its ability to grow its dividend at a level satisfactory to be included in the portfolio.
While we expect design changes, customer remuneration and other penalties to have some financial impact, similar to 2013, we believe a temporary working capital build will be the largest factor impacting Boeing’s financial statements in the near term. We do not believe the company will experience any meaningful market share losses and would expect the stock to return to previous levels once the 737 MAX is returned to normal flight operations and deliveries can resume. We continue to hold our position and will consider new information as it arises.
Peter Simmie Izet Elmazi
Chief Investment Officer Senior Portfolio Manager
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