Joe Nadol, the aerospace analyst at JP Morgan, this week opined that Boeing may make a decision on the 777’s future before that of the 737.
Here’s what he has to say:
Boeing faces two critical development decisions in the coming months: one on the 737 (re-engine, replace, or defer) and one on the 777 sized aircraft category. Most recent industry commentary has focused on the 737 and whether Boeing will develop an all-new narrowbody, while the 777 issue has faded into the background. Both markets are clearly important, and Boeing must ultimately reach a narrowbody decision, but we believe the company will first address the 777 market. In this note we walk through our reasons, which fall into two categories: the first is the competitive landscape, which we believe requires action on the 777 first and makes 777 a better investment; the second is technology, which we believe dictates that a new larger aircraft will generate more value than a new smaller one. These decisions will impact the first two of Boeing’s three major EPS drivers over the next 3-5 years: the sustained level of R&D, the 777 production rate, and 787 margins.
- Boeing still needs an answer to the A350XWB. Airbus launched the current incarnation of the A350 in mid 2006. Four years later, Boeing has yet to respond, and while some sort of A350 delay looks increasingly likely, the aircraft is still scheduled to enter service only 3 years from now. Two A350 variants—the -900 and the -1000—are aimed directly at the 777 and have enjoyed success thus far. The 777 backlog peaked in 1Q08, not long after the launch of the XWB. The A350’s impact on 777 demand has so far been most pronounced on the -200, for which backlog has dwindled to 35 aircraft from 90 in mid 2006, while Airbus has racked up 273 A350-900 orders. 777-300ER orders have held up better, and A350-1000 demand has been more contained, but this could easily change as the 2015 planned entry into service draws nearer and more detailed specifications begin to firm up.
- 737 backlog does not look that vulnerable; 777 backlog does. With 2,000 737s in backlog, or 4.8 years of production at the planned 2012 rate of 35/month, we believe Boeing has ample time to prepare its next narrowbody move. We see a more urgent need for action on 777, which was the only Boeing or Airbus platform in serial production to see a rate cut during the recession and which still looks like the weakest link in backlog. The ~270 777s on order amount to only 3.2 years of production at the expected 2012 rate of 7/month. We could see this slipping below 3.0 years by the end of 2011 vs an average of 4.4x next year’s production since 1995.
- More competitive narrowbody market means lower return on investment. We see Boeing’s development dollars as better directed toward the widebody market, where it competes only with Airbus, rather than the narrowbody market, which could include six competitors by the middle of the decade once the Bombardier CSeries, Chinese C919, Russian MS-21, and potentially a larger Embraer offering get off the ground. All these competitors are state subsidized or supported to some degree, and some, such as China’s C919, should receive preferential treatment in sizable home markets. Regardless of what Boeing does, the days of a cozy narrowbody duopoly are over. Boeing is likely to see narrowbody market share shrink and face more intense price competition, and we expect the return on developing a new aircraft in this category will be lower. Ultimately Boeing must offer a new or re-engined narrowbody to defend its position in a more competitive market, but when weighing what the highest-return and best use of the next investment dollar is today, the widebody option looks more appealing for investors.
- Composite technology scales up easier than it scales down. Either a new 777 or a new 737 will include more composite content than legacy models. However, the size and thickness required for certain composite structures—such as parts of the wings—mean they lose much of their weight advantage on a smaller aircraft. This issue drove Mitsubishi Heavy Industries, which manufactures the 787’s wings, to abandon composite material in favor of aluminum on its own MRJ despite the resulting costly delay to the program.
- Widebodies can better leverage the lower weight of composite material. Because they fly only one or two long routes per day and spend more time cruising, widebodies derive greater benefit from lower weight than narrowbodies, which undertake multiple takeoffs and landings per day and fly shorter routes.
- A new narrowbody could require more investment in physical plant. The supply chain for a new narrowbody must presumably accommodate 35-40 aircraft per month, whereas a 777 replacement will likely have capacity in the high-single digits to perhaps 10/month. 787 technology is highly capital intensive (such as the autoclaves and the mandrels), and the physical plant is not very scalable, meaning that a new narrowbody could be far more capital intensive.
- Future R&D hinges on 777 and 737 decisions. The 787 and 747-8 have kept BCA R&D running at an elevated ~$3 bil since 2007, and investors expect a decline as these platforms conclude development. Boeing forecasts a drop of at least $500 mil in 2011, but R&D beyond that will depend on how management addresses future development program. We have a hard time seeing how R&D can fall much further than $2.5 bil if Boeing opts for simultaneous development of a new 777 and an all-new 737, and we could even see it moving back toward $3 bil if management pursues this course, which could put pressure on the earnings outlook. Management has indicated that it does not expect to have to address 777 and 737 development simultaneously, and approaching them one at a time would allow falling R&D to provide a bigger earnings boost. If management chooses this path, we believe revamping the 777 will be the top priority.