Thursday, May 12, 2005

Is it Cereal or Airlines? Boeing-Airbus and the Hunt for Zero Profits

For the past couple of years, business journals have been flooded with articles detailing the high-stakes stand-off between Boeing and Airbus. This drama is currently being played out in every medium imaginable: political, business, and legal. As these two behemoths point fingers at each other while trying to launch their respective savior planes (Boeing has the Dreamliner while Airbus has the A380), another interesting game has begun to emerge: announcing orders in succession, with rarely a mention of underlying profitability, in an effort to create a sense of momentum. With the media fanning the flames, this practice shows the signs of an intense rivalry that could damage a once highly profitable industry.

We have noticed a recurring pattern over the years; Boeing and Airbus announce multiple airplane orders all at once with the latest installment being exhibited in an Economist article titled “Taking Off in Toulouse (and Seattle).” This article details Boeing’s recent success in landing orders with Air Canada, Air India and Northwest Airlines, as if they all signed on the same day. Airbus had a similar multi-deal announcement at the end of last year that seemed to show the tide was rolling in its favor. The timing of Boeing’s latest proclamation could not have been an accident; this week, Airbus accomplished the first successful test-flight of its super-jumbo plane. While the timing is inconvenient for Airbus, this action and the order announcement process itself depicts the troubling symptoms of an intense rivalry. For example, orders are obviously withheld and then announced together in succession in an attempt to create momentum; this makes it appear that planes are flying off the production line (pun intended). The firms likely hope this leads other airline executives and purchase agents to believe one company is superior to the other, which will eventually lead to a cycle of even more orders. In reality, bunching orders together seems to simply lead to a dearth of orders afterwards. The strangest fact in this drama seems to be that both firms have done quite well over the years suggesting that both firms can prosper, or at least could a few years ago. Is this changing?

Before digging deeper, we thought about why some industries have long-term profitability while others do not. For example, why is it that an industry like airlines is so competitive while an industry like cereals is not? Why can some industries migrate to equilibrium profits and others have negative industry-wide profits over time? One could argue that airlines provide more value to society, while cereals are only a minor convenience, so the bottom line of these industries is obviously not a function of importance to humanity. Industry structure itself must play an integral role. In cereals, the giants seem willing to live with each other and do not institute price wars. Overcapacity and despair have plagued airlines with price wars with each firm attempting to maximize utilization by under-cutting competitors (a lose-lose situation for all). Does the growing competitive rivalry in airplane manufacturing mean that a once profitable industry is moving from a cereal to a more airline dynamic; we think so.



The industry is changing, and Boeing and Airbus are the leading catalyst to their own demise.

While articles praised Airbus last year, current articles praise Boeing in the same manner (see BusinessWeek “Takeoff At Last” and New York Times “China Airline Places Big Boeing Order”). What these journalists fail to mention is the most important factor: profitability! The goal of a business is not to collect the most orders, but to provide the best return to shareholders or, in Airbus’ case, to its parent company, EADS. As vanquished internet retailers showed in the late nineties, you cannot make up losses on higher volume. A recent article in the Wall St. Journal has suggested that Boeing is “mortgaging its future selling planes at deep discounts,” while yet another quoted an Air Canada executive saying they received “significant discounts” on their recent order.

The only rationale we can find to defend a volume-focused, cutthroat strategy is that Boeing and Airbus feel that winning the plane wars in 2005 will lead to a monopoly in the future as one firm drives the other out of business. While it is true that Boeing, with its deeply discounted 787 Dreamliner sales, could force Airbus into developing a whole new model rather than continue promoting an inferior revamped A330 (dubbed the A350), this would only give Boeing a short-term lead in the industry. In reality, the probability of one of these firms faltering is slim and even unnecessary since both firms can survive together. Due to the massive government subsidies that each firm enjoys, neither firm is going to vanquish its competitor. In fact, Airbus was created to compete with Boeing; its initial subsidies were intended to help it gain the critical mass necessary to compete. Therefore, their very public confrontation is simply cutting into the bottom line by increasing competition amongst each other. This rivalry surprises us since plane manufacturing on a large scale is essentially an oligopoly. One other explanation could be simple confusion. The use of government subsidies clouds each company’s true profitability. This hinders price leadership or implicit market agreements.

We admit that the fate of Airbus and Boeing are closely linked to an abysmal industry: the airlines. The competition may be so abnormally fierce simply because its consumers, airlines, are hemorrhaging cash at an alarming rate. But, this has always been the case with airlines. The airline industry has had negative industry profits going back as far as the Kitty Hawk. Therefore, the only firms that can really stop the rise in competition are the major players themselves: Boeing and Airbus. In reality, airlines have a distinct incentive to keep these two companies alive and competing against each other; it leads to lower prices and they could badly use lower costs themselves. All this to say, a few orders in a row are not necessarily indicative of a surging plane manufacturer at all, but simply portray the highly competitive nature of an industry that is competing away profitability. By competing so fiercely, both firms are transferring power to airlines.

The firms may want to think about solidifying their own partnerships and providing exceptional service to existing customers. Since airlines have an incentive to keep both firms alive, they should both gain future orders regardless. In the mean time, look for a deluge of orders out of Airbus in the next few months and a slew of articles claiming them as the victors of this lose-lose game, and also expect a slow-down in orders from Boeing in the next few months as well. Maybe if they focused more on profits (i.e. maintaining a win-win oligopolistic industry) and a little less on momentum, they wouldn’t be in such a poor predicament in the first place.

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