Analysts view the Re-Engine competition
We were traveling last week and are only now getting around to going through the analyst reports we receive, commenting on the American Airlines order. We put together a long synopsis after the jump.
Meanwhile, there are a couple of charts we want to highlight before getting into the recaps.
UBS put together the following charts of 2010 and 2011 orders at Airbus and Boeing. What we find notable is the break-out of A320 family Legacy orders vs NEO, with the clear preference for the NEO. Note that Boeing’s 737 orders are low this year. Compare the A320 Legacy orders last year, as the market waited for Airbus to decide what it was going to do about reengining. We previously wrote that we felt 737 orders were likely on the low side (though in fact YOY they were roughly the same through June) pending a Boeing decision on the 737′s future. The UBS tables support this view. Click on the tables for a more crisp and readable view.
Credit Suisse put together a good chart on the potential USA orders Airbus and Boeing will compete for:
July 21: Boeing implications from the American Airlines decision – positive on balance because it forced the reengine decision:
Positive. Size of the order is an indicator of the strength of demand, which should support planned production rate increases and possibly an additional increase.
Positive. Reengining is much more attractive than an all-new approach.
Reengining should have more bounded costs, lower risks and better near term traction with airlines than would an all-new airplane.
Positive. Boeing’s reengine decision preserves the historical duopoly at 130 seats and above by making it very difficult for new entrants to displace these OEMs.
Negative. Boeing loses a share of the American narrowbody fleet with the Airbus win, materially reducing the future size of its installed base position in the US. In addition, we expect that Boeing had to make substantial price concessions to win its share of the order against Airbus.
Negative. Boeing will take on credit exposure as the company has guaranteed American Airlines financing for operating leases at market rates. We believe, however, that Boeing should be able to offload the lease exposure to aircraft leasing companies, given the strength of the current environment.
As expected, American Airlines announced a split-buy order for 460 Airbus and BA narrowbodies this morning. Further, BA offered AMR a re-engined 737NG that would feature the CFM Leap-X engine, ending the 737 re-engine or replace debate.
The 460 plane order is for 200 737’s and 260 A320’s. The 200 plane BA order is split evenly between in-production 737NG’s (deliveries beginning in 2013) and a re-engined 737NG with the CFM Leap-X engine. The 260 plane Airbus order is also split evenly (130/130) between the original A320 (deliveries beginning in 2013) and the A320NEO (deliveries beginning in 2017). Lastly, AMR has options to purchase an additional 100 737’s and options and purchase rights for another 365 A320’s.
While AMR announced it was buying ‘A320 family’ aircraft, we believe today’s order was most likely for the A321NEO, indicating that the 737-900 did not stack up favorably against the competing Airbus product. We also believe that AMR intends to replace MD-80/90 series planes with the 737-800.
Clearly, BA is under significant competitive pressure from Airbus on both price and the ability to meet near-term demand for capacity. BA’s assessment that it had time to make a decision on whether to re-engine or replace the 737 appears incorrect, and, as a result, BA is now in a reactive position to Airbus. Today’s order demonstrates that airlines are demanding capacity near-term and reinforces our assertion that they cannot wait for a New Small Airplane from BA later in the decade. We also note that today’s order represents a significant step forward and market share gain for Airbus into traditional BA territory as AMR currently flies an all-BA fleet.
We think there has been an overhang on BA shares since the Paris Air Show when press announcements indicated AMR was leaning towards buying Airbus airplanes. While today’s news and share loss to Airbus is negative for BA (but expected), we believe that the stock was pricing in a possible all-Airbus AMR order.
July 20: Re-Engine a Key Positive, Reiterate OP & $94TP: Over the past few months, BA’s narrowbody strategy has evolved on three fronts: (1) The overwhelming success of A320NEO evidenced airlines’ greater willingness to buy a re-engined aircraft; (2) CFM apparently figured out how to deliver the requisite fuel efficiency with a 3-4 inches smaller fan diameter LEAP, eliminated the need to lengthen the nose gear saving up to 10-20% of the cost of re-design; (3) We suspect sole source engine supplier CFM is heavily subsidizing the re-engine effort, making this a less expensive & lower risk endeavor for BA.
Cleansheet Takes Back Seat for Now: The case for a New Small Airplane (NSA) offering for end of decade EIS was likely compromised given high development costs and likely senior management / board concern about another major financial commitment before 787 and 747-8 are generating cash, especially since the timeframe for materialization of cash flow would have caused BA to miss AMR’s deadline, and possibly those for upcoming decisions from DAL, LUV and UAUA. Further, we think technology and production system uncertainty were major hurdles. While it doesn’t disappear, we think NSA simply moves to the right.
Awaiting Board Approval: Given the re-engine decision was made in the context of a late to the table offering to nab part of the AMR order, BA is yet to formally launch the re-engine as it is awaiting board approval (expected this fall). Configuration, specs & EIS (we think mid-decade) are also pending.
Financial Implications: We think this meaningfully lowers the R&D profile despite incremental widebody spend (787-10X, 777). The R&D required for a re-engine (we est. at $300M/year for ~3 yrs) seems like a small cost considering it will enable mkt share retention and offers a path to potentially higher production rates beyond the 42/mth already targeted in 2014 depending on order momentum, which would clearly be a positive for EPS.
July 24: American Airlines announced a 460 jet order, the largest in history. More importantly from our perspective, securing part of the order prompted BA to offer a re-engined 737 as its next narrowbody rather than an all-new plane. We believe BA made the right choice and this decision should pave the way for more orders. CFM’s LEAP-X will power the 737RE and Boeing management will seek board approval for the program in August or October. We understand that Boeing still has a lot of work to do before going ahead with the project, so while we view it as very likely to move forward, there are still a number of uncertainties. The American order includes 200 737s and 260 A320s, with each order expected to be split evenly between current and re-engined variants. Deliveries are to begin in 2013. Please see our BA note from July 20 for more.
July 20 (second note): Aircraft market implications – As we wrote in our Flight Bag publication last week (click here for the report), Boeing really wanted to build a new 737 replacement, but two issues stood in their way, one being the supply chain risk imbedded in building a composite aircraft at a rate well north of 50/month by the end of the decade and, more importantly, large customer desires for some sort of fuel-saving offering sooner rather than later. It looks like AMR basically demanded a re-engined 737 well before a clean-sheet 737 version would be ready. Rather than cede incremental share to Airbus, Boeing will now offer its own 737neo (for lack of a better term). Kudos to Adam Pilarski from Avitas, who in March at the ISTAT Conference predicted with conviction that Boeing would inevitably re-engine the 737 when the sentiment and market conjecture at the time was heavily leaning towards a clean sheet aircraft. Now all eyes are on Southwest and whether or not a 737neo satisfies their needs (our best guess is yes, and this has implications for other manufacturers as well). AMR’s peers will indeed order more aircraft over time, and these orders will be significant as the narrowbody fleets at Delta (RFP already in the market) and United (formal RFP forthcoming) are beginning to look a lot like the current Boston Celtics or San Antonio Spurs (old and past their prime for those of you not into basketball). But keep in mind that the US Airways re-fleeting post-America West is largely complete, United-Continental already has a wide-body replacement order in place, Delta’s widebodies are among the industry’s youngest, and so forth. On that latter point, we continue to believe one such solution for Delta’s narrowbody needs (and for Southwest) could include a 717 transaction, whereby Delta would purchase/sub-lease AirTran 717s as a replacement for aging DC9-50s (which the 717, originally named the MD-95, was in fact designed to replace) – though obviously such a transaction could only occur with the blessing of Boeing Capital. Just as today’s AMR news serves as a disappointing blow to capital discipline at that carrier, in our view, Delta’s continued willingness to explore used-aircraft strategies highlight that carrier’s leadership position within the industry when it comes to capital discipline and balance sheet repair. Click here for our colleague Joe Nadol’s note on the re-engining decision at Boeing.
July 20 (first note): Today’s commitment to 737s by AMR finally establishes Boeing’s narrowbody strategy — it will re-engine the 737. This decision does not prevent Boeing from continuing to work toward introducing a new airplane in this size range in the middle part of next decade, but it does mean that the next major fleet move for the largest airline narrowbody fleets out there, particularly in the US, will be either this new variant of the 737 or the A320neo. We expect a flood of orders in the coming months, and while Airbus will fight aggressively for them and win its share, we expect Boeing to retain a large number of its existing customers that have been waiting for it to make a decision and therefore pick up many hundreds of orders.
Details yet to come, but this looks like the right move. We are still awaiting details and board approval (likely in August), but this looks like a good result for shareholders. A re-engined aircraft will have much lower development costs than a new airplane (potentially nearly an order of magnitude lower when considering total investment net of supplier contributions), carry far lower risk, and enable Boeing to come to market much quicker to satisfy the strong customer demand for refleeting with new engine technology. It takes a good amount of the R&D risk off the table, and we feel increasingly comfortable with our view that BCA R&D will continue to decline in the coming years. We are not surprised by the announcement given the change in tone from Boeing management over the past four months, but clearly this marks a substantial change from its commentary on the subject for much of the past year. Looking nearer-term, this decision supports our expectation of a pendulum swing back toward Boeing in terms of orders, which we see as likely to boost the stock.
Re-engining looks like a critical save. The announcement will have strategic implications for the aerospace industry and its investors for years to come from many different angles. Starting at a high level, a chess analogy is tempting since Airbus clearly took the initiative, thought several steps ahead, and seized the mantle of progress on fuel burn reduction with its launch of the A320neo late last year. However, while this may be a result of watching some of the Women’s World Cup in recent weeks, we are more partial to a soccer analogy at this stage. Airbus stole the ball at midfield last year, turning it into a breakaway at the Paris Air Show last month and was driving toward the net to put away its competitor with a massive takeaway of one of Boeing’s largest customers, but the Boeing goaltender made a diving save. This analogy also enables us to cast Nicole Piasecki, VP of BCA Business Development and a major proponent in recent months behind the scenes of a re-engining, in the role of Hope Solo, the US goalkeeper. Admittedly the analogy breaks down a bit when considering that the streaking Airbus striker would need to be John Leahy, COO-Customers…
On the other hand….. While this may have ended in an acceptable way for investors, it does look as though Boeing badly misread the market and dithered while its primary competitor moved forward aggressively. Boeing deserves credit for realizing its mistake and moving to salvage its major customers before it was too late, but, in our view, this is an egg on the face moment. Investors will ask management many questions on product strategy in the weeks and months to come and will look for signs that it will be able to recover from this lack of market recognition and be the one that can seize the initiative next time.
Pricing is key. One of the items that will be toughest to analyze but bears close watching is what this does to pricing and its implications for BA profitability down the road. The challenge posed by the neo was never about making the 737 uncompetitive from a cost standpoint but rather the major implications it had on the equilibrium between pricing and operating costs. Boeing would have been forced to lower its 737 pricing fairly significantly to remain competitive with the neo, and the re-engining will help it stave off that outcome. However, the equilibrium has still been upset, and there is still the chance that margins could be pressured on this critical program. We will be looking carefully for data points that help us understand what margins on this aircraft will look like a few years down the road.
July 20: What’s new: American Airlines announced plans for a split buy of 460 narrow-bodies beginning in 2013 through 2022, the largest aircraft order in history. The order is split between Boeing (200 737s, of which 100 will be new engine) and Airbus (260 A320s, of which 130 will be NEOs). This announcement is the culmination of nearly a month of speculation that started at the Paris Air Show, and which saw all three scenarios (all-Airbus, all-Boeing, split order) rumored at some point.
Impact on our BA views: While better than the worst-case all-Airbus scenario, this is clearly a more muted win for BA with some worrisome edges. The Airbus order successfully ended BA’s long-standing monopoly at AMR and Boeing’s strategy for its re-engine vs. new plane looks now more reactionary with what appears a hasty promise of a re-engined 737. Despite all this, AMR ordered more planes from Airbus than its once longstanding airplane supplier. Some sources have the opinion Boeing viewed Airbus aircraft manufacturing plants in the U.S. as highly untenable and part of the importance of winning the KC-46 tanker was to block Airbus from gaining a foothold in the US. Given the magnitude of this order, Airbus may build a plant in the US, effectively sidestepping Boeing’s attempt, if this is correct, to remain the sole large aircraft manufacturer in the US.
Impact on our EADS views: This is clearly a significant positive for EADS given the bias of the US airline market to Boeing aircraft and concerns that this contest could have followed the path of US Tanker (where EADS was seen as a frontrunner right until the very last moment). As mentioned above, it not only breaks the Boeing monopoly of AMR but more importantly Boeing’s hasty decision to re-engine the B737 is a clear indication of the success and strong competitive positioning of the A320neo.
July 21: * Our take on 737 RE: It now appears that Boeing will re-engine the 737, a significant and sudden reversal from its prior plan. On net, we view this negatively as EPS expectations will likely have to move $0.30-0.50 lower to incorporate incremental R&D to re-engine, and while less complex than a new airplane, we still see meaningful development risk and questionable economics relative to A320neo.
* Pros: We see positives to re-engining including a likely uptick in near-term order activity as airlines move to secure early delivery slots with potential large replacement orders still looming from Delta, Southwest and others. Re-engining will involve lower overall R&D compared to an all new airplane, and is ultimately the lower-risk alternative. It will also free up resources for a potential 777 refresh in the middle of the decade.
* Cons: We think there is significant technical risk to improve upon 737 NG’s economics as 737’s low wing currently is unable to accommodate as large a fan diameter as the neo can. We also see backlog risk as airlines won’t want to take the last of the NGs in 2014-16 and will likely look to convert to the re-engined model instead.
* Additional: Questionable economics: While Boeing maintains the current generation
737-800W is already 2% better than the A320neo in terms of total cash operating cost per seat, we are skeptical about why in that case Boeing would re-engine at all. We think Boeing will need to take on significant technical risk to improve upon 737 NG’s economics as 737’s low wing currently is unable to accommodate as large a fan diameter as neo can.
Technical risk could be higher than Boeing is letting on.