2013

Lockheed TriStar Case Study

Group 6
Leon Krolikowski
Sitaram Koppaka
Brian Manning
Tushar Mahajan
Ryan Maggiorini
Nicholas Manning

UNIVERSITY OF MASSACHUSSETS
SUMMER 2013
SCH MGMT 640
PROFESSOR RAJ GUPTA

Table of Contents Executive Summary 2 Introduction/Motivation 3 Data Analysis and Results 4 Conclusion 8 Appendix 9 References 10

Executive Summary

Lockheed’s L-1011 Tri Star Airbus program was a long-term, capital-intensive endeavor projected to strongly position Lockheed to compete in the commercial aircraft market. The initial preproduction investments for the program were made in 1967, with continued investments occurring during the subsequent four years, until the program commenced production in 1972. However, during the intervening period, initial program assumptions began to unravel, and Lockheed, which was also a major contractor to the United States Department of Defense, was before Congress, requesting a $250 million bank loan guarantee to complete the L-1011 program. By 1971, over 80% of Lockheed’s market capitalization had already been lost.
During the ensuing debate that followed, it appeared that Lockheed had not taken due diligence in the planning for the project, and that initial unit sales and revenue estimates would fall woefully short of being what Lockheed’s CEO termed as a “commercially viable endeavor”. As the continued difficulties of the program unfolded before the public and the investment community, it became clear that no combination of increased revenues, reduced production costs, or increased market share yielded a realistic scenario by which the L-1011 could create shareholder value.
As this case was analyzed, it became apparent that achievement of an accounting break-even objective was simply unrealistic unless wildly optimistic assumptions about sales revenues, production cost reductions, industry growth rates and market share capture each occurred simultaneously. Even if these favorable outcomes were each achieved it is unclear as to whether it was possible to achieve true economic break-even for shareholders, as discounting eroded the present value of cash-flows which were heavily weighted toward the end of this ten-year capital investment project. It was next to impossible to justify a set of business conditions supportive of a positive net present value for the L-1011 project. In the end, perhaps not surprisingly, the L-1011 program did not meet unit sales projections and Lockheed common stock plummeted over 95% to $3.25 per share.
What happened? Was the L-1011 program undertaken without rigorous financial analysis? Were initial program assumptions simply erroneous? Did decision-makers at Lockheed and within Congress simply “double down” on a bad investment decision by considering the program’s cumulative sunk costs incurred between 1967 and 1971? Was it simply a political decision by the federal government to protect a valued defense contractor?
What is not entirely clear is why Lockheed did not heed a simple NPV/IRR analysis which shows that the TriStar was not viable from an investment perspective. Perhaps, Lockheed planned to pass along project costs to defense projects or wanted to be a “loss leader” and in turn reestablish itself within the commercial aircraft market (Reinhardt, 2001).
The analysis that follows will demonstrate that it was likely a combination of these factors that contributed to the failed L-1011 project. Proven principles of investment analysis were not undertaken (or were not undertaken based upon realistic business assumptions). On that basis, it is not surprising that the outcome was extremely damaging to Lockheed and its shareholders.
Introduction/Motivation
This is an interesting case since it raises two major mutually dependent issues one is the raging debate about federal bail outs of large corporations and the other about the value of money generated off these federal backed businesses that could justify the guarantees from government. It is truly amazing that we have the same discussion today that happened around 40 years ago.
The Lockheed L-1011 TriStar was a medium-to-long range, wide body trijet airliner. It was the third wide body airliner to enter commercial operations, after the Boeing 747 and the McDonnell Douglas DC-10. It was born when American Airlines approached Lockheed and competitor Douglas with a need for an aircraft smaller than the existing 747, but still capable of flying to distant locales such as London, the Caribbean, and Latin America. Lockheed having experienced difficulties with some of their military programs was eager to re-enter the civil market, and their response was the L-1011 TriStar (Lockheed L-1011 Tri Star, 2006).
In order to create a more advanced, quieter design aircraft, L-1011 exclusively tied up with Rolls-Royce for their RB2012 engine. TriStar had problems in the beginning when American Airlines opted for McDonald Douglas due to lower price. Also, Douglas beat TriStar production by a year. In addition, the high production costs of the RB2012 engine drove Rolls Royce to file for bankruptcy, halting L-1011 final assembly. The British government did not approve the large state subsidy used to restart Rolls-Royce operations until after the U.S. government had guaranteed the Lockheed loans previously provided to Rolls for the extensive engine contract (20th Century Aviation.com, 2012).
The company pleaded with the federal government, claiming that 60,000 American jobs were on the line, and narrowly won $250 million in loan guarantees from Congress (St. Petersburg Times, 1971). The bailout helped Lockheed bring the L-1011 TriStar to market in 1972. At the time of Lockheed’s CEO testimony, 103 firm orders were placed for the wide body commercial jet with an additional 75 options to buy. This was well short of the company’s break even estimate of 195-205 aircraft (Edleson, 1993).
We intend to study this case and perform analysis to investigate if it was a program worth federal backing. The analysis will include: * True value of the program * Accounting break even VS financial break even * Validity of growth projections * Impact of the expected growth on value of the program

Data Analysis and Results
From the given data and analysis we can gather enough information to show where Lockheed over estimated their abilities to sell their aircraft and ultimately took on a project that should have never made it to production. In 1968 when Lockheed was trying to secure federal guarantee for the bank credits required for their project they stated, in their favor, the following; * The Tri Star program was economically sound * The need for federal guarantee was simply due to reduction in other product lines, that this project was indeed profitable * Between 195-205 aircraft needed to be sold for total revenue to cover accumulated costs * Production would run from 1971 to the end of 1977 * Estimated output was around 210 aircraft * At states production levels production costs would be $14mm per aircraft * Sales revenue was estimated at $16mm per unit sold (25% of which was received roughly two years before delivery of the plane)

One point that puts the estimated breakeven sales figure into prospective is that Lockheed only had 103 firm orders with an additional 75 options to buy in place. Assuming that all buy options were exercised Lockheed would only have obtained 178 orders; this still fell short of their required breakeven sales by 17 aircraft at the company’s most optimistic values. Furthermore, from the information provided by Lockheed, the project had a net present value of over -$584 million dollars which indicates that this project should have never been considered from a financial perspective. Another indicating factor that lends itself to showing the poor return of Lockheed’s production plans is the projects internal rate of return (IRR). With the same information that was indicating a negative NPV the plan’s IRR is calculated at -9.09%.

Had the members of the Congressional hearing been aware of the enormous loss perhaps guaranteeing the bank loans would have never happened; instead Congress bought into their position and before long the true market conditions and realistic factors played out and proved Lockheed to be unable to obtain their far reached goals?
A few years later Lockheed was again defending their position and produced new market share numbers and new breakeven analysis, both were slowly starting to show how much more was needed to turn a profit on the new jetliner. In 1972 Lockheed announced revised projections with updated sales estimations, production costs, and market share estimates: * Breakeven sales around 275 aircraft * Production costs at this level would be roughly $12.5mm per unit * If sales were able to reach 500 units production costs might fall as low as $11mm per aircraft * Lockheed would hold 35-40% of market share for this particular type of product (roughly 270-310 planes) * Predicted a 10% annual growth in air travel creating a need for their product

With the new information given Lockheed was going to need to product a minimum of 70 additional aircraft to allow the revenue of those planes to cover the total cost invested in the product line, proving the original breakeven point to be drastically underestimated. Another estimate that later proved to be highly optimistic was Lockheed’s goal of obtaining 35-40% market share for wide body aircraft in an industry growing at 10% annually; more acceptable and more realistic estimates put the growth rate of air travel at a meager 5% per year. This overestimate created a demand for the aircraft that in reality did not exist. Regardless of the project’s pending doom the new figures painted a brighter picture for the company. NPV was lowered to only -$311 million and IRR actually turned positive and became 1.08%.

Given these new indicators, the project should still have never been taken on and the government should have never agreed to guarantee their bank loans. Net present value remained negative (Brealey, 2012).
Additionally, if we consider the projections by industry analyst, the scenario looks as follows:

In order to reach the true economic break-even, Lockheed would have to sell 480 aircraft while controlling per unit cost to $12.5M. In the most optimistic scenario, if Lockheed could sell 323 aircraft while controlling costs at $11 million per annum, it could have been able to generate true value of $25 million.

Conclusion
The group initiated its inquiry into the Lockheed Tri-Star case with the intention of analyzing two major issues: first, the debate about federal bail outs of large corporations; second, the value of money generated from federally-backed businesses that could justify the guarantees from government.
The NPV calculated at different scenarios are summarized in (See Appendix Exhibit One). Looking at these results, it is obvious that the Lockheed Tri-Star project was an overambitious project and should not have been kicked-off in the first place. At the onset, the program assumptions included the sale of 210 aircraft, over a period of six years. Unfortunately, these assumptions led to a plan that featured a negative NPV of approximately $500 million. Four years after the project kick-off, when Lockheed approached the federal government for a loan guaranty, the project was still not an attractive investment. As this analysis shows, in order to achieve true economic break-even, Lockheed would need to sell 480 aircraft, which ultimately proved to be unrealistic considering the total market for wide-body aircraft. As the results of this great failure, the common stock price of Lockheed plunged almost 94%, from $71 to $3.25 over the period of 6 years and investors lost around $765 million of marker value (See Appendix Exhibit Two).
Despite the dubious profit potential, Lockheed may have known the TriStar would be a loss and moved forward in the hope that lost costs would be covered by other defense projects or that they hoped to be a “loss leader” in their desire to re-enter the commercial airline industry (Reinhardt, 2001). Industry experts such as William F. Rockwell, the Chairman of a prominent aerospace company, stated: “…The only way that Lockheed could conceivably break even on the project is by getting the entire market for the airbus.” This strategy, of course, was not feasible and was never successfully realized. (Reinhardt, 2001).
The aforementioned analysis and evidence raise concerns as to the government deciding to provide a loan guaranty of $250 million. Why did the government intervene and protect Lockheed from free market economic forces? There are two probable reasons: (1) 60,000 jobs were dependent on the program and; (2) Rolls Royce was financially dependent on the Lockheed Program. In support of the notion that, “history repeats itself”, recent years have featured numerous federal government bailouts—most notably those of AIG, General Motors, as well as many financial institutions, all of which were not based on sound financial analysis. I
In the instant matter, the failure of the TriStar program, (which was not sound from an entry-level financial analysis perspective), private interest groups and government forces combined to make decisions that were not fact-based, financially sound decisions. Instead, decisions were made that led to a small group (contractors and subcontractors) seeing financial benefits while the public loses, which led to losses throughout the financial marketplace. Ultimately, poorly structured financial bailouts do more harm than good. The Tristar program was a poor investment for both Lockheed and the federal government—many smart people made bad decisions—hopefully a lesson learned.

Appendix
Exhibit 1: Summary of NPV calculated at different scenarios Scenario | Total Sales | $ Price (M) | $ Cost (M) | NPV (M) | Initial Plan | 210 | 16 | 14 | (584.05) | At the time of Federal bail-out | 276 | 16 | 12.5 | (311.15) | Expected sales forecast by industrial Analyst | 300 | 16 | 12.5 | (274.38) | Optimistic scenario with sales 323 and cost 11 M | 323 | 16 | 11 | 25.08 | Break-even by optimum sales and cost savings | 480 | 16 | 12.5 | 1.37 | Exhibit 2: Total value lost by investors Value lost by Investors | | Stock price before Lockheed project in Jan'68 | $71 | Stock price after Lockheed project in Jan'74 | $3.25 | Total value lost | $67.75 | Total number of stocks outstanding | 11,300,000 | Total value lost by investors | $765,575,000.00 |

References
Lockheed L-1011 Tri Star. (2006). Retrieved July 2013, from Aviastar.org - Virtual Aircraft Museum: http://www.aviastar.org/air/usa/lok_tristar.php
20th Century Aviation.com. (2012, June). What Happened to the Lockheed L-1011. Retrieved July 2013, from 20th Century Aviation.com: http://20thcenturyaviationmagazine.com/v-aircraft/what-happen-to-the-lockheed-l-1011/
Brealey, R. A. (2012). Fundamentals of Corporate Finance. New York: The McGraw-Hill Companies, Inc.
Edleson, M. (1993). Investment Analysis and Lockheed Tri Star. Harvard Business School, 3-6.
Reinhardt, U. (2001). Break-Even Analysis for Lockheed's Tri Star: An Application of Financial Theory. Journal of Finance.
The St. Petersburg Times. (1971, July 16). Why Lockheed Feels U.S. Should Cosign Its Loan. The St. Petersburg Times.