The Boeing 7E7 ‘Dreamliner’

Case #3

Section 1, Group 8

Introduction:
The Boeing 787 Dreamliner case provides us with a brief background of Boeing’s business through the end of the 1990’s, and how company management recognized the importance of reinventing their core business in order to remain competitive in the consumer air travel segment. We learned how in-depth of a process it can be to successfully design and produce a new airplane with revolutionary technology and high-tech manufacturing requirements. Boeing struggled with these aspects of the plane, and as we learned, greatly underestimated the amount of time and money that the project would require.

1.)
A: Boeing and Airbus both issued corporate reports regarding the demand for aircraft in different segments going forward. Despite differences in the overall outlook in terms of segment popularity and the exact volumes of aircraft to be required by the market, both reports were very obviously positive.
The main differences between the reports were seen in Boeing’s willingness to forecast for the increased popularity of mid-range aircraft, versus Airbus’ decision to place a higher weight on the importance of international-scale jetliners. Boeing predicted demand over 20 years would call for “5,437 intermediate twin-aisle airplanes; and 889 747-size or larger airplanes” (Boeing’s 2003 Current Market Outlook). Airbus’ predictions were shifted toward the larger aircraft segments, citing “3,842 twin-aisle aircraft; 1138 very large aircraft, and 706 freighters” (Airbus’s 2002 Global Market Forecast 2001-2020).
These predictions seem to be sound, and have actually proven to represent a pessimistic view on the state of air travel, with both companies having recently increased their outlooks for aircraft to be produced over the next 20 years. Air travel continues to be a surprisingly resilient industry, as it becomes a staple of the global transportation picture. Emerging markets, specifically in the Asia-Pacific region, stand to require more planes as routes and volumes increase with the size of middle-class populations that can afford to travel by air. Boeing has recently predicted demand for 7,950 twin-aisle aircraft and 790 large aircraft over the next 20 years (Current Market Outlook 2012-2031). This new number also serves to highlight Boeing’s view that the Dreamliner will become perfected, and drive the growth in the mid-range, twin-aisle segment as regional flights become an increasingly popular and affordable mode of transportation. B: We believe that it is evident Boeing underestimated the total cost of developing such a revolutionary aircraft. In fact, there is a great chance that the methods Boeing relied upon to cut costs (outsourcing component parts) ended up having exactly the opposite effect, when considering the problems with quality control that have cost significant amounts of time and money to resolve. In order to evaluate this, we constructed an estimate of the Weighted-Average Cost of Capital (WACC) for Boeing back in 2002. Our results can be found in Appendix A, where the WACC was calculated to be 5.85%. We derived the percentages of debt (65.17%) and equity (34.83%) from the 2002 financial statement data that was given. Our cost of debt figure was taken from the average YTM of Boeing’s outstanding debt issuances (Exhibit 11). We factored in a tax rate of 23.89% by averaging the taxes paid in 2001 and 2002 as a percentage of net income. Our cost of equity figure was driven by a CAPM calculation in which we factored in a risk-free rate of 4.56% (given), a beta of 1.535 (avg. of given numbers), and 10.73% market return rate, which is the average return of the S&P 500 in 2002.
When examining the decision process that Boeing executives and board members had to undergo in order to approve the Dreamliner, it is easy to understand why they acted the way that they did. Boeing’s management projected that the IRR (using standard estimates) for the project would be 15.7%. Given a WACC that is even in the range of what we calculated, the investment in a new plane made a lot of sense financially. With that said, no amount of forecasting can account for the uncertain nature of the future. The Seattle Times estimated that upon the delivery of Boeing’s first 787 Dreamliner to Al Nippon Airways, the company had spent over US $32B on the Dreamliner. This number represents a 50/50 split between development costs, and production costs for the planes being built at the time. Under Boeing management’s own projections for the Dreamliner, these costs blew their estimates out of the water in a very bad way. Looking simply at the numbers given to us in Exhibit 9, the most that the Dreamliner was expected to cost in the development stage was US $10B. This would normally not represent too much of an issue, so long as margin strength allowed Boeing to make that money back. However, the cost of the plane has also increased many times, with design flaws and manufacturing defects hampering production timing as well. Analysts now predict that the Dreamliner will not be profitable for Boeing until 2020. Looking at Exhibit 9, it is easy to understand how this may be true, especially with low margins. Assuming the worst case, Boeing management projected an 8.6% IRR with 16% margins and US $10B in development costs. Since development costs ended up being in the range of US $15B, it is easy to see how this project could have run into losing territory, especially given a WACC of nearly 6%.

2.) For years the market for commercial jet airliners has been dominated by the intense competition between Boeing and Airbus, resulting in a duopoly, each with its own strengths and weaknesses. The differential characteristics between the two companies shed light on these strengths and weaknesses, so we will address each in turn. Boeing caters to two markets, the commercial airline market and the integrated defense systems market. Its Commercial Airline segment is a lot more volatile than the defense contracts it receives from the U.S. government in the Integrated Defense Systems segment. The two segments of the company is an effective hedge against the riskiness of the commercial airline industry. Boeing’s strength in diversity is one of Airbus’ weaknesses since it is not as diversified as Boeing. Other strengths and weaknesses reflect the market for commercial jet airliners. The commercial airline industry is extremely risky. Both companies can have trouble analyzing the market and understanding what customers want because needs and worries change quickly. Lots of money can be invested in a project, like the Sonic Cruiser, only to see it fail because of a change in what customers want. In addition, it takes large amounts of capital to engineer and build jet airliners, so it is always a gamble when new ones are built. One of Airbus’ greatest strengths is its rapid growth. The growth of Airbus through the years reflects their impressive engineering. The company boasts both the largest and longest-flying airliner. Airbus has found success by engineering airliners that directly compete with a family of Boeing’s. The A350, for example, is under construction to be the competitor to Boeing’s 787 Dreamliner. This has been a strength of Airbus’ because they learn from Boeing’s mistakes to attempt making a better airliner. The 787 Dreamliner has recently had issues with the ion-lithium battery used by the Dreamliner, so Airbus has decided to use a different battery. This is just one example of how these companies compete in a beneficial way. The role of government in defense contracts and subsidies is a topic of ongoing controversy between Boeing and Airbus. Each company continually protests the use of government subsidies by its competitor. Airbus claims the defense contracts given to Boeing by the U.S. government is at an unfair level. Boeing claims Airbus also receives unfair subsidies from various European governments. Several disputes have been settled by the WTO, and rulings have concluded that both companies are correct in their accusations. Just this past year, a ruling by the WTO stated the use of large amounts of subsidies by both companies. Boeing was found to have received $3 to $4 billion in unfair subsidies, while Airbus had received $18 billion. This is not the first time subsidies have been used and it probably will not be the last. Boeing receives its subsidies in the form of defense contracts and tax breaks while Airbus receives them from various European governments in the form of credits.

3.) Boeing had high hopes for the 787 Dreamliner as the first one was being rolled out, and for good reason to. By 2007, during the first unveiling of the 787, it had already reached about 677 orders, which broke the record for any previous wide-body airliner. The development of the 787 Dreamliner was meant to cater to the current needs of customers. Airliners wanted a jet with low operational costs, and the 787 Dreamliner was meant to be that plane. The Dreamliner was well received and looked to be a positive endeavor for Boeing, yet problems soon surfaced. News about the problems with the Dreamliner’s ion-lithium batteries quickly went public after fires occurred on board and a Dreamliner had to be grounded when a problem with the battery occurred. In January of 2013, all 787’s were grounded in the U.S. Other countries that had 787 Dreamliner’s quickly did the same. Critics of the 787 Dreamliner thought the name fit the development plans perfectly; they did not see how it would be possible for Boeing to pull off the engineering of such an airliner. Boeing wanted to build an airliner that was 10% cheaper to operate than an Airbus A330-A200, be capable of short and long distance flights, and use 20% less fuel. A jet airliner that fit this description is just what commercial airliners want, and the benefits to Boeing if they pulled it off would be great. Yet skeptics were worried about the feasibility of such an airliner, and thought that Boeing was trying to promise too much. Critics had a lot of reason to be skeptical about the building and marketing of the 787 Dreamliner but Boeing really had no other option. In the industry of commercial airliner manufacturing, great risks have to be taken. There will inevitably be critics to any decision made by either Boeing or Airbus, so these companies cannot let the naysayers deter them. Philip Condit voiced this opinion when saying he knew if Boeing did not take great risks, they would not be able to compete with Airbus. The manufacturing of the 787 Dreamliner was necessary at the time because Boeing was having trouble turning a profit. It had been a while since the company released a new jet airliner, so pressure from customers was mounting to get a new jet in the air. And to compete with Airbus, which had taken the #1 spot in the industry, Boeing had to unveil a jet airliner as progressive and hopeful as the 787 Dreamliner.

4.)
During the early 2000’s Boeing was seeing an increased rate in competition in the market from Airbus. In 2002 Airbus had surpassed Boeing and became the number one largest dealer for commercial airlines in the industry. As a result of the increased competition Boeing decided to build a new plane called the 7E7. When building this plane Boeing decided to have various parts of the plane build all over the world in various different countries. This had never been done before Boeing in the past. Boeing always built all the parts for each plane they constructed; no outside contractors were ever used.
The reason Boeing initially chooses this approach was due to risk of failure of the 7E7 project. In recent years before Boeing decided to build the 7E7 Boeing had multiple products such as the 747 and the Sonic Cruiser, which incurred the company huge expenses and never resulted in any profits. There for company executives did not want the same thing to happen with the 7E7 project. Having parts of the plane built around the world led to only 35 percent of the actual plane being made by Boeing. This took a lot of pressure off Boeing and led to the risk being spread among suppliers all over the globe as opposed to Boeing assuming all of the risk. If the project started to fail they could just cancel orders from outside contractors and scratch the project.
Although Boeing believed they were acting in the companies’ best interest they were not. Since Boeing chooses to use many different outside contractors they could not oversee all areas of the plane that were being built tiny discrepancies arose when trying to assemble the plane. These discrepancies led to delays in project throughout the entire construction of the 7E7. Boeing was at a greater disadvantage outsourcing their work globally for this project even though they believed it would take the risk of the company if the project had to be scratched similar to previous endeavors.

Sustainability Considerations:
Boeing can be a controversial company who is damaging the environment due to the amount of fuel that is released into the environment on a daily basis by Boeing flights all over the world. Boeing realizes this and has decided to take a major role in sustainability efforts. Boeing R&D teams look for new ways to create sustainable Biofuels as well as alternative energy solutions and other sustainable practices.
Boeing is currently researching ways to contribute les to global climate change. Boeing is researching fuels that are petroleum-based and introduce new CO2 to the atmosphere for a net increase, which will help lower climate change. Boeing is also researching solar cells that can help convert 40 percent of sunlight into electricity for the Earth (Boeing). Boeing is working on many different projects to improve sustainability and help to improve environment conditions all over the earth.

Conclusion: In conclusion, we found that Boeing management drastically underestimated the cost of designing and bringing the 787 Dreamliner to market. At the time, the case that was made was compelling. However, unforeseen complications have hampered the project from day one. Production delays, design problems, quality control, and even maintenance (battery problems) have made the inaptly-named Dreamliner one of the biggest headaches that Boeing has ever dealt with. It remains to be seen how long it will take for the project to become profitable for the company. As a group we learned several things from studying this case. First of which was that with every new technology comes new problems. Issues with rivets, and ill-fitting component parts made Boeing’s new international sourcing plan for the 787 obsolete. The company would’ve been better off keeping all production in-house. From this situation we also observed an old adage; ‘if it isn’t broken, don’t fix it’. Boeing bit off more than they could chew by trying to reinvent their assembly process for the Dreamliner, and the effects of that mistake will probably be felt for at least the next five years.

Appendix A:

Works Cited

Bruner, Robert F., Kenneth M. . Eades, and Michael J. . Schill. "The Boeing 7E7." Case Studies in Finance. New York, NY: McGraw-Hill, 2009. N. pag. Print.

"Environmental Technologies ." Boeing . Boeing, n.d. Web. 16 Feb 2013. .

Gates, Dominic. "Business / Technology." The Seattle Times. N.p., 24 Sept. 2011. Web. 16 Feb. 2013.