Models With A Projection Of Airbus's Investments example essay topic

I. INTRODUCTION In December 2000, Airbus formally committed to develop and launch a super jumbo plane known as the A 380 at a launch cost of $13 billion. Prior to and after Airbus' commitment, Boeing started and canceled several initiatives aimed at developing a "stretch jumbo" with capacity in between its existing jumbo (the 747) and Airbus' planned super jumbo. In addition to making the super jumbo one of the largest product launch decisions in corporate history, this figure represented 26% of total industry revenues in 2000 ($45.6 billion) and more than 70% of Airbus' total revenues in 2000. The inherent risk associated with this major strategic commitment is magnified by the fact that Airbus must spend the entire amount before it delivers the first plane. History has shown that many firms including General Dynamics, and, more recently, Lockheed, have failed as a result of attempting such bet-the-company product development efforts.

If, however, the launch effort does succeed, Airbus is expected to dislodge Boeing as the market leader in commercial aircraft after more than 50 years of market dominance by the latter. This paper presents an analysis of this new product commitment and, more generally, of competition in very large aircraft (VLA is defined as planes capable of seating more than 400 passengers). II. CASE BACKGROUND In the early 1990's, Airbus and Boeing independently began to study the feasibility of launching a super jumbo. Both agreed there was a growing need for a super jumbo because of increasing congestion at major hubs.

Alternative solutions were seen as either infeasible, in the case of greater flight frequency, or ineffective, in the case of flights to secondary airports. Fairly quickly they realized that there was room in the market for only one competitor. Finally, Boeing and Airbus agreed to collaborate on a joint feasibility study for a Very Large Capacity Transport (VLC T) plane that could hold from 550 to 800 passengers. When the collaboration began in January 1993, they envisioned the plane would cost $10 to $15 billion to develop (with estimates ranging from $5 to $20 billion) and would sell for $150 to $200 million each.

Their preliminary demand estimate was reported to be 500 planes over the next 20 years. In July 1995, however, the collaboration ended. Airbus realized that Boeing's participation in the joint effort may have been only to stall the market so that Airbus did not develop anything itself. The two firms also disagreed at a very fundamental level about industry evolution. Boeing maintained that increased fragmentation in the form of point-to-point travel would solve the problem of congestion at major airports. Airbus, on the other hand, believed that hub-to-hub travel would continue to grow.

With the collaboration over, both competitors returned to independent study of the super jumbo market. For its part, Boeing considered two updated and "stretched" versions of its popular 747 jumbo jet. In fact, Boeing never formally announced it was going to develop the stretch jumbo yet did, in January 1997, announce it was canceling the development effort. A little more than two years later, however, Boeing reversed course once again and now said it was going to build a stretch jumbo at a cost of $4 billion. The 747 X-Stretch was supposed to hold up to 520 passengers and, according to Boeing, would be available by 2004, two years ahead of Airbus' A 380. Concurrently, Airbus forged ahead with development of a super jumbo jet and finalized plans in 1999 to offer a family of very large aircraft.

The first model, the A 380-100, would seat 555 passengers and second passenger model, the A 380-200, would seat 650 passengers in the three-class configuration and up to 990 in an all-economy version. Airbus also planned to build a freighter version, the A 380-800 F, capable of carrying up to 150 tons of cargo. In terms of pricing, the A 380's list price is significantly higher than the 747's list price, $220 million vs. $185 million. Developing the first passenger model and the freighter version of the super jumbo is expected to cost $13 billion. Between June 2000, when the Airbus supervisory board gave approval to begin marketing the plane, and December 2000, airlines placed orders for 50 super jumbos and bought options on another 42 planes. With these orders in hand, including a number from important 747 customers such as Singapore Airlines and Qantas Airlines, the Airbus board officially launched the new plane.

According to its internal projections, Airbus forecast a need for more than 1,500 planes of this size over the next 20 years, expected to capture up to half the market. In addition, Airbus estimates it will break even with sales of 250 planes (on an accounting, but not cash flow basis) and they currently have 100 firm orders and extra 100 options. On March 29th, 2001, Boeing announced it was stopping the development of its stretch jumbo and would begin development of a new aircraft known as the sonic cruiser (7 E 7). This plane would fly faster (Mach 0.95 vs. Mach 0.80), higher, and more quietly than existing aircraft.

It would also be significantly smaller than the stretch jumbo (200 passengers vs. 520 passengers), though it would cost more to develop ($9 billion vs. $4 billion). The sonic cruiser is not only more consistent with Boeing's predictions regarding industry evolution towards greater point-to-point travel, but also adds a third dimension-speed-to the capacity / range product space.. FINANCIAL MODELS A - Base case: Go to Heaven. To help us assess the valuation impact of various strategic actions in this sequence of competitor interactions, we built financial models of Airbus's super jumbo development project. We begin our reviews of these models with a projection of Airbus's investments in and returns from the super jumbo over a 20-year horizon.

The model uses inputs from Airbus as well as from equity research reports on Airbus and EADS by analysts at Lehman-Brothers (LB), an industry consulting and data tracking service. All the data taken from the case are summarized in Appendix 1. Before getting into the details of the model, two limitations are worth noting. First, this investment is incredibly complex and we have, by necessity, vastly simplified inputs to create a more tractable model. Second, many of the inputs are informed estimates because Airbus has released few details other than expected investment costs. Critical details surrounding pricing, volume, and funding remain shrouded in secrecy.

The discussion here focuses on the key assumptions of the model and the principal results. A first important assumption is that we estimate project value as of year-end 2001. We also take into consideration that Airbus has spent $700 million on the plane by December 2000 (Airbus Briefing, 2000). Finally, we calculate the value accruing from years 1 to 21 (2001 to 2021) and did not use any terminal value. In the base case, which is reproduced in Appendix 2, we assume Airbus will sell 50 planes per year in steady state after an initial ramp-up period (12 aircraft the first year, approximately 25% of production capacity then 38 for the second year which is approximately 75%) for a total of 750 planes by 2021.

This number is slightly less than its stated goal of capturing half the projected market for super jumbos (1/2 1,550 planes = 775 planes). By way of comparison, most analysts are predicting that Airbus will sell from 515 planes to 665 planes in their base case scenarios. More interestingly, Airbus' assumption exceeds the average number of 747's Boeing has sold over the past 30 years (34 planes per year). We also assume the realized price in 2008 will be $225 million, which will produce an operating margin of 25%. Also, analysts tend to assume that Boeing, a monopolist with more than 1,000 planes of cumulative production, has operating margins of 15% to 20% on its jumbo the 747. Using a discount rate of 9%, these inputs imply a positive NPV of $199.1 million, consequently the IRR of the project is 10.47% which is higher than the discount rate.

With respect to the break even point, we reach an accounting break even point (basic method applied by Airbus) at 242 aircraft sold, different than 250 announced by Airbus. On the other hand, if we improve the formula by taking into account commercial discounts or prices evolution, then we find a break even at 377 AC reached in 2014. B - Pessimistic case: Go to Hell. If we stop our assumptions at the end of the first study, then the problem is solved: we just have to launch the A 3 XX! The difficulty comes from the fact that the debate offers different opinions among specialists (economics, accountings... ).

Some say that this project is viable; others will say that Airbus made a big mistake. Though we can think that people from Airbus thought twice before taking this decision, we decided to change assumptions linked to the future. Indeed, in 2001, nobody can really know what the next years will bring to this industry. Moreover, in 2001, A 3 XX was not called A 380 yet: the project was just at its beginning, the studies were not mature which involves that design, performances or even investments linked to the dedicated tooling were not definitely frozen. All the data given in the case (Appendix 1) could be modified... just to see if Airbus was not a bit optimistic. In this second study, we have taken 4 main assumptions.

The first one is based on demand which decreases significantly in 2011 and 2017. This is done to simulate either economic crises, either a new Boeing (7 XX?) that come on the market, either the effect of terrorism. The second one is about commercial discounts that have to be applied. The first 200 aircrafts will be discounted at 35%, as suggested in the case text and afterwards, each A / C will be discounted at 10%. The third assumption is about production costs. In 2001, the industrial process wasn't defined at all and the aircraft definition was not either.

All difficulties met due to the large volume of this A / C, the flexibility of parts or the tolerances concerns involved costly solutions sometimes. The assumption of increasing the production cost is therefore realistic The fourth one is about Tax rate, which is increase every year in the financial model. All the assumptions about this study are summarized in Appendix 3. The conclusion about this study could be catastrophic...

The NPV found after 20 years was so negative the forecasted period has to be increased with 10 years. And even on a period of 30 years, the NPV is still negative. The basic break even does not change a lot in the method used by Airbus, as we find 302. But as this method does not take into account the real price paid by customers, the second one is more realistic facing the NPV results, as it gives a break even at 2161 A / C! Some will think that this case is really pessimistic, but at the beginning of 2001, who could have thought about September the 11th? Moreover, Boeing has enough experience and resources to make a new A / C if it decides it's reliable.

Economic crises unfortunately also exist. What is the good way of thinking between these extreme studies? To help us taking the best decision as possible, we need to study the main parameters that have an influence on NPV to know their effects. IV - IMPACT OF VARIABLE DATA This section analyzes the impact of variable data such as pricing, sales forecasts, production cost, additional investments and tax rates. We assume that only one data changes while others remain same. A- The key factors.

A-1) Pricing Pricing in very large aircraft are of additional interest because pricing pressures drive the theoretical predictions that the entrant will introduce the new product (the super jumbo, in this case) and that intermediate products will be unprofitable for the incumbent. It is useful to begin this examination of pricing by noting several basic facts about it. First, both Boeing and Airbus post list prices for their entire product lines. Boeing, for example, shows a price range for each aircraft on its corporate web site, where the range depends on the specific configuration. Second, both companies announce nominal changes to their price lists annually.

Third, planes sell at large discounts to list prices, ranging from 18-40% for Boeing and 16-27% for Airbus and 35 to 40% for the first firm A 380 orders placed. With that background, several indicators of pricing pressure in the very large aircraft segment can be cited. Let start with Airbus' A 380 which has a list price of $218-$240 million in 2000. Given the 17-21% discount typical for the largest Airbus planes, the realized prices should be around $178-$187 million assuming a list price of $225 million. As it turns out, however, the early sales have occurred at prices as low as $135-$140 million or, in other words, essentially at "steady state" cost. While some of the early launch customers like Qantas and Virgin reportedly paid approximately $150 million per plane.

For instance (base on the current financial model enclosed in Appendix 1), if we assume that Airbus applies an average discount of only 5% on all its sales, then, we must wait until 2028 to find a positive NPV for a total number of 1100 aircraft. A-2) Sales Forecasts A-2-1) Demand Forecasts The forecast of the demand is a key factor for the success of the A 380 project; however, the demand can be deeply influenced by several external factors such as: new entrant in the super jumbo market (e.g. Boeing) economic crisis, increase of fuel cost or, as we have recently experienced the dramatic effect of terrorism. To simplify our study, we will focus on the effect of the new comer on the VLA market. Because large aircraft take years to design and develop, require enormous up-front investment, and have useful lives of over 30 years (some people think that the 747, for example, will have a useful life of 50-plus years), Airbus and Boeing both generate long-term demand projections for their products.

Airbus's Global Market Forecast (GMF) is based on annual demand for new aircraft on each of 10,000 passenger routes linking almost 2000 airports. In contrast, Boeing's Current Market Outlook (CMO) forecasts economic growth in 12 regions around the world and then uses these assumptions about growth to forecast traffic flows in 51 intra- and inter-regional markets. Although both had decreased their growth forecasts in response to the Asian financial crisis in the late 1990's, they disagreed sharply, however, about demand for the VLA segment due to their divergent view on industry evolution-Boeing towards greater fragmentation and Airbus towards greater capacity planes. Table 1 summarizes their evolving 20-year forecasts regarding the number of VLA deliveries.

Its most striking feature is the fact that Airbus' market forecasts have consistently been more than three times larger than Boeing's forecasts. And while both companies' forecasts fell in the late 1990's, primarily because of the Asian crisis, Airbus' latest forecasts are down only 15% from their 1997 high, compared to nearly 30% for Boeing's. Table 1 20-Year Forecasts of the Number of VLA Deliveries (Passenger Jets 500 seats only) Boeing CMO Forecast Airbus GMF Forecast 1995 n / a 1374 1996 n / a n / a 1997 460 1442 1998 405 1332 1999 365 1208 2000 330 1235 Source: Boeing Current Market Outlook (CMO) and Airbus Global Market Forecast (GMF), various years. The magnitude of the discrepancy is surprising given Boeing and Airbus's collaborative efforts in the early and mid 1990's, a process that must have involved detailed discussion of different market forecasting techniques. It provides a sense of some of the ambiguities inherent in coming up with long-run demand forecasts for such products. And the direction of discrepancy is interesting, too: Boeing's forecasts are lower than Airbus's, not the other way around.

Although Boeing's more pessimistic forecasts may represent its best estimate of future demand, an alternative interpretation is that they fulfill a strategic purpose. One possible purpose, more likely to have been important before Airbus committed to develop the A 380, might have been to discourage entry by downplaying super jumbo demand. Additionally, perhaps, Boeing wanted to reinforce its point of view by signaling to third parties- investment analysts, investors, governments, customers, suppliers and even employees- that Boeing is acting responsibly in not launching a very large aircraft. Symmetrically, Airbus might be expected to overstate demand to make the case that it is acting responsibly in launching. Such signals of "taking care" tend to be most important in high-ambiguity environments.

As a result, the possibility of strategic manipulation of forecasts-understatement by Boeing, overstatement by Airbus-merits mention, even though the statistical power with which it can be tested on its own (as opposed to in conjunction with other pieces of evidence) is limited. Once again, if we compare the average sales of Boeing 747 over the last 20 years (34 aircraft per year) and if we apply this figure to our financial model from 2010 then, we need to wait more then 10 years to find a positive NPV. The demand is therefore a key factor for this study because it's influenced by hypothetic competition, economic crises, political events, prices, terrorism etc... A-2-2) Production Capacity Forecasts The demand forecast being a key factor, we chose to base our study on the sales forecast. Indeed, if demand is higher than production capacity, then some customers won't be able to be delivered their aircraft.

Demand forecasts were therefore a necessary factor, but not enough to take into account Airbus production capacity. As a result, all is summarized in sale forecasts factor. A-3) Production costs The assumption of the financial model is that the operating margin is 25%. However, if we refer to the operating margin estimated by Boeing on the 747's which is 15 to 20% then it has a consequence on the Airbus projection. For example, with a 15% operating margin, we need an additional 10 years of full production capacity to get a positive NPV. Even with a 20% operating margin (consistent with Lehman-Brothers estimate) an extra 6 years of full production / demand (we assume that Airbus sells all the aircraft produced) is needed to make the project viable.

As the operating margin is a direct consequence of the Aircraft price (which is taken into account) and the production cost, we chose to study the effect on production cost (that remains the same whatever the A / C price is, whereas the operating margin changes). A-4) Investment expenditure Increasing the R&D investment from $11 billion to $13 billion, an additional 3 years of full capacity (150 aircraft) will be required to get a positive NPV with a total number of aircraft about 1250... Therefore, the investment expenditure is also a key factor, all the more as in 2001, as the aircraft was not fully defined yet, the precise investment could not be definitely known. A-5) Tax rate The taxes paid on OPT have an influence an NPV. Within the next 20 years, what will be their evolution? To make a rough estimate, the tax rate was defined as a linear function increasing from 38% every year.

B - Study: Between hell and heaven. B-1) Process Those key factor being defined, a third study was achieved in 5 parts. These 5 parts (3.1 to 3.5) are released in Appendix 4. The purpose of this study is to determine "radar graphs" that indicate areas defining the "Heaven" area where NPV 0. As these key factors consist of many other parameters, they had to be simplified by taking their average value, expressed in percentage increase relative to a reference value. Each study changes one of these 5 parameters so that it can represent a "bad situation" for the project.

As a result, the NPV decreases and becomes negative. During the study, the other parameters are adjusted so that they remain at an "acceptable" value for the project, until the NPV equals 0 (or be as close as possible from 0). As a result, we obtain the limit value between Hell (NPV 0) and Heaven (NPV.