America’s biggest exporter is having a banner year, thanks to a surge in global demand for jetliners. The Boeing Company has just experienced the most profitable quarter in its hundred-year history, and with a backlog of $376 billion in orders for commercial transports such as the 737 and 787 it looks like E.P.S. could reach $10 by the end of the decade — twice what it was when the decade began. With no end in sight to the growth of passenger travel and hunger for more fuel-efficient transports, there are whispers that Boeing revenues might hit $100 billion in 2016, the centennial year of the company’s founding (they will be about $90 billion this year).
(Disclosure: Boeing contributes funding to my think tank.)
The one big question mark in this picture is what will happen with Boeing’s defense business. That operation, which focuses mainly on military aircraft, space systems and aerospace services, has held up surprisingly well in the recent defense downturn — typically generating over $30 billion in sales annually. But with congressional mandates capping defense outlays and commercial orders continuing to grow, Boeing Defense, Space & Security (as it is called) now only generates about a third of corporate sales. Many investors barely seem to notice the military component of the business, focusing instead on Boeing’s reputation as the biggest builder and leading innovator in commercial flight.
With so many opportunities beckoning in the commercial transport sector, it is inevitable that somebody somewhere will raise the question of whether Boeing’s capital could be better deployed by going full-bore on new jetliners while scaling back in defense. The sizable charge recently taken on an Air Force tanker program is just the latest evidence that defense is far from being risk-free for Boeing. Several of the biggest bets the company has made in next-generation military systems over the last decade have not panned out, forcing painful adjustments at Boeing facilities in Alabama, California, Missouri and elsewhere.
When I raised that issue with Boeing Vice Chairman, President & COO Dennis Muilenburg this week, I got a firm response. According to Muilenburg, “Our concept of One Boeing assumes an integrated business mix of deep commercial and military expertise applied across the global marketplace.” Muilenburg says the strategy of combining commercial and military lines in a single synergistic enterprise was crafted two decades ago when Boeing merged with McDonnell Douglas, and has remained central to the company’s identity ever since. Under Chairman & CEO James McNerney, the company’s incentive structure and promotion system have been crafted to reinforce the idea that Boeing’s military and commercial lines are inextricably united.
That got me to thinking about the logic of such a strategy — about how you would explain it to somebody who was trying to understand the Boeing enterprise beyond this year’s results, as the only large aerospace company that has managed to survive intact since the dawn of flight. Most of Boeing’s big competitors didn’t exist two generations ago, and some of them came into being only as the result of massive subsidies from friendly governments. Why has Boeing thrived for so long without government handouts, and how does that inform its strategy of remaining committed to both the commercial and the military parts of the aerospace market? Here, to my way of thinking, are the top reasons why maintaining a big presence in both market segments serves Boeing’s shareholders and stakeholders.
1. Defense and commercial demand cycles tend to be complementary. Historically, the commercial transport sector has been a boom-and-bust business. So has military contracting. But the two market segments follow very different demand cycles, so much so that they sometimes seem to be varying inversely. For instance, demand for jetliners plummeted after the 9-11 attacks, while demand for combat systems surged. Today, the opposite is happening. That would be quite a roller coaster ride for investors if Boeing operated in only one market segment, but because it is in both, revenues and returns can be smoothed out from year to year. Some Boeing insiders have used the metaphor of counter-rotating gears to describe this dynamic, however to make it work the company must have a robust presence in military contracting to balance the ups and down of commercial demand.
This 787 Dreamliner epitomizes the success Boeing’s commercial jetliner business is currently experiencing, but over the long haul military sales may be just as important to sustaining the enterprise’s profitability. (Image: Wikimedia)
2. Aerospace skills are fungible across defense and commercial markets. When Boeing announced this week it was moving defense jobs out of the Seattle area, it noted that some of the defense workers in the region might shift over to jobs at the company’s commercial operations. That possibility underscores the fact that while defense and commercial lines have different customers, they require many of the same skills to succeed. Boeing builds military, commercial and civil satellites at the same factory in Southern California, and increasingly is sending commercial work packages to defense sites with excess capacity. The fungibility of skills across market segments thus allows it to get maximum utilization of resources and retain talent even when demand in one segment is softening.
3. Business characteristics of defense and commercial aerospace are similar. Boeing’s core business is the design, production and support of complex capital equipment such as satellites and jetliners. Whether that equipment is destined for civil, commercial or military use, it exhibits certain shared characteristics in terms of how it is financed and sustained. For example, products typically take a decade or longer to develop, and then remain in service for many years. Creating such products requires the company to make huge up-front investments, and returns on that investment may not materialize until many years after production has commenced. Barriers to entry are high, but so are risks for those who have managed to establish a presence in the business. Even the operating margins are similar; Boeing projects an operating margin of somewhat above 10% in commercial aircraft this year, compared with 9.5% in its defense business. All these similarities make it easier to manage what appears to be a very diverse business mix.
4. Military customers are migrating toward commercial products and processes. The Pentagon has recently proposed reducing barriers to purchase of commercial items, signaling dissatisfaction with its traditional reliance on military-unique technologies. That is good news for military suppliers like Boeing who have long experience in refining commercial manufacturing and logistical systems. Many of the joint force’s next-generation reconnaissance and mobility aircraft will be military derivatives of Boeing commercial transports, and the satellites the company builds for NASA and the Defense Department leverage technologies developed in its commercial comsat business. Thus, there are functional and engineering synergies between its military and commercial lines that transcend mere economies of scale.
5. Defense is less vulnerable than commercial markets to predatory trading. Although Boeing’s jetliner business is riding high today, it faces serious challenges in the future from state-subsidized market entrants in Brazil, Canada, China, Japan and Europe. Some of the governments working to help local companies penetrate the commercial transport market are far more supportive of indigenous enterprise than Washington (witness the current controversy surrounding reauthorization of the Export-Import Bank). The U.S. defense market is less subject to such pressures for the simple reason that America can’t risk being dependent on countries like China for its combat systems. So defense offers Boeing a partial sanctuary against the predatory trading practices of foreign competitors, even as it strives to maintain market share in the commercial transport sector.
When you survey all the ways in which Boeing military and commercial lines overlap and support each other, it becomes obvious why the company needs to remain a big player in the military marketplace. Nothing lasts forever, and that includes the current surge in demand for jetliners. One day — probably the next time there’s a global recession — demand for commercial transports will soften. If past experience is any indication, military demand may be surging at the same time. Being in both markets is the best way to assure that Boeing can sustain its market leadership in aerospace for another century.
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