The origin of problems with the Boeing 737 MAX and a possible solution via return to fundamentals. :PART THREE

PART THREE

Ironically, Boeing’s “bet the company” strategy — built on Engineering & Design excellence — in connection with each successive introduction of new generation commercial jet aircraft was/is less risky than its more recent focus on maximizing short-term earnings by reshuffling assets, emphasizing cost cutting at the expense of long-term value creation and upgrading older aircraft models not conducive for incorporating the latest aviation technologies.  Boeing needs to give strong consideration to refocusing on what made the company great, and applying those fundamentals to help regain its leadership in commercial jet aviation.  See attached PPT slides titled RISK AND FINANCIAL DECISION MAKING.  The template for more than half a century of aviation excellence arises from its signature 707 jet airliner — which launched the mass market for commercial jet air travel.  This special PPT slide presentation provides the backstory.

Agenda
Introduction / Observations

How Financial Markets Price Risk

Risk vs Uncertainty: What is the difference?

Decision Making, Risk & Behaviorist Finance

BOEING 367-80: A Case Study in Betting it All

Lessons Learned

Author Notes / Closing Thoughts

About the Speaker

Reference Sources

Introduction / Observations
In Finance, risk adjusted return is measured by
the Coefficient of Variation (CV). This is
mathematically expressed as: CV =
σ / ṝ
where
σ = standard deviation of historic return
and ṝ = mean average historic return.

In Finance, rational decision making (RDM) is
where market participants seek to minimize risk
in relation to return (i.e., a lower CV) or
conversely, maximize return in relation to risk
(i.e., the inverse of the CV or ṝ /
σ ).

How Financial Markets Price Risk
The present value (V) of an initial end-of-year
perpetuity payout of $C (growing at g% ) per period
with a required return of r% is:

V = C / (r g)

Explanatory Notes: (1) When calculating value into
perpetuity, the “g” is less than “r” because as a practical
matter it is embedded into the “r” as natural rate of
growth governed by mathematical limitations associated
with base “e.” (2) Risk premiums are included in “r”
where higher risk lowers “V” and vice versa. Therefore
Financial Markets price risk via required return “r” (aka
cost of funds).

Risk vs Uncertainty
In Finance, “risk” and “uncertainty” are two distinctly
different concepts.

Risk implies that decision makers can form a
probability distribution on future outcomes.

Uncertainty implies that decision makers are not able
to form a probability distribution on future outcomes.

Probabilities are established based on a fusion of
historic data, comparables and intuition.

Uncertainty lowers Value more than increased risk due
to unknown probabilities. Investors overcompensate
for the unknown vs known probabilities.

Behaviorist Finance & Decision Making
In Finance, a Rational Decision Maker (RDM) may be
faced with situations having both known and unknown
probabilities, and often across multiple time periods.

In these situations the RDM will most certainly act as
though he or she is seeking to maximize return in
relation to risk or minimize risk in relation to return,
even when probabilities are unknown. Behaviorist
Finance is applied here to understand the motivations,
culture, norms and disposition in relation to risk-taking.

This can be especially useful with situations where
transformative concepts are involved.

BOEING 367-80
A Case Study in Betting it All

Background on 367-80
Since helping launch the commercial jet aircraft age with its
prototype 367-80 model in the 1950s, the Boeing Company has
taken very large risks on developing new generations of wide-body
commercial jet aircraft. This approach has historically been known
as a “bet the company strategy.”

Despite a few close calls, Boeing has emerged successfully from
each cycle, enabling it to maintain industry leadership and generate
satisfactory long-term financial returns. In this presentation, as part
of our ongoing research on risk-taking behavior we focus on the
367-80 model that formed the template for Boeing’s “betting it all”
corporate strategy associated with the launch of new generations of
wide-body aircraft over the ensuing decades.

The prototype 367-80 is the airframe from which the 707
commercial airliner and military KC-135 tanker aircraft were built.

The Context for Betting the Company
Capital investment decisions at Boeing are unique
andto some degreerisky. In the mid-1950s,
despite failing to profit on civilian planes in two
decades, Boeing spent $185 million to develop
the 367-80 for the commercial aircraft market,
despite not having made money in a non-military
plane in twenty years.

To put this in context, this capital investment was
$36 million or 25% more than Boeing’s total net
worth of $149 million in 1956!

Cost of Launching the 367-80
FINANCIAL CATEGORY AMOUNT (US $ Millions) BREAKDOWN in % TERMS
PROTOTYPE 16 9 %
ENGINEERING & TOOLING 100 54 %
PLANT & EQUIPMENT 35 19 %
THRUST REVERSER &
SOUND SUPPRESSOR
7 4 %
ADVERTISING & SALES 4 2 %
FLIGHT TEST & RESEARCH 23 12 %
TOTAL $185 Million 100 %
Financial Outcomes
• Boeing did “risk the company,” as measured by the cost to
develop the program ($185 million) versus its net worth
($149 million) with the cost for the prototype exceeding its
average annual Net Income by 33% ($16 million versus $12
million) over the same period.
• This risk was tempered by leveraging the cost over two
end-user markets rather than one PLUS 70% commonality
of major components for military and civilian variants.
Boeing established a sales-and-earnings platform on an
already strong, well-established business (defense/military)
that could be adapted for creating a global civilian
commercial segment.
• With the military variant (KC-135) having recovered the
original investment, the subsequent commercial variant
(707) led to a 2.5x increase in Net Income (late 1950s/early
1960s versus mid-1950s) and by 1967-68, Net Income was
2x higher than its 1961 level.
DESIGN FOR COMMERCIAL SUCCESS
GREAT PROTOTYPE = COMMON PARTS 70% = REDUCED COST!!
COMMON PARTS
MILITARY
COMMERCIAL
The Legend: Boeing 367-80
• Proof of concept prototype model: Jet propulsion engines
• Units manufactured: 1
• CTC: $16 million in 1950’s ($149 M in 2018)
• Legend: 1st jet aircraft in USA
• Served as the base design for:
• KC 135 – Military variant
• 707 – Commercial flight
Military Variant: KC 135
• Units manufactured: 820
• (732 no. used as tankers, 88 no.
modified and used for special purposes
such as reconnaissance & transport of
high level government officials.
• Current status: Production discontinued. Older
models have been refurbished for used until
2040
• Major difference:
• Fuselage shape and capacity
• Cargo hold
Commercial Variant: 707
• Units manufactured: 1010
• Current status: Decommissioned
• Major difference:
• Fuselage shape and capacity
• Windows
• Passenger Seats
• Luggage
UNIQUE
PARTS –
30%
COMMON
PARTS
70%
UNIQUE
PARTS –
30%
Time Line & Basis for Making it Work
• In 1955, Boeing secured production order of 400 military units from
the US Air Force (Strategic Air Command) for its 367-80 airframe.
• With this strong endorsement and burgeoning world travel,
commercial airlines started to express interest. Airline executives
were sold on the 707 after seeing its double-barrel roll demo flight.
• Boeing differentiated itself from both foreign and domestic
competitors by maintaining flexibility with its own customers.
Specifically, Boeing was able to widen its cabin space by four inches
with minor engineering and tooling costs plus retain the core
features incorporated into its military prototype.
• This enabled Boeing to have faster time-to-market deliveries and
higher absorption rate of fixed overhead for both military-and-
commercial aircraft assembly operations.
• Boeing achieved breakeven with its 707 commercial variant in late
1956 due to USAF production order for the KC-135 variant.
Commercial deliveries (e.g., Pan-Am, American, TWA & BOAC)
provided further increase to corporate net income.
How Investors Viewed Boeing’s Betting the
Company on Launching the Jet Age
• Investors initially responded positively to military shipments
(KC-135) and while taking a “wait-and-see” on burgeoning
commercial interest. Boeing’s stock price reached a high of
$79.63 in 1955 and then fluctuated for the next three years
going down to $36.62 in 1957 and then up to $45.62 the
following year.
• The surge in commercial shipments (707) enabled Boeing to
fly high. Stock price achieves high of $166.75 in 1966,
anticipating peak net income in 1967-68 [driven by triple-
digit unit shipments in same period]. Author Note: Boeing’s
stock price tends to track shippable order rate rather than
corporate net income.
Lessons Learned
• Boeing’s success in commercial jet aircraft
stemmed from its military aircraft business in
terms of risk sharing (e.g., 707 and its military KC-
135 version) and diversification PLUS efficiency
through commonality of major components for
both variants.
• When faced with unknown probabilities Boeing
bet its entire corporate financial fortune on
transformative aircraft technology where the
return or payoff was ownership if not dominance
of the new market it helped to create! 
Author Notes / Closing Thoughts
• Research Support: Sonal Badavaram
Surendranath. Financial Research/Analytics.
University of California at San Diego – Extension
Division. Graduate Assistant – Finance Certificate.
• This presentation is dedicated in blessed memory
of Dr Vassilios Elias Haloulakos (1931-2019)
whose pioneering work on rapid explosive
decompression with wide-body jet aircraft helped
to make commercial air travel safer for millions of
global travelers.
About the Speaker
• George Haloulakos is a Chartered Financial Analyst (CFA), university
instructor, author and entrepreneur [DBA Spartan Research and
Consulting] who provides strategic financial insights on various
historic aircraft.
• George’s signature books are CALL TO GLORY, an economic
reappraisal of the Convair B-58 Hustler nuclear strike bomber, and
HIGH FLIGHT, a compendium of case studies on various American
and British aircraft from World War II through the Cold War.
• CALL TO GLORY (ISBN 9780692475454) and HIGH FLIGHT (ISBN
9780100727380) are available at: www.ucsandiegobookstore.com
or phone order 858-534-7326.
• Other books by George are Dollars and Sense: A Workbook on the
ABCs of Investments and Directed Studies in Advanced Financial
Analysis. These titles are also available from the same source.
Reference Sources
• The Art of Finance – Focus on Investing. Dr.
Harry Markowitz. Loring Ward. 2017
• Boeing Company. Public Documents 1950-2015.
• CALL TO GLORY. George A. Haloulakos. UC San
Diego Bookstore Publishing. 2015.
• HIGH FLIGHT. George A. Haloulakos. UC San
Diego Bookstore Publishing. 2014.
• Jane’s U.S. Military Aircraft Recognition Guide.
By Tony Holmes. Collins. 2007.
• The Observer’s Book of Aircraft. William Green
(compiler) and Dennis Punnett (silhouette
artist). Frederick Warne & Co. (London and New
York). 1965.
• “Reformulating Corporate Financial Theory for
the 21st Century.” George A. Haloulakos –
Graduate Assistant. Research support for M.C.
Findlay, III (Finance Chair – USC Marshall School
of Business). 1981.
• Spartan Research and Consulting. Case Study
Files, Interviews and Research Notes on Capital
Goods and Military Aircraft (1979 –to date).
• “The Wave Dynamics of Explosive Decompression in
Jumbo Jets.” Dr. Vassilios Elias Haloulakos. 1975.
• “The Wave Dynamics of Explosive Decompression in
Jumbo Jets – UPDATE 2011/2012 – The Resolution of
DC-10 Cargo Door Problem.” Dr. Vassilios Elias
Haloulakos. 1975.
• https://defpost.com/boeing-awarded-17-5-million-
c-kc-135-engineering-sustainment-support/
• http://www.flugzeuginfo.net/acdata_php/acdata_7
07_en.php
• http://www.flugzeuginfo.net/acdata_php/acdata_kc
135_en.php
• http://www.boeing.com/commercial/airports/3_vie
w.page
• https://www.sierrafoot.org/aviation/dash80.html
• Interviews with Dr Vassilios Elias Haloulakos. 2013-
2015
• Interview with Dr Harry Markowitz. Oct 16, 2017
 

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