Cash Management

Air Wars

As Airbus sales outpace Boeing's for the first time ever in 2003, the European manufacturer is also crowing over a victory for its financing strategy.
Tony McAuleyDecember 1, 2003

In the annals of great rivalries, the long-running feud between the world’s two dominant aircraft manufacturers, Boeing and Airbus, is the Ali vs Frazier of the corporate world. As 2003 comes to a close, Airbus is basking in the publicity that comes with surpassing Boeing in annual commercial aircraft sales for the first time in its 33-year history. Though garnering somewhat less attention, Airbus is also cock-a-hoop about another victory—the European manufacturer’s consistently conservative approach to financing has been vindicated, as Boeing Capital Corporation (BCC), the once expansionist Boeing lending arm, has had its wings clipped.

At Toulouse, France-based Airbus, where the vendor financing portfolio had been reduced from a peak of nearly $6 billion (€5 billion) in the late 1990s to a relatively modest $3.6 billion, Benoit Debains, senior vice president of finance, contends that Boeing’s strategy to expand BCC rapidly was doomed from the start. “The timing of their strategy is completely wrong,” he says. “They grow their portfolio when the financial market is open, therefore competing with their own banks and leasing customers. And they have entered the current credit crunch fully loaded.”

Faced with mounting losses, Boeing conceded defeat in November, announcing that it was reversing strategy for its financing unit. On the heels of the news, BCC president James Palmer, 54, took early retirement, being replaced by Walt Skowronski, Boeing’s treasurer—the fourth person to hold that job in as many years. Heralding a “new era” for BCC in a press release, Boeing’s then CFO, Michael Sears, confirmed that BCC’s status was being downgraded. Whereas BCC presidents used to report directly to Boeing CEO Philip Condit, now they would report to the CFO. (Underlining what a miserable year it has been for Boeing, Michael Sears was fired by Condit in late November for, among other things, allegedly acquiring confidential information about an Airbus bid for a Pentagon contract. Soon after that, the CEO himself was forced to carry the can for the escalating Pentagon contract scandal. Boeing’s board forced Condit aside and brought back former president and COO Harry Stonecipher as CEO.)

More importantly for BCC, its activities in the future will be limited to helping customers find financing and lending only if necessary via Boeing business units. The days of aggressive growth for BCC are over.

So what went wrong? Boeing’s financial report for the first nine months of 2003 stated the problem clearly: BCC’s $12.5 billion lending portfolio was concentrated among a small number of troubled commercial airline customers. Indeed, $4.7 billion was accounted for by just five—and two of those are in bankruptcy protection.

For Boeing, with 2002 revenues of $54 billion, the unit had become a headache. BCC recorded a net loss of $17 million in the six months ending with June 30th 2003, compared with profits of $49 million in 2002 and $152 million in 2001, according to the ratings agency Moody’s. As far as Boeing is concerned, BCC had become a diversion of management time and attention.

Brutal Lessons

The trouble at BCC highlights the starkly different approaches to sales financing at Boeing and Airbus. While both companies have always considered financing for their customers to be a key component of their business, Airbus viewed its financing role as “lender of last resort,” not the profit center Boeing wanted BCC to aim to be.

“Airbus and Boeing have pursued radically different financing strategies,” explains Sash Tusa, European aerospace and defence analyst at Goldman Sachs. “One of the major issues is that the European aerospace and defense industry in general, and the Airbus partners in particular, were stung badly by the civil aviation downturn in the early 1990s and learned some brutal lessons on financing.”

The largest operating unit of the publicly listed European Aeronautic Defence & Space Company (EADS), the group competes with Boeing for defence and space contracts too, and is controlled by a European consortium that includes Aerospatiale Matra of France, CASA of Spain, DASA of Germany, and BAe Systems of the United Kingdom. In 1992, BAe took a $1 billion (€1.4 billion) charge against bad vendor financing. “BAe Systems vendor-financed all of its output at the time … they were just kidding themselves that they were selling aircraft,” Tusa says.

Bad experiences such as BAe’s helped galvanise both Airbus and its constituent partners to set up complementary financing units (now merged)—in Dublin, because of its favourable tax laws. Throughout the 1990s, Debains recounts, these companies sought ways to offload the financial exposure they acquired to win deals, especially the burgeoning U.S. business financed by “tax lease” financing, which used third-party companies, for example Disney, to lease aircraft to airlines to exploit a tax loophole.

These deals could be of brain-scrambling complexity. Debains talks about one of the early deals, a tax-lease financing for 20 A300-600 planes for American Airlines, a component of which was a “triple-dip” structure exploiting tax laws in the United States, Ireland, and Japan.

“It was an incredible transaction,” he recalls. “But the big danger is, when you get these types of deals, you are caught up by the complexity for the sake of complexity. We did it once—c’est bon. Intellectually it was fun. But it is a danger. At some point you are losing control of what you are doing.”

In short, the approach at Airbus was not to develop a separate financing company but to keep financing as an integral part of the commercial operation, says Debains. “We do the deals that nobody else wants to do. Then we sell them into the market when we can.”

This led to tension when the finance side of the market was booming. In 1998, Debains says, he wanted to sell the United and American Airlines financing exposure. “We said we were going to sell all our exposure to United and American. Some people in the company said, ‘Why should we spend money to do that; after all, there is no risk.’ The big difference between the Boeing strategy and our strategy—which I call ‘hold-and-sell’—is we take the exposure when nobody wants to do it, or when the cost of doing it is far too expensive, and we sell it when we are able to. It is not our business to be in financing.”

The exposure to United and American was removed “synthetically” through a complex financing arranged by Lehman Brothers and Salomon Brothers and sold as more than $1 billion of securitised bonds, dubbed AIR 2 US, in 1999.

“Now, of course, selling United and American exposure looks like genius!” says Debains.

Lift Off

Things took a different turn at Boeing. As part of CEO Condit’s strategy to diversify after the commercial aircraft slump ten years ago, the company bought defence contractor McDonnell Douglas in 1997. The purchase included MD Financial Services (MDFS), a diversified vendor-financing unit that Condit initially wanted to sell. But Deborah Hopkins, who in 1998 arrived as CFO from GM Europe, where customer financing was a well-developed business, argued that MDFS could help diversification by being a vehicle for Boeing to develop its own financing unit, similar to GE Capital Aviation Services (GECAS). Lease- finance specialists such as GECAS, and insurer AIG’s subsidiary ILFC, captured about a quarter of the world commercial aircraft market through a buy-and-lease strategy, bankrolled by sophisticated financing.

As one industry observer put it, “Boeing developed ‘GE envy.’ They developed the view that vendor financing could be a ‘stand-alone’ business that could grow returns for the parent.”

Thus BCC was created, incorporating MDFS and two other financing units. Hopkins became chairman of the new unit alongside her job as CFO of Boeing, until she left 18 months later for Lucent Technologies. The financing portfolio, which had been coasting along at between $2.6 billion and $3 billion up to then, more than tripled between 1999 and 2001 to $9.8 billion. Net income doubled from $78m to $152m in the same period. But as the world economic slowdown in late 2000 and the September 11th terrorist attacks a year later hammered the airline industry, BCC’s portfolio kept on growing—to more than $12.5 billion by the end of 2002. Soon the profits turned to losses.

Down to Earth

Boeing’s management has now decided that, in the future, the company will copy the Airbus approach. “The leadership of the company has taken a look at the environment, taken a look at BCC and decided to operate within a band of risk that they feel comfortable with,” says Skowronski. “It is a change of course.”

The new “two-pronged” strategy, Skowronski explains, will focus on facilitating financing for customers, mainly by arranging third-party financing, as well as “managing down the risk”—that is, offloading the existing loan and lease portfolio. Neither of these tasks is helped by an environment that is tough for both aircraft sales and financing.

As the end of 2003 approached, there were some tentative signs of improvement in the airline industry—United Airlines’ restructuring was on track and American cut its loss from more than $3 billion in 2002 to $1 billion in the first nine months of 2003.

But many in the industry are bleak about the near term. Even after cutting production to 280 aircraft from 527 in 2001, Boeing executives say they still see industry over-capacity of between 15 percent and 20 percent, and Skowronski predicts commercial aircraft deliveries in 2004 will be flat. Airbus did not reduce its capacity at all in 2003, churning out 300 aircraft. And while some analysts are forecasting an industry recovery in 2005, Goldman Sachs sees no meaningful upturn until 2007. With industry losses still running at between $5 billion and $10 billion, according to analyst forecasts, aircraft purchasers will find it hard to source financing.

In a downbeat report in October, Moody’s aircraft finance analysts wrote that the decline in air travel since the September 11 terrorist attacks “has sent the aircraft leasing industry into an unprecedented decline. As a result, Moody’s has downgraded the vast majority of bonds issued in pooled aircraft lease securitizations.” It said, overall, this meant that lease rates had fallen by between 25 percent and 60 percent. The lease companies, so important to financing in the market, weren’t likely to be big financiers of aircraft purchase until rates pick up again.

Skowronski acknowledges that the task of scaling back its financing portfolio will be tough. “We are looking at what we can do to mitigate the risk,” he says. “There are several things we can pursue—securitization, monetizing by selling off physical assets, various things in the insurance market place. But the markets have to be there, and for several of these right now, the markets aren’t there.”

Also, BCC’s portfolio has momentum that could see it grow more before it can be scaled down. For example, exposure to the top five airlines in the portfolio grew by $1 billion in the first nine months of 2003. And Boeing accounts show that there is another $4 billion in potential financing commitments that BCC might have to honour up to end-2005.

Meanwhile, Airbus is taking steps to limit its financing exposure. Last spring, it created a new Dublin-based company, Avion Capital, with partners CIT, Credit Agricole Indosuez, and Kreditanstalt für Wiederaufbau, a vehicle that will allow it to “finance an inventory of financial assets. It is like a funnel out to the market,” says Debains. “It is going to be just one additional tool. We have to continue to invent new ways to finance aircraft.”

But the main control mechanism for Airbus is that it has restricted itself to financing a maximum of 5 percent of sales in the current depressed market, expecting to offload when the market gets better.

At Boeing, things are tougher. As Tassos Philippakos, aerospace and defence analyst at Moody’s, says, “You have to make a distinction between the past, present, and future at Boeing. In the past, it was looking to grow its BCC portfolio by at least 30 percent a year. But the thinking at Boeing has changed. I believe we will see, in the future, a much more conservative approach. But for a couple of years it may be difficult for them to slow down or to decline the financing significantly because of the commitments they have made in prior years.”

There has been some speculation that Airbus exposure is understated, that they have hidden risk in things like “residual value guarantees” to purchasers. But Tusa at Goldman Sachs says that Airbus has “consistently surprised to the downside in terms of their exposure, and that’s a good thing.”

As Debains points out, the risk factors that suddenly hit the industry at the end of 2001 are still with us. “After 9/11 there was a reality check. People realised it was a good idea not to double your credit risk in the industry, because when things go wrong it all happens at the same time.”

Turbulence

Boeing Capital Corporation’s top five exposures:

  • AirTran. Exposure at the end of September 2003 was $1.4 billion (€1.2 billion), nearly 12 percent of the portfolio. The low-cost airline was reconstituted out of ValuJet, which was grounded in 1996 after a notorious crash in the Florida swamps. With revenue in 2002 of $733 million and assets of $430 million, AirTran effectively runs a fleet of aircraft on behalf of BCC.
  • The exposure to UAL, parent of United Airlines, was $1.2 billion. UAL, which filed for bankruptcy protection in 2002, has been negotiating new financing terms with Boeing and other creditors.
  • AMR, parent of American Airlines, which had lost more than $6 billion in the previous three years, accounted for $910 million of the portfolio.
  • ATA, another budget airline, accounted for $718 million. It reported a small profit this year, but still rescheduled lease payments in September with BCC and other aircraft lessors.
  • Hawaiian Airlines, which accounted for $536 million, also was in bankruptcy protection.