Tragically, on the morning of March 10th, Ethiopian Airlines flight 302 crashed minutes after takeoff from Addis Ababa. None of the 157 passengers and crew survived. All crashes involving modern commercial airliners are immediately international news. Modern air travel is statistically very safe and crashes uncommon. Sadly they also often involve significant casualties, as this one did.
This crash was more newsworthy than most, as the crash involved a virtually brand new aircraft, a four-month-old Boeing flown by an airline with a good safety record. Even more noteworthy, it was the second crash of a brand-new 737 MAX, a new variant of the short to medium-range single-aisle airliner Boeing introduced in the late 1960s, in the span of several months. In the earlier crash of a Lion Air flight in Indonesia, a faulty sensor and anti-stall software unfamiliar to the pilots known as “MCAS” allegedly pushed the nose down in an automated maneuver intended to prevent a “stall”. The pilots, unaware of the cause or how to correct it, repeatedly tried to level the aircraft only to have it recur several times before ultimately losing control.
Boeing is the most successful aircraft manufacturer in history, and the 737 is the highest selling commercial jet. Boeing has sold nearly 10,500 of them over the past 50 years, and nearly 5,000 of them are on order by airlines around the world. The success of the 737 over the years reflects modern air travel and consumer preference. Several other commercial airliners are arguably better known despite being produced in far smaller numbers. The Boeing 707, 747 and more recently the 777 and 787 Dreamliner represented the pinnacle of what the company could produce. Competitor Airbus built the largest commercial airliner, designed to exceed the twin-deck widebody 747 in most respects with the enormous A380. While the jumbo jets may give the manufacturers (and their respective countries) bragging rights, the largest jets are better suited to hub and spoke transportation models, which tend to involve connecting flights. Unsurprisingly, however, passengers prefer the fastest direct routes and prefer to fly on single-aisle aircraft such as the 737 and Airbus A320 or regional jets from Bombardier or Embraer to get to their destinations faster.
So while the largest jets are impressive, and have utility for long-haul international flights, the smaller and mid-sized airliners represent the bulk of commercial flights. The Airbus A380 is being discontinued, and the 747 phased largely into cargo duties. Until recently, operating an airline, in the aggregate, was not a profitable business. Characterized by boom and bust cycles, the capital intensive nature of the business left airlines struggling to contend with everything from deregulation, to volatility in fuel costs, to economic cycles, overcapacity and disputes with unions regarding pay. Consolidation mitigated some of these competitive issues. An increased focus on point to point travel reduced competition from several airlines to perhaps only a couple airlines on a given route, or even none. Discipline with capacity and sophisticated optimization helped the airlines increase load factors and maximize revenue per seat mile (PRASM). In recent years fuel costs, which at one point represented as much as 50% of an airlines operating costs fell to as low as 25% or less.
Finally profitable, airlines around the world seek to meet growing demand and grow their routes and fleets, and cut operating costs. Fuel costs are an ever-present risk, thus the fuel efficiency of airliners remains a top priority, and the most recent versions of the 737, the MAX 8 and MAX 9 promised improved efficiency. These aircraft represented a win/win for both Boeing and their customers. The 737 fills the critical short and mid-haul niche, is proven, and is easier and less expensive for Boeing to produce than a clean sheet design which they contemplated. Airlines can appreciate the benefits of transitioning flight crews to newer versions of existing aircraft rather than training for completely new planes as well. However improving the efficiency of an airliner designed over half a century ago does involve some changes, some of which even casual observers will recognize. 737s, like many modern airliners, now have aerodynamic improving “winglets” on the tips of the wings, distinctively in the case of the 737 MAX, both up and down. The 737 has also gotten much longer over the years to increase capacity, and naturally more efficient engines. However optimizing engine efficiency involves some possibly significant tradeoffs.
The new engines used on the 737 MAX series aircraft are substantially more fuel efficient than the engines they replace, but they are also much larger. The new engines are 850lbs heavier and have fan diameters 11.5% larger. The increase in size required other significant changes. To accommodate the larger diameter engines while maintaining sufficient ground clearance, a longer nose wheel strut is used. A more significant change, the engines are mounted further forward, and slightly above, the wing. Installing a larger heavier engine further forward changes the flying characteristics and stability of the aircraft. To address the stability issues this created, Boeing also introduced new software “Maneuvering Characteristics Augmentation System” or “M.C.A.S.” to maintain flying characteristics similar to the prior generation 737s. Engineers endeavor to make every aircraft easier and safer to fly, part of which includes attempting to incorporate systems that will avoid the risk of a crash due to pilot error. In aviation a stall, which can be caused by an overly aggressive angle-of-attack relative to the incoming wind, results in a decrease in lift. A common feature of modern aircraft designed to warn pilots of an impending stall is a “stick shaker”. Pilots appropriate response is to push the nose down, thus reducing the angle of attack and increasing speed. Reportedly Boeing recognized that the modified engines and placement of the 737 MAX reduced stability and possibly increased the risk of a stall, so MCAS was designed to offset this increased risk by automatically pushing the nose down when a stall was imminent as determined by the plane’s sensors. In theory, this should enhance safety however, if the system engages improperly or if pilots do not how to regain control of the aircraft once it engages, one potential danger may be replaced by another.
In the case of the Lion Air crash, pilots who had flown the plane earlier had reported that the anti-stall systems engaged improperly, and questions arose around maintenance procedures that permitted the plane to fly despite a potentially faulty angle-of-attack sensor. Parallels between the two flights were quickly drawn as one of the pilots in the doomed airliner reported flight control problems, and data provided to the FAA now suggest similarly erratic flight patterns occurred on both flights prior to crashing, hinting that the same malfunction may have been culpable in both cases. Consequently, the FAA joined regulators from around the world ordering the temporary grounding of Boeing 737 MAX aircraft.
Boeing was criticized after the Lion Air crash for not properly advising operators about the new systems, and how to override them. However, this most recent crash occurred after additional information was provided to operators. Although it remains uncertain whether the plane’s less stable design or MCAS were at fault, the potential implications are enormous. Boeing has approximately 5,000 737 MAX aircraft on order. At $120mm average per aircraft that represents $600 billion in revenue. Will any of these orders be canceled? How many? There are more immediate potential liabilities as well associated with two catastrophic crashes and the huge expense of grounding the remaining 374 737 MAX planes that were already delivered.
Boeing has an enviable reputation, but reputations that take a long time to build can be tarnished quickly. The company has historically traded at a deserved premium to both defense contractor peers like Lockheed, Raytheon, and Textron and also to major commercial airliner competitors such as Airbus. At 18x forward earnings, 12.3x EV/EBITDA sporting 11-16% growth in those categories respectively the valuation seems reasonable and is supported by secular tailwinds. However, these disasters present a serious storm cloud that will cap upside gains until the causes are fully understood and airlines and their customers are confident any risk or issues have been completely resolved.
If valuation and fundamentals create some level of support, but concerns create a headwind, that suggests BA could be somewhat rangebound. Yet short-term options premiums have doubled since mid-late February. Does this present an opportunity then to sell premium (e.g. short straddles, strangles or iron condors). I’m inclined to say yes with respect to the upside sale. Nothing short of an exoneration would push Boeing back to $440 where it was at the beginning of the month between now and earnings in late April. However, the downside could be considerably lower than where the stock is currently trading. BA traded as low as $294 in December, and it was, at least by measures such as RSI, overbought even before this most recent tragedy.
The investigation into the cause of this most recent crash is still just beginning, and the black boxes, which could provide important details regarding the doomed flight, were damaged in the crash and have been sent to Paris for analysis. Even if the data point to another cause, Boeing has been working on software changes since the Lion Air crash, a process that reportedly may be months away from completion according to the FAA. Retesting recent highs, let alone surpassing them, is unlikely. Meanwhile, Boeing did trade 20% lower than the current level as recently as December, a level it could retest if the news gets any worse.
