Boeing Versus Airbus

by John Newhouse

  According to published reports, the Japanese suppliers would receive $1.6 billion of direct assistance from their government in return for their work on the 787—an amount at least equivalent to the launch aid Airbus was intending to request from its official patrons. The idea of commercializing launch aid had appealed for some time to various politically shrewd Airbus executives who wanted their Paris-based management to give up launch aid altogether and to rely solely on commercial paper. They were aware of pockets of support within each of the member governments—stronger in some than in others—for proceeding without this kind of help.

  Rightly or wrongly, however, various British and German advocates of commercializing the aid have worried that if they didn’t provide it, the French would, and then insist on locating all the work on a new aircraft program in France. (It’s known, tongue in cheek, as the “Franco-French” scenario.) So the issue was partly about jobs and about making certain that key pieces of Europe’s aerospace industry remained in each partner country.

  For example, although the British have talked a good game in private about giving up launch aid, some parts of their system like what they see as a decent return on the money under current arrangements. Also, on the A350 program, Britain would acquire much the largest share of launch aid because its industry would be responsible for the wing, the most innovative part of the new airplane and the one that would hence absorb most of the engineering.

  Airbus was being victimized or was victimizing itself by the warfare among its various patrons. The member governments that supplied the launch aid were mad at one another and at the European Commission, which they thought wasn’t much help. In turn, the Commission resented their encroachment on its turf. And all sides were mad at Airbus, because the company didn’t seem to know what it wanted but did resent their interference.

  The problem, or mess, was circular: Airbus couldn’t say what it wanted because these same governments—French, British, and German—were the ones that could dictate the decisions that mattered. And these governments, especially the French, were internally divided over what to do. “It’s like trying to herd cats,” said one disgruntled Airbus official. “My hope,” he said, “is that Jim McNerney [Boeing’s new leader] will decide that his first big task is to fix Boeing and then say to himself, Why should I screw around with this trade issue? Let’s make a deal.”21

  As Airbus saw it, the foolishness was compounded by its own corporate manager, EADS, which aspires to replace Boeing as the supplier of aerial tankers to the U.S. Air Force, and hence has wanted to end the fight over subsidies. The company’s hierarchy worried that continuing to accept launch aid for Airbus would allow elements in the U.S. government and Congress to block efforts by EADS to break into the high-margin U.S. defense business. The steady decline in Europe’s spending on defense pointed up EADS’s concern, and also the gap between its priorities and those of Airbus, which has no interest in trading launch aid for military aircraft sales.

  During the Paris Air Show, a biennial event held outside Paris at Le Bourget Airport, the Europeans tried belatedly to clear the air on the dicey question of a trade on subsidies. But their position was largely rhetorical. Airbus would give up launch aid for the A350 provided Boeing surrendered most of what the Europeans were complaining about—indirect subsidies from the Pentagon, plus the help from Japan on the 787, plus a subsidy from the state of Washington, where the 787 will be assembled.

  Boeing swatted that back. Even though the company’s declaratory position was “Everything is on the table,” its chairman, Lewis E. Platt, argued that the only issue was the $15 billion in launch aid that Airbus had received over the previous thirty years. “It’s very hard to imagine a quid pro quo,” he said. “To me, their position seems to be, ‘We’ll give up launch aid if you give up something.’ We think we’ve made our position clear that we have no launch aid to give up.”22

  Instead of asking for so much, Airbus could have proposed zero launch aid for both the A350 and the 787, or a different sort of arrangement whereby each party would receive up to $1.5 billion in subsidies for its new airplane. Either approach would have amounted to a step toward a level playing field.

  Airbus has some talking points. What it gets in launch aid is limited to one-third of a new product’s development costs, and how much that works out to per program is a matter of record. But the details of the Japanese government’s financial involvement with the three heavies are often described as murky. What is known is that the terms of this assistance are more generous than what Airbus receives from its patrons and that the amounts are larger.

  Boeing would probably have said no to any proposal that equated launch aid in Japan with launch aid in Europe, if only because the 787 program already harbored several risks and uncertainties. The company is depending heavily on this new airplane because its portfolio of products is aging.

  The importance that Boeing attributes to the 787 resonates in its company rhetoric. “It will be the mother and father for whatever we build for probably the rest of this century,” a Boeing spokesperson said grandly at the Paris Air Show,23 which made more news than usual. Possibly. For now, it seems to be the most interesting, advanced, and potentially successful new airplane that the world airline market has seen in recent years. But it has still to be built.

  Boeing would recoil from having to redesign its complex relationships with key suppliers and thereby slow down its development of the 787. However, a proposal from Airbus linking launch aid for the A350 with comparable Japanese government support for the 787 would have been fully compatible with the WTO and have put the ball in Boeing’s court. Airbus could have said to Boeing, “This is what we will do. What will you do in return?” And Airbus could have started talking with the Japanese about launch aid.

  That sort of conversation would not have been possible so long as Airbus continued to accept launch aid. The Japanese had already said that much and more about their unwillingness to become a party to the dispute. But by aligning its position with WTO rules, Airbus would have been better positioned to nudge the Japanese toward serious talks.

  However, the Europeans were split on whether to play the Japanese card. “We don’t want to upset the Japanese,” Henri Courpron said with little conviction. “Airbus would love to do business in Japan. We have a one or one and a half percent market share there on a good day,” he added sardonically, “and this would make it more difficult to sell the A380 in Japan.”24 Japan Airlines is on a short list of Asian carriers that are judged likely to buy the A380. Incidentally, the European Union, in filing its countercomplaint against Boeing, did not mention Japan.

  The importance to Boeing of its Japanese connection cannot be overstated. Boeing has been a presence in Japan for more than half a century. Japan’s government and its aircraft industry are deeply involved with Boeing. The informal arrangement amounts, in effect, to what is characterized as offset: in return for Japanese industry having acquired a privileged-supplier relationship with Boeing, Japan’s airline market—the world’s second strongest (after the United States) until the Chinese market matures—has become a Boeing preserve. The two principal airlines, Japan Airlines (JAL) and All Nippon Airways (ANA), have fleets composed almost entirely of Boeing aircraft. Offset, it’s worth noting, is in direct conflict with WTO rules.

  In return, Japan’s three heavies built about 15 percent of the Boeing 767 and 20 percent of the 777. Now the three are designing and building a substantial part of the 787, including the wing, the clever part of any airframe; it is Boeing’s first new airplane since the 777 entered service in 1994.

  Boeing draws on low-cost financing from the world’s second-largest economy to pay a major share of its airplane’s development costs. Why else build major parts of it four thousand miles away from Puget Sound? Clearly, this is about having access to cheap money and, again, to what remains the world’s prize airliner export market. Briefly, Boeing can use Japanese money to carry a big part of the 787’s deve
lopment costs and worry later about fine-tuning the financial arrangements with the three heavies.

  Still, while the relationship is of vast importance to both sides, it does remain one between a principal and three suppliers who have acquired a demanding and exacting role that Boeing no longer wants to play. These three do have leverage. They know—and so does Airbus—that the attraction to Boeing of the Japanese suppliers lies mainly in the strong financial support they receive from their government.

  The three companies do have differences with Boeing over how to operate, and there have been contentious issues concerning money, some of which won’t go away. These were reflected in the prolonged absence of formal agreements between Boeing and the three heavies, which felt that the 787 posed huge risks for them, including an all-composite fuselage and other novel features and uncertainties. Boeing, they felt, was expecting too much from them in return for their taking on these risks. At one point, they judged that the deal on offer from Boeing would cover just 70 percent of their costs. Boeing had asked one of them, Mitsubishi Heavy Industries, to accept an even larger role, but MHI refused.

  Another of the large uncertainties has involved the market price of the 787, more exactly, the size of the discounts offered to various customers. The issue is who feels the pain—the airframe maker or its suppliers—that is caused by selling airplanes at concessionary prices. “There are always discounts on any airplane,” says Larry Clarkson, who in the 1990s was Boeing’s senior vice president of planning and international development and managed negotiations with the Japanese. “The 747 may have been the only one that has sold somewhere close to its list price. On the 787, some of the pain will be shared, but Boeing will absorb most of it, because the company won’t allow any of the parties, even its risk-sharing partners, to know the size of the discounts. Although the biggest customer for the 747 was Japan Airlines, the discounts it got on price were among the smallest given in the 1980s and ’90s.”25 If the three heavies knew that, JAL would presumably also find out—and very quickly.

  The contractual arrangements on the 787 were not agreed to until May 26, 2005, eighteen months after the decision to go forward with the airplane. Boeing’s relationship with Japanese industry harbors vulnerabilities. A less confused, opaque, and divided European leadership might have probed them to advantage. As for who exactly decided to downplay the Japanese issue, Henri Courpron said, “No one can find the fingerprints of whoever made the decision.”26 It’s hard to see how this messy dispute can be settled unless the parties dispose of the Japanese issue in one way or another.

  In October of that year, the EU proposed restarting negotiations over launch aid, after EADS announced that it would postpone taking launch aid in the meantime. Within hours, the U.S. Trade Representative’s office replied that it would continue legal action against the EU at the WTO.

  In the spring of 2006, these same official parties were in control, and not much was happening other than talks about talks. At the Farnborough Air Show, James McNerney, Boeing’s chief, said, “I am optimistic that we will get a negotiated settlement, but I believe it will take time. This is a goverment-to-goverment issue. I don’t want to get out in front of my government.”27 The companies, seemingly weary of the stalemate, could do little about it.

  CHAPTER FOUR

  Market Share—the Airlines’ Enemy

  THE MAJOR U.S. AIRLINES are floundering. In little more than three years after September 11, 2001, the industry worldwide lost more money than it had earned since the start of powered flight. Rising oil prices enlarged the difficulties, as did the SARS epidemic. The heaviest losses were incurred by American carriers.

  Although the impact of 9/11 on airlines everywhere was substantial, their problem was not and is not passenger traffic. Over the years, demand for air travel has shown itself to be reliably resilient. It normally falls off in periods of turbulence and then bounces back quickly. Boeing estimates that air travel worldwide has tripled since 1980. Boeing and Airbus are both forecasting 5 percent annual growth in airline travel over the next twenty years.1

  The woes of America’s airlines were largely self-inflicted, decades in the making, and are worsening. Much of what has gone wrong can be traced to 1978, when the Airline Deregulation Act was adopted. It liberated the airlines by allowing them, instead of a government agency, to decide which routes they could fly and at what cost to the passenger. Government supervision of what had been judged a public utility gave way to free market economics.

  Predictably, the industry’s irrational tendencies took over, and it quickly outgrew itself. By the late 1980s, the legacy carriers—the half-dozen major carriers that have been around longer than most of the others and operate both nationally and internationally—had embarked on a feeding frenzy, adding new airplanes to their fleets without retiring older ones. (These are hardy, long-lived vehicles.) Credit wasn’t a problem—there was a great deal of money chasing airplanes; airlines were borrowing 120 percent of the net purchase of their new aircraft. And they were busily expanding their hub airports.

  Airline deregulation, a useful step in principle, was never about building a strong industry; it was about lowering ticket prices by creating competition. And it did give rise to a commodity marketplace, hence competition. But most airlines either didn’t favor deregulation or, like Delta Airlines, openly opposed it.

  United Airlines, the nation’s largest carrier at the time, was the only strenuous advocate. The other big airlines had been reluctant to give up a regulated environment, which had offered an unstable industry protection against its prodigal tendencies. The new freedom to choose the routes they flew might enhance profitability, but it also meant that they would live or die in the marketplace. With the arrival of marketplace economics, the carriers all responded to the pressure to expand service and invade routes flown by competitors.

  Some of them expected to see a Darwinian logic that would gradually work to the advantage of both the industry and the public by strengthening some airlines and pushing the less fit toward mergers or oblivion. Or, as various industry people felt, deregulation might breed chaos and, sooner or later, some form of regulation.2

  The carriers had invited a perfect storm. Having foolishly over extended themselves, they became largely oblivious to the harmful effects on earnings of rampant competition, much of it mindless. Their new equipment not only allowed but dictated expanded service—more airlines battling one another on more routes.

  Richard Ferris, for a time United’s CEO and chairman, was asked in 1981 about the tendency of the liberated industry toward self-destructive behavior. “Watch the blood on the floor,” he said. “It will get so deep that the carriers will become rational.”3 They didn’t.

  A decade or so later, three of them—Trans World Airlines (TWA), Continental Airlines, and America West—were in Chapter 11 bankruptcy proceedings. The industry’s big three—United, American, and Delta—were themselves under serious financial pressure and complaining bitterly about the protection from creditors afforded carriers in Chapter 11 and the fare wars to which they were addicted. In turn, the all-but-bankrupt airlines blamed their problems on the big three, especially American, for their extravagant overbuying of equipment, a behavior pattern that weakened the industry’s financial base.

  But the larger problem was the battle for market share. Most of the carriers were losing their shirts chasing it. Then as now, their mantra seemed to be: HE WHO DIES WITH THE BIGGEST MARKET SHARE WINS. “Deregulation gave them all a chance to die,” recalls Edward Colodny, a former CEO and chairman of US Airways who spent most of his career in the airline industry.4

  Herb Kelleher is sometimes described as having reinvented air travel some years before deregulation was enacted. Kelleher has made a massive success of Southwest Airlines, the carrier he founded, by doing the opposite of just about everything the bigger airlines have done and continue to do. From the time Southwest began operating in June 1971, his priority was keeping costs down, not buil
ding market share. “Market share has nothing to do with profitability,” he said. “Market share says we just want to be big; we don’t care if we make money doing it.” Some companies, he said, increased their costs by 25 percent in order to get an additional 5 percent share of the market.5

  In 1990 and 1991, the embattled airline industry lost $7 billion and was astride $75 billion of debt. The debt-equity ratio within the industry was about 75 percent. Net cash flows were covering just 25–35 percent of capital expenditures, and financial leverage on some carriers was so strong that they couldn’t cover fixed costs.

  Around this time, calls for imposing re-regulation on the industry began to be heard. The deregulated environment had fallen far short of the claims that had been made by its advocates. In the main, it had allowed the carriers to enfeeble themselves and leave the United States with the oldest fleet of airliners of any industrialized country.

  Within aviation and congressional circles opinion was divided. Some voices that carried were heard expressing “philosophical opposition” to regulation. But many such people would add that if the carriers couldn’t discipline themselves, perhaps some way of imposing a code of sensible behavior on them should be found. That sort of talk never came to anything, largely because the argument that deregulation was, in principle, a good idea was generally acknowledged.

  Nor did the talk reflect reality—that the industry was still tightly regulated. Aside from broadcasting, probably no other industry has comparably narrow restrictions on where companies can operate or on foreign ownership. This restrictive attitude stems from outdated notions about airlines as instruments of national security—ferrying troops to combat zones, for instance.