Boeing's leasing, loan business amplifies its risk
Seattle Times aerospace reporter
Three years and more than $7 billion ago, Boeing embarked on an aggressive but risky expansion of its finance business. The hope was leasing jets would be more profitable than building them.
But now, amid the unprecedented collapse of global air travel, that big bet is weighing down the company's balance sheet and could, in turn, deepen production cuts and job losses in the Puget Sound area.
Following a road map drawn by former Vice Chairman Harry Stonecipher, Boeing has borrowed heavily and lent the proceeds to airlines buying the company's jetliners. The idea was to fatten profits while attracting new customers and strengthening ties to old ones.
But financing airlines is a high-risk, high-reward proposition, even in good times. It requires betting huge sums on carriers' ability to prosper. Boeing has amplified its risks by emphasizing sales of poor-selling jets to airlines on shaky financial footing.
When Boeing reports its first-quarter results Wednesday, profits will be trimmed by $251 million due to loan defaults and declining aircraft values at Boeing Capital, its financing subsidiary, Boeing noted in a pre-release statement. A similar charge last October brings the six-month total to half a billion dollars.
The worst may be yet to come. Two of Boeing Capital's largest customers, United Airlines and Hawaiian Airlines, are in bankruptcy. Two others, American and Varig of Brazil, are teetering on the brink.
Consequently, missed lease payments, loan defaults and early returns of aircraft could plague Boeing Capital until the airline industry recovers, which could take years.
Boeing executives declined several requests for interviews to discuss Boeing Capital in recent weeks, citing a government-mandated "quiet period" before the release of its earnings.
Most of Boeing's debt
Boeing Capital's debt stood at $9.5 billion at the end of 2002, nearly twice as much debt as all other Boeing business units combined.
Any long-lasting disruption of airlines' payments to Boeing Capital could hinder the finance unit's ability to make its own debt payments. That could force Boeing to divert cash from its aircraft, military and space units, meaning less money for strategic expenditures such as research and development and marketing.
With the company hoping to launch its new 7E7 jet by 2008, such spending is sure to increase in size and importance. To finance the 7E7, Boeing is asking potential suppliers — and state and local governments — for unprecedented financial help.
Meanwhile, Boeing has invested very rapidly in Boeing Capital; the finance unit raised $3.9 billion from debt offerings in 2001, and another $2.2 billion last year.
In all, Boeing Capital's debt is comparable to what it would cost to develop a new plane. European rival Airbus estimates its new 555-seat A380 jet will cost $10.7 billion to bring to market in 2006, roughly $3 billion more than Boeing has raised to fund Boeing Capital since the end of 1999.
The model: GM to GE
The idea of creating a finance subsidiary to help sell products is not new. General Motors has been doing it since 1919, when its GMAC division began offering financing to get drivers into GM cars.
More recently, computer-network equipment makers such as Cisco and Lucent Technologies crafted multibillion-dollar financing for dot-com and telecommunications companies. When the Internet boom went bust much of that money disappeared.
Boeing's model has been GE Capital, the respected finance arm of General Electric. GE Capital lends money to people buying GE products such as jet engines and electric turbines, as well as insurance, real estate and aircraft.
With net income of $1.7 billion in the first quarter, GE Capital was GE's most profitable division.
Harry Stonecipher spent three years at GE in the mid-1980s, and when he arrived at Boeing he believed Boeing Capital could emulate GE Capital's success.
Stonecipher was also keenly familiar with the finance business of McDonnell Douglas, which he guided as chief executive from 1994 until the company merged with Boeing in 1997.
McDonnell Douglas Finance Corp., which was formed in 1968, had a $1 billion portfolio when the Boeing merger closed. Most of that money supported loans and leases of McDonnell Douglas jets. MDFC also financed nonaviation goods such as trains.
Boeing, by contrast, maintained only a small financing portfolio prior to the McDonnell Douglas merger.
Following the counsel of chief financial officer Boyd Givan from 1990 to 1998, Boeing rarely opened its checkbook to help customers buy Boeing products.
"The policy pre-Harry Stonecipher, from both Boyd Givan and his predecessor, was that we really shouldn't be in that business," said a former Boeing executive who structured numerous aircraft sales. "Developing airplanes was risky enough."
The company financed only vital deliveries to strategic customers. Givan believed Boeing's money was best spent on product development, rather than in competing with banks and third-party aircraft lessors in the financing business.
"The temptation is to say, 'Criminy, why should someone else get the depreciation and lease benefits?' " said another former Boeing executive. "But every time we tried to do it, we looked back over 25 years and saw things that have happened recently (defaults, falling aircraft values) happened a whole bunch of times."
Two developments changed Boeing's mindset. The first was the arrival of Stonecipher and his confidants from McDonnell Douglas. The second was the discouraging returns from airplane sales in the late 1990s.
Despite delivering a record 1,200 jets in 1998 and 1999, Boeing earned less and less on each plane due to stiff price competition from Airbus.
Boeing Chairman Phil Condit had already decided to expand into the defense and space businesses to counter the deteriorating profit margins in commercial aircraft.
At Stonecipher's suggestion, and only after a vigorous internal debate that set longtime Boeing executives against their new McDonnell Douglas colleagues, Condit agreed to join the finance game, too.
On Oct. 4, 1999, a press release announcing the creation of Boeing Capital outlined the company's new direction.
"This reorganization is intended to enhance The Boeing Company's ability to address the financing requirements of its diverse customer base and to capitalize on global growth opportunities to increase shareholder value for the company," said Walt Skowronski, then Boeing's vice president of finance and treasurer.
How it works
Boeing Capital uses a complicated web of financial tools to raise and distribute money. But its services to airlines work essentially two ways.
In most cases, Boeing Capital actually buys airplanes from Boeing and then leases the jets to the airlines; at the end of 2002, Boeing Capital owned 317 airplanes, more than US Airways and nearly three times as many as Alaska Airlines.
That enables Boeing Capital to reap the depreciation tax benefits of owning the planes. But it also increases Boeing's susceptibility to missed payments and a declining value of its planes.
In other situations, Boeing provides loans to carriers to purchase jets, just as banks provide mortgages to homebuyers.
Unlike traditional financial institutions interested only in the return on their investments, Boeing Capital must sometimes do business with high-risk customers to bolster aircraft sales.
Among some of Boeing Capital's biggest customers:
• United Airlines, which filed for Chapter 11 bankruptcy protection in December, owes Boeing Capital $1.2 billion on leases covering 13 777s, two 767s and five 757s. Roughly $600 million of that financing supported planes delivered after Sept. 11, 2001, when United's troubles were apparent. The carrier is negotiating with Boeing Capital to lower its payments and could return some jets, forcing Boeing Capital to remarket them in a down market.
• Hawaiian Airlines, which filed for Chapter 11 bankruptcy protection March 21, owes Boeing Capital $546 million on leases covering 13 717s and three 767s. Hawaiian said it was forced into bankruptcy because its lessors would not reduce lease terms to reflect the declining value of aircraft after Sept. 11. Boeing Capital countered by accusing Hawaiian Chairman John W. Adams of taking more than $20 million out of the airline.
• Varig, Brazil's largest carrier, hopes to improve its fortunes by merging with TAM, the country's second-largest carrier. Varig lost nearly $600 million in the first nine months of 2002. Varig owes Boeing Capital $452 million on leases, is past-due on its payments, and has previously defaulted several times in recent years.
• American Airlines secured $1.8 billion of labor concessions last week to avert bankruptcy, although the flight-attendants union is calling for a new vote after revelations of the size of executive bonuses. The airline owes Boeing Capital $381 million on leases covering 43 MD-80s, two 757s and one 777. Further, Boeing Capital is to provide American up to $575 million more for nine 767s and two 777s this year; American has said it doesn't want the planes.
In all, these four troubled carriers hold nearly 30 percent of Boeing Capital's $9.1 billion aircraft portfolio.
"Personally, I don't think (Boeing) should be investing dollars in their own airplanes at this stage of the cycle, especially with customers like American that are on so much shaky ground," said Joseph Nadol, who follows Boeing for J.P. Morgan Chase.
When 'no' is not an option
Adam Pilarski, senior vice president of Avitas, an aviation-consulting firm, says in retrospect that there were inherent problems with Boeing's plunge into the highly competitive leasing business.
Given that independent leasing companies' rates are lower, "The only deals the manufacturer gets are the ones others don't want. So by definition you will be getting the higher-risk deals," he said.
Additionally, Pilarski said, Boeing Capital inevitably has had to steer its business toward making sure airlines take delivery of the planes coming out of Boeing's factories. Boeing Capital thus has incentives to take on deals traditional finance companies would avoid.
Boeing Capital's commitment to extend another $575 million to American this year, even though bankruptcy could be days away, is a perfect example.
"They are the largest airline in the world, and they fly almost exclusively Boeing (planes). Is there a benefit to helping them? Sure, if you think there is a future in aviation," Pilarski said.
David Bowermaster: 206-464-2724 or firstname.lastname@example.org