Should EADS's threats about the A400M program be taken seriously?

Over the past week or so, aviation and military writers have provided considerable coverage to EADS’s assertion that it might terminate the A400M airlifter program if more money is not forthcoming from its customers. This threat became more tangible yesterday when EADS CEO Louis Gallois told a press conference in Seville that

        We cannot continue beyond the end of January without knowing where we are going financially. I am sending a message of urgency to governments. We are ready to negotiate at any time. [1]

Speaking after his boss, Airbus CEO Tom Enders added that

        We cannot continue without a significant financial contribution from our customers. If we don't press for that it will jeopardize the whole of Airbus. The A400M as it is set up today will put the whole of Airbus in jeopardy and I will not go down that road. [2]

Strong stuff, and this threat of bankruptcy has worked before for manufacturers of big airplanes, both civil and military. As I argued in a paper a few years ago [3], the US Air Force seems to try to bail out an American manufacturer of commercial aircraft with a well-financed military program about every ten years:

• 1971: Lockheed, with the C-5A (and separate loan guarantees for the L-1011)
• 1982: McDonnell-Douglas, with the KC-10
• 1990: McDonnell-Douglas, with the C-17
• 2002: Boeing, with the KC-767 leasing deal

What hasn’t worked out so well is the underlying but implicit industrial policy of trying to keep players in the game: Lockheed exited the business anyway, the last remnant of Douglas in Long Beach is winding down with C-17 production, and Boeing’s tanker leasing debacle actually sent people to jail.

Of course, the C-17 could get a new lease on life if the A400M really doesn’t proceed past initial testing. Moreover, EADS has been making threats on this side of the Atlantic as well—as I discussed in my last column, if the USAF doesn’t change its RFP for tanker aircraft, Airbus and Northrop Grumman may not bid on the program. So, from the interest of the seven governments signed up to finance the A400M program (of Belgium, Britain, France, Germany, Luxembourg, Spain and Turkey), and from that of Boeing and its suppliers in the C-17 business, it’s worth asking just how seriously to take this latest threat.

For that, let’s consider a few facts about the program [4]:

• The initial fixed price was about €20 billion: roughly €6 billion for development, and €14 billion for production of 180 aircraft.
• EADS has received €5.7 billion in advance development payments, and has spent all of it.
• Pricewaterhouse Coopers estimates that EADS will need another €5 billion to finish the program; Enders suggested yesterday that this figure might be as much as €6 billion.
• EADS has already put aside provision on its balance sheet for a further charge of €2.4 billion related to the program.

This suggests that, by the auditor’s (lower) estimate, development will take another €2.4 billion, and production another €2.6 billion above the previously forecast cost—assuming that EADS’s charge is wholly related to development costs.

Now, to put this in some context, let’s consult EADS’s financials from the past years, courtesy of the company’s website:

EADS’s financial results (€MM)	2004	2005	2006	2007	2008
Revenues	31,761	34,206	39,434	39,123	43,265
Operating EBITDA	3,841	4,365	2,033	1,751	4,439
EBIT	2,432	2,852	399	52	2,830
Free Cash Flow	1,614	2,413	2,029	3,354	2,559
Net Cash	3,961	5,489	4,229	7,024	9,193

In absolute terms, EADS has the cash on hand that it needs to finance the A400M program, at the new cost projections, without hitting up its customers for more than they agreed to pay. Indeed, its cash position has been improving over the past few years, and its free cash flow could make up the deficit caused by the A400M mess in two or three years. More so, it’s reasonable for these governments to complain about these revelations, whatever unrealistic assumptions they encouraged previous management to make, because they had alternatives. The C-17 could be more airplane than most of them need for their transportation requirements, but if the A400M is to be 25 percent more expensive than they signed up to pay, then one of more of them might have bought some Boeings instead.

That said, recall the definition of free cash flow:

        FCF = NI + DepAmor – ∆WK – CapEx(req)

The question of required capital expenditure is important here. While the money on hand and soon to be generated may be enough to cover the A400M problem, it may not be enough to cover that and all of EADS’s other needs. As Enders told the news conference, “the A380 will remain a financial liability for Airbus for some years to come,” [5] and earlier this month, noted aviation industry analysis Scott Hamilton openly questioned whether the time has come “for Airbus to cut its losses and terminate the program.” [6] Further, while the Power 8 program has apparently provided billions of euros in cost savings, there is always more work to be done in a competitive but technologically demanding industry like jetliners.

In the short term, EADS looks more than sustainable. The A400M debacle is not enough to kill the company, and on the strict basis of considering what is best for its shareholders, the €5.7 billion that EADS would owe in prepayment liabilities (if it terminated the program) roughly matches the €5-6 billion that it would yet need to pay without a negotiated price increase. Given the potential for tremendous loss of goodwill and brand image, withdrawal from the deal is thus very unlikely, and EADS’s threat still callable financially.

In the long run, though, the twin drains of the A400M and the A380 are putting the company’s industrial health in some jeopardy. Indeed, the situation of EADS today is remarkably reminiscent of that of Lockheed in 1971. The company had signed up for a fixed-price development contract for the C-5A Galaxy airlifter program, had almost simultaneously launched the ill-advised L-1011 Tri Star airliner project. Then, as I wrote in my 2007 paper (slightly edited for clarity),

        Lockheed urgently petitioned the US government for $250 million in loan guarantees needed to launch the L-1011, and for $500 million in payments to finish its work on the C-5A. Informational asymmetry and a peculiar case of the winner’s curse combined to gravely damage the contractor’s finances: the USAF’s insistence on a fixed-price contract in the development of the C-5A transport would have forced Lockheed into bankruptcy, and this event was appealing to neither party. [7] ...To shore up its large aircraft business, Lockheed argued that it also desperately needed low-cost funding for the Tri Star, and Lockheed assured the Air Force and the US Congress that the project would break even at sales of 195 to 205 aircraft.

        The problem lay in what Lockheed knew, and when it knew it. Subsidy can be costly, as (amongst other problems) it is subject to sharp informational asymmetries: Lockheed knew more about the project than the government, and was able to color its estimates quite effectively to its own purposes. A less-impassioned analysis of Lockheed’s cost estimates—critically, including the company’s cost of capital—predicted break-even at nearly twice that number of aircraft. [8] Indeed, by 1981, when the company decided to terminate Tri Star production, Lockheed had amassed cumulative orders for 244 L-1011s (still not a large number in the context of the market), and the company expected to lose roughly $2.9 billion on the project overall. [9]

In the end, Lockheed could not manage the financing—even with a government bailout—to stay in both the military and civil transport aircraft businesses. Something had to go. The question in today’s context is what might happen to EADS and its flagship subsidiary, Airbus. While the threat may be callable financially, whether it is callable politically might have been considered, in times past, wholly another question. The trouble for EADS is that the blanket of dirigisme is not what it once was. While the consortium procurement approach worked well to bind customers into the Eurofighter program long after none of them deeply wanted that airplane, it is in this case creating a collective action problem. The Spanish government’s industrial enthusiasms are obvious. The French government indirectly owns 15 percent of EADS, and as such, would share in the losses (even if not up to what it has contributed in development funds so far). The British government, however, has precarious finances today, and the RAF already operates a squadron of six C-17s, with a seventh on order. How this is a crisis for the Belgian or Turkish government is even less clear. And as noted above, the track record for nudging aircraft firms back into particular market segments has been rather bad.

In the end, then, neither the A400M nor the A380 will sink EADS generally, and Enders was probably exaggerating when he claimed that “the whole of Airbus [is] in jeopardy”. Still, to paraphrase Robert Parr, given the stakes involved in large aircraft development programs, no matter how many times one saves companies like these, they always seem to get back in jeopardy again. These two financially messes might just, then, together force a serious reprioritization of Airbus’s future product portfolio. The frank admissions about the state of the A400M and A380 projects rather clearly show what we all have long suspected—that EADS and its forerunner, the Airbus consortium, have allowed politics to control too much of the decision-making over the years. The company may be a political creature, as many large military contractors are to some extent, so some of this may have been unavoidable. However, as Manfred Bischoff, a rather commercially-minded former chairman of the EADS once said, “often, the word strategic can be replaced with not making money.” [10] Exacerbating the natural commercial risks with political adventures is no path to glory. For EADS, that now must stop.

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Notes

1. Robert Wall, “A400M: EADS Waits For An Invitation To Negotiate,” Ares, 12 January 2010.


2. Murdo Morrison, “A400M 'cannot continue' without more funding, warns Airbus CEO,” Flight Global, 12 January 2010.


3. See my briefing “Unstated and Unsuccessful: Observations on thirty years of the United States Air Force’s efforts at industrial policy in the transport aircraft industry”, 14 April 2007.


4. Emma Vandore, “Airbus threatens to drop A400M military plane,” Associated Press, 5 January 2010.


5. David Pearson and Daniel Michaels, “Airbus Results Offset by A400M Woes,” the Wall Street Journal, 12 January 2010.


6. Scott Hamilton, “Outlook for Airbus, Boeing in 2010,” Leeham News & Comment, 4 January 2010.


7. Some insights courtesy of Mary Beth Savio of Charles River Associates.


8. U.E. Reinhardt, 'Break-Even Analysis for Lockheed's Tri Star: An Application of Financial Theory,' Journal of Finance, September 1973 (28 #4), p. 830.


9. Robert R. Ropelewski, ‘Heavy Losses Cited in Decision to Terminate L-1011s,’ Aviation Week & Space Technology, 14 December 1981 (115 #24), pp. 26-29.


10. Vago Muradian and Martin Agüera, “Interview: Manfred Bischoff, EADS Co-chairman,” Defense News, 22 March 2004.