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MAX8 Tragedies Implicate Flight Controls

The 737MAX 8 was developed from the 737NG and certified by the FAA on March 8, 2017.  The aircraft is powered by CFM LEAP-1B engines which are 12% more fuel efficient than the CFM56-7B engines used on the 737NG.  The airframe has a length of 129 ft. 6 in. (39.47m), a wingspan of 117 ft. 10 in. (35.9m), and a maximum payload of 46,040 lbs.  It includes a newly designed winglet (the 737 MAX AT Winglet) which maximizes the efficiency of the wing. The MAX 8 offers seating capacity of up to 210.  Undiscounted sticker price? $121.6 million.

The 737 ‘Classic’ was originally designed in the 1960s and over time was revised to increase range and passenger capacity.  In 1991 Boeing developed the 737 NG (“Next Generation”) to compete with the Airbus 320. Boeing has delivered 350 of the 737 MAX 8 since 2017 and has an order backlog for 5000 more.  The more fuel efficient MAX 8 engines are larger and heavier.  To accommodate their larger diameter they needed to be moved slightly forward under the wing and higher up to keep them out of the way of the landing gear (and for ground clearance).  The repositioned engines changed the handling characteristics of the aircraft. As an aircraft takes off the angle of attack (“AoA”) of the wings is higher than at cruise. Because the engines had to be repositioned forward the nacelles that hold the new LEAP-1B engines are actually ahead of the aircraft’s center of gravity.  This forward placement creates greater lift at higher angles of attack (the engine thrust on takeoff is downward which adds more lift forward of the center of gravity as the aircraft takes off).  It’s this additional lift created by the engines that produce a pitch-up effect that further increases the angle of attack the moment the pilot releases pressure on the yoke.  The result can send the aircraft into a stall. To compensate for this pitch up effect, Boeing introduced the Maneuvering Characteristics Augmentation System (“MCAS”) which causes the aircraft to tilt its nose downward.  It is the aircraft design and engine placement that requires the installation of the MCAS to automatically trim against this extra lift effect.  Why? So that the plane and pilot population could fly the aircraft without the time or investment needed for a new type certification and additional pilot training.

During manual flight, as in takeoff, if the angle of attack is too high (or if the AoA indicator is faulty) the MCAS will trim the aircraft stabilizer ‘nose down’ a maximum of 2.5° (for a maximum of 10 seconds).  It can be interrupted by the flight crew by using the electric stabilizer trim which will stop the MCAS. However, after the MCAS has been stopped once, it will reactivate in 5 seconds and requires additional pilot manual trim commands.  To prevent constant manual trim (‘runaway trim’) the stabilizer trim cutout switches must be moved to ‘cutout’ to resolve a false or a continuing high angle of attack indication.  If the cutout switch is not used the MCAS will not reset the trim tabs from their current position and will continually pitch the nose down in additional increments of 2.5%, ultimately pitching the nose down as steeply as it can.  Without adequate training a flight crew’s reaction would be to pull back on the yoke and increase engine thrust which would not act to overcome ‘runaway trim’ but would result in an accelerating nose down dive.  Until the flying public regains confidence in Boeing’s correction of this MAX8 flight control issue other 737 models will experience a short term period of higher demand similar to what we witnessed with other widebody aircraft during the 787 Lithium ion battery issue a few years back.  Most importantly the MAX8 tragedies remind the airline industry that safety never stops being job number one.

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A Platform For Sustainable Investment

Until Hunter Harrison, there was a lack of focus on how efficiently rail assets could be employed. Customers demanded service and the railroads invested. More equipment was better. The result was a consistent inability of the roads to cover their cost of capital. Herb Kelleher founded Southwest Airlines as a low cost no-frills regional. It first took off in 1971 and changed the nature of air transportation for millions of Americans. Both Hunter and Herb focused on transforming operations. Hunter’s message? Here’s what really matters: “Precision Scheduled Railroading”. Sales and customer service focus on driving top line growth while operations and investment measures focus on asset turnover and margin improvement (e.g. lowering the ‘operating ratio’ for railroads). In both the Air and Rail industry the challenge is to design, invest in, and manage network capacity so that it best meets customer demands while managing pricing, maximizing profitability, and meeting society’s goals. As Matt Rose, the retiring Executive Chairman of the BNSF recently stated, “It’s a three legged stool”. Customers, Capital, People (and politics).

What’s the key metric? Return on invested capital (ROIC) is the one metric that captures both operating margins as well as the capital required to generate it. It tells us how much a firm earns for each dollar invested. When ROIC is greater than your weighted average cost of capital you are creating “investment” value. Identifying the components of ROIC and acting on those components is what creates value. But ROIC is a Wall Street investment analyst measure and discussions are generally confined to finance departments. The genius of both Hunter and Herb is that they understood the components of ROIC. They inspired, motivated, and challenged their people to focus on constantly improving performance. Net operating profit after tax (‘NOPAT’) as a percent of Invested Capital is used to generate ROIC. The main components of invested capital include equipment, spare parts inventory, operational facilities, and the ‘working’ capital needed to run operations. But the formula doesn’t identify how to influence the value drivers. The ‘DuPont’ analysis disaggregates ROIC into its key parts: return on sales (NOPAT/Sales) and asset turnover, or capital productivity (Sales/invested capital). Both return on sales and capital productivity measures can be further broken down. It’s these components that managers must act upon. Understanding this allows operations to identify the causes of differences in performance over time and among competitors. Activities can then be designed to increase both return on sales and capital productivity, thus maximizing value. Strategies that improve capital asset productivity are the focus of precision scheduling railroading. Eliminating excess equipment from the system and increasing the productivity of remaining equipment. For Southwest Airlines it’s a commitment to their people and to operating a single type of plane (the Boeing 737). The other component of capital productivity is sales. So, finding ways to expand offerings that drive revenue growth using existing equipment is key.

The BNSF’s focus is on long term investment results. Charlie Munger, Buffet’s right-hand man, says “We don’t have to make the last dollar”. And, as Southwest’s Herb Kelleher once said, “We have a strategic plan. It’s called doing things.” With a focus on the mechanics of Air and Rail equipment finance, industry conditions, competition, customers, investment returns required to deliver capacity, and the people and politics of service delivery, we’ve designed a platform for sustainable Aviation and Rail investment. If you are interested, call us. Call RESIDCO.

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Value Investing in a Turbulent Market

“The Chinese use two brush strokes to write the word ‘crisis.’  One brush stroke stands for danger, the other for opportunity. In a crisis be aware of the danger but recognize the opportunity.” – John F. Kennedy

2019 will create opportunities for those who are prepared.  The reasons? Politics, the continued strength of the U.S. economy, and the economic challenges facing Europe and China.

China’s Economic State

In China, the economy is slowing.  It’s burdened by excessive debt and dependent on government subsidies.  Recognizing its low labor cost advantage, China has advanced its country interests by forced transfer of intellectual property so that products can be manufactured in China without the need to pay research and development cost.  The result? Firms (and countries) that initially designed products can be out-priced and killed off. If you can see the future, you’ll recognize that Trump’s 90-day reprieve from increased U.S. tariffs (which expires March 1) is not likely to change the Chinese Communist Party’s basic industrial policy.  In Europe, economies are slowing, and the United Kingdom faces a March 29 deadline to officially exit the European Union.

Transportation Investment Landscape

Since both aviation and rail transport assets are long term investments, it’s best to gather and analyze information that is available about trends taking place, and then adjust your investment tactics based on current investor behavior playing out around you.  The Aviation and Rail investment markets are competitive. FlightAscend has identified 100 new names that have entered the commercial aircraft operating lease sector over the past 10 years. The competition has pushed lease rate factors on some deals to sub-0.5 levels with relaxed maintenance reserves and less stringent return requirements.  Airline operators are pushing for shorter lease terms due to ASC 842 and IFRS 16.  Sale-leaseback financing valuing aircraft at more than original airline capital cost is being supported by aggressive residual value estimates (on NEO and MAX aircraft).

The landscape for transportation investment has always been non-linear, turbulent, and in a state of flux.  If you accept that the industry cycle has peaked and is heading on a slow downward trajectory, you’ll see today’s environment as providing a greater opportunity for value acquisitions.  Strategy is done above the shoulders (tactics below) and a challenging market reduces competition. Interest rates, crude oil, and labor cost all affect the psychology of the market and influence the availability of capital and level of risk-adjusted returns available. Strategy recognizes the structural risks of financial and operating leverage which magnify the impact on profits of rising and falling revenues.  The aviation industry is global (and its hard dollar assets are liquid). Since no one knows what the macro future holds, successful secondary market transport investment is created by developing opportunities that create current value. Superior investment results do not require the purchase of newly built equipment.  Rather they come from buying existing equipment when the deal is good, the price low, the potential substantial, and the downside limited.  

Value investing.  For insight, experience, and confidence in judgment,  call RESIDCO.

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Navigating Transportation Investment

Factors to Consider for Transportation Investment

Transportation asset finance is a growth business.  Both the Aviation and Rail markets are healthy and long term investment trends remain favorable.  With recent market volatility comes higher ranges of uncertainty. While investment risk may or may not increase over time, uncertainty grows at the square root of time.  The more time, the harder it becomes to predict the future. The investment models you choose provide investment decision support. But the investment decision itself is a marriage between the decision model results and your level of personal experience.  What drives the flow of capital into transportation investment alternatives?

What are the strategic alternatives?  What contributes to value? What are you expecting?  Traditional tools include income, cost, tax benefits, and market value analysis.  Upside is an ally to be capitalized on while downside exposure should be limited. The future value of aircraft, aircraft engines, railroad rolling stock, their condition, and remarketability are a critical component of investment returns.  Estimates of the future value of aircraft and railroad rolling stock can be described in terms of a distribution at any point during the investment term. Recognize that inflation will increase the price you can sell equipment for in the future.  Inflation’s effects are fairly powerful. A 2.5% inflation rate over 20 years increases prices 64%, a 3% rate over the same period increase price 81%.  It’s your risk tolerance that affects the future value you are willing to incorporate in your investment return calculations.  

But risk also exists during the term of any lease and every lessor expects some percentage of its lessees will default.  Supporting that investment is your transaction structure. Equipment values act as a backstop. Many things can happen while equipment is in the hands of a lessee; physical wear and tear, mandated regulatory changes, technological improvements, the price of market inputs (fuel, steel, monetary policy [credit]), and the stage of an ever-changing business cycle.

How the Economy Affects Company Decisions

The U.S. economy grew 2.9% last year (2.6% in the fourth quarter) driven by deregulation and tax reform efforts.  The Federal Reserve predicts 2.3% growth for 2019. Recent months have brought crosscurrents and conflicting signals.  Issues on the horizon include weaker growth in China and Europe, the Politics of trade negotiations, and the impact of the U.K.’s decision to leave the European Union.  Reality is multidimensional and dynamic.

Examples?  The three major U.S. Air Carriers are negotiating pilot contracts this year.  Wages and scope clauses are on the table. Frontier Airline pilots recently overwhelmingly approved a new contract with a 53% pay increase.  NetJets Pilot’s union signed an interim agreement that improved compensation for both long-term and new-hire pilots.  The Rails are focused on improving operating ratios using Hunter Harrison’s precision scheduled railroading principles in order to better manage investment.  Airlines and Class One Railroads are capital intensive businesses, tying up significant amounts of capital in their equipment and facilities. Both industries are using the current upcycle to strengthen their financial position as they prepare for a choppier environment.

To navigate successfully you’ll need access to market intelligence, relationships, technology and the practical experience gained from real life lessons.  Call RESIDCO.

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