Financialization and Boeing: Making Airbus Great Again

Financialization refers to the increasing role that financial institutions such as markets and banks play in our economy.  Early economists began their analyses by considering the “real” economy to consist of making or growing things and selling them.  In order to do this, borrowing and lending must take place.  Finance was always necessary, but it was thought of as a cost of doing business not something that contributed to economic value.  Over time, and particularly recently, financial activity has become a growing component of the economy.  But does this growth represent a contribution to economic activity or should it still be thought of as a “cost” to the economy which is actually extracting wealth from it. 

The publicly funded corporation was one of the great creations of capitalism.  Governments created these as legal entities and provided appropriate protections and restrictions on them on the premise that they would be beneficial to society.  It was the accepted view that these corporations had stakeholders that included society-at-large, employees, consumers, and those who would fund them by buying shares through a stock market or lending them money.  In their endless quest to mess things up, economists sold the notion that the shareholders were not only investors, but also owners.  Therefore, shareholders were the predominant stakeholders, and the goal of a corporation must then be to maximize shareholder value (MSV).  One can do this by paying a significant share of profits to shareholder in the form of cash dividends which are taxable as normal income.  Since most shareholders are not interested in consuming cash dividends, they are better served by taking steps to increase the value of their shares on the stock markets.  It is at that point that financial maneuvers can become costly to the economy and to the individual corporation.  Mariana Mazzucato considers these issues in her book The Value of Everything: Making and Taking in the Global Economy.

In the 1930s, Keynes observed that it was in the nature of markets and investors for them to focus on short-term performance rather than the long-term prospects of an individual corporation.

“A successful speculator himself, Keynes knew what he was talking about.  He warned that the stock market would become ‘a battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years’.  He would be proved right.”

The result has been that shares are being held for ever shorter periods of time.  Share prices can rise and fall quickly based on the slightest of news.

“Increasing turnover is a sign that institutional investors’ sights are trained on the short-term movement of stock prices rather on the intrinsic, long-term value of the corporation.  High turnover can be more profitable for institutional investors than passive, long-term holding of shares…The result has been a corporate fixation on quarterly performance, which encourages consistent earnings growth to generate acceptable share price performance.”

Tying corporate executives’ compensation to share price behavior combined with MSV provides a “perfect storm” of incentives for corporate irresponsibility.  Traditional approaches to generating increased earnings include cutting costs and investing in new production capabilities and new products.  These tend to be longer-term moves that may or may not make sense for a particular company, and they may not be sufficiently promising to satisfy investors.  Companies have discovered that surest path to investor satisfaction is to use its profits not in long-term investment but in immediate share buybacks.  These purchases will drive up the share value without any improvement in company performance.

“MSV, then sets off a vicious circle.  Short-term decisions such as share buy-backs reduce long-term investment in real capital goods and innovation such as R&D.  In the long run, this will hold back productivity, the scope for higher wages will be limited, thus lowering domestic demand and the propensity to invest in the economy as a whole.  The spread of financialization deep into corporate decision-making therefore goes well beyond the immediate benefits it brings to shareholders and managers.”

Dan Catchpole provided a perfect example of how financialization of a corporation can lead to long-term harm.  He provided an article for Fortune magazine titled The forces behind Boeing’s long descent.  He began with this lede.

“A shareholder-first culture fueled the 737 Max crisis. Now it may keep the aerospace giant from recovering.”

Catchpole claims the 737 Max episode is the latest result of a change in corporate culture that occurred when Boeing merged with McDonnell Douglas in 1997.  Prior to that time, Boeing focused on producing well-engineered commercial aircraft.  McDonnell Douglas, and its executives, had a different view based on acceptance of MSV as its fundamental strategy.  The result was a Boeing that placed cost-cutting and returns to shareholders before investments in product development.

“In the years prior to the merger, Boeing had largely avoided share repurchases; McDonnell’s board, led by its CEO Harry Stonecipher, had pursued them enthusiastically. Within a year of the merger, buybacks became a cornerstone of Boeing’s strategy. As a Boeing executive and later CEO, Stonecipher also advocated aggressive cost-cutting, pushing the company to deliver an after-tax profit margin of 7%—a mark Boeing had not hit since the 1970s. His successor, Jim McNerney, continued to put profit margins first. ‘When people say I changed the culture of Boeing, that was the intent, so that it’s run like a business rather than a great engineering firm,’ Stonecipher told the Chicago Tribune in 2004. ‘It is a great engineering firm, but people invest in a company because they want to make money’.”

“For all of Boeing’s business coups and innovation, one stark statistic has come to symbolize the company’s priorities: Over the past six years, Boeing spent $43.4 billion on stock buybacks, compared with $15.7 billion on research and development for commercial airplanes. The board even approved an additional $20 billion buyback in December 2018, less than two months after the first 737 Max crash, though it subsequently shelved that plan.”

The first indication that the MSV philosophy was hurting product development came with the disastrous development of the 787 airplane.

“The downsides of cost-cutting soon appeared in Boeing’s 787 Dreamliner program, which began in 2003. Management pushed the company to save money by outsourcing development of critical components to suppliers, many of which proved not up to the task, leading to repeated breakdowns and delays. When the jet finally flew in 2011, it was three years late and $25 billion over budget. In 2013, after the plane was in service, electrical fires in batteries on two 787s prompted regulators to ground the airplane for nearly a month.”

Boeing has a viable competitor in Airbus which has been gradually approaching parity in new aircraft orders.  The next big market will involve planes that can carry 200-plus passengers longer distances with improved fuel efficiency than the established 737 class of planes.  Such planes would open up the possibility of direct flights between many more cities in the international market.  Boeing delayed the development of such new aircraft, presumably fearing the costs would impact its profit margins.

“By the middle of the past decade, Boeing was confronting its lack of a new mid-market airplane (known in-house as the NMA). This category of jetliner carries around 250 passengers over distances of 4,000 to 5,000 miles. Mid-market is the only segment of the commercial-jet business expected to see strong demand in the near future, making the category critical to Boeing and rival Airbus. ‘Boeing likely needs two clean-sheet airplanes this decade,’ says Richard Aboulafia of consulting firm Teal Group.”

“In 2016, however, then-CEO Dennis Muilenburg pledged to double Boeing’s profit margins to the mid-teens, a goal that made plane development that much more challenging. Punting on the decision to begin designing an NMA became an annual tradition for Boeing leadership.”

Boeing decided to take a half step in that direction by adding new engines and making minor changes to its 737 and calling it the 737 Max.  Meanwhile, Airbus has been cranking out new planes for that market.

“Boeing’s indecision has given Airbus room to dominate the market. Given its problems with the Max, analysts and consultants agree that the earliest Boeing can start an NMA project is 2021. Even on that timetable, Boeing ‘will have lost market share to the A321XLR and maybe the A330neo,’ two new Airbus models, says Ron Epstein, an aerospace analyst for Bank of America Merrill Lynch. ‘Some of it is fait accompli,’ he adds. ‘The XLR is here—that’s [lost] market share’ for Boeing.”  

Analysts seem to agree that Boeing needs to return to its original roots and become again a competent developer of aircraft, but it isn’t clear that they will take that advice.

“But the fallout from the Max crisis may well push Boeing in the opposite direction. Costs related to the Max have topped $9 billion and could easily double. To shore up its balance sheet Boeing is reportedly considering borrowing money to pay shareholder dividends—and cutting R&D spending.