Bombardier: Spreadings Its Wings
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Bombardier’s history of developing new and underserved market segments began with Joseph-Armand Bombardier, the inventor of the modern recreational snowmobile. Similarly, Bombardier’s two CSeries jets are a contribution to the previously underserved middlerange jet segment – a step away from Bombardier’s core aerospace offering, short-range Q400 Turboprops. While Bombardier is a leader in transportation solutions and the third largest aircraft manufacturer in the world, CSeries development delays have pushed the company to lay off 1,700 employees, terminate the promising Learjet 85 program, and increase debt by 242%. When Bombardier does eventually get production off the ground, it needs a large quantity of orders to ensure the ballooning investment in the project, currently at $5.4B, makes a return. Originally, Bombardier intended to have 300 firm orders for the CSeries before launch – on an initial investment of $3.4B. With this investment having increased almost 60%, it would follow Bombardier should currently be aiming for 475 to meet the original corporate targets. However, even with the well-publicized purchase order from flymojo, Bombardier has still only managed to secure 263 firm orders after five years. Altogether, Bombardier is well shy of the original 300 order, let alone 475. With ongoing delays and a lack of orders, questions about Bombardier’s CSeries project linger.
The Blue Sky
The two major players in the aerospace industry are Airbus and Boeing. For the past two decades, both members have focused resources on larger narrow body aircrafts in the 150+ seat-range. Largely overlooked in this competitive struggle has been the smaller 100-150 seat narrow body segment. Airbus estimates that there will be 31,000 total airplane orders in the next 20 years. While the 150-240 segment – Airbus’s and Boeing’s core competency – is expected to generate 9,660 of these orders, the 100-150 seat segment is expected to generate 7,100, representing about 22% of the total market. Despite significant market potential, only 1.3% and 3.3% of Airbus and Boeing’s respective orders are for this 100-150 seat segment. This suggests a significant industry capacity gap, which Bombardier plans to exploit.
Buyers in the airline industry are extremely price sensitive, with respect to both initial pricing and operating costs. Ongoing costs are impacted by aircraft design, fuel efficiency, and fleet integration, as each type of plane in a fleet requires specific pilots, support staff, and facilities. If fleet integration is not possible, buyers require either an upfront discount or unusually high operational savings to offset lost efficiencies. In the past, smaller planes have sold poorly as it tends to be more profitable to operate a larger aircraft even with a slightly lower occupancy as opposed to operating a smaller.
The Plane Field
In the early 2000s, a need for new aircrafts and highly anticipated growth made the 100-150 seat segmented an attractive opportunity for Bombardier. The solution to this gap in the market was the CSeries. The CS100 and CS300 are clean sheet (designed from scratch) fly-by-wire (fully electrical flight control systems) aircrafts, designed to be the most cost efficient aircrafts in the segment. Unlike reused models, clean sheet projects bear a higher upfront development cost, but tend to yield significantly better cost-per-available-seat-mile for potential buyers. Despite the added efficiency, few incumbents attempt clean sheet projects given the low margins in the aerospace manufacturing industry. As a result, Embraer, Airbus, and Boeing all planned on releasing new vehicles based largely on older, proven, but less efficient designs.
Currently, while Boeing has a substantial number of orders, Airbus’s 100-150 seat narrow body offering has struggled to gain traction. Despite having a trusted customer base seeking the operational efficiencies inherent in the Airbus fleet, the company has only received 46 orders to date. Unlike Boeing, customers seem to be avoiding Airbus’s refurbished design. Due to the cost saving advantages of fleet integration, failing to successfully enter the smaller plane segment will leave Airbus in a position of weakness. As a result, Airbus inevitably has to generate more orders in the 100-150 seat segment in the foreseeable future, so as to not lose a toehold against Boeing, even if immediate financial results are not encouraging.
Buyer Beware
The major limitations of the CSeries’ success is Bombardier’s inability to generate unit sales. Given the buyer power in the industry, there are several major factors contributing to low demand for the aircraft.
1 – Service Infrastructure Weakness
Bombardier has relatively weak service infrastructure compared to its competitors. The company outsources most training services, has a limited service center network, and lacks software offerings. For example, the industry standard is for manufacturers to set up their own crew training facilities in order to generate additional revenue and provide an auxiliary service for aircraft buyers. Except in the case of private jets, Bombardier typically uses a third party provider and simply refers its clients. Even though it is a less capital-intensive solution, it does not provide the services often expected following a $70 million product. In contrast, players like Embraer are capable of offering extensive auxiliary services alongside their aircrafts to entice customers and yield ongoing services revenue beyond the purchase of aircraft.
2 – Manufacturer Risk
Buyers operate in a high risk, low ROI environment, and therefore tend to be very risk averse. Bombardier’s investment in the CSeries and resultant financial woes has placed the company in a precarious position with solvency issues looming. Should Bombardier’s financials worsen, buyers would contend with an increasing risk of never receiving their order – prompting hesitation in the market. Airlines simply can’t afford to wait on an aircraft that may never arrive. One example of this is Lufthansa’s Austrian division, who recently ordered from the Brazilian government backed Embraer, backing out of a potential order for the CSeries.
3 – Timing Risk
“We have completely forgotten about it because you cannot wait indefinitely,” said Qatar Airways CEO Akbar Al Baker to Reuters on March 4th. Bombardier’s release delays have not only deterred potential clients, but also greatly dissatisfied existing customers with 2014 orders now expected to ship in 2018, instead of initial estimates more than a year earlier. Many potential buyers may opt to sacrifice operational efficiency in exchange for timely delivery. Bombardier has not received a single new order in 2015, likely as a result of its order backlog. Airlines are less willing to put a down payment on aircrafts that will not arrive for three or four years at the earliest, when competitors can promise delivery in 2017.
Waypoints
At this point, there are three clear options for Bombardier. First, the company can keep developing the CSeries, releasing it as soon as possible. According to analyst reports from Canaccord Genuity, proceeding with this plan will generate the firm $3.9B in incremental cash flow. However, considering that the firm has already invested $5.4B in the project, these incremental gains would result in Bombardier losing $1.5B in total on the project. Alternatively, Bombardier could attempt to sell the CSeries to the highest bidder. Accounting for its investment, Bombardier would have to sell the CSeries line for more than $4B to beat the $1.5B loss from proceeding alone. Even assuming the buyer can price the CSeries 10% higher than Bombardier, the buyer would still need to capture 75% of the market to break even on its investment, making the quest to find a buyer difficult. There is, however, a third option for Bombardier – a joint venture.
It Takes Two
Bombardier needs to significantly increase the number of firm orders from buyers to make the CSeries project a success. In order to do so, it must address the many the issues that buyers have with Bombardier’s manufacturing. Most of this risk stems from Bombardier’s small size, lack of extensive service reach, and instability. Alternatively, Airbus is struggling to sell its smaller narrow body aircraft and lacks a clean sheet product. Airbus could develop a new plane, but development would only be possible by 2030. Meanwhile, Bombardier’s product boasts an innovative design enabling the best-in-class operational savings.
Therefore, Bombardier should seek to enter a joint venture agreement with Airbus. Through an agreement of this nature Bombardier is able to mitigate most of the buyer’s risk associated with purchasing a CSeries aircraft, while Airbus is able to enter a fast growing segment it currently has few viable products in, all while making a profit. This move would be mutually beneficial, enabling Airbus to shift the dynamics in the duopoly in its favour while allowing Bombardier to secure the coveted third position in the market, and its financial future.
Joint ventures are not a novelty for aircraft manufacturers, as both Bombardier and Airbus have participated in multiple joint ventures in the past. The risk-sharing nature of the joint venture will abate Bombardier’s default risk and allow both companies to accelerate development of next generation aircraft using modern technologies. Currently, Bombardier has patented a proprietary technology that stands to improve the composite materials in wing production. Despite significant IP, the firm has little manufacturing experience applying this technology. As Airbus has significant experience using composite materials, together these firms could improve wing-manufacturing output, thereby increasing each firm’s competitive profile against Boeing and Embraer. This is feasible, as Bombardier’s wing production facility in Belfast is just over 300 km away from Airbus’s Northern Wales facility that specialized in manufacturing composite wings for Airbus’s widebody products.
A joint venture also allows Bombardier and Airbus to combine and improve service network capabilities. For example, they could couple Bombardier’s Smart Parts program, which offers an insurance-like product on airline parts, with Airbus’s FlySmart software solutions, a program to manage these operations. Together, this system would provide an all-in-one operations solution, likely generating additional service revenues from the venture and increase product-service bundling for the CSeries. Further, this package would lower operational costs for potential, increasing the appetite for purchase.
Request for Fly-by
This move would change the competitive landscape of the industry in favour of Bombardier and Airbus for years to come. Bombardier would own most of the IP on arguably the best plane in the segment, and Airbus would have better prepared its engineers and manufacturing facilities for the following generation of its own aircraft. While Airbus and Bombardier are flying ahead, Boeing and Embraer are left behind trying to extract value from recycled designs.
Altogether, with Airbus and Bombardier joining forces, the project most strongly resembles what the CSeries was intended to be – the strongest product in the market. Looking at what analysts expected the CSeries to sell before the numerous delays, a fully valued CSeries plane was expected to generate 50% more unit sales on average. Since a joint venture between Airbus and Bombardier would create a similarly demanded plane, it is expected the discounted cash flows of the joint venture is 36% higher compared to Bombardier operating alone. Applying a 50/50 equity split would result in over $3B of incremental cash flow to Airbus, and greatly reduce the financial impact of increased debt and prior project delays on Bombardier, as compensated by additional sales.
There is a lot of media attention, rumors, and uncertainty surrounding the CSeries. Bombardier has focused all of its strategic resources to ensure that its flagship is a success. Management is confident that plane will succeed and will establish Bombardier as a medium and, potentially, long range manufacturer in the future. However, just releasing the aircraft will not convince potential buyers to sign a contract; time, scale, churn rates, and many other factors can prevent Bombardier’s success. Both Airbus and Bombardier are fighting on an order-by-order basis with their respective rivals and this strategy could result in locking manifold benefits for both parties moving forward.
