Jan 17, 2024 8 min read

Razor's Edge: Boeing and Regulatory Capture in Capitalism

Boeing down another 8% yesterday with a whole mish mash of noise from new FAA requests, a Wells Fargo downgrade, and a supposed wingtip collision on the ground at Ohare Airport that involved "Boeing planes".

This whole never ending Boeing saga I think is worthy of some further color by me. So, when the stock dropped the Monday after the Alaska air blowout the appeal in trading it was that there seemed to be a decent chance the blowout was not do to a fault of their own and that it would prove totally to very mildly undisruptive financially. The latter I think is still probably true based on backlog and Max 9 mix, but the former is now looking far less likely. This is why the AAR denial on plugged door wifi work prompted me to 180 so quickly on the trade. But developments since have got this back to a you got to start thinking about the big picture again with this name..

Is it a buy? Is it a sell?

I think the best place to start with all of this is the entire history of the 737 Max drama. For those of you not familiar with the details, the Max was Boeing's response to Airbus' 2010 efficiency breakthrough with the A320 NEO. The 6% leap that plane delivered on fuel efficiency caught Boeing flat footed. Management at the time really had two options. One was was to start from scratch and design a new narrow body plane to replace the outdated 737. This would obviously take more time and billions more in engineering costs and Boeing would potentially risk massive share loss to airbus or they could update the 737 platform again. Not much of a choice if you think about how capitalism works.

This is how the Max was born. It was a stop gap measure to match the A320 NEO time table, and it worked wonderfully till it didn't. But underlying all this strategic decision making around a new plane vs an update was complying with the FAA's certification rules. A pilot can only fly one type of certification at a time. So, the MAX achieving common certification with other 737's was critical for Boeing customers with respect to fleet flexibility and orders. This was the genesis of the MCAS problem.

The MAX was promised to be 8% more fuel efficient than the A320 NEO and pilots could switch from the previous 737 model to the MAX with only 2.5 hours of computer simulation training. Basically, a wet dream for customers, and the orders naturally followed.

But again the Max was a stopgap response to avoid losing a decade to Airbus. At its core the plane was designed around a new set of engines called the LEAP-1Bs. These engines were much more efficient than the previous model, but they were also much heavier and larger. These bigger engines in the same spot as the 737 NG model engines would be too close to the ground which meant the designers had to move them forward and slightly higher on the wing. This changed the planes aerodynamics in steep climb scenarios.

That solution created an aerodynamics problem. Due to their size and altered position, the engines on the Max create lift when the airplane enters a steep climb. This extra lift causes the Max to handle differently than previous versions of the 737, but only when it’s climbing steeply. But if the plane handled differently the FAA could conclude it needed to be classified separately thus negating one of its key selling points to customers. MCAS was designed to address this issue. A software fix for the handling problem which Boeing basically felt pilots didn't need to know much about and which the FAA ultimately predicted in 2018 would cause an acceptable 15 crashes over 30 and did not result in its immediate grounding.

This is what you call regulatory capture in capitalism. Boeing stock naturally went on to crush under the MAX with the stock 4x and net income doubling from when the plane was introduced till the first crash, but one can easily argue that most of the corner cutting was still pretty unnecessary in the grand scheme of things. The promise of the plane to customers could have still been achieved if regulatory flexibility existed in a manner that didn't require the MCAS system being treated as it was. But you could also argue that if MCAS was so critical to achieving this end result that not adding one more sensor was the greatest bonehead decision ever.(MCAS it turned out had safety redundancy issues with their AoA sensor issue failing every one in 6 million flight hours vs the 10ml required for critical systems and that was naturally addressed post grounding)

Anyway, the point I'm trying to make is that the Max MCAS/Grounding saga/crisis was way more about the FAA response and certification process than it was about Boeing egregiously cutting corners. The FAA stuck to their guns after the first crash despite pilots coming head on at Boeing with respect to Max training and the MCAS system and refused to ground the plane. This proved catastrophic once the subsequent Ethiopian Airlines crash flight recorder findings were revealed. MCAS had effectively caused that crash and the pilots struggling to counter it both by disabling it and then desperately reenabling told you the FAA has massively fucked up. There was no way around it now and MAX was then grounded for nearly 18 months as the MCAS issue was remedied.

Now there have been documentaries on what happened and the culture at Boeing, but really at the end of the day this all boiled down to their relationship with the FAA and their customers. Little blame is placed on the airlines in this whole drama but they are just as guilty of not wanting to pay for new pilot training as they get ever more fuel efficient planes. The FAA could have changed their certification criteria long ago and the industry would have figured out how to pass most of the cost onto the consumer. But as all regulatory agencies don't tend to pivot till disaster strikes it's no surprise we ended up where we did.

BTW-I can think of several of these reg capture drama examples throughout my investing career...

1) Financial Crisis- Can't exactly call this a clear cut regulatory agency capture example and the blame has been placed more on congress with the repeal of glass stegall amongst other things, but the bank regulators definitely were asleep at the wheel. Also, nobody will dispute the independent rating agency capture by the banks that contributed to this crisis.

2) BP MACONDO SPILL- I was involved in this event as it unfolded and traded almost everything related to it and looking back on it the MMS situation with the department of the interior was clear example of a regulatory agency that had been totally captured by the industry it was regulating. Basically, it was rubber stamp agency with almost no ability to do anything to prevent a disaster like the deep water horizon blowout from happening. You could draw analogies with respect to this spill and haliburton/bp/transocean and how boeing and their suppliers operate and also the dynamic with the end customer which effectively is consumers wanting cheap energy.

3) Purdue Pharma and Oxycontin- This is one that played out throughout my entire professional career but I never really knew much about it till it got to the news. This doesn't get the total agency level capture play, but its tough to find something more egregious than this. Hollywood has taken care of that by making Curtis Wright famous for approving Oxy in 1995. Purdue's application to sell the opioid, a class II narcotic, was approved and included specific wording in the prescription information that allowed the company far broader scope in marketing the opioid as less addictive, and therefore suitable for a wider range of patient pain than any other previously FDA-approved opioids of similar strength. This turned into a license to print money for Purdue and a subsequent opioid epidemic in America.Wright left the FDA in October 1997 and by December of 1998 was working at Purdue. Can't really argue the FDA was totally captured by pharma as MMS clearly was by time of BP spill so one individual actually stands out a lot more here. Anyway, Purdue clearly understood the process and manipulated as best as they could for a new product.

So, where does Boeing fit in all of this?

Well, during the pandemic there was quite a spirited debate about whether the airlines/cruiselines should be bailed out. Many sided with the airlines getting a pass while quite a few folks singled out the cruise lines companies as undeserving of such a pass. I actually had a nice debate with captain twilio on the whole buybacks/bailouts during which i think he made great points. Namely, it would be absurd for these companies to manage their balance sheet and capital return programs with the risks of a pandemic in mind. The cruise lines though tended to get way more heat as they pay almost no taxes. I had a friend running a large distressed fund who did quite well on the credit side buying up their debt. And the rationale there was these are floating return vehicles. Taxes and labor laws based on flags of convenience and liability based on Fed maritime law which essentially means anti-consumer common law.

Boeing obviously isn't viewed the same way, but I think this new drama makes things a lot more interesting. The FAA obviously had to grow a pair and assert its independence after the MCAS fiasco, but I think in aggregate this plugged door incident is ultimately a core cost of capitalism in this industry. The FAA/Airlines/Part Suppliers are likely just as much to blame as maybe some sort of lapse in QA on Boeing's part might be. This is going to be remedied a lot faster than people think and i think the end takeaway from all of this will be Boeing is now far more resilient going forward on this front. Also, people should remember that despite all the drama the overall safety track record has been phenomenal and makes the auto peers look like drunken drivers. And i imagine AI machine vision inspection going forward remedies a lot of QA potential cost concerns for this whole industry if you are remotely worrying about that here.

So, while you will get a whole host of notes saying it's time to pause on Boeing and uncertainty is an issue again; I can't think of a case where the perception around their failures is really overblown and more of an industry dynamic that has now been progressively remedied. I don't think this is going to be some systemic operational problem because frankly if it was, aviation wouldn't be as safe as it is today. So, you really should step back and think about the fact the whole industry largely operates with this understanding and that backlog now looks better than ever.

As to yesterday's note, got question on the server market compares and this old next platform article touches on some of this and calls out 1999 numbers vs 2017 specifically for those looking to dig a little deeper.