FINANCING THE ACQUISITION

drjohn11aDr. John Psarouthakis, Executive Editor of www.BusinessThinker.com, Distinguished Visiting Fellow at the Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland, publisher of www.GavdosPress.com and Founder and former CEO, JP Industries, Inc., a Fortune 500 industrial corporation  

            You should begin planning the financing of your acquisition at the very start of your search.  This includes figuring out how much you are likely to need and where you will get it.  You help to establish your credibility with brokers and potential sellers early in the search process by providing evidence that you have the funds to carry out the deal should it go through. 

            How big a company you search for, as part of your initial search parameters is dictated in large part by the amount of funds you can access. Conversely, the nature of the deal may dictate the level of interest you can generate for financing.  The two issues are interdependent. Of course, you will not have all the details or commitments worked out from investors or lenders until they can examine the actual company you plan to purchase. On the other hand, you cannot afford to wait until you are well into negotiations, only to find that you lack a means for financing a deal.  Thus, similar to negotiations,  the process of obtaining your financing is likely to unfold throughout the acquisition process.

 Estimating Your Financial Needs

            Early in your search process, you want to figure out how much you will need.  The amount of money you need to purchase a business varies greatly by industry.  In the manufacturing sector, the price usually translates into one or two times the annual sales volume.  In distribution, the multiple is around three.  You can ask your brokers what ratios to expect in the industries you are considering.  You should get an estimate of what you need before your search so that you know what your goal is. 

Funds needed to make the deal  Figure out the expenses you are likely to incur for the acquisition itself.  As mentioned in earlier chapters, it is not unusual to spend between $50,000 and $100,000 or more, depending on size and complexity of the candidate company to close a deal, including the costs of preliminary and formal due diligence, legal fees for contractual negotiations, and so forth.  If you have a management team that can work for free, obviously you can reduce the overall cost somewhat, but it would be wise to develop a financial plan that covers not only the funds needed to close the deal, but the initial costs of the acquisition process itself.

Debt to equity ratio  Once you know the total amount of funds you will need, you also need to consider the ratio of debt to equity that you feel comfortable with.  Many highly leveraged deals took place in the 1980’s for as high as a ten to one ratio of debt to equity.  However, these are very risky endeavors, and many companies fell far short of succeeding in servicing this debt.  Psarouthakis generally tries to limit the debt-equity ratio to three or less.  In the manufacturing sector, this ratio provides a better cash flow cushion in a company downsizing scenario in case the economy suddenly takes a nosedive. 

            To keep everything in balance–your assets, debt level, cash, inventory payables, receivables–you need to be very cash flow sensitive, not just accounting sensitive.   A conservative debt-to-equity ratio will allow you to manage your assets and generate cash flow to respond to loan covenants.  Thus, resist the temptation even if the banks are willing to go higher.  Be very wary of a bank or other lender that encourages a highly leveraged position.  They may be the ones owning your business at the next business downturn, not you!  When you are too highly leveraged, even with careful management of your cash and inventory levels, you can run into serious problems servicing the debt. 

Types of Funding Available

            In addition to figuring out your funding needs, you should also figure out where you will get the funds to buy the target company.  You may have to investigate a combination of several different sources and types of funding to cover the entire price of the deal.  Funding generally falls into two overall categories: debt and equity. 

Types of debt

            Before describing different sources of financing, we will review certain basic financing terms, including secured versus unsecured debt, primary versus secondary debt, messaline debt and revolving credit or working capital debt (also referred to as an operating line) and equity.  Let’s review these terms briefly.

Secured versus unsecured debt Secured debt is a loan backed up or “secured” by some type of collateral, whether from the company to be acquired, your personal sources, or another company, if an existing company is doing the purchase. An unsecured loan is just that.  There is no collateral to back up the loan in case of default.

Primary versus secondary debt   In the case of limited funds, there is a pecking order

established from the start, as to who gets paid first.  Typically, secured lenders are also in a primary position.  In the case of liquidation, secondary position lenders are paid after primary lenders.

Mezzanine debt   Mezzanine debt bridges the gap between loans from traditional secured lenders and equity contributors.  Equity kickers or other arrangements might be used to attract one of these lenders.  The seller, for instance, may provide some of the mezzanine debt not covered by equity and other bank loans. Convertible bonds are a common form of mezzanine debt.  Insurance and finance companies are also often interested in this type of debt. Mezzanine debt is senior to equity, usually junior to bank debt, and often converts to equity over a period of time.

Revolving credit Revolving credit, also referred to as an operating line or working capital debt, is short term debt usually secured by accounts receivable, inventory, or both. It is always in a primary position against short term assets.

Equity 

            Equity sources are funds contributed by owners in the business.  In the event of a liquidation, proceeds are distributed to equity holders only after creditors are satisfied.  On the other hand, whereas the return for debt is usually for some specified, fixed amount, equity holders are unlimited in potential returns, depending upon the earnings and asset growth of the business. Thus, this source of financing has both the highest risk and the highest reward.

Sources of Debt Financing

            Within the general category of debt, you may choose among several types of lenders depending upon the availability of collateral and your business reputation.  Some of the most common sources for secured and unsecured debt financing are discussed in this section, including commercial banks, finance companies, insurance companies, pension funds, and the seller.

Commercial banks  Although first time buyers are probably most familiar with commercial banks, they are an unlikely source of long term debt financing unless they have a finance company subsidiary.  However, they are a primary source of working capital or revolving credit financing.  In your initial planning stages for buying the business, therefore, it is worth establishing bank relations for your new business even if you don’t use services from a commercial bank immediately.

            If you are turned down by a commercial bank, one option worth exploring is the U.S. Small Business Administration (SBA) loan. The U.S. government does not actually lend the money, but it does guarantee a commercial bank’s loan in case of default.  The SBA loan still requires collateral although it will often accept personal collateral if you lack assets in the business.  Since the laws and regulations change from time to time, it is worth checking with your local Small Business Development Center or local Chamber of Commerce to obtain the latest information.  Beware the personal loan guarantee requirement of the SBA loan however.  You are not only risking your current personal assets but future assets as well.

            Finally, consider a bank for short-term debt, if you have receivables, inventory, or real estate available for collateral and if the loan amount is under $1 million.

Finance companies Another type of financial institution, referred to as the asset-based lender, is more apt to provide you with an acquisition loan if you have hard asset collateral such as real estate, equipment or machinery.  They are also often willing to leverage the deal with a much higher debt to equity ratio than would a commercial bank.  However, be cautious.  Such companies can also be in the position to force an auction to liquidate the company for late payments.  Check out the company you are planning to borrow from thoroughly with several customers before signing a loan agreement.

            Use an asset-based lender for long term debt, where you have machinery, equipment or real estate as collateral, and if the amount of the loan is in excess of $1 million.

            Factoring companies are expensive and risky.  They have no problem liquidating the business. You should avoid factoring companies in any deal.

Insurance companies  Insurance companies can be good sources for loans and are often more patient than finance companies.  Very large companies such as Prudential or Aetna or those specializing in life insurance are worth looking into.  You probably won’t be able to approach them directly but a good merger and acquisitions consultant may be able to help you make contacts.

Pension funds Pension funds are another source of debt. Once again, you will probably need a third-party to help you approach one of these sources.  They vary in how involved they want to be with the business. Again, it is worth checking with other borrowers to see what their experience has been.

The Seller Finally, if you still have a gap between the seller’s asking price and the financing you are able to obtain from debt and equity, the seller is frequently used as a source to make up the difference.  For instance, you might provide a note secured by inventory. Typically, sellers will recognize a much higher value for inventory, as high as 75% or even 100% of its value, as security for the loan, whereas a bank typically may provide only about 50% of inventory value in a loan, if it is used as collateral.  In this type of loan, the seller can be placed in the first position before the bank, but for inventory only.  This would reduce the amount a bank might lend, but since you get a larger percentage to borrow against inventory, you increase the total amount of debt available to you to purchase the company.

Sources of Equity

            Just as with debt, several sources of equity are available to you. This section reviews the more common sources.

Personal investment You must weigh several factors in deciding how much of your own funds to invest.  On the one hand, you may want to maintain personal control over your company. On the other hand, you need to evaluate how much of your own capital you want to risk. If you are young, and have no one depending upon you for financial support, you are obviously in a better position to take risks than an older person with family obligations. However, you also want to consider that if the venture is so risky that others do not want to be a part of it, you may be foolish to put all of your own funds into the venture.

Investment from family and friends One of the most common sources of capital for entrepreneurs is funding from family and friends, whether as a loan, equity or both.  You need to consider this source carefully.  First of all, if these relatives provide part of your own financial safety net, you want to be careful not to overextend their personal commitment to the total business either.  You also want to be sure that a complete loss of equity will not jeopardize important personal relationships in your life.  Approach family and friends as you would a stranger — with a formal business plan, an accurate portrayal of the risks involved and a clear proposal for how the investment will be returned to the investor.  By treating friends and family in a business like manner, you reduce the chances of misunderstandings that might jeopardize your friendship in the future.

Venture Capital Firms Increasingly, venture capital firms today manage funds for wealthy investors. Although discussed frequently, venture capital is a source of funds for a very small percentage of entrepreneurs.  Venture capitalists expect a very high rate of return.  If you plan to purchase a rapid growth, high potential company, it may be worth investigating this avenue.  Venture capitalists also look very closely at the experience of the management.  They will be more interested in someone with previous entrepreneurial experience. However, many venture capitalists today prefer acquisitions to start-up companies, with the former being viewed as lower risk.  It is worth checking into, especially if you are in need of a very large sum (half million dollars or more).

Small Business Investment Companies (SBIC) SBIC’s are venture capital companies licensed by the federal government.  The program began in 1958 as a way to make money available for small company investment. SBIC’s actually can provide either debt, equity, or both. 

Angels and other private investors  Angels are a much more common source of equity than venture capital firms.  Angels are likely to be wealthy individuals interested in investing their own funds in an entrepreneurial venture. Area doctors, dentists and successful business people may be angels.  Business opportunities are often screened for such individuals by lawyers, accountants, brokers and business associates in the area. You may contact your network of business associates.  Venture capital clubs in the larger business communities also often attract angels and/or their representatives. That is why you often see so many attorneys and accountants at such meetings, listening for good opportunities to recommend to their clients.  As with a venture capital firm, you will need to prepare a

detailed business plan to present at such events, or to share with these contacts.

Investment banks  Investment banks are a rapidly growing source of both debt and equity.  Investment bankers increasingly serve roles other than that of intermediary in the purchase of the target company.  For instance, many also assist in putting together a financing package for an acquisition.  For instance it may pull in funds from other sources such as an operating line from a commercial bank or long-term secured debt from a financial institution.  The investment bank might also provide some of the mezzanine financing and/or equity, itself. Investment banks should not be confused with venture capital firms however.  The latter  are rarely interested in a debt position. Nor are venture capital firms likely to provide financial consulting.   Try to find the right sized investment banker for your size of firm.  Although investment banks are not interested in very small firms, they are becoming a growing resource of funds and expertise for many entrepreneurs.1

Earn outs and seller employment fees  Earn outs and seller employment fees are some other techniques used to close the gap between the agreed upon sales price and the available debt and equity.  An earn-out is an agreement whereby part of the seller’s compensation for the business is based on the performance of the business after the deal is closed.  It may be based on a percentage of gross sales , net sales or net profits.

            Consulting and employment fees may also make up some of the gap in the difference between other financing and the purchase price.  In this case, the seller is paid a salary or consulting fee for his or her assistance in the transition of ownership.  If you use such a fee, you should review current tax implications carefully with a tax consultant. 

            Sometimes the mere timing of the deal might affect the net cash to the seller–for instance whether the sale is closed at the beginning or end of a tax year. 

Dealing with the Banks

            Since most deals include a bank loan for at least a portion of the overall financing, it is worth examining some issues related to bankers’ relationships in greater detail.

Shop around to different banks  First of all, in spite of the ratios and numbers, you will find a wide variation in ratios across banks, whether it be debt to equity, earnings to interest ratio or some other yardstick.  It is worth shopping around at different banks to see what they expect.

Minimize your personal risk Secondly, although it is a common practice to do so, we feel it is a mistake to use your house as collateral in a business loan.  A bank asks for your house as collateral when they do not feel you have enough equity.  The banks should say this directly, but they do not always do so.  Rather than put yourself and/or your family at greater financial risk, you should seek other sources of equity to balance the debt.  Decide on your limit and then inform the bank that this is all the money you are going to put in. If this approach doesn’t work, you should consider searching for another bank.

Limit the bank’s involvement in the business Third, some banks try to get too heavily involved in the operating aspects of the business.  Ask the bank what requirements they have with respect to performance and outcomes but don’t allow them to get involved with issues that pertain to the management of operations.  Management at JPE, Inc., at times has had to say point blank to a banker, “Look friends, you know how to manage a bank.  Just do that.  We know how to manage operations and we will take care of that.  Tell us what covenants you don’t want us to violate or what your requirements are in terms of performance so that you feel comfortable giving us the loan.”

Be sensitive to the banker’s needs Fourth, try to realize that sometimes the individual loan officer might be faced with internal issues that affect his or her behaviour toward you.  For instance, Tuller (1990) shares an anecdote about a loan applicant for a business that waited two months impatiently for a banker’s answer. Annoyed, he almost walked away from the deal.2  Tuller, who is an experienced business broker, contacted the banker, to learn that the banker was concerned about meeting his quota for the coming month and was trying to push more business into that month.  Tuller patched things up between the banker and his client, the client got his loan and the banker was happy, too.

Beware banks with liberal policies Fifth, be cautious about banks and other lending sources that are too liberal in their policies, for instance in the debt-to-equity ratio.  Sometimes a poorly run bank will call in their good loans before their bad ones because they need the money.  Or they may be less understanding if and when you miss a payment.  Check out your banker thoroughly to be sure that you feel comfortable with the type of business relationship that you will experience

Financing when You Have an Existing Company                  

            Most of the guidelines described so far pertain whether you are a first time buyer or own a pre-existing company.  However, there are differences.  In providing a loan to an existing company, a lender will examine the impact that the target company will have on the balance sheet of the existing company.  You may be able to secure some of the debt with collateral from your existing company.  And of course, you may have some cash or other assets available to invest in the target company from the existing company.  Finally, you may have a longer track record and thus have an easier time obtaining a loan from the bank, although commercial banks may still be wary of providing a loan for the direct purpose of purchasing a new company. However, the other sources of debt and equity, and most of the other general remarks are still applicable, even for those who already own a business.

Summary

            Financing the acquisition requires thorough and careful planning.  You need to consider the different sources of funding accessible to you.  The amount required for purchasing the company may dictate the types of sources that you seek out.  Some combination of debt and equity is likely. Be wary of overextending yourself with too much debt. On the other hand, be careful to protect your immediate family by not taking too great a risk with your personal assets.  It should not be necessary to put your entire life’s savings up for collateral.  If the deal makes sound business sense,  if a bank or other lending institution starts making unreasonable demands, check out another bank, review your business plan, or try some other approach.  Lending institutions vary from the unscrupulous to the impeccably correct.  You need to be especially cautious with any lender that is likely to take your company away from you if you fall behind on a few payments.  Check out your sources, both equity and debt, as thoroughly as you check out the seller.  Are you dealing with honest individuals?  Have you reviewed the fine print for hidden commitments that might jeopardize your ownership?  The earlier you begin to develop your financing plan, the more likely you will be ready to close, when the purchase agreement is finally negotiated and signed.

                                                                    Footnotes

1.A New Source of Money: Financing Through Investment Banks, in Tuller, Lawrence, Buying In: A complete guide to acquiring a business or professional practice, Chapter 12, Liberty Hall Press, pp. 175-186.

2  Tuller, Lawrence, op cit

General Reference:; How to Acquire the Right Business, John Psarouthakis and Lorraine Uhlaner, Xlibris, 2009

Evidence on the Debate on Fiscal Multipliers

Perry Gogas 15xx (2)
Dr. Periklis Gogas is a frequent contributor to The Business Thinker magazine. He is an Assistant Professor of Economic Analysis and international Economics, Department of International Economics and Development, Democritus University of Thrace, Greece
Ioannis Pragidis
Dr. Ioannis Pragidis is a co-author for the Business Thinker magazine. He is a Lecturer of Economic Analysis at the  Department of Business Administration, Democritus University of Thrace, Greece


Fiscal Multipliers

The “rescue plan” for Greece and other economies in trouble in the recent European fiscal crisis was designed by the IMF based on one very important factor: the fiscal multiplier. The latter is a measure of the total decline of GDP after a reduction in government spending or a tax increase. The IMF assumed that the fiscal multiplier for Greece was 0.5. Thus, a €1 reduction in government spending would ultimately decrease GDP by €0.5. But both economic theory and empirical evidence suggest that depending on the case and the phase of the cycle the fiscal multiplier may be well above unity. Even the IMF admitted that they were wrong and the actual multiplier may be between 0.9 and 1.7 in an economy in a recession and in the middle of a fiscal crisis. This suggests that the final effect of the austerity measures to the Greek GDP was surprisingly at first 2 or 3 times higher that was assumed. The result of this austerity program based on wrong assumptions is evident: a cumulative 25%-30% real GDP decline in the past 4 years and an unemployment rate that reaches 28%! It is embarrassing that the IMF used a value totally inappropriate for Greece’s case. Finding empirical evidence that the fiscal multiplier is 0.5 in the U.S. or Japan does not necessarily mean that this value is appropriate for Greece too and especially in the midst of a crisis! The fiscal multiplier increases as the economy enters a recession. Thus, a contractionary fiscal policy during recession time could have much larger contractionary results than in a boom time.

The Theory
In a Keynesian model and under a closed economy (an economy with no international trade) economic theory predicts that the fiscal multiplier is large and above unity and there is a crowding out effect of private investment. This means that when government spending is increased, private investment falls as a result of a rise in the interest rate. In an open economy (an economy with international trade): the fiscal multiplier is larger when we have a fixed exchange rate regime (peg) than under floating exchange rates. The crowding out effect is larger under a floating exchange rate regime than under a peg. In a classical model on the other hand, the fiscal multiplier is near zero and the crowding out effect of government spending on private investment is large.

Empirical Evidence so Far
In the empirical evidence found so far in economics literature, the exchange rate regime and its effect on the fiscal multiplier is not exploited in depth. So far, the empirical papers have found that:
• The fiscal multiplier is larger under a peg than under a float.
• The crowding out effect is larger under a float than under a peg.
• However, the differences in the crowding out effect between the two regimes is not found to be very large as well as the differences in net exports
• There is no consensus about net exports: some find that they increase and some others that they decrease.
• The same ambiguity in empirical evidence exists for the interest rate as well.

Evidence from the Long Run Derivative
In our current study (Gogas-Pragidis, June 2013) we use data spanning both the fixed exchange rates regime of Bretton-Woods and the recent floating exchange rate period. We use data on several macroeconomic variables from the U.S. economy and we employ for the first time in the empirical literature and in this context the Long Run Derivative methodology of Fisher and Seater (1993). This methodology allows us to explore the evolution from the short to the long run of the effect of government spending on several macroeconomic variables of interest that are in the heart of the relevant policy debate. Our empirical findings are summarized in the following:
• The fiscal multiplier is positive in the short run and neutral in the long run under a peg but negative under a float.
• The crowding out holds for both regimes, although under a peg there is no crowding out in the long run. Nevertheless, the difference in the results between the two regimes is quite large.
• Net exports deteriorate in both regimes after a fiscal expansion. Under a float though this turns to positive in the long run.
• Private consumption increases under a peg in the short run and returns to its initial value in the long run. Under a float, private consumption decreases in the long run confirming Ricardian equivalence.
• We also confirm the decrease of gross savings in both regimes
Thus, we confirm the very large differences in the fiscal multipliers and the crowding out effects with respect to the exchange rate regime. We also confirm the transmission mechanism predicted by economic theory: under a float, an increase in government spending will increase the interest rate, so the exchange rate will appreciate, crowding out both net exports and private investments. Due to Ricardian equivalence, the private consumption will decrease as well as the total output. Thus, under a float the expansionary fiscal policy can have contractionary results. The inverse holds in the case of a peg. An expansionary fiscal policy will have expansionary results. In this case the transmission mechanism works differently. The interest rate is accommodative and the crowding out effect in both net exports and in private investments are smaller. Private consumption increases resulting to an increase in total output.

Conclusion
From our analysis it is evident that the exchange rate regime plays an important role with respect to the effects of government spending on key macroeconomic variables. Following this, we may bring into the multiplier’s debate the fact that Greece is an economy operating in a de facto peg: it cannot use the monetary policy as a tool to stimulate its economy in this crisis. This has significant implications to the fiscal multiplier as under a peg, as the evidence suggests, the multiplier should be large and positive. Thus, government spending cuts and tax increases have a large and negative effect on real GDP irrespective of the phase of the economic cycle. Going back to the miscalculation by the IMF, It is not only the crisis and the recession that is the main driver of the large fiscal multiplier; the fixed exchange rate regime that Greece faces in terms of the euro is another issue that was not considered and properly included in the models. So the IMF used wrong fiscal multipliers not only because it failed to take into account the recession phase of the Greek economy but also it failed to incorporate the exchange rate regime, the fact that Greece is a member of the Eurozone, into its calculations. 

 

 

THE BOEING COMPANY: A Case Study on Betting it All

George A. Haloulakos, CFA DBA Spartan Research and Consulting, Core Adjunct Finance Faculty – National University

Co-authored with: Farhang Mossavar-Rahmani, DBA, Professor of Finance – National University

 

Since helping launch the commercial jet aircraft age with its 707 model in the 1950s, the Boeing Company has taken very large risks (some might even say gambles) on developing new generations of wide-body commercial jet aircraft.  This approach has historically been known as a “bet the company strategy.” As each new generation of wide-body jet aircraft has placed enormous financial pressure on Boeing (including, but not limited to up-and-down earnings results, increased debt burden and a cyclical stock price) thereby significantly increasing the risk of corporate financial failure.  Yet despite a few close calls, Boeing has emerged successfully from each cycle, enabling it to maintain industry leadership and generate satisfactory long-term financial returns.  In this paper, as part of our ongoing research on risk-taking behavior we will focus on the 707 model that formed the template for Boeing’s “betting it all” corporate strategy associated with the launch of new generations of wide-body aircraft over the ensuing decades.

Introduction

Now the world’s largest aerospace company, Boeing was founded in 1916 by William E. Boeing in Seattle, Washington. The company is composed of multiple business units: Boeing Commercial Airplanes (BCA); Boeing Defense, Space & Security (BDS); Engineering, Operations & Technology; Boeing Capital; and Boeing Shared Services Group. As top U.S. exporter, the company supports airlines and U.S. and allied government customers in 150 countries. Boeing’s products and tailored services include commercial and military aircraft, satellites, weapons, electronic and defense systems, launch systems, advanced information and communication systems, and performance-based logistics and training.

Boeing Commercial Airplanes

Boeing has been the premier manufacturer of commercial jetliners for over 40 years. Today, their main commercial products are the 737, 747, 767 and 777 families of airplanes and the Boeing Business Jet. New product development efforts are focused on the Boeing 787 Dreamliner, and the 747-8. The company has nearly 12,000 commercial jetliners in service worldwide, which is roughly 75 percent of the world fleet. Through Boeing Commercial Aviation Services, the company provides round-the-clock technical support to help operators maintain airplanes in peak operating condition. Commercial Aviation Services offers a full range of world-class engineering, modification, logistics and information services to its global customer base, which includes the world’s passenger and cargo airlines, as well as maintenance, repair and overhaul facilities.

Capital Investment Decisions

Capital investment decisions at Boeing are unique and—to some degree—risky. For example, in the mid-1950s, despite failing to profit on civilian planes in two decades, Boeing spent $185 million to develop the first American all-jet transport, the 707, despite not having made money in a non-military plane in twenty years, Boeing spent $185 million to develop the 707, the first American all-jet transport.   To put this in context, this capital investment was $36 million or 25% more than Boeing’s total net worth of $149 million in 1956!

 

Table 1

COST OF LAUNCHING THE 707 PROGRAM

 

Financial Category

Amount (US$ millions)

Prototype

16

Engineering & Tooling

100

Plant & Equipment

35

Thrust Reverser & Sound Suppressor

7

Advertising & Sales

4

Flight Test & Research

23

TOTAL

$185 million

 

Boeing’s attitude toward risk can be better understood if we look at the company’s earnings during that time. From 1946-49, Boeing’s average annual net income was less than $1.4 million.   From 1950-53, average net income increased to $12 million as the company benefitted from its military aircraft business, led by its signature B-52 jet bomber.  Since the cost of building a prototype commercial jet aircraft was estimated to be $15 million (versus the eventual/ actual cost of $16 million), Boeing determined it was too great a risk as a stand-alone project.  The numbers implied such a project would put the entire company at grave financial risk.  At that time airlines were reluctant themselves to commit their financial stake entirely on reliance or use of jet aircraft alone.

However, Boeing determined the risk of launching a commercial jet aircraft was worth undertaking given the following additional considerations.  As it turned out, Boeing’s B-52 jet bomber fleet deployment worldwide necessitated demand for a tanker jet-aircraft for refueling purposes. Existing prop aircraft flew too slow and too low for efficient refueling.  Given the aforementioned sharp increase in average net income, Boeing determined that the $15 million+ cost to develop a prototype 707 would be less risky because it would be designed to serve two (instead of one) potentially very large global markets, thereby lowering risk and increasing expected returns.

In 1955, Boeing secured an order for production of 400 military units from the US Air Force for its 707 model, equal to the projected (and eventual) installed base of B-52s for US Strategic Air Command.  With this strong endorsement of the 707 aircraft and burgeoning world travel, commercial airlines started to express interest.  Boeing was able to differentiate itself from both foreign and domestic competitors by maintaining flexibility with its own customers.  Specifically, Boeing was able to widen its cabin space by four inches with minor engineering and tooling costs plus retain the core features incorporated into its military prototype.  This enabled Boeing to have faster time-to-market deliveries and higher absorption rate of fixed overhead for both military-and-commercial aircraft assembly operations.  Total 707 commercial deliveries were 1011 (from 1958-94).

During the 1954-58 cycle in which Boeing invested heavily in the 707, corporate Net Income was stable-to-lower while Total Liabilities increased 2.3 times.  In 1954, Net Income and Total Liabilities, respectively, were $32.4 million and $171.9 million.  By 1958, Net Income was $29.4 million and Total Liabilities were $403.7 million, or Total Liabilities exceed annual Net Income by a factor of 13.7.  By comparison, during1950-53, average Total Liabilities exceeded average annual Net Income by a factor of 12.

Stock Price

Investors initially responded positively to the new project. The Company’s stock price reached a high of $79.63 in 1955 and then fluctuated for the next three years going down to $36.62 in 1957 and then up to $45.62 the following year.

In sum, Boeing did “risk the company,” as measured by the cost to develop the program ($185 million) versus its net worth ($149 million) with the prototype exceeding its average annual Net Income ($16 million versus $12 million) over the same period.  But this risk was tempered by leveraging the cost over two end-user markets rather than one. Additionally, Boeing established a sales-and-earnings platform on an already strong, well-established business (defense/military) that could be adapted for creating a civilian commercial segment.  Earning power as measured by Net Income increased at about the same rate (2.5x) as the increase in Total Liabilities (2.3x) when measuring the 1954-58 period with the pre-707 era of 1950-53.

Time Line for Launching New Era: Milestone Events (1955-1958)

The Boeing 707 helped revolutionize commercial air travel, and thereby generated enthusiasm while boosting its worldwide prestige and brand name.

TIME PERIOD

MILESTONE EVENT

MAJOR CUSTOMER

March 1955 Order for 400 aircraft United States Air Force
October 1955 Order for 20 aircraft Pan American Airways
November 1955 Order for 30 aircraft American Airlines
February 1956 Order for 33 aircraft TWA
October 1956 Order for 15 aircraft BOAC
1957 Completes delivery of 200 aircraft (1/2 of 1955 order) United States Air Force
1958 Delivery of 8 commercial aircraft Commercial airlines with Pan Am taking first delivery

Significant financial payback took longer to occur.  While Boeing achieved breakeven with the 707 in late 1956, the long-term nature and large capital investment for the aircraft business meant that it took 10 years for the 707 to reach peak-production while simultaneously helping the company achieve peak-earnings in 1967-68.  Unit deliveries for the 707 in 1967-68 were 118 and 111, respectively, as company Net Income exceeded $83 million both years.

After the 707: SST, Wide Body Jet Aircraft, Bigger Bets and Bigger Risk

By the mid-1960s, Boeing had firmly established itself as a leader in commercial jet aircraft with the 707 as its flagship product worldwide.  In anticipation of demand for supersonic jet travel, and with airlines extrapolating the shift of passengers from trains and transoceanic ships into a need for wide-body jet aircraft, Boeing made an even bigger bet by simultaneously pursuing both markets. Boeing did this without having the military aircraft market as a “hedge” or back-up like it did with the 707.  Boeing appeared to be flying high with Net Income topping $83 million in 1967 and 1968, concurrent with triple-digit unit deliveries of the flagship 707 aircraft each of those years.   However, Net Income dropped 88% to $10.2 million in 1969 as economic slowdown, declining air travel and financial retrenchment by the airline industry caused 707 unit shipments to fall by nearly 50%.  In such a weak economy, Boeing only delivered four 747s in 1969, which implied low absorption of fixed overhead and profit margin pressure.  Federal funding of the SST was cancelled in 1971, forcing Boeing to take a loss on this project.

During a peak in the late 1960s and a bottom in 1971, the stock fell 88% as the development of a supersonic transport to compete against the Concorde was called off. And in response to the sharp decline in demand for commercial jet aircraft, Boeing cut its commercial aircraft workforce from 83,700 in 1968 to 20,750 in 1971.

The only reason Boeing did not fail was due to the financial offset by its strong, stable military business in the form of its Minuteman and Cruise missile programs.  Eventually, the long-expected increase in air passenger travel materialized and the accompanying need for wide-body jet aircraft gained momentum with Boeing’s 747 as the prime beneficiary.

Boeing’s financial resurgence, its diverse family of aircraft (narrow-and-wide body models) able to serve all worldwide markets and its strong, stable military business enabled it to outlast and outdistance its competitors. Lockheed exited commercial aircraft in 1981, with McDonnell Douglas and European Air Bus remaining as prime competitors, but with far fewer product offerings versus Boeing.  By 1997, McDonnell Douglas was acquired by Boeing, thereby eliminating it as a competitor.

The commitment of capital and time associated with being a leader in commercial aircraft would appear to support a “bet the company approach” with each successive generation of new jet aircraft. However, Boeing has utilized different tactics to achieve financial success and maintain its market leadership.  The 767 was the company’s first twin-jet wide-body model; the 777 was the first “fly by wire” airliner and the first computer-designed commercial jet aircraft; the 787 is comprised of over 80% composite materials enabling it to be more fuel efficient due to significantly less weight.  Boeing has diversified (and thereby lowered) its risk by outsourcing manufacture of key components and sections of its aircraft models while retaining the design, development and final assembly functions.

This lower degree of vertical and horizontal integration versus the approaches taken in its 707 and 747 models has enabled the company to more efficiently utilize all its resources while still taking the necessary risks to maintain its leadership.  As noted earlier, the success of Boeing’s 707 and 747 programs can be partly attributed to the company’s core competency in military and defense sectors. The 707 was launched on the basis of potentially, and ultimately serving two very large markets, commercial and military. Thus, the company’s missile business was able to sustain Boeing’s overall financial viability while the company weathered the industry downturn in the early 1970s.  As the company launched its later generations of jet aircraft, military/defense business remained a key contributor to overall corporate success for the same reasons noted for the 707 and 747.  The company’s strategic posture was further strengthened when Boeing acquired McDonnell Douglas, which was the largest military aircraft player.

CONCLUSIONS

Boeing’s “bet the company strategy” appears to have successively increased earnings power (measured by Net Income) with each generation of new commercial jet aircraft.  Each new revolutionary jet aircraft program eventually is the primary driver in raising total Net Income by several-fold (versus the cycle immediately prior to it).  The 707 led to a 2.5x increase in Net Income (late 1950s/early 1960s versus mid-1950s) and by 1967-68, Net Income was 2x higher than its 1961 level.   The 747 helped Boeing surpass the 1967-68 peak by a factor of 7-times by 1980, with the 767 and 777 programs leading to an eventual 7-fold improvement in Net Income by 2011 versus 1980.  For more information, please see Exhibit 1.

Boeing’s success in commercial jet aircraft stemmed from its military aircraft business in terms of risk sharing (e.g., 707 and its military KC-135 version) and diversification.  The strong position in defense-related projects (e.g., Minuteman and Cruise missiles) provided stable, steady cash flow for the entire corporation thereby providing an additional financial cushion to undertake development of new generations of jet aircraft.  The acquisition of the largest US military contractor, McDonnell Douglas, further strengthened Boeing’s corporate business portfolio in terms of earnings, cash flow and diversification.

Cyclical, financial and execution risks remain perennially relevant for the commercial jet aircraft business. However, Boeing has a proven performance record of being able to maintain its market leadership and increasing its earning power with each generation of new aircraft.  This includes, but is not limited to, accommodating unique customer demand requirements on a global scale, rationalization in down cycles, improvement of assembly and manufacturing processes and either buying out (e.g., acquiring McDonnell Douglas) or driving out (e.g., Lockheed) its major US commercial jet aircraft competitors.

While Boeing’s stock price has been cyclical, investors have learned to be patient every time the company undertakes a bigger bet when launching a new generation of aircraft. In general, as shown in Exhibit II the price of stocks have been more in line with future orders rather than net profit.

 

EXHIBIT 1

 FINANCIAL POSITION (Net Income and Total Liabilities)

& COMMERCIAL JET AIRCRAFT UNIT DELIVERIES – 707 & Wide Body Models

(Financial Figures in US$ Millions) / Years 1951 – 2012

Year

NET INC

Total Liab.

707

747

767

777

787

Stock Price

1951

7.1

103.8

0

1952

12.3

113.4

0

1953

18.3

188.9

0

1954

32.3

171.9

0

1955

27.3

146.7

0

1956

32.1

183.2

0

1957

38.2

312.1

0

1958

29.4

403.7

8

1959

12.4

386.8

77

1960

24.5

300.2

91

1961

35.7

330.9

80

1962

27.2

377.3

68

56.13

1963

22.6

414.0

34

39.13

1964

45.3

345.0

38

39.75

1965

78.3

390.5

61

66.12

1966

76.1

880.8

83

166.75

1967

83.9

1278.8

118

70.12

1968

83.0

1375.7

111

76.12

1969

10.2

1806.4

59

4

59

1970

22.1

1812.4

19

92

23

1971

42.2

1621.5

10

69

19.5

1972

30.4

1262.6

4

30

25.37

1973

51.2

782.9

11

30

23.37

1974

72.4

791.3

21

22

14.25

1975

76.3

778.8

7

21

17

1976

102.9

833.8

9

27

27.62

1977

180.3

1209.1

8

20

38.25

1978

322.9

2099.6

13

32

0

26.37

1979

505.4

3049.7

6

67

0

75.37

1980

600.5

3616.5

3

73

0

65.5

1981

473.0

4298.5

2

53

0

39.75

1982

292.0

4780.0

8

26

20

21.5

1983

355.0

4433.0

8

22

55

36.5

1984

787.0

4790.0

8

16

29

44.5

1985

566.0

4882.0

3

24

25

62.38

1986

665.0

6242.0

4

35

27

48.25

Year

NET INC

 

Total Liab.

707

747

767

777

787

Stock Price

1987

480.0

7579.0

9

23

37

50.25

1989

973.0

7147.0

5

45

37

63.38

1990

1385.0

7618.0

4

70

60

59.25

1991

1567.0

7691.0

14

64

62

49.38

1992

552.0

9916.0

5

61

63

50.88

1993

1244.0

11292.0

1

56

51

35.25

1994

856.0

11763.0

1

40

41

43.25

1995

393.0

12200.0

25

37

13

44.5

1996

1095.0

16313.0

26

43

32

77.5

1997

-178.0

25071.0

39

42

59

107.12

1998

1120.0

24356.0

53

47

74

47.63

1999

2309.0

24685.0

47

44

83

34.69

2000

2128.0

31008.0

25

44

55

44.5

2001

2827.0

37518.0

31

40

61

58.5

2002

492.0

44646.0

27

35

47

40.95

2003

718.0

44896.0

19

24

39

31.39

2004

1872.0

42677.0

15

9

36

41.59

2005

2572.0

48999.0

13

10

40

50.6

2006

2215.0

47055.0

14

12

65

68.31

2007

4074.0

49982.0

16

12

83

89.56

2008

2672.0

55073.0

14

10

61

83.18

2009

1312.0

59828.0

8

13

88

42.31

2010

3307.0

65703.0

0

12

74

60.6

2011

4018.0

76378.0

9

20

73

3

69.48

2012

3900.0

82929.0

31

26

83

46

74.1

 

 

Exhibit II

Percentage changes in Stocks 1962-2013

Date

Open

High

Low

Volume

Close

%   Change

1/2/2013

76.55

78.02

72.68

9497200

73.87

-0.4179

1/3/2012

74.7

76.7

72.74

5428200

74.18

6.7645

1/3/2011

66.15

72.99

66

6661000

69.48

14.6535

1/4/2010

55.72

63.4

54.8

7336400

60.6

43.2286

1/2/2009

42.8

47

39.51

7440100

42.31

-49.1344

1/2/2008

87.57

87.84

74.12

9118100

83.18

-7.1237

1/3/2007

88.9

90.34

84.6

5173500

89.56

31.1082

1/3/2006

70.4

71.27

65.9

4052400

68.31

35.0000

1/3/2005

51.85

52.25

49.52

3609600

50.6

21.1976

1/2/2004

42.5

44.71

41.47

3312700

41.75

32.1621

1/2/2003

33

34.59

30.2

2852700

31.59

-22.8571

1/2/2002

38.54

41.89

37.65

4044700

40.95

-30.0000

1/2/2001

65.31

65.31

54.56

4107200

58.5

31.4607

1/3/2000

41.44

48.13

39.75

4570200

44.5

28.2790

1/4/1999

32.81

36.75

32.56

4846300

34.69

-27.1678

1/2/1998

48.94

49.81

42.81

5055900

47.63

-55.5358

1/2/1997

105.87

114.5

103

3436700

107.12

38.2194

1/2/1996

78.37

81.37

75.37

2661500

77.5

74.1573

1/3/1995

47

49.75

44.38

2187700

44.5

2.8902

1/3/1994

43.38

45.5

42.25

2264900

43.25

22.6950

1/4/1993

40.13

40.88

34

3176000

35.25

-30.7193

1/2/1992

47.25

54.63

46.63

2980600

50.88

3.0377

1/2/1991

45.25

49.63

43.13

2434900

49.38

-16.6582

1/2/1990

59.38

63.25

56.63

2422800

59.25

-6.5163

1/3/1989

60.63

63.75

57.88

3450600

63.38

38.5355

1/4/1988

37.38

46

37.38

2557600

45.75

-8.9552

1/2/1987

51.38

53.5

49.13

5349400

50.25

4.1451

1/2/1986

52.25

53.5

46

3637100

48.25

-22.6515

1/2/1985

56.5

63

54.25

4182900

62.38

40.1798

1/3/1984

43.75

49.88

43.75

3239700

44.5

21.9178

1/3/1983

33.88

37.25

31.87

2295300

36.5

69.7674

1/4/1982

22.62

23.25

20.37

1140500

21.5

-45.9119

1/2/1981

44.13

44.25

39.38

1879100

39.75

-39.3130

1/2/1980

50.63

68.87

48.13

4579100

65.5

-13.0954

1/2/1979

71.37

79.37

69.75

3613200

75.37

185.8172

1/3/1978

28.12

28.12

25

1440900

26.37

-31.0588

1/3/1977

44.75

44.88

37.5

1784300

38.25

38.4866

Date

Open

High

Low

Volume

Close

%   Change

1/2/1976

24.37

28.75

24.37

1424000

27.62

62.4706

1/2/1975

15.75

17.37

15.13

620700

17

19.2982

1/2/1974

12.38

14.5

11.63

965400

14.25

-39.0244

1/2/1973

25.37

26.87

22

1007500

23.37

-7.8833

1/3/1972

19

26.5

19

2847800

25.37

30.1026

1/4/1971

14.63

19.5

14.63

1806400

19.5

-15.2174

1/2/1970

28.12

31.87

21.25

1182000

23

-61.0169

1/2/1969

56.88

60.38

55.13

688000

59

-22.4908

1/2/1968

90.25

90.25

76

903400

76.12

8.5568

1/3/1967

67

74.87

61.75

1736100

70.12

-57.9490

1/3/1966

130.75

172

130.75

1913100

166.75

152.1930

1/4/1965

68.87

70.37

62.75

1404200

66.12

66.3396

1/2/1964

36

39.88

36

564600

39.75

1.5845

1/2/1963

37.13

39.88

36.63

781200

39.13

-30.2868

1/2/1962

50.88

56.25

48.13

1225700

56.13

 

REFERENCE SOURCES

Air International. “367-80(707 Prototype)” – N.P., N.D.

Boeing Company.  Various public company documents, 1950 – 2012.

Boeing 747-400, Aircraft of the World. N.P.:International Master Publishers., N.D.

Boeing 777-400, Aircraft of the World. N.P.: International Master Publishers, N.D.

Connolly, Patrick. “‘Old Bird’ Ushered in Jet Era.” Page A-40; The San Diego Union [San Diego, CA] 8 Oct. 1978, Weekend Edition, Business Section.

Fortune Magazine.  “The Selling of the 707.”  October, 1957

Green, William (compiler) and Punnett, Dennis (silhouette artist). The Observer’s Book of Aircraft.  Frederick Warne & Co. (London and New York). 1965.

Haloulakos, V.E.  Aerospace Engineer, Scientist and Professor.  (BSME, MSAE and ENGR.D.  Viterbi School of Engineering, University of Southern California).

Harris, Neil. “Boeing 747: Constructing the Colossus.” FLIGHT Internationa.l December 19. 1968: Page 1027.

History Link.Org – Washington State History.

The San Diego Union [San Diego, CA], “Boeing Jet’s First Flight Called ‘A-ok.'” September 27, 1981: Page A-4.

Securities & Exchange Commission (SEC) EDGAR System – 10 K Reports.

Thompson, R. G. “Dash 80.” Air and Space Magazine. April-May 1987: Pages 63-65

Wharton Research Data Service.

RESEARCH SUPPORT

Ku, Yueh Su.  Financial Research/Data Mining.  UC San Diego Extension – Finance Certificate post graduate student.

Shannahan, MeglynAnne Price. Industry/Economic Research.  UC San Diego Extension – Finance Certificate post graduate student.