George A. Haloulakos, CFA DBA Spartan Research and Consulting, Core Adjunct Finance Faculty – National University and Instructor-Finance, University of California at San Diego (UCSD) Extention
The Lockheed L1011 Tri-Star, a tri-jet wide body aircraft introduced in the early 1970s, was regarded as a technical marvel whose commercial success was severely limited by financial and developmental problems with Rolls Royce, the sole developer of the Tri-Star’s engines. Despite being a quiet, efficient, easy to handle wide-body aircraft with a stellar safety record (of the five fatal accidents involving L1011s, only one was due to a problem with the aircraft) the Tri-Star program was unable to overcome its late entry into the commercial market, and Lockheed announced in 1981production would end with the 250th and last L1011 on order in 1984. Since then, the Lockheed Tri-Star has become a classic business school case study in finance. The typical solution offered usually involves a variation of shutting down the commercial aircraft program and refocusing on Lockheed’s military aircraft and avionics businesses, or a “work-out” in which the firm struggles to drive commercial sales to the elusive break-even mark. In this paper, it is shown that a positive Net Present Value for the Tri-Star was, in fact, achievable but requires one to depart from the oft-linear and sometimes limited vision from the standard MBA playbook. The solution offered here requires a change in corporate strategy (utilizing a proven business model serving not one, but two end-user markets) and leveraging Lockheed’s significant competitive advantage in high-performance military aircraft.
FINANCIAL DECISION MAKING & THE CASE STUDY METHOD
Financial decision making requires one to make recommendations including, but not limited to capital budgeting, competitive strategy, marketing and other such areas with the goal of optimizing Net Present Value. The case study method forces a person to define-and-solve the problem within the historic time frame in which the case takes place by utilizing given background information as well as supplemental data gathered from independent research. Time pressure means that one does not have the luxury of dotting each “i” or crossing each “t” but to provide a defensible solution in accordance with the situation. Playing it safe via risk-averse solutions (that are often self-evident from a strict, linear-based accounting prism) usually means staying within the realm of consensus views, while playing to win means having to take greater risk, but if done with a creative, non-linear approach can sometimes lead to more satisfactory outcomes. As such, the goal with financial decision making using the case study method is offering a solution that provides the highest probability of success. This paper presents a play-to-win strategy that incorporates a behaviorist view of finance aimed at achieving a financial outcome above consensus expectations
A synopsis of the facts of the case is as follows: The L1011 Tri-Star is a wide-body commercial aircraft with a capacity of up to 400 passengers. Lockheed was late to enter the market due to jet engine production delays by Rolls Royce (sole supplier for the Tri-Star). In the early 1970s, Lockheed sought a $260 million federal loan guarantee to secure bank credit to complete its L1011 Tri-Star aircraft. Preproduction costs were $960 million during 1967-71. The production phase beginning in 1972 would be in the range of 210 – 300 aircraft, and extend as far as 1980. The project was regarded as inventory intensive and front loaded; 35 planes per year was the planned annual output. Unit production costs were given at $14 million for the low end of the output range and $12.5 million for the 270-300 unit output range. Unit production costs above the 300 unit threshold were $11 million due to the learning curve effect. To achieve unit sales of 270-300 aircraft assumed an optimistic 10% annual growth in commercial air travel. Cash receipts from the sale of aircraft were based on: (1) advance deposit of 25% of total price received two years prior to delivery, and (2) the balance due of 75% received when aircraft was delivered. This implies that for 35 aircraft built (and presumably sold at an average selling price of $16 million) in a year, $140 million of the $560 million in total annual revenue is received as cash flow two years earlier.
The required rate of return on Lockheed assets (prior to Tri-Star) was estimated to be 9%-10%, with 10% cited as the initial rate used by the company for valuing the project. The main focus in evaluating the economic value of Tri-Star was primarily based on its commercial prospects. Divergent views on commercial market potential ranging from 270-300 units as approaching break-even (versus an original plan of 210 aircraft) to theoretical sales potential of 500 aircraft, as well as differences in accounting versus economic results puts forth the question on whether or not to proceed with the program. This situation is exacerbated by direct competition from the Airbus 300B and McDonnell Douglas DC-10 tri-jet, and indirect competition from the Boeing 747.
Betting the Company on a Single Project is an Industry Norm
Since the inauguration of the commercial jet age with the Boeing 707 in the mid-to-late 1950s, the behavioral norm among industry players is essentially to “bet the company” in launching a new generation of aircraft. Part of this behavior arises from the enormous investment of financial capital and time (often a decade or more) inherently required for designing, developing and launching a new aircraft. The propensity to undertake such risk is underscored by the prestige and brand equity associated with a successful jet aircraft program that can often create financial synergy for other related businesses that in turn, can generate very large, extended cash flows. The notion of withdrawing from a new jet aircraft program carrying so much prestige and large financial stakes (even when caution is warranted) may be an acceptable alternative in the MBA playbook, but in the boardrooms where “betting it all” behavior is the norm, such a strategy is regarded as playing not to lose rather than playing to win. As such, a strategy in this business environment aimed at resolving financial difficulty that will actually be implemented requires daring and a willingness to take risk. Sir Isaac Newton, mathematician, once said that “No great discovery was ever made without a bold guess.” This saying fits the jet aircraft industry where leading firms achieve technical and financial success with bold risk-taking behavior that seeks to go beyond linear-based consensus thinking.
Leveraging Cost Over Two Rather One End-User Markets = Better Return/Risk
Using the Boeing 707 program as the appropriate business model shows that financial success in commercial jet aircraft stems from having a military aircraft business that allows for risk sharing and diversification. Specifically, 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. Boeing received orders for 400 KC-135 jet aircraft tankers in March 1955 from the US Air Force, and completed production-and-delivery of ½ of that order (or 200 aircraft) two years later that enabled the 707 to reach break-even in late 1956. Commercial aircraft orders did not translate into large scale unit shipment until 1959-60 with 77 and 91 707s delivered to US and overseas airlines during that period. Significant financial payback for the commercial 707 version did not really occur until 1967-68 when Boeing achieved triple digit unit deliveries, respectively, of 118 and 111, that enabled the company to post record corporate net income over the same period. The triple-digit threshold for the 707 commercial deliveries, had proven elusive until that point, and was never achieved thereafter for the 707 model, thereby affirming the importance of its military version (which did achieve triple digit annual unit deliveries very early in the program life cycle).
Lockheed is the Premier High-Tech Military Aircraft Company
By the end of the 1960s, Lockheed established itself as the leading high-tech military aircraft manufacturer with a significant competitive advantage in speed, performance, efficiency, safety and ease of handling. Lockheed’s product portfolio included interceptors (T33 Shooting Star and F104 Starfighter), transport aircraft (C141 Starlifter) and special reconnaissance (U2 Spy Plane and YF12 or SR71 Blackbird). All of these aircraft featured a very sleek or streamlined look, plus utilized special materials that facilitated the aforementioned advantages. This characteristic carried over into the Tri-Star: the L1011’s tri-jet configuration featured one jet under each wing, and the third, center mounted with an S-shaped duct air inlet embedded in the tail and upper fuselage. With the Cold War still at its peak in the early 1970s, Lockheed’s expertise in this field was a most valuable national security asset. The company’s competitive advantage in all the facets of this area resulted from a bold and visionary strategy implemented by its famed Skunk Works operation that handled top-secret classified projects.
Runner-up for the Super Sonic Transport (SST) Was a Game Changer
During the 1960s Lockheed’s L2000 was the company’s entry in the government funded competition to build the first supersonic transport for the United States of America. On December 31, 1966 the contract was awarded to Boeing. Federal funding was cancelled in 1971, forcing Boeing to take a loss on the project. In the interim, Lockheed staked its commercial aircraft fortunes on the L1011 Tri-Star, eventually investing $960 in pre-production costs for this wide-body jet aircraft from 1967-1971. Finishing as runner-up to Boeing was a “game changer” as it forced Lockheed to narrow its focus to a single program (rather than two) to gain foothold in the commercial market. Ultimately, the cancellation of Federal funding for the SST further changed the game because now Boeing was forced to narrow its focus, thereby intensifying the competition in the wide-body jet market, with Airbus and McDonnell Douglas as direct competitors, and Boeing as an indirect competitor to Lockheed’s Tri-Star.
Commercial Wide-body Aircraft Warrant Additional Risk Premiums
Wide-body jet aircraft carry additional risk premiums that warrant a required rate of return that is greater than the rate given for Lockheed assets (prior to Tri-Star). On the business side, not only is the Tri-Star risk elevated due to reliance on a single supplier for its jet engines, but unlike Boeing and McDonnell Douglas who are already well established in the commercial jet aircraft market, Lockheed has no installed commercial customer base upon which to leverage Tri-Star sales efforts. The increased liquidity risk due to high up-front working capital is due to the large scale of manufacturing required for all wide-body jet aircraft versus the narrow-body predecessors. On the financial side, there is a litigation concern due to the explosive rapid decompression risk that is inherent to all wide-body jet aircraft. For these reasons, any calculation of economic value for Tri-Star necessitates use of a required rate of return that is greater than the 10% initially given. We estimate that a 13% required rate of return is warranted and provide a breakdown on how we arrive at this calculation.
CALCULATING REQUIRED RATE OF RETURN FOR L1011 TRI-STAR
Initial Required Rate of Return (Prior to Tri-Star)
All Lockheed Assets
+ Business Risk
No installed commercial base, only one jet engine supplier (Rolls Royce)
+ Financial Risk
Explosive rapid decompression for wide-body jets = litigation risk
+ Liquidity Risk
Inventory intensive (front-end) of manufacturing cycle
= Tri-Star Required Rate of Return
Lockheed Assets + Tri-Star Risk Factors
In the context of this case study, it is recommended Lockheed revise its L1011 Tri-Star strategy to focus on both the commercial and military end-user markets in order to leverage its significant competitive advantage in high-tech military aircraft with the goal of positioning the Tri-Star to replace the original 200 Boeing KC-135 jet refueling aircraft deployed in 1957.
This change in strategy would produce a positive Net Present Value of $149.85 million for the Tri-Star arising from: (a) spreading cost over two end-user markets rather than one, (b) reduce unit production costs (learning curve benefit) due to higher volume and (c) lower risk due to increased cash flow from a diversified sales base. As noted in the OBSERVATIONS section, the higher risk associated with this project necessitates using a proven business model better suited for such considerations.
The theme for this strategy is driving cash flow via a “replacement cycle” as the aforementioned 200 Boeing KC-135 tanker aircraft would be due for replacement by the mid 1970s on account of metal fatigue and need for improved efficiency. It is self-evident that with the Cold War necessitating round-the-clock deployment of strategic bombers worldwide that the KC-135 aircraft would be in constant use and therefore have take-off/landing cycles that are 2.5 to 3 times greater than its commercial 707 model. This coupled with the fact that those first 200 KC-135 aircraft utilized lower strength 7178 aluminum alloy instead of the fail-safe standard with 2024 alloy underscores if not exacerbates the concern about metal fatigue arising from the aforementioned inherently greater number of take-off/landing cycles.
Lockheed’s L1011 Tri-Star with its high performance, efficiency, safety, special materials with greater durability and longevity plus ease-of-handling make it an ideal candidate to enable the US Air Force to significantly upgrade as well as diversify its tanker fleet. Moreover, the technology transfer of Lockheed’s high-tech military aircraft into Tri-Star would transform the wide-body tri-jet into a complementary support vehicle for refueling the various military aircraft (bombers, interceptors, and reconnaissance plus transport vehicles) deployed worldwide. The need to replace the first 200 KC-135 tankers is immediate for reasons already noted, and Lockheed could fulfill the task in a two-year time frame as Boeing did in the late 1950s. This would ease financial pressure by enabling Tri-Star to achieve positive Net Present Value on the strength of its military unit shipments and give Lockheed the flexibility to further expand its commercial presence. In sum, this shift in strategy would allow Lockheed to leverage its competitive advantage in high-tech military aircraft, reduce risk, lower unit costs and significantly increase sales volume.
This strategy expands Lockheed’s opportunity set and thereby increases the probability of greater overall financial success with a bold, “play-to-win” approach that reflects the company’s risk-taking style. While politics may come into play with military contracts and is often the great unknown factor, Lockheed’s premier position in high-tech military aircraft versus its peers gives it considerably greater leverage than either Boeing or McDonnell Douglas, and this recommended change in strategy puts Lockheed in the best position to succeed with its Tri-Star L1011.
In this section, we present three scenarios that examine the accounting (earnings) and economic (cash flow) perspectives of the Tri-Star project. Scenarios 1 and 2 demonstrate that while the Tri-Star achieves positive accounting profits, the economic value is negative because of negative Net Present Value arising from unsatisfactory sales volume by focusing only on the commercial market. Scenario 3, the recommended strategy, yields much higher sales volume due to serving both commercial and military markets (with a 60/40 mix) and thereby achieves positive accounting and economic outcomes.
Scenario 1 (300 unit shipments @ 10% required rate of return)
Scenario 2 (300 unit shipments @ 13% required rate of return)
Scenario 3 (500 unit shipments @ 13% required rate of return)
Estimated Impact on Lockheed’s Stock Price
The equation for valuing an investment into perpetuity is: V = C / (r – g).
C: Cash flow
r: Required rate of return
g: Long-term growth rate
The “r” is given initially as 10% (for valuing Lockheed assets prior to Tri-Star) and later estimated to be 13% for the Tri-Star project itself. The “g” for valuing investments into perpetuity will have upper limit of 3% based on “e” – the mathematical constant which is the base of the natural logarithm – “e” is the base amount of growth shared by all continually growing processes [and this includes business or economic entities]. The natural logarithm is the logarithm to the base “e” where “e” is an irrational constant approximately equal to 2.718281828459. This number falls between 2 and 3, and so the use of 3 as an upper boundary for the growth rate when estimating Value into perpetuity.
Part a: Explaining the Decline in Stock Price Based on Given Case Information
It is given that Lockheed’s stock price declined from $71 (1967) to $3.25 (1974) due to financial difficulties associated with the Tri-Star and unrelated military contracts, but no information is provided regarding cash flow, so it can be inferred that “C” is the unknown variable. Using the aforementioned data we calculate the following:
V = C / (r – g)
71 = C / (0.10 – 0.03)
71 = C / 0.07
C = 4.97
Thus it can be mathematically inferred that at its peak share price of $71, Lockheed’s cash flow per share “C” was $4.97.
V = C / (r – g)
3.25 = C / (0.115 – 0.03)
3.25 = C / 0.085
C = 0.28
Thus it can be mathematically inferred that at its low share of $3.25, Lockheed’s cash flow per share “C” was $0.28. Note that in calculating “C” we used an “r” of 11.5%, which is halfway between 10% and 13%. Our reasoning is that Tri-Star became a more influential factor on Lockheed’s total required rate of return, but not sufficient to increase the total corporate “r” to the 13% Tri-Star level.
The conclusion from this exercise is a demonstration of stock price as the market’s estimated present value of cash flow. In the case of Lockheed, the 95% decline in market value from 1967 – 74 tracks the equal percentage decline in cash flow and also reflects an upward revised required rate of return to incorporate higher risk premiums arising from the Tri-Star capital project.
Part b: Where Does the Stock Price Go From Its Low?
Here the problem can become a bit difficult as the case references both Tri-Star and military contracts as contributors to Lockheed’s financial difficulties, but there is no further information disclosing relative significance of each. Since the case study itself concerns Tri-Star, our focus will be on estimating how improving the financial returns of the L1011 Tri-Star may translate into potential (and in this instance incremental) stock price appreciation with the caveat that the company stabilizes its other portfolio business groups. Since stock price performance reflects the firm’s record in either adding or subtracting from intrinsic value based on execution of its capital projects, we may infer that a capital project yielding a positive Net Present Value (NPV) adds to stock price while a negative NPV reduces stock price.
The Scenario 3 Financial Model quantifies our recommendation that a dual commercial and military business model for Tri-Star yields a positive NPV of $149.85 million or $13.26 per share [based on 11.3 million shares outstanding given in the case study]. A simple, but reasonable inference is to impute the $13.26 per share NPV directly into the Lockheed stock price, and this yields a target stock price of $16.51 (or a 5-fold stock price improvement from its low). The stock price equation quantifying the benefit for finding a way to retain and convert Tri-Star into a financial winner:
Target Price = Low + NPV per share
Target Price = 3.25 + 13.26
Target Price = 16.51
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