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John Engle
John Engle
Articles (367) 

Boeing: Regulatory Capture and Broken Covenants

Investors hoping for a swift return to normalcy should think again

August 15, 2019 | About:

The 737 MAX jet was meant to lead Boeing Corp. (NYSE:BA) into the 21st century, replacing the aging but still popular 737 jetliner. That story was thrown into doubt after a pair of lethal crashes. The proximate cause of both fatal crashes was a fundamental failure of the planes' maneuvering characteristics augmentation systems.

With the 737 MAX still grounded by aviation regulators around the world, Boeing faces an uncertain future. Yet the market seems convinced this crisis represents nothing more than a speedbump. It appears investors believe the same regulatory capture that has benefited Boeing immensely to date will result in a swift restoration of the 737 MAX’s flight status.

Regulatory failure

The seeds of the Boeing crisis were sown years ago thanks to the decision by the Federal Aviation Administration to give aerospace companies wide latitude to regulate themselves. This growing laxity was exemplified by the agency’s approach to oversight of companies’ MCAS. Yet, as the New York Times has reported, the FAA was almost completely disengaged from Boeing’s lethal MCAS redesign:

“The FAA eventually handed over responsibility for approval of MCAS to the manufacturer. After that, Boeing didn’t have to share the details of the system with the two agency engineers. They weren’t aware of its intricacies, according to two people with knowledge of the matter. Late in the development of the Max, Boeing decided to expand the use of MCAS, to ensure the plane flew smoothly. The new, riskier version relied on a single sensor and could push down the nose of the plane by a much larger amount. Boeing did not submit a formal review of MCAS after the overhaul. It wasn’t required by FAA rules. An engineering test pilot at the regulator knew about the changes, according to an agency official. But his job was to evaluate the way the plane flew, not to determine the safety of the system.”

Ignoring concerns

The dangers of delegating safety oversight to Boeing itself has been made quite clear, if too late. But as Bloomberg recently reported, some FAA employees expressed concerns about the wisdom of these moves long before the two 737 MAX planes suffered catastrophic failures:

“Under a program established in 2005, the FAA had delegated to Boeing the authority to perform some safety-certification work on its behalf. Some FAA employees warned as far back as 2012 that Boeing had too much sway over safety approvals of new aircraft. Boeing said in May that it had known months before the Indonesia crash that the cockpit alert wasn’t working the way it had told buyers, but it didn’t share that with airlines or the FAA until after the Lion Air jet went down.”

Still captured

Despite all the revelations of dangerous (indeed, lethal) regulatory capture, it seems the FAA has not yet given up on its cozy relationship with Boeing. According to Bloomberg, federal aviation regulators may be poised to let the 737 MAX fly again without requiring pilots to undertake extensive re-training beforehand:

“U.S. aviation regulators are increasingly convinced they don’t need to mandate new simulator training for pilots of Boeing Co.’s 737 Max before returning the grounded jet to service, according to people familiar with the discussions. Pilots would be required instead to take a computer-based training course they could perform at home or in a classroom, according to the people, who weren’t authorized to speak about the matter and asked not to be identified. More extensive simulator-based training for all 737 Max pilots may be required in the months after flights resume, the people said.”

Temporary turbulence

Almost incredibly, despite the litany of damning revelations that have exposed major failures of leadership at Boeing, the company’s stock is actually up year to date. Evidently, investors believe the 737 MAX grounding is nothing but a bit of turbulence, soon to be flown past on a long-term path to normalcy. This rather bizarre attitude was summed up rather eloquently by Wolf Street Research in a recent market research note:

“Markets don’t care about any of this. They don’t care about real engineers either. They love corporate cost-cutters and financial engineers. They want share buybacks, and if something bad happens, they’ll overlook the $5 billion to pay for the fallout because it’s just a ‘one-time item.’ And now Boeing still has this plane, instead of a modern plane, and the history of this plane is now tainted, as is its brand, and by extension, that of Boeing. But markets blow that off too. Nothing matters.”

A broken covenant

The aerospace industry operates in two worlds, since it essential to both civilian transport and military capacity. The first world is what most consumers see, but the second is what gives companies their protective armor. The federal government would never allow Boeing to fail, and it is willing to keep paying often inflated government contracts for long stretches of time. But this largesse comes at a price: guaranteeing safety and certainty for ordinary travelers. With the 737 MAX, Boeing appears to have allowed its feeling of invulnerability override the rules of its covenant with government. That may come at a steep price now that Boeing has broken its nigh-sacred covenant to protect ordinary citizens and provide safe, reliable vehicles.

In our analysis, the market’s reaction to the 737 MAX crisis is extremely irrational. The notion that Boeing will be able to coast by on its close relationship with regulators and the U.S. government is understandable to a degree, but it misses a fundamental aspect of the story. The company's lofty and protected position has been predicated on its covenant with government. Boeing has broken that covenant and may end up paying a steep price.

Verdict

The market imagines that everything will return to normal ere long. Yet with hundreds of deaths and significant uncertainty on the part of potential customers about the air-worthiness of the 737 MAX, reality could prove far uglier for Boeing. With a balance sheet stretched by an overindulgence in stock buybacks in recent years, the company could end up paying a steep price for its laxity. The equity does not currently reflect the very significant risks facing the once honored aerospace giant.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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