A grounded 737 Max (photo credit: Lindsey Wasson/NY Times)
“Designed By Clowns… Supervised By Monkeys”
This airplane is designed by clowns who in turn are supervised by monkeys.
Nevertheless, readers who have followed the reporting on Boeing since the Ethiopia crash last year shouldn’t be surprised by this. There is evidence that Boeing’s challenges run deep. I’ll briefly detail some of that evidence here, and then for Boeing shareholders who remain bullish, I’ll present a couple of ways you can stay long while strictly limiting your risk.
Evidence Of Boeing’s Challenges
Investigations into the development of the 737 Max following the fatal crashes in Indonesia in October of 2018 and in Ethiopia in March of last year suggest the company increasingly cut corners to save money in ways that may have sacrificed safety. One example of that cost-cutting is the 737 Max itself. As the Financial Times detailed last March (paywalled here), rather than take the time to build an all-new plane designed to handle the larger, more fuel-efficient engines, Boeing retrofitted 737s to hold the new engines in position that caused the nose of the airplane to tend to rotate upward, risking stalls. Boeing then added a software fix, the MCAS (Maneuvering Characteristics Augmentation System), to push the plane’s nose down to avoid stalls. The FT went on to suggest in that article that regulatory capture may have been behind the FAA’s somewhat lax oversight of this:
The MCAS system was certified as a new element, but the 737 Max fleet was classified as a derivative of earlier models, meaning it did not require the same amount of certification. […]
Boeing has long been one of the most politically well-connected companies in the U.S.
Another example of Boeing’s cost-cutting was it moving manufacturing to South Carolina, which doesn’t have Washington State’s tradition of aerospace manufacturing but does have a reputation for cheap labor. As the New York Times reported last May, the South Carolina factory received a number of customer complaints about manufacturing quality, which led to increased federal oversight.
A third example of Boeing putting cost-cutting ahead of safety was its decision to outsource some of the development of the 737 Max’s MCAS software to contractors earning as little as $9 per hour:
Increasingly, the iconic American planemaker and its subcontractors have relied on temporary workers making as little as $9 an hour to develop and test software, often from countries lacking a deep background in aerospace — notably India.
In offices across from Seattle’s Boeing Field, recent college graduates employed by the Indian software developer HCL Technologies Ltd. occupied several rows of desks, said Mark Rabin, a former Boeing software engineer who worked in a flight-test group that supported the Max.
The coders from HCL were typically designing to specifications set by Boeing. Still, “it was controversial because it was far less efficient than Boeing engineers just writing the code,” Rabin said. Frequently, he recalled, “it took many rounds going back and forth because the code was not done correctly.”
As that article went on to note, Boeing’s hiring of an Indian software firm was motivated not just by the prospect of cost savings, but also by the prospect of selling more planes to Indian firms (offsetting some aspects of production to a particular country to sweeten a large aircraft deal is an old practice, but in other cases it was aspects of aircraft interiors offset, not mission critical software).
Monopoly scholar Matt Stoller has argued that this culture of cost savings over quality goes back to the merger of Boeing and McDonnell Douglas in the 1990s. Whether or not that’s the case, it seems likely that Boeing replacing its CEO was only the beginning of a long process of righting the ship at the company. As Matina Stevis-Gridneff writes in the tweet below, Dennis Muilenburg oversaw a “culture of arrogance and cynicism”; it’s hard to believe that he was the sole cause of it.
With Boeing’s challenges in mind, let’s look at ways you can limit your downside risk if you’re still bullish and want to stay long the stock (if you’re not still bullish, of course, you shouldn’t stay long).
Adding Downside Protection To Boeing
Each of these hedges is designed for an investor who has 100 shares of Boeing and can tolerate a 20% decline in his shares, but not one larger than that. I’ve circled the annualized cost as a percentage of position value in both cases.
Uncapped Upside, Positive Cost
As of Friday’s close, these were the optimal, or least expensive, put options to protect against a >20% decline in Boeing by late August.
Here, the cost was $1,065, or 3.23% of position value, calculated conservatively, using the ask price of the puts (in practice, you can often buy and sell options at some price between the bid and ask). That worked out to an annualized cost of 5.28% of position value.
Capped Upside, No Cost
If you were willing to cap your possible upside at 18% between now and late August, this was the optimal collar to protect against the same, >20% decline as the hedge above.
Here, the net cost was $0, assuming you bought the puts and sold the calls at the worst ends of their respective spreads. So the net cost as percentage of position value, and the annualized net cost as a percentage of position value were both 0%.
Wrapping Up: Which Hedge?
Deciding which hedge to go with here really depends on your estimate of how well Boeing might do over the time frame of the hedge. You have to consider the cost of the hedges here too. So, for example, if you think there’s a good chance Boeing might climb 25% between now and then, it might make sense to go with the first hedge, as your return in that case, net of hedging cost, would be 25% – 3.23% (the cost of hedging) = 21.77%, and 21.77% is greater than the return you’d have with the zero-cost hedge which caps your return at 18%. On the other hand, if you think Boeing is likely to have a more modest return over the same time frame, the zero-cost hedge would make more sense. With either hedge though, you’d have the comfort of knowing that your downside risk was strictly limited.
Alternatives To Boeing
Since June of 2017, I have presented my system’s top ten names to my Marketplace subscribers each week. So far, those top names have outperformed SPY over the next six months by 1.98% annualized. To see the latest top names cohort, you can sign up for a free, two-week trial here. Each of the current top ten names is also significantly less expensive to hedge than Boeing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.