Category: Analysis and Opinion

On ‘America’s Baby Bust’

Editors

Jonathan Last’s recent article in The Wall Street Journal sounds a powerful alarm alongside the release of his book What to Expect When No One’s Expecting, with the tagline America’s Coming Demographic Disaster.  ‘No One’ is an exaggeration since there were about 4 million births in the US last year, but the title is a playful reminder of Heidi Murkoff’s blockbuster book on pregnancy.  As to the phrase ‘Coming Demographic Disaster’, it could put Last, years from now, in the category of overly pessimistic forecasters alongside Paul Ehrlich, author in 1968 of The Population Bomb. Forecasting is a difficult task and extrapolating the known past and present into the future has often proven to be an inadequate approach.  There are usually new hitherto unknown factors which intervene down the road and which derail any linear or semilinear prediction.

However, none of this should diminish the fact that Last’s article is an excellent must-read for anyone who still believes that US demographics are strong and supportive of future economic growth.  As I wrote a few months ago, there are many, including many in leadership positions, who still live with this illusion. Last’s main point is absolutely correct.  The birth rate (and fertility rate) has declined since the 1970s and the growth rate of the US population has been on a downward trend.  This phenomenon yielded a large demographic dividend from about 1982 to 2005, but it is now leading to large negative consequences for the economy. I covered several of these points in previous articles on this site. Most critical in my view is the rise in the dependency ratio which is likely to last now for several decades.  US demographics provided steady tail winds to the US economy for decades and added a large demographic dividend when the birth rate fell and more women joined the work force, but we are now over that hill and are facing intensifying demographic head winds.

I differ with Last on his recommendation that we need more children now.  Children born now will not contribute to the economy for another twenty years and their numbers will only further exacerbate an already climbing dependency ratio.  We cannot rewrite the past but what we need now are more adults in their 20s, 30s and 40s, in other words more children born in the 1970s, 80s and 90s.  Yet, had we had these children back then, the economy would not have been as strong in the 1980s and 1990s because less capital would have been available for saving and investing.  In many ways, we front-loaded demand, saving, investment and prosperity in those two decades and now face some inverse complications.

All is not lost however. Instead of boosting the birth rate now, a four-point solution would include 1) raising the age of eligibility for Social Security and Medicare, 2) improving labor force participation, 3) continued innovation and 4) more exports.  The first two would slow, delay or neutralize the rise in the dependency ratio.  Innovation is the most important driver of the economy but innovation without a large demographic audience does not achieve its full wealth creating potential.  An iPhone introduced to a market of 3 billion people clearly will create more wealth than an iPhone introduced to a market of 30 million people. Because US demographics are getting weaker and US demand will be less strong than in the past, an obvious solution is to look for new sources of demand outside our borders.  For this reason, it is essential that the US cultivates new export markets, in particular in countries with attractive demographic profiles.  As I wrote in this article, these markets are chiefly India and the countries of SubSaharan Africa, notably Nigeria, Tanzania and Uganda where the population is large and the fertility ratio is expected to decline, raising the possibility of a demographic dividend in coming decades.  This dividend is not guaranteed to happen. It is only a window of opportunity which opens and closes. And countries are able to capitalize on it only if they strengthen their institutions and improve their governance and transparency.

The Economy’s New Boss: Demographics

Editors

The next President will have to contend with unfavorable demographics.

An enormous amount of money will be spent in the last few weeks of the Presidential campaign. Each side will promote its candidate and his platform with much passion and conviction. In the end, one side will treat victory as the road to salvation and the other will see defeat as an unprecedented and largely irreversible calamity. But in reality, this time around, the identity of the winner will probably matter less to future growth prospects than in previous contests. This is because the demographic input in the economy for the next four years is already programmed on an immovable trajectory and it is less positive than in the past.

Because of the overhanging debt and a poor demographic picture, the next four years will continue to be challenging (though not necessarily recessionary), regardless of whether Barack Obama is re-elected or Mitt Romney replaces him. Like it or not, the boss of the economy, and therefore to some degree of all of us, will be demographics. One could argue that this boss has been with us since at least 2005 when the dependency ratio started to rise again in the United States.

Among all the important factors which drive economic growth, the demographic factor is now weaker than it has been in decades and as a result, domestic demand for most goods and services will be weaker than it has been in a long time. The most telling numbers are as follows:

– The US population grew by over 1% a year until 2007 and is now growing by less than 1% per year. Its rate of growth will continue to decline as the number of baby boomer deaths rises relative to the number of new births.  Since 2008, the US total fertility ratio (TFR) has fallen below the replacement level of 2.1 and is now approaching 1.9 children per woman. See the data here and here. (Note that the TFR is an imperfect measure and a decline may only mean that more women are delaying, not altogether foregoing, having children.)

– The total number of Americans aged 30 to 60 years, the most economically active bracket, grew by over 1% per year for 30 years, from the mid 1970s to around 2005.  It has levelled off and will essentially remain flat at around 120-125 million until the end of this decade. Stagnation in the size of the most economically active bracket combined with growth in the young and elderly brackets will result in lower economic growth. I made a case here that the resulting effect on housing will not be positive.

– The US dependency ratio, which is the sum of people under 14 and over 65, divided by the number of people aged 15-64, has declined for several decades from 0.67 in 1960 to 0.49 in 2005 but, according to UN estimates (see pages 478 and 479 of this UN report), it is now expected to climb back to 0.53 by 2015, 0.56 by 2020, 0.64 by 2030 and 0.67 by 2050. Discretionary spending is bound to come under pressure as more funds are diverted to take care of dependents. (Note that the dependency ratio as defined by the UN and others considers any person under 14 and over 65 to be a ‘dependent’.  This seems antiquated on both ends. In the US, a young person is still a dependent until at least 18, and in some measure as late as 25. And an older person may not become a dependent until the retirement age of 67, or more likely 70.  I ran the numbers for these brackets here and they show that raising the retirement age from 67 to 70 would buy us some time and help the economy.)

– Assuming a run rate of 1 million newcomers per year, immigration, though a clear net positive in the long run, will be insufficient to neutralize or reverse these negative effects in the short run. It would take a much greater number of immigrants to offset the slack. But as noted by some demographers, citizens of any given country become less welcoming of immigrants when that country’s fertility ratio declines or when the economy is weak.

Although much frustration is expressed on the stagnation of the economy, in particular the unemployment rate and the rising deficit, pinning the blame on one or the other of the two political parties ignores a stronger underlying dynamic. The next POTUS will be similarly constrained as POTUS 43 (Bush) in his second term and POTUS 44 (Obama) and will have to implement some steps to mitigate the negative demographic effect. If demographics are failing us, there are other levers to stimulate  growth but we will need to work them harder.

US Demographics not as Strong as Widely Believed

Editors

A recent op-ed in the Wall Street Journal by Mr. Ben Wattenberg, a senior fellow at the American Enterprise Institute, takes an optimistic view on US demographics and on their likely impact on the economy.  The WSJ today published my response in which I repeat the argument I made in America Heading Towards Zero Population Growth? that the growth of the US population is in a multi-decade decline.

Text of my letter:

“Regarding Ben J. Wattenberg’s (“Immigrants and ‘Comparative Advantage’,” op-ed, Aug. 9): It is true that the U.S. is in better shape than Europe or Japan, but the rate of growth of the U.S. population has fallen below 1% per year and will decline further over the next four decades. Due to the passing of baby boomers in increasing numbers, the two decades starting in 2030 will see no population growth except for immigration.

Mr. Wattenberg’s figure of 400 million Americans in 2050 is too high and would be reached only if the birth rate, life expectancy or the number of immigrants rises significantly in coming decades. My own estimate is 375 million in 2050, which is 61 million more Americans than we have today. This may appear nominally attractive, but the population grew by 60 million, or 24%, in the 22 years since 1990. A 60 million increase by 2050 would be equivalent to growth of only 19% in 38 years.

Even Mr. Wattenberg’s optimistic scenario would be growth of 27% in 38 years, a rate which is well below that of recent decades, with predictable consequences for domestic consumer demand.”

End of letter.

Mr. Wattenberg is not alone in holding an optimistic view.  In fact, robust population growth is seen by many as one of the unique assets of the US economy.  Last month, Goldman Sachs CEO Lloyd Blankfein argued that US economic prospects look promising in part due to demographics:

“The U.S. has a number of major competitive advantages that we sometimes overlook — especially given the focus of the 24-hour news cycle on sensational, and mostly deflating, events. First, the U.S. has favorable demographics — thanks to its relatively high birth rates and immigration. While the BRIC countries — Brazil, Russia, India and China — have generated extraordinary economic growth, the U.S. remains a magnet for many of the smartest, most ambitious people in the world. […] Immigration is one of the main reasons why the U.S. has grown faster than many other developed economies. The growth in the foreign-born population contributed roughly 30 percent to 40 percent of total U.S. population growth from 1980 to the mid-2000s. New immigrant workers provide a boost to economic growth. Just think about the effect new workers have on demand for housing, let alone creating new businesses.”

Because they are only partially accurate, some of these comments end up painting an overall picture which is too optimistic. First on the birth rate, it is higher than that of Japan or Europe, but it had been until recently near replacement level, equivalent to a total fertility rate (TFR) of 2.1 children per woman.  But since the financial crisis  began in 2008, the TFR has fallen below 2.1, as recently reported by The Economist. The TFR may well recover to replacement level as the economy improves. That is better than sub-replacement but a TFR of 2.1 is not sufficient to turn demographics into a source of economic strength. In addition, discussing birth additions without mentioning death subtractions presents only half of a full picture.  As increasing numbers of baby boomers pass away in the next three decades, the population will grow at a slower rate than in recent decades.

Another factor to consider within the overall population numbers is the evolution of each age group.  The expected increase in the number of older people has been widely documented and discussed, in particular as it relates to the pressure it will place on government social programs. A subsidiary measure of this development is the rise of the dependency ratio, which is the number of dependents (children and retired people) per working adult. In the US the ratio had been declining for decades and it is now set to start rising. (See Our Growing Inactive Population).

Turning to immigration, it is true that the US could open its doors wider to more immigration and by doing so, reach any population level that it wishes. But few commentators or politicians are advocating this approach. If we continue with the current run rate of 1 million new (legal) immigrants per year, the growth rate of the US population will continue to decline. And that would be true even if we raised annual immigration to 1.5 million newcomers.

There is nothing wrong with being too optimistic on demographics except that it could prevent policymakers from considering other steps to promote economic growth. If there is a widespread belief (as seems to be the case) that population growth will be a strong driver of the economy, we may forego some other growth-boosting measures which are in fact necessary.

In my opinion, growth for the US economy in the next few decades has to come from two main engines, first the perennial innovation engine, and second the manufacturing and export engine. The US can become once again an export powerhouse, not just in agriculture and technology, but also in other manufactured products along the entire value-added chain. Whether this requires a dramatic devaluation of the US dollar remains to be seen. If such is the case, we would not be the only country racing for a depreciated currency. Europe certainly does not want to see a stronger Euro, and if the Euro breaks up, virtually all countries except for Germany, Finland (and possibly France) will end up with currencies which are relatively weaker than the Euro. Germany may end up with a new Deutsche Mark which like the Swiss Franc will be stronger than its exporters would like to see.

Repatriating as many manufacturing jobs as possible and searching for new markets overseas are likely to be two important elements of a future growth strategy. Based purely on demographic trends, India and Sub-Saharan Africa look especially promising because improving health care and declining fertility rates (the two go hand in hand) could possibly yield the same kind of very large demographic dividend which we have seen in China and other Asian countries in recent decades.

Demographic Megatrends of the 21st Century

Editors

The world’s changing demographics will have a far-reaching impact on our economy.

Context, as we know, can be very important in economics and in investing.  Some of the most successful investors of our time might have been unknown humble laborers if they had instead been born in a poor country far away or born in this country at a less propitious time. Context is made of several components including, among others, political risk, the rate of innovation, fiscal and monetary policy, and of course demographics.  Some or all of these components can remain unchanged for years or even decades, which may lead a majority of economists and investors to mistakenly view them as permanently fixed. Yet each inevitably comes to an inflection point which destabilizes economic or investment projections built on assumptions derived from the old paradigm.

In the case of demographics, they have acted for decades as sustained tailwinds for the US and global economies. The main drivers of these tailwinds were 1) the rise of the baby boomers and 2) the subsequent decline in the birth rate in North America, Asia and Europe, which resulted in a fall of the dependency ratio (number of dependents per working adult). Because these tailwinds have now largely died down (except in India and other parts of Asia), demographics can no longer be seen as a fixed component of the economic or investment context.  What was true for decades is no longer true because we have recently passed an inflection point in demographics.

Going forward, changes in the populations of North America, Europe, Asia and Sub-Saharan Africa will likely undermine economic projections derived from the habits and assumptions of an obsolete context.  Unlike the past few decades, demographics should now be considered as a moving variable which may be supportive or adverse to one’s economic or investment thesis. (In my view, every investment portfolio should be subjected to a ‘demographic audit’ which incorporates the impending changes).

Some demographic megatrends were quantified in 2010 by a United Nations report, World Population Prospects, and are summarized in the table below.  Forecasting is a difficult endeavor and the UN tries to mitigate the uncertainty by creating four different scenarios, or ‘variants’ of the Total Fertility Rate (TFR), for population projections: constant-fertility, high, medium and low. The constant-fertility variant assumes that the fertility rate (the number of children per woman) in each country and region of the world remains at the same level as it was in 2005-10.  This variant shows a shocking increase in the world population to levels which are probably unmanageable, from 7 billion today to 11 billion in 2050 to 27 billion in 2100.  It is highly unlikely therefore that fertility rates will remain unchanged. They are today exceedingly high in Sub-Saharan Africa and exceedingly low in Russia, Germany and Japan.  The three other variants all result in lower population counts for 2050 and 2100.  I use the medium variant below and all figures are UN estimates, not my own (for more detail on fertility assumptions of the four variants, see pages 27-35 of the UN report).

The key points are as follows:

The population in each of the more advanced economies of North America, Europe and Oceania will either grow slowly, stagnate or fall precipitously.  In the US and Canada, it will grow slowly. In a large majority of European countries, it will stagnate or shrink moderately. And in Russia, Japan and Italy, it will fall or fall precipitously.

Europe

Europe faces a significant demographic challenge.  It is in its causes and chronology similar to the challenge we face in the United States but it is more severe because Europe has a lower fertility rate. How do you keep the economy growing when the size of the population and its age distribution are no longer working in the direction of growth? It can be done but it is certainly more difficult. And how do you maintain Europe’s cherished social programs when the number of workers stagnates or declines and the number of retirees increases?

Europe’s population is expected to fall from 738 million in 2010, to 719m in 2050 to 675m in 2100. Because of some growth in Ireland, France and the United Kingdom, the population of Northern Europe would maintain itself or grow modestly. But it will decline in Southern Europe in large part because of Italy, Portugal and Serbia. On medium variant estimates, the number of Italians would shrink from 61m in 2010 to 59m in 2050 to 56m in 2100.  Germans would also be fewer, from 82m to 75m to 70m. Eastern Europe (including Russia) would shrink from 295m to 257m to 222m, with every state except the Czech Republic, Hungary and Slovakia losing 20 to 30% of its population count by 2100.

The UN report projects that, at constant-fertility rates, the population of Russia would fall from 142 million in 2010 to 114m in 2050 to 67m in 2100. The more probable medium variant predicts a Russian population of 126m in 2050 and 111m in 2100, still a decline of 31m by the end of the century. Russia suffers from a low fertility rate and a low life expectancy, two factors which are likely to improve in coming years.

Africa

Africa presents the opposite profile with the population of Sub-Saharan Africa continuing to grow rapidly.  In 2010, the fertility rate in Africa was 4.37 children per woman (5.43 in Nigeria) compared to 1.59 in Europe and 2.08 in the United States.  Although fertility rates are expected to fall dramatically, the population of Africa will first grow from 1.02 billion in 2010 to 2.19b in 2050 to 3.57b in 2100 (again, using the UN’s median variant). Of these numbers, Sub-Saharan Africa which has 856 million people today will total 1.96b and 3.36b. Given that the world population is expected to grow from 6.9 billion in 2010 to 9.3b in 2050 to 10.1b in 2100, it is easy to see that a huge part of this growth, 77%, will be coming from Sub-Saharan Africa.

If these numbers are surprising, consider that the world fertility rate stands today at 2.45 children per woman but that it is 4.78 in Sub-Saharan Africa.  And while the Sub-Saharan rate is expected to decline to 2.85 by 2050 and 2.14 by 2100, it will not decline fast enough to avert the incoming boom. Indeed, the numbers above already assume such a decline. A fall in the fertility rate usually follows an improvement in health care and a fall in the mortality rate. There is excellent news on this front. As recently reported by the Economist, “16 of the 20 African countries which have had detailed surveys of living conditions since 2005 reported falls in their child-mortality rates”.  The World Bank calls this “a tremendous success story that has only barely been recognised”.

China, India and Japan

China was the most populous nation in 2010 with 1.35 billion people but it will be overtaken by India around 2020 when both countries will have 1.39 billion. The impact of China’s one-child policy means that its population count will fade to 1.3b by 2050 and 952 million by 2100, while India continues to grow to 1.69b by 2050 before it also fades to 1.55b in 2100. The assumptions built into these numbers are not extreme. Starting at 1.56 in 2010 (well below the world average), China’s fertility rate would rise to 1.81 by 2050 and 2.01 by 2100.  India’s TFR now 2.54 (slightly higher than the world average) would fall to 1.84 by 2050 and tick up to 1.88 by 2100.

Like Europe, Japan’s population will fall by a large percentage.  Japan’s fertility rate of 1.42 was in 2010 one of the lowest in the world, but the UN is expecting it to recover to 2.04 by the end of the century. This will not be soon enough to avert a precipitous decline from 126m Japanese in 2010 to 109m in 2050 to 91m in 2100.

North America

The UN expects the population of North America to grow from 344 million in 2010 to 447m in 2050 to 526m in 2100 with nearly all of this growth taking place in the United States (respectively at 310m, 403m, 478m). My own estimate of the US population, published in America Heading for Zero Population Growth?, is lower.  Without new immigration, I found that the US population would not grow at all in the 2030s and 2040s.  The difference between my estimate and the UN estimate is of the order of 25 to 35 million Americans by 2050, which is significant for the US, but not so significant in the context of global demographics where the numbers are much larger.

On the Demographic Dividend

The demographic dividend is an economic benefit which can occur after mortality and fertility rates decline in a given country.  A decline in the mortality rate is generally followed by a decline in the fertility rate, as more women gain access to better health care and to some form of birth control. Over a period of decades, each adult and each working person will have fewer dependents to support. In the right context and with the right policies, this decline in the dependency ratio will yield a demographic dividend.  The best examples of the demographic dividend are found in East Asia, and in developed countries.  The demographic dividend in the US has largely been reaped and it now threatens to turn into a liability unless we enact the policies needed to deal with its aftermath. I wrote in Our Growing Inactive Population that the dependency ratio is about to reverse unless the retirement age is raised to 70 years.

In theory, Africa could be the next place to benefit from a demographic dividend. This would require not only a big decline in mortality and fertility rates, but also the adoption of government policies which foster political stability and encourage economic development. As to timing, it may be decades before the dividend appears, if at all. Outside of Africa, India could also reap a large demographic dividend.

Other Considerations

Outside of the sheer numbers which are startling enough, there are other considerations which flow from the age distributions and economic conditions in various countries.  The challenges posed by aging populations on developed economies and their government social programs are well known and documented.  It is enough to say that the status quo is untenable since it would lead inevitably to an explosion in government liabilities and to a severe deterioration of the economy. This statement applies easily to North America, Europe and Japan.

Less known are the demographic issues facing developing nations.  Nicholas Eberstadt of the American Enterprise Institute described them in a 2011 working paper:

On China:

“China is confronting the demographic version of “the perfect storm” and these new demographic realities may ultimately force us to revise today‘s received wisdom about “China‘s rise”.”

“China‘s future demographic profile will differ substantially from its current population situation, mainly because of the country‘s low levels of fertility. Although there are some inconsistencies and problems in official Chinese population data, population specialists believe that China became a sub-replacement fertility society about two decades ago—and that birth rates have fallen far below the replacement level since then.”

“In the decades immediately ahead, China will see the emergence of a growing host of essentially unmarriageable young men. This outcome will be the all but inescapable arithmetic consequence of the gender imbalance that has accompanied the country‘s “One Child Policy” – while ordinary human populations regularly and predictably report 103 to 105 baby boys for every 100 baby girls, China‘s officially reported sex ratio at birth (or SRB) was almost 120 boys for every 100 girls in 2005. This imbalance between the numbers of little boys and little girls in China sets the stage for a “marriage squeeze” of monumental proportions in the decades just ahead.”

In India, Eberstadt sees a significant North-South divide correlating the birth rate with education and economic opportunity:

“[India’s] dilemma can be highlighted by contrasting the prospective educational profiles of Kerala (which is now one of India‘s most prosperous states) and Bihar (one of its poorest). In just over a decade and a half, Kerala‘s working-age population will be on the brink of stagnation—but the state‘s working age manpower will be fairly well trained (roughly half of Keralites aged 15-64 would have high school education or better). By contrast, Bihar‘s working-age manpower will still be growing briskly—but as 2030 approaches, these projections suggest that well over half of working-age Biharis will have received no more than some primary schooling, and nearly a third of the state‘s working age manpower will have no formal education at all.”

Globally, Eberstadt sees a slowdown in the growth of the working-age population:

“By the reckoning of the UN Population Division, the world‘s population of “working age” (conventionally, albeit somewhat imperfectly, defined as men and women 15-64 years of age) grew by 1.3 billion, or about 40%, between 1990 and 2010: a pace averaging about 1.7% a year. Given the pronounced global fall-off in fertility over the recent past, however, the world‘s manpower of economically-active ages is set to grow much more slowly between now and the year 2030. By the Census Bureau‘s projections, the absolute increase in the world‘s working age population for 2010-2030 would be around 900 million—400 million fewer than over the past two decades—and the projected average rate of global manpower growth for the coming decades is 0.9% per annum—that is to say, only just over half the tempo for 1990-2010.”

Demographics are not the be all and end all of economics but they are one important factor among many important factors.  They open or close a window of opportunity. There is always a risk in extrapolating the present to predict the future and we should view these figures with some skepticism. However the trends outlined above are undeniable, even if their magnitude turns out to be greater or smaller than the figures suggest.

Portfolio 004 – Boeing vs. Airbus: Orders and Profits

SAMI JOSEPH KARAM

Boeing has a better product lineup and is more profitable but Airbus has more room for improvement.

The rising tide of globalization has boosted growth prospects for the airline industry all over the world, and in particular in emerging markets such as China and India.  As air travel has become more accessible to hundreds of millions of people, airplane orders and deliveries have boomed. We examine the evolution of orders and profits at Boeing and Airbus.

Airbus Market Share Strategy

Given the Boeing – Airbus duopoly and buoyant demand markets, both manufacturers should now be highly profitable but this is only true of Boeing.  Airbus made some strategic decisions in the late 1990s and early 2000s that continue to depress its profitability, namely the development of the super jumbo A380 which is still loss-making, and the sale of planes below cost or at razor-thin margins in the early 2000s in a drive for market share.

If Airbus’s main mission has been to gain market share, one has to recognize that this mission has so far been highly successful.  In the year 2000, Airbus delivered 311 planes to airlines and Boeing delivered 489.  Eleven years later in 2011, Airbus delivered 534 planes and Boeing 477.  As important, the backlog at EADS (European Aeronautic Defence and Space Company, the parent of Airbus), including non-Airbus divisions, grew from €132 billion in 2000, the equivalent of 5 years of revenues, to €541 billion in 2011, the equivalent of 11 years of revenues.  Boeing’s comparable backlog grew from $153 billion in 2000, 3 years of revenues, to $355 billion in 2011, 5 years of revenues.  Because the Euro has appreciated against the dollar in that decade, these figures actually underestimate the scale of the shift in favor of EADS/Airbus.  In dollar terms, EADS’s backlog has grown from $124 billion in 2000 to $700 billion in 2011, a near six-fold increase.

But Boeing has been more profitable.  In 2011, its EBIT margin in commercial planes was 9.7% vs. 1.7% at Airbus. This dichotomy between one party’s push for market share gains and the other’s focus on profitable orders has defined the relationship between the two competitors for over a decade.

In a decade of astounding revenue and order growth, Airbus has not improved its profitability.  In fact, its operating income (EBIT) was negative in three of the last six years (2006-2011) despite healthy revenues and deliveries.  Boeing has remained profitable but its commercial airplane sales and operating income have been range-bound for a decade.  From 2000 to 2011, Boeing sales grew at a small 1.4% annualized rate and EBIT at only 2.3%.  At Airbus, sales have grown at a 7.6% annual rate (11% in dollar terms) but EBIT has nosedived into the red for the past six years.  Boeing’s commercial plane division accounted for 66% of its group sales in 1999 and now accounts for 52%.  Airbus sales have remained consistently above 60% of EADS group sales and reached a new high of 67% in 2011.  Airbus’s drive for market share at the expense of profits has had a very measurable impact: its revenues are up, its profits are down, and Boeing’s airplane sales and earnings have flatlined.

EADS went public in July 2000 at €19 per share and ended 2011 near €24, a subdued performance for an 11-year period in which sales more than doubled. In January 2012, Airbus promised better returns for its shareholders for the years ahead and the share responded by rising to €31 in March (it recently traded at €28.8). EADS’s reasons for optimism are a decline of the Euro vs. the US dollar and a long-awaited improvement in operating margins for its superjumbo A380.

Prospects

Long-term headline prospects look nominally encouraging. Airbus and Boeing estimate that 25,000 to 33,500 new planes (including both passenger and cargo) will be delivered to airlines in the next twenty years.  However, according to Boeing, single-aisle aircraft (the A320 for Airbus, the 737 for Boeing, and their successors) will account for two thirds of units sold and for half of the value.  And as many as one third of new planes will be sold in the Asia-Pacific region.

As a market segment, ‘single-aisle in Asia-Pacific’ is not the ideal sweet spot for profit growth because smaller planes have lower margins and because Airbus and Boeing face new entrants in the single-aisle category, notably from China’s COMAC C919 and from Russia’s Sukhoi Superjet 100. The COMAC C919 seats 165 to 190 passengers and is therefore directly positioned against the larger versions of the A320 and the 737. It already has 175 orders, nearly all from Chinese airlines, and it plans to start deliveries in 2016.  Note in passing that Airbus is now assembling some of its own A320s in Tianjin, China, with a target production rate of four per month in 2012. It says on its web page Airbus in China that it “has several major technology transfer programmes underway” some of which have ostensibly already been filtered to COMAC.

The Superjet 100 is smaller than the C919 at 75 to 95 passengers and is positioned against the smallest versions of the A320 and 737 and against Brazil’s Embraer and Canada’s Bombardier. Although it has 240 orders, there are only eight in service now, seven of them with the Russian carrier Aeroflot. Last week’s tragic crash in Indonesia raises fresh safety concerns about Russian aviation just as it tries to rebound from its accident-prone Soviet legacy.

Turning to recent orders, we see that as of the end of April, Boeing had received 415 new plane orders in 2012 and Airbus 95. This huge lead in favor of the American is a temporary anomaly because most of it comes from orders for the new Boeing 737MAX which came on line about 12 months after the competing Airbus 320NEO.  If 2012 is the year of the MAX, 2011 was the year of the NEO with Airbus logging a commanding 1419 total orders (of which 1226 for the NEO) against 805 at Boeing (of which 150 for the MAX).

Wide-bodies

Looking at wide-body categories, the Airbus lineup includes the A330, the A340, the perennially loss-making superjumbo A380, and the A350 still under development.  Boeing’s competing lineup includes the aging but ever-updated 747, the 767, the new 787 ‘Dreamliner’, and most importantly today, the hugely successful 777. Stripping out single-aisle aircraft from 2011 orders, we see that Boeing secured 254 orders for wide-bodies and Airbus 193.

The 777 in particular now enjoys a quasi-monopoly in some segments, vindicating Boeing’s decision to develop this plane while Airbus exhausted itself on the prestige-minded A380 double-decker. Boeing delivered its 1,000th 777 to Emirates in March.  Airbus has positioned different versions of the upcoming A350 against both the 777 and the 787 Dreamliner. The A350 is years away from service but it now has a total of 548 orders. Recent cancellations by Abu Dhabi-based Etihad Airways have slowed down the momentum for the largest version A350-1000 which competes with the 777-300ER.

Airbus still loses an estimated €30+ million on each A380 that it builds but it expects the program to break even in 2014-15 on an EBIT pre R&D level, which is break-even on an operating level, ignoring much of the upfront investment.  That would place the EBIT break-even point somewhere between 200 and 250 unit deliveries (so far 72 A380s have been delivered).  In 2005, Airbus estimated the program would break even on an IRR basis at 270 units.  But in 2006, it revised the break-even point to at least 420 units.  The A380 now has 253 orders, two thirds of which have come from airlines based in emerging markets. And one airline, Dubai-based Emirates, accounts for 90 orders.

Airbus sees a total market of over 1,200 units for the A380 (all versions) in the next 20 years, but Boeing believes the potential market is only 325 units. Depending on where one stands on either end of this range, the A380 will either be handsomely profitable in a few years or one of the most visible financial failures in modern industry. For context, consider that in the 42 years since the introduction of the Boeing 747 in 1970, Boeing has sold nearly 1,500 versions of the plane.  With its A380 projections, Airbus is hoping to sell 80% as many units in as few as 20 to 25 years. It is true that the overall market is much bigger today but it is also true that airlines seem more interested in smaller planes. Rising world demographics do not necessarily create a correspondingly large demand for jumbo planes, as much as they do for a larger number of destinations and higher frequency of flights serviced by smaller aircraft.

It would be beneficial for both manufacturers if the A380 turned a profit (at least at EBIT level).  The plane has a list price of $375 million but list prices are generally above contracted prices.  Boeing’s revamped 747, the 747-8 Intercontinental, has a list price of $318 million. If the A380 stays in the red, the question becomes how long will Airbus continue to build it at a loss? Thousands of European jobs depend on the plane and Airbus will probably keep the program for as long as possible. Selling the A380 at a loss for an indefinite period would be detrimental to the Boeing 747-8’s own profitability if Airbus has to offer greater and greater discounts in order to keep the program alive.

It is still early in 2012 but both manufacturers have had difficulty selling wide-body aircraft this year.  Of Boeing’s 415 net orders, only 2 were for wide-bodies (there were 8 new orders and 6 cancellations). Of Airbus’ 95 net orders, only 6 were for wide-bodies (there were 22 new orders and 16 cancellations). The A350 has lost a net 7 orders in 2012. Boeing’s newest plane, the 787 Dreamliner lost a net 6 orders. However, both manufacturers have large backlogs, equivalent to 5 years of 2011 revenues at Boeing and to 11 years at Airbus, which should keep their factories humming in any downturn, barring large cancellations.

Profitability

Airbus is trying to improve its poor profitability.  Its EBIT margin in 2011 was a dismal 1.7% vs. 9.7% at Boeing’s Commercial Airplanes division. Airbus management is targeting an EBIT margin of 10% for 2015, a level last reached in 2005. The margin is expected to start expanding in 2012 as A380 losses subside and low-margin orders from the early 2000s are finally phased out.

By contrast, there may not be a lot of room for margin improvement at Boeing. Its group EBIT margin was 8.5% in 2011 and its margin in commercial planes was 9.7%.

Long-term expectations remain high and both manufacturers are likely to add more capacity in coming years. Because these expectations are predicated on continued growth in emerging markets, a cyclical downturn in these markets will depress utilization rates and put pressure on pricing at the same time that new competitors enter the lower end of the market. On the other hand, continued expansion of emerging market airlines and operational improvements at Airbus could result in better pricing power unless COMAC manages to gain significant market share.

In conclusion, both companies stand to benefit or suffer from emerging market developments. Operationally, Airbus has more room to improve. If it can narrow the margin gap with Boeing, EADS’s EV/Sales and stock should rise correspondingly. But its manufacturing location in Europe may make it difficult to reach its stated margin targets.