The dollar's prolonged decline against the euro has not hurt Airbus yet. But it is finally beginning to cloud the European manufacturer's future, threatening to squeeze...
The dollar’s prolonged decline against the euro has not hurt Airbus yet.
But it is finally beginning to cloud the European manufacturer’s future, threatening to squeeze profit margins and hurting the business case for the A350, the new jet Airbus last week committed to pitching against Boeing’s 7E7.
“Costs are higher; revenue is the same; so the rate of return is lower,” said Adam Pilarski, an industry analyst with Avitas. “When the dollar gets weaker, it’s not good for [Airbus].”
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Airbus has delayed the effect of the dollar’s decline through a meticulous currency-hedging strategy, which ensures that it will feel little pain at all until 2007. But with the reckoning ahead, it plans a fresh round of cost-cutting.
In the past three years, the U.S. dollar has lost more than a third of its value against the euro. By making American products cheaper, the shift helps U.S. exporters and places a heavy cost burden on European competitors.
So far, the dollar’s fall has certainly not held Airbus back. During that long currency slide, Airbus has consistently outsold Boeing and risen to become the world’s No. 1 airplane-maker.
Just last month, with the dollar at its lowest point in years, Boeing executives blamed aggressive pricing when Airbus won a crucial large order from Air Berlin.
But beyond 2007, the dollar’s plummet will take an increasing toll, eating gradually into Airbus profit margins.
That makes the planned A350 a riskier investment. And it could force Airbus to increase airplane prices, making it harder to sustain the constant undercutting of Boeing.
Hedging the dollar
In commercial aviation, the U.S. dollar is the standard global currency. Airplanes are bought and sold in dollars. That means all of Airbus’ revenues come in dollars, even when it sells a jet to Air France or Lufthansa.
Luckily for Airbus, because the dollar is standard for many aviation suppliers, more than half of its expenses also are paid in dollars. When it buys aircraft engines, even from Rolls-Royce of Britain, it pays in dollars.
But about 43 percent of its expenses must be paid in euros labor costs, overhead, taxes, payments to general suppliers, as well as a chunk of the payments to airframe suppliers.
With its revenue in one currency that is falling steeply, and a big portion of its costs in another currency that’s rising, Airbus has a recipe for lower returns and squeezed margins.
Last week industry analyst Joe Nadol of JP Morgan identified foreign-currency exposure as his primary concern for the stock price of Airbus parent company EADS (European Aeronautic Defence & Space).
In a research note to clients, Nadol wrote that at an exchange rate lower than 0.80 euros to the dollar, Airbus’ earlier cost cuts will be insufficient to maintain its profit margins beyond 2006. Yesterday’s exchange rate was 0.75 euros per dollar.
Yet because airplane transactions play out over years, no impact is visible yet.
Between firm aircraft order and actual delivery, there is often a gap of two years or more. To protect itself from currency swings in that interim, Airbus enters into a financial hedging contract as soon as any airplane order is firm. The contract locks in the current exchange rate for an amount that will cover Airbus’ euro expenses on that particular order.
With hedge contracts in place, Airbus can be confident of stable costs and margins on all airplanes in the firm-order book.
Because the jets scheduled for delivery in 2005 and 2006 were all ordered when the dollar was much stronger, Airbus has already locked in its expenses for almost all of those airplanes at very favorable exchange rates at an average of one euro per dollar.
“We are protected until at least 2007,” said Airbus spokeswoman Mary Anne Greczyn.
Airbus needs at least $10 billion in hedging coverage per year, depending on how many jets it delivers. After 2007 the amount of coverage Airbus has in place successively decreases, and the locked-in exchange rates rise because those airplanes were ordered as the dollar fell.
By 2009, less than half of Airbus’ euro expenses are covered by hedging contracts and the average rate locked in is 0.92 euros per dollar.
As Airbus lands future firm orders for delivery in 2009, it will be hedging at current exchange rates, and that average locked-in rate will fall steeply.
The impact: Airbus’ cost of airplane production will correspondingly rise. It’s difficult to predict how much, but assuming a continued need for $10 billion a year to cover euro expenses, a slide from the current average locked-in exchange rate of one euro per dollar to an average of 0.85 euros per dollar would cost Airbus $1.5 billion a year.
The A350 risk
When Airbus’ forthcoming super-jumbo A380 jet launched in 2000, the dollar was riding high. Along with low interest rates that kept down the cost of borrowing, that helped launch the airplane.
Airbus’ next development effort, the mid-size A350 that will go head to head with the 7E7, won’t have those advantages.
“The A380 seemed to have all the luck,” said analyst Pilarski. “The A350 may have the bad luck of a weak dollar and increasing interest rates.”
The A380, scheduled to fly next year, is not unscathed, though.
In 2000, Airbus’ A380 business case pegged the exchange rate at what then seemed a conservative 0.89 euros per dollar, according to a presentation last summer by Airbus CFO Andreas Sperl.
Sperl estimated that a sustained exchange rate of 0.77 euros per dollar would reduce the rate of return on the A380 investment, originally projected to be 20 percent, by almost 3 percent.
Last year, specifically to counter the effect of the dollar’s fall, Airbus introduced a sweeping cost-saving program aimed at cutting $1.5 billion per year in expenses. Now 90 percent implemented, that program isn’t enough.
At an EADS investor conference in New York two weeks ago, Airbus announced a new program to cut overhead. The new plan, still formative, envisages saving money in part by reducing outsourcing the reverse of Boeing’s cost-saving ideology.
Airbus is also expecting to pay a bigger share of its expenses in dollars from 2006 on, when revenues bulk up with deliveries of the A380.
“The A380 program is good news for our dollar issue,” said EADS spokesman Rainer Ohler. “The U.S. content is higher than in any other program, and more suppliers than ever before have agreed to sign a dollar contract.”
Indeed, because many of Airbus’ euro costs are overhead costs that remain fixed whether it delivers 300 jets or 350, the more market share Airbus wins, the less impact it will feel from expenses paid in euros.
Airbus hopes that with hedging, cost-cutting and increased market share, it can counteract the dollar’s slide.
That’s one challenge Boeing doesn’t have to think about.
Dominic Gates: 206-464-2963 or email@example.com