Military Crowding Out (August 2021 Letter)

Dear Fellow Historical Number Crunchers,

To understand our industry’s future, set the Wayback Machine to 1967. It was a year of weird dynamics, with booming demand, but paradoxical economics. The military market’s strength effectively crowded out the civil side of the industry. This resulted in McDonnell Aircraft taking over Douglas Aircraft. There are big lessons for today.

First, a bit of history, courtesy of Teal Group’s markets database. Jetliner deliveries grew from $18.3 billion in 1965 to $31.7 billion in 1967 and $42.8 billion in 1968 (all in 2021 adjusted dollars). On the military side (also in today’s money), output went from $54.6 billion in 1965 to $78.4 billion in 1967 and $84.3 billion in 1968. This was a guns and butter economy, reflecting LBJ’s presidency, coupling the War on Poverty with the Vietnam War.

However, Inflation went from <1% in 1964 to 4.7% in 1968, and aerospace led the way in this unfortunate metric. Within aerospace, McDonnell Douglas led the way, propelled by a massive F-4 Phantom production ramp. F-4 output peaked at an incredible 72 per month in 1967. The type entered service in 1961; by February 1971 4,000 were built.

The result was a sinister dynamic. McDonnell could pay its workers anything, really, since its F­4 and other DoD contracts were cost-plus; labor and other expenses were promptly reimbursed, so inflation was irrelevant to them. But commercial jets were fixed-price, with limited pass-through provisions. For production resources, particularly labor, Douglas was basically crowded out by the military guys. The results were catastrophic for the world’s second largest jetliner prime. Adam Pilarski, former chief economist at McDonnell Douglas (and now resident guru at Avitas), told me, “We couldn’t build the jets the market wanted. We simply ran out of cash.” Given this horrible reality, Douglas had no choice but to sell. By some accounts, McDonnell made them an offer they couldn’t refuse.

Fast-forward 54 years. After a crushing pandemic-induced downturn, jetliner deliveries fell by 50% last year. They are now slowly rebounding, but as travel resumes, so will output. The market in 2020 ($54.7 billion) will double to $109.6 billion in 2025.

Meanwhile, defense never got hit – it just kept growing. President Trump raised it to record post-1945 levels, and President Biden kept it at that peak in FY 2022, with Congressional add-ons likely to set a new record. Crucially, the Biden budget prioritizes Research Development Test & Evaluation (RDT&E). The FY 2022 budget request is for $112 billion, the largest RDT&E request in DoD history. This will continue, driven by the emphasis on countering China.

This RDT&E emphasis is important. When we talk about inflation today, very broadly, we’re talking about three things: energy, materials, and labor. The first two aren’t a big concern – long-term pricing agreements, pass-through contract provisions, and most of all, the absence of any serious historical upward pricing trends all limit risk.

Labor is a completely different story. It isn’t just your latest restaurant experience; it’s a tight labor market across the board. Skilled manufacturing workers are in short supply. Military aircraft – particularly the F-35, B-21, F-16, and T-7 – are all ramping up. Few are ramping down. That means strong demand for workers, which means higher salaries (happy late Labor Day!).

With a few exceptions (KC-46, T-7, apparently a classified LockMart jet) most of these military planes are cost-plus. However, the 11,000 jetliners on backlog at Airbus and Boeing have pricing locked in (after a multi-decade run of real-term price deflation). The disparity between commercial and military program profitability will widen as costs grow for both, while prices rise only for military aircraft. This industry might experience 1967 on steroids.

The engineering picture is much more challenging. Air Force Secretary Frank Kendall recently said, “One thing that I think we need to do is make sure we have more engineers....We’re in a technological competition, in part, and developing technologies and then applying them more effectively than our potential adversaries is key to success.”

Here too, that military RDT&E ramp means strong demand, which means higher salaries, since the US isn’t great at creating engineers. Can civil aero pay equivalent wages, even when they won’t be reimbursed by government cost-plus contracts? Also, Advanced Air Mobility is turning into a giant source of demand for engineers too. This AAM bubble will burst in a few years, but cash flowing to scores of speculative new-start companies will help inflate aerospace engineer wages for years to come. For young, newly-minted engineers, AAM is the shiny new object.

It's the engineering dimension which will see the most significant consequences. Boeing’s Commercial unit cut R&D 27% last year, following years of previous cuts; if the company ever again launches a new jetliner (as it badly needs to do), will they be willing to pay the rising costs of resurrecting their design teams? Boeing spent the last 15+ years de-prioritizing engineering. As engineers gain negotiating power, will Boeing meet their demands, or will it continue its ill-advised strategy of trying to do more with less? That’s a rhetorical question, of course.

It isn’t just Boeing. Airbus is in better shape (European defense spending isn’t growing much, so there’s less competition for engineers), but without a new Boeing jet to react to, the Europeans have less impetus to innovate. Then there are the systems suppliers, who are often the biggest innovators in this industry. Most have a civil-military balance; what are the odds, given higher engineer costs and booming military demand (with guaranteed profit margins), that they’ll favor the civil side of their houses? Consider, for example, Raytheon. Are they more likely to prioritize hypersonic weapons research or hybrid-electric civil aircraft propulsion?

Thus, here’s the big Second Order Effect: Less innovation, more commoditization in the jetliner business. Unexpectedly high fuel prices could impact this, serving as a catalyst for more innovation, but otherwise the jetliner business is going to get much less exciting. For engineers, commercial aero will be even less exciting, making it harder still to attract talent, drawn instead towards defense, new space, AAM, and whatever speculative bubble forms after AAM.

Yours, ‘Til Someone Creates A Less Depressing Future,

Richard Aboulafia