When I become interested in a company, I usually like to read about the company’s history. Who started the company—and why and how? How did the company’s industry come into being? Histories can be informative, interesting, and sometimes entertaining. The way I look at it, the holdings in our portfolios are my career’s family members—and I would never agreeably marry a girlfriend without first learning about her background and meeting her parents.

From the earliest days of recorded history, we have evidence of man’s interest in flight, especially the flight of birds. If birds could fly, why couldn’t man? Imaginations ran. In Greek mythology, Daedalus used wax to attach wings of bird feathers to his son Icarus. Daedalus’s device worked, until Icarus disobediently flew too close to the sun, with exceedingly ill consequences when the sun’s heat melted the wax. Many centuries later, in 852 A.D., one Armen Firman tried to mimic a bird in flight. He constructed two wings out of vulture feathers, attached the wings to his arms, “flew” out of a tower in Cordoba (Spain), and promptly crash landed, injuring his back in the process. Then, in 1010, an English monk tried flying from a tower in the Abbey of Malmesbury. He broke both legs. Not to be deterred, in 1496 a man named Seccio attempted to fly from a tower in Nuremberg (Germany). He broke both arms. Thus, wax fasteners and tower jumping did little to advance the flight of human beings.

Leonardo da Vinci did advance the science of flight. After studying the flight of birds, he designed a number of possible flying machines, including types of gliders, rotorcrafts, and parachutes. In 1496, da Vinci actually built a glider. However, the glider never was tested, so human flight continued to remain an unfulfilled dream.

The dream advanced in the early seventeenth century when Galileo proved that air has weight. If air has weight, then man could fabricate a hollow sphere out of lightweight material, pump the air out of the sphere, and thus create a lighter than air vehicle that could rise into the sky. Such a vehicle was called a balloon. It is difficult to form a vacuum inside a balloon made out of lightweight material, but if the inside of the balloon were filled with hot air (which is lighter than room temperature air), man finally could build a device that could fly. On August 8, 1708, Bartolomeu de Gusmao, a Brazilian priest, made a small balloon out of paper, placed the open end of the balloon over a fire, and, with members of the Portuguese royalty in audience, watched as the balloon lifted into the air by more than 10 feet.

Balloon technology developed slowly for the next 75 years, but then accelerated sharply in 1783, which was a breakout year for the success and popularity of lighter-than-air flights. On June 4, 1783, the French brothers Joseph and Jacques Montgolfier, who owned a paper mill, held a flame under a large silk-lined paper balloon and, in front of a large crowd of onlookers, watched as the balloon lifted by more than 6,000 feet into the air. Then, on September 19, the Montgolfiers flew a hot air balloon carrying a sheep, a rooster, and a duck for eight minutes at Versailles in front of King Louis XVI, Marie Antoinette, much of the French court, and a crowd of tens of thousands of curious onlookers.

At the same time that the Montgolfiers were hard at work with their hot air balloons, French Professor Jacques Charles, along with the Roberts brothers, were busy designing and building a hydrogen balloon. In 1766, Henry Cavendish discovered hydrogen, which is lighter than air. Jacques Charles believed that hydrogen balloons would be vastly superior to hot air balloons. But first, a gas-tight material had to be invented. This happened when Jacques Charles and the two Roberts developed a gas-tight rubberized silk, made by dissolving rubber in turpentine and then varnishing the solution on a sheet of silk. In August 1783, Jacques Charles and the Robert brothers fabricated a rubberized silk balloon, filled the balloon with hydrogen, and released it from the Champ de Mars in Paris, now the site of the Eiffel Tower. A large crowd, which included Benjamin Franklin, was on hand for the release. When untethered, the balloon rose and headed north, followed by dozens of chasers on horseback. When the balloon landed 13 miles away in the village of Gonesse, local villagers were so terrified of the strange, alien looking object that they attacked it with pitchforks, which became an inglorious end to a glorious and historic flight.

Now that a sheep, a duck, and a rooster had flown, the Montgolfiers were anxious to launch a manned flight. On October 19, in a test flight, three Frenchman successfully rose into the air in a balloon that remained tethered to the ground. Next, it was time for a manned free flight. At first, King Louis XVI suggested that condemned criminals should be the guinea pigs for the dangerous first free flight, but the scientist Jean-Francois Pilatre de Rozier and the Marquis Francois d’Arlandes successfully volunteered to be the pioneers. On November 21, a balloon carrying the two Frenchman lifted off from the center of Paris, rose to an altitude of about 500 feet, and drifted about 5 miles in 20 minutes before landing. The manned flight was considered an historic event that excited the spectators. Benjamin Franklin, after witnessing the flight, wrote in his diary: “We observed it lift off in the most majestic manner. When it reached around 250 feet in altitude, the intrepid voyagers lowered their hats to salute the spectators. We could not help feeling a certain mixture of awe and admiration.”

After the November 21 manned flight, a balloon craze swept through France. Dinner plates were decorated with pictures of balloons, as were chairs and the dial of clocks. Balloons became the talk of the town and throughout much of Europe.

The hot air and hydrogen balloons of the late eighteenth and early nineteenth centuries were interesting and popular novelties, but largely were impractical because they depended on winds to float from one locality to another. A breakthrough came in 1852 when Henry Giffard designed a nonrigid, steerable hydrogen airship that was powered by a 3-horsepower steam engine attached to a three-bladed propeller. On September 24, Giffard made the first powered and controlled air flight in a 17-mile trip from Paris to Trappes. But it was inconvenient to have a steam engine aboard an airship, and a 3-horsepower engine was not powerful enough to buck winds any stronger than a breeze. Thus, the Giffard airship was an advance but not a solution to air travel.

Over the next few decades, progress toward pragmatic manned flight was slow but steady. One advance came in 1884 when a French army captain and colonel flew the electric-powered La France airship (now called a dirigible) at four miles per hour in a five-mile loop that included an upwind leg as well as a downwind leg. The La France’s 8.5-horsepower electric engine was powered by chlorochromic batteries that weighed about 1,000 pounds. Because of the heavy weight and limited capacity of the batteries, the La France was not the answer to commercial manned flight.

In 1872, Paul Haenlein, a German engineer, designed a 164-foot-long dirigible that was powered by an internal combustion engine attached to a propeller that was 15 feet in diameter. The engine was fueled by coal gas. On December 13, Haenlein’s dirigible was successfully tested at Brunn, Germany. Other tests of dirigibles powered by internal combustion engines continued in the 1880s and 1890s. By the late 1890s, it became clear that commercially successful steerable dirigibles powered by internal combustion engines someday could be designed and produced. But, as the nineteenth century came to a close, to quote from a Robert Frost poem, the sky “at least this far, for all the fuss of the populace, stays more popular than populous.”

Then, in the early 1900s, Count Ferdinand Zeppelin successfully tested a 385-foot-long steerable dirigible that could travel at a speed of close to 20 miles per hour for several hundred miles at an altitude of several thousand feet. The count had become interested in the concept of manned air travel in 1874 after hearing a lecture on the possible use of dirigibles to carry mail. After retiring from the army in 1890, the count went to work designing a rigid frame air ship that was durable and reliable. The first “zeppelin” was tested in Germany over Lake Constance on July 2, 1890. While the first test and many subsequent tests were aborted due to problems, by 1909 the zeppelin was ready for commercial flights. The count then formed an airline (popularly called DELAG) and started offering pleasure cruises for up to 20 adventurous passengers at a time. Commercial aviation was born.

However, the use of zeppelins for air travel soon was eclipsed by the commercialization of heavier-than-air flight. While many scientists contributed to understanding how heavier-than-air vehicles someday could fly commercially, many believe that Sir George Cayley, the sixth Baronet of Brompton, is the true father of the airplane. Born to wealth in 1773, Sir Cayley became an inventor and engineer. He is credited with inventing self-righting lifeboats, automatic signals for railway crossings, seat belts, an internal combustion engine fueled by gunpowder, and several types of “flying machines.” His most important aeronautical achievements include a scientific understanding of how birds fly; a clarification of how a cambered airfoil could provide sufficient lift to offset gravity; an improved understanding of thrust and drag; and the design of gliders that included wings, fuselages, and tails with horizontal stabilizers and vertical fins. In 1848, he built and tested a glider large enough to carry a child, and five years later, he built a glider large enough to carry a full-sized man. The first manned glider flight took place on a sloped meadow at Brompton Dale, which was about a mile from Cayley’s Brompton Hall estate. The glider was carried to the top of the slope, a “pilot” (one of Cayley’s coachmen) climbed into the craft, and then workmen grabbed ropes that were attached to the craft and started hauling it down the slope until it lifted into the air. The glider flew about 600 feet across a small valley before it crash-landed.

Sir Cayley had helped prove that a fixed cambered wing attached to a fuselage could provide sufficient lift to fly human beings through the air. Now, if engine-driven propellers could be used to provide the thrust needed to drive the gliders forward, gliders could become airplanes. In 1896, Samuel Pierpont Langley, an American scientist and inventor, designed such an airplane, which he named the Aerodrome #5. Langley was born in Roxbury, Massachusetts, in 1834. He attended Boston Latin School where, at the age of 9, he started reading books on astronomy. After false starts as an apprentice architect and a telescope maker, Langley accepted a job as an assistant at Harvard College’s observatory. This led to subsequent jobs at other observatories where he researched and advanced the science of astronomy. In 1886, he was awarded a medal from the National Academy of Sciences for his contribution to solar physics, especially to the understanding of sunspots. A year later, he was appointed the third secretary of the Smithsonian Institution, which was an honor as well as a recognition of his abilities.

In the 1880s, Langley developed an interest in aeronautics. He first experimented with aircraft that were powered by rubber bands, but he soon abandoned rubber bands in favor of small steam engines. On May 6, 1896, Langley placed Aerodrome #5, which was powered by a steam engine and was unmanned, on top of a houseboat that was anchored on the Potomac River near Quantico, Virginia. To provide a requisite initial thrust, #5 was attached to a spring-actuated catapult. When the catapult was released, #5 flew more than 3,000 feet at a speed of about 25 miles per hour before landing in the river. A second test on May 6 also was successful. Then, on November 28, Aerodrome #6, also unmanned, flew about 5,000 feet. The November 28 test was witnessed and photographed by Alexander Graham Bell. Buoyed by these successes and their favorable publicity, Langley moved full speed ahead, and with funding from the U.S. government, he designed and successfully tested aerodromes that were powered by 52-horsepower internal combustion engines. Finally, after several years of design and testing, Langley was ready for a manned test of an aerodrome. On October 7, 1903, Charles M. Manley, a Cornell-educated mechanical engineer, attempted to pilot the aerodrome off the anchored houseboat, but a wing clipped the catapult, and the plane plummeted into the Potomac. Luckily, pilot Manley was not injured. Then, on December 8, Manley climbed into the aerodrome for a second test. This time, the plane broke apart just after leaving the catapult. Again, Manley escaped injury. Upon study, Langley concluded that the aerodrome was too fragile for a 52-horsepower engine.

Nine days after the second aerodrome crash, the Wright brothers successfully flew the Kitty Hawk Flyer 1 at Kitty Hawk, North Carolina—and history was made. Wilbur (1867–1912) and Orville (1871–1948) Wright were born in the Midwest at a time when the industrial revolution sparked unusual interest in science and experimentation. In 1878, the boys’ father brought home a toy helicopter for his sons to play with. The helicopter was about a foot long and was made of paper, bamboo, and cork. A rubber band powered its rotor. The boys were fascinated with the helicopter and played with it until it broke. Then, they built a replica. Years later, Wilbur and Orville claimed that the toy helicopter sparked their interest in flight.

Wilbur and Orville both attended, but did not complete, high school. Orville dropped out of school in 1889 to design his own printing press, and soon the entrepreneurial brothers started publishing a weekly newspaper, the West Side News, with Wilbur as editor. Three years later, the brothers became interested in the bicycle craze that was sweeping the nation soon after the invention of the modern “safety bike.” The brothers opened a bicycle sales and repair shop in Dayton, Ohio, and later started manufacturing their own brand under the name of the Wright Cycle Company. Then, in the late 1890s, intrigued by newspaper reports of Langley’s experiments with flying, the brothers became interested in designing an airplane of their own. In May 1899, Wilbur wrote a letter to the Smithsonian Institution requesting publications and information on airplanes. Then, using the discoveries of da Vinci, Cayley, Langley, and others, the brothers started designing an airplane. From the start, the Wright brothers were convinced that existing knowledge of lift and thrust was adequate for successful flights, but that the problems of controlling flights had not been solved. Based on observations of birds and bicycles, the brothers came up with the notion that airplanes should bank during turns. This notion led to the design of wings that could change shapes, thereby permitting aircraft to roll into turns. They also invented other methods and devices that allowed pilots to control flights, such as using rudders to eliminate adverse yaw. With their new methods for controlling flight, between mid-1900 and the fall of 1902, the brothers conducted more than 700 tests with gliders. The hundreds of successful tests convinced the brothers that they were now ready to build a powered aircraft. In early 1903, the Flyer 1 was built and tested in a wind tunnel. After a failed search to purchase an efficient lightweight motor for the Flyer, the brothers asked their shop mechanic, Charlie Taylor, to build an engine. The Taylor engine was rated at 12 horsepower, far less than the 52-horsepower engine that proved too powerful for Samuel Langley’s aerodrome.

By December, the Flyer was ready to fly. With Wilbur as pilot, an attempted flight was made on December 13, but the engine immediately stalled and the plane flew for only three seconds. After repair of minor damage, another attempt was made on December 17. At 10:30 a.m., with Orville at the controls, the Flyer successfully flew 120 feet in 12 seconds. The flight was witnessed by five people, including John Daniels, who photographed the plane in flight. Three other manned fights were conducted that day, with Orville and Wilbur taking turns as pilots. The fourth flight covered 852 feet in 59 seconds. The Wright brothers were to become famous.

Between 1904 and 1908, the brothers worked on improving the reliability and mobility of their planes. A major advancement came in August 1908, when Wilbur made a series of technically challenging flights, including figure eights, at the Hunaudieres horse-racing track near Le Mans, France. Thousands came to witness the flights. The French originally were skeptical of the Wrights’ achievements, but after the demonstrations at Hunaudieres, the French treated the brothers as heroes. Louis Bleriot, a leading French aviator, wrote: “For a long time, the Wright brothers have been accused in Europe of bluff … but today they are hallowed in France.” The Wright brothers, and aviation in general, had become front-page news.

For the next several years, there was a constant parade of firsts. In 1909, a woman (Baroness de la Roche) learned to fly. In 1910, a U.S. Navy pilot flew a Curtis plane off the deck of a ship. Also in 1910, Henri Fabre became the first to fly a floatplane. In 1912, Harriet Quimby flew across the English Channel in a Bleriot monoplane. And in 1914, the first aerial combat occurred when Allied and German pilots fired at each other with pistols and rifles (all without much effect).

On July 4, 1914, a flight took place in Seattle, Washington, that had a major effect on the history of aviation. On that day, a barnstormer named Terah Maroney was hired to perform a flying demonstration as part of Seattle’s Independence Day celebrations. After displaying aerobatics in his Curtis floatplane, Maroney landed and offered to give free rides to spectators. One spectator, William Edward Boeing, a wealthy owner of a lumber company, quickly accepted Maroney’s offer. Boeing was so exhilarated by the flight that he completely caught the aviation bug—a bug that was to be with him for the rest of his life.

William Boeing was born in Detroit in 1881 to Mary and Wilhelm Boeing. Wilhelm, who had immigrated to the United States from Germany at the age of 20, became a wealthy owner and operator of timberlands. Young William spent most of his adolescence at Swiss boarding schools. He then studied at Yale, but left before graduating in order to start a logging company of his own in Grays Harbor, Washington.

Boeing had first become interested in airplanes when he attended an air show in Los Angeles in 1910. Upon returning from the air show to his home in Seattle, he approached a friend, George Conrad Westervelt, a naval officer and engineer who had studied aeronautics at MIT, about the possibility of building an airplane. The discussions initially were preliminary in nature. However, after Boeing’s ride with Maroney in 1914, the discussions became serious and led to a decision to enter the business of manufacturing airplanes. Westervelt would design a single-engine floatplane, and Boeing would provide the financing and the “manufacturing plant,” which initially was a boathouse on Lake Union owned by Boeing. In 1915, Westervelt went to work designing a plane and Boeing went to California to take flying lessons from Glenn Martin, a pioneer aviator. The first Westervelt-designed aircraft, a two-seat floatplane called the B&W, was ready to fly by late spring 1916. On June 15, with William Boeing at the controls, the plane taxied across part of Lake Union, picked up speed, and lifted majestically into the sky. The inaugural flight, as well as subsequent flights later in June, confirmed that the plane was a technological success. By July, Boeing was ready to start producing B&W planes in mass. He formed a company called Pacific Aero Products Company to build and market the planes. The U.S. Navy was an obvious early prospect for B&Ws, but the Navy turned Boeing down, instead opting to stick with the more proven Curtis floatplanes. Undeterred, Boeing finally sold two planes to the New Zealand Flying School. Pacific Aero Products (which was renamed the Boeing Airplane Company in 1917) was in business.

During the early days of aeronautics, improvements came rapidly. In late 1916, Boeing designed an improved floatplane, which it called the Model C. The Model C was ready to be marketed in April 1917, the same month that the United States entered World War I. Boeing believed that the Navy now might need training aircraft. He was correct. The Navy ordered two Model Cs that were shipped to the Naval Air Station in Pensacola, Florida. The planes performed so well that the Navy ordered 50 more. The order put Boeing on the map.

Boeing’s business flourished during the war, but predictably fell off sharply after the armistice. The company responded to the fall-off by designing a plane for commercial use. Fishing enthusiasts were interested in accessing the many isolated lakes in the Northwest United States. Boeing designed a small floatplane (called the B-1) to satisfy this need, but initially only a few were purchased. Interest in aeronautics had waned after the end of World War I.

However, interest in air flights quickly accelerated after Charles Lindberg’s highly publicized 1927 transatlantic flight in the Spirit of St. Louis, and Boeing eventually was able to sell 13 of the B-1s. Thirteen is not a large number, but was a respectable number for the era because in the 1920s, air travel remained an uncomfortable novelty. Airplane fuselages were thin sheets of uninsulated metal that often rattled. Passengers often stuck cotton in their ears to dampen the noise of the engines. Cabins were not pressurized, so airplanes had to fly around mountains. Flying at night was unsafe. Even in the late 1920s, travelers could cross the United States by train faster than by air (and much more comfortably to boot). In 1926, only 6,000 Americans traveled on commercial airliners.

While Boeing sold a number of planes to the military in the 1920s and early 1930s, sales of commercial planes were almost nonexistent until 1933, when the company started marketing its model 247. The twin-engine 247 was revolutionary and generally is recognized as the world’s first modern airplane. It had a capacity to carry 10 passengers and a crew of 3. It had a cruising speed of 189 mph and could fly about 745 miles before needing to be refueled. It was the first plane used for regularly scheduled service between New York and the West Coast, a flight that took 20 hours, with seven stops. Seventy-five of the planes were sold before Boeing replaced the 247 with the much larger model 307 Stratoliner. The Stratoliner had a capacity of 33 passengers and a crew of 5. It could cruise at 220 mph and had a range of 2,390 miles. Importantly, the Stratoliner had a pressurized cabin, so it could fly above mountains and above turbulence. The Stratoliner should have been a winner, but the plane did not make its maiden flight until the last day of 1938, and World War II commenced before the plane became established. Only 10 were ever built.

Boeing helped the Allies defeat Germany. The Boeing B-17 Flying Fortress bomber and the B-29 Superfortress bomber became legendary. More than 12,500 B-17s and more than 3,500 B-29s were built (some by Boeing itself and some by other companies that had spare capacity). Boeing prospered during World War II, but at the end of the war, the Air Force immediately canceled orders for thousands of planes, and Boeing was forced to reduce its employment levels by 70,000 and redirect its efforts back to commercial aviation. The company then redesigned the B-29 into a four-engine, long-range commercial plane named the 377 Sratrocruiser, which first flew in mid-1947. However, the Stratocruiser soon was obsoleted by a destructive technology: the jet engine. In mid-1949, the de Havilland Aircraft Company started testing its Comet jetliner, and the Comet commenced carrying paying passengers three years later. It was clear that Boeing had to respond. And it did. Boeing started to develop its 707 jet in 1952. Tests started two years later and commercial flights in 1958. The 707 was a hit and soon became the leading commercial plane in the world.

Over the next 30 years, Boeing grew into a large and highly successful company. It introduced many models of popular commercial planes that covered a wide range of capacities, and it became a leader in the production of high-technology military aircraft and systems. Moreover, in 1996 and 1997, the company materially increased its size and capabilities by acquiring North American Aviation and McDonnell Douglas. Between 1960 and 2000, Boeing’s revenues increased from $1.56 billion to $51.32 billion, and its net income increased from $25 million to $2,128 million.

In the 1990s, Boeing realized that it needed to find a replacement for its aging 767. Initially, the company considered two alternatives. The first was a plane that could travel just under the speed of sound and that had about the same fuel efficiency as the 767. The second was an enlarged version of the 747 that could compete head-on with Airbus’s planned A-380. However, in 2002, Boeing dropped both alternatives in favor of a lightweight, carbon-composite, fuel-efficient aircraft that would offer about 20 percent reduced fuel consumption instead of higher speed or larger capacity. The proposed new model was named the 787 Dreamliner. Boeing completed the basic concept of the new plane by the end of 2003. Four months later, Japan’s ANA became the 787’s first customer, with an order of 50 planes. By the end of 2005, a total of 288 orders had been received. The large number of early orders verified the need for a new fuel-efficient plane.

The 787 required many new technologies. Strong and lightweight carbon fiber composites, which previously had not been used structurally on commercial aircraft, make up about 50 percent of the plane’s primary structure, including its fuselage and wings. There are many other firsts. For example, each section of the fuselage is one piece of wrapped composite material. On previous Boeing planes, each section was made of about 1,500 sheets of aluminum held together by more than 40,000 fasteners. Also, the 787 has new hydraulics, new engines, new landing gears, new electronic controls, new avionics, and new lithium-ion batteries. It is manufactured from 2.3 million parts. In spite of the newness and complexity, Boeing hoped to reduce the time to develop the plane from the normal six years to four years, with a first test flight scheduled for August 2007.

However, in January 2007, the 787 program started falling behind schedule. Suppliers were late delivering parts, some fasteners were improperly installed, segments of the wing needed to be redesigned, and some software was incomplete. Finally, on December 15, 2009, more than two years late, a 787 taxied down a runway in Everett, Washington, and lifted off for a three-hour maiden test flight. For the next nearly two years, Boeing extensively tested the 787 and found and corrected a number of “bugs.” Many investors criticized Boeing for the bugs, but I was both sympathetic and understanding. To my way of thinking, it would be unreasonable to assume that Boeing could assemble 2.3 million parts into a newly designed plane without incurring some serious problems, especially since many of the structures and systems were new and advanced technologies.

On September 27, 2011, about three years late, ANA accepted delivery of its first 787. Thirty days later, after testing and training, the plane was placed in commercial service, carrying a full load of passengers from Tokyo to Hong Kong. ANA auctioned tickets for the inaugural commercial flight, with the highest bidder paying $34,000 for a seat.

But the 787 still experienced start-up problems. On February 6, 2012, Boeing said it discovered manufacturing errors in some fuselage sections. On July 23, 2012, defects were found in five Rolls-Royce engines. Five days later, a 787 engine failed during testing. On September 5, ANA was forced to abort a take-off after white smoke billowed from the left engine (the white smoke was caused by a breakdown in a hydraulic system). On December 5, the Federal Aviation Administration (FAA) ordered inspections of all 787s following reports of fuel leaks.

In late 2012, the media and Wall Street generally were highly critical of Boeing for the myriad of problems. After reading the criticism, I reasoned that the negativism likely was weighing on the price of Boeing’s shares and that the price could appreciate materially once the start-up problems were solved. I decided to research and analyze the company.

I started with Boeing’s balance sheet. I quickly noticed that the company had more cash than debt, even after investing more than $20 billion of cash in the development of the 787. However, the company did have large pension and health care liabilities: $23.0 billion versus only $8.2 billion five years earlier. I would need to analyze this $23.0 billion balance sheet liability before purchasing any shares, but first I would analyze the other key fundamentals of the company.

Boeing has two businesses: (1) commercial aviation and (2) defense. The production of larger commercial planes is a duopoly with almost impenetrable barriers to entry, as evidenced by the technology and preproduction costs required to produce the 787. Michael Porter, the highly respected professor at Harvard Business School, identifies five forces that should determine the long-term profitability of a company. Boeing’s commercial aviation business passes Porter’s five forces test with flying colors:

1. Threat of new entrants. It would require decades and tens of billions of dollars for a new entrant to develop and test planes that could compete with Boeing’s and Airbus’s larger planes. Furthermore, a new entrant would have to win the confidence of the airlines and the flying public.
2. Threat of substitution. I could not imagine that high-speed trains or ships, or any future new method of travel, would dent the demand for air travel in the immediate future.
3. Power over suppliers. Boeing is a very important customer for many of its suppliers, and Boeing has the option of playing one supplier off against another. It can tell a supplier that, unless it reduces price, it will lose future business to a competitor. Thus, Boeing has large bargaining power when negotiating price.
4. Power of customers. The airlines can and do seek bids from both Boeing and Airbus. However, some of Boeing’s models sometimes are a better fit for a particular need. In particular, Boeing’s 777 seems to have an edge over Airbus’s long-distance wide-body planes. And, importantly, the 787, because of its fuel efficiency, has a competitive edge. In spite of all of the 787’s problems and adverse publicity, by December 2012, Boeing had 799 orders for 787s valued at an estimated $100 billion. On balance, the commercial airplane business is competitive, but the competition is limited. Airplanes are far from being a commodity.
5. Degree of rivalry. Boeing and Airbus certainly were rivals, but both enjoyed large backlogs that should have mitigated cutthroat competition. In December 2012, Boeing had an undelivered firm backlog of about 4,300 airplanes, which, based on 2012 deliveries of 601 aircraft, equaled 7.1 years of production.

Boeing also seemed to have an experienced and talented management and an excellent reputation with the airlines and the flying public. Furthermore, because of the strong demand for new airplanes, Boeing’s annual production was expected to increase from 601 planes in 2012 to more than 750 in 2015. The company’s commercial business was booming.

Boeing’s defense business, on the other hand, was not booming. The U.S. government was reining in its expenditures for defense. Some of the decline in demand was being offset by increased demand from foreign governments, but, on balance, it appeared likely that Boeing’s defense revenues would decline slightly between 2012 and 2015. However, Boeing was reducing its costs to the extent that defense profits might be held flat, or even increase some.

Based on the preceding preliminary analysis, I made a model of Boeing’s future earnings. The preliminary model concluded that the company could earn at least $7 per share in 2015. The shares at the time were selling at about $75, or at less than 11 times the $7—a very low price-to-earnings (PE) ratio for such a strong and well-positioned company. Thus, I was inspired to delve deeply into Boeing’s fundamentals.

After a few weeks studying Boeing and thinking about the company’s probable future, I decided to build a more detailed model of the company’s earnings per share (EPS). The model would contain (1) estimates of 2015 earnings for each model of Boeing’s commercial planes; (2) an estimate of 2015 earnings for the defense segment; (3) a projection of nonoperating expenses, including research, pension, and net interest; (4) the expected effective tax rate; and (5) the projected number of shares outstanding.

When calculating the profits of its commercial airplanes, Boeing uses “program” accounting. Under program accounting, Boeing first makes a conservative estimate of how many planes of a given model will be built. This quantity is known as the block size. Then, for the planes in the block, Boeing estimates the average price that will be received and the expected average cost per plane. Thus, the profitability of each plane in a block is relatively constant and predictable from year to year, except in years when there is a major revision in the block size or in the estimated average price or cost. I had reasonably good estimates of the profitability of each of Boeing’s models, so, by knowing the projected production rate for each, I could estimate the 2015 profits for each model. I note that the 787 was expected to be only marginally profitable in 2015. My best information was that the average price of a 787 was roughly $125 million and that the average projected cash cost of producing the first 1,100 planes (which was the initial block size) was a bit over $100 million, indicating a cash profit of something under $25 million per plane. Boeing had capitalized more than $20 billion of the 787’s design and preproduction costs—and this $20+ billion would be amortized over the 1,100 block size at a rate of about $20 million per plane. Thus, I guesstimated that, while the average cash profit per 787 in the block would be close to $25 million, the average reported profit would be only about $3 to $4 million. Boeing’s 2015 production of 787s was expected to be 120 planes. Thus, in 2015, the operating profit of the 787s was estimated at only $360 to $480 million, or only $0.30 to $0.45 per share after taxes.

I then projected that the profits of Boeing’s defense segment would remain relatively flat, that research and development expenses would decline some now that the 787 was in production, and that interest expense would remain flat.

The next step was to take a close look at pension expense. Boeing used generally accepted accounting principles (GAAP) for its earnings statements. Under GAAP accounting, when calculating pension liabilities and pension expense, future liabilities are discounted to reflect the value of time. The discount rate used is a function of longer-term interest rates on bonds. Between 2008 and 2012, longer-term interest rates fell by about 2.25 percent. This meant that Boeing’s reported pension liabilities and reported pension expense increased sharply. I strongly believed that interest rates at the end of 2012 were abnormally and likely unsustainably low and, therefore, that Boeing’s balance sheet overstated pension liabilities and that its income statement understated reported earnings. For each 1 percent future increase in interest rates, Boeing’s pension liabilities and pension expense would decline by $9.1 billion and $930 million, respectively. Therefore, if interest rates returned to 2008 levels, Boeing’s stated pension liabilities and pension expense would decline by about $20 billion and $2 billion, respectively. After reaching this conclusion, I no longer was concerned about the magnitude of the company’s pension liabilities, and I was convinced that the company’s reported earnings were understated because the true economic costs of funding the pension obligations were far less than the costs reported under GAAP. Many other companies were experiencing the same disparity in their pension accounting, and many had started to report non-GAAP earnings that adjusted pension expense to reflect economic costs. Would Boeing also start reporting non-GAAP earnings? I did not know, but I decided that my model should include two estimates for 2015 EPS, one based on GAAP and one based the economic costs of the pension plans.

After projecting Boeing’s effective tax rate and diluted share count, I double-checked my model for reasonableness. Based on the assumptions in the model, which did seem reasonable, I concluded that Boeing’s 2015 GAAP and non-GAAP earnings could be roughly $7.50 per share and $8.25 per share, respectively.

Next, I had to value the shares. In 2015, about two-thirds of the company’s total estimated earnings would be from commercial aviation and the remaining one third from defense. I believed that Boeing’s commercial aviation business was unusually attractive and was worth close to 20 times earnings (I settled on 19 times). The defense business could be divided into two subsegments: (1) sales to the U.S. government, which I believed was a subpar business, and (2) sales to foreign governments, which I believed was an above-average business. On balance, I valued the defense business at 15 times and, therefore, the whole company at about 17.7 times. I was convinced that the 17.7 PE ratio should be applied to projected non-GAAP earnings and, thus, that Boeing might be worth about $145 in 2015.

The $145 valuation appeared compelling versus the existing share price of about $75. However, before purchasing the shares, I had to consider the risks that the 787 program might develop unsolvable problems. The plane had been tested for nearly two years, had been approved by the FAA, and was in commercial service. Boeing’s engineering-oriented management had a history of successfully solving technological problems. But what if the many problems that had recently plagued the airplane were more than just normal start-up problems and could not be solved, leading to large cancellations of orders? What if one or two planes crashed due to problems that previously had not been anticipated? Given everything I knew, the chances that the 787 program would have to be abandoned appeared tiny, but what would the consequences be? One consequence would be a very serious blow to Boeing’s reputation. However, the cash charges of canceling the program likely would not be large relative to the strength of Boeing’s balance sheet. And the 787 was projected to account for only about 18 percent of Boeing’s revenues and 4 to 5 percent of its earnings in 2015. The price of Boeing’s shares might fall sharply upon the announcement of a very serious 787 problem, but the company still would have estimated 2015 non-GAAP earnings in excess of $7.50 per share, and thus there appeared to be a large margin of safety for shareholders who paid about $75 for the shares.

In December 2012 and early January 2013, we established a large position in Boeing’s shares. On January 7, at a time we were still purchasing shares, a battery caught fire in an empty 787 parked at Logan Airport. Then, on January 16, an ANA-owned 787 made an emergency landing after one of its batteries caught fire. After the second fire, the FAA ordered the grounding of all 787s, and the price of Boeing’s shares immediately fell by 3.4 percent to $74.34.

On Thursday, January 17, I received a telephone call from an investment manager. He was selling his holdings in Boeing because he was fearful that, if serious problems developed with the 787, his clients would criticize him for unwisely sticking with Boeing after there had been warning signs about the reliability of the plane. I tried to convince the manager that, even if the 787 did develop serious lasting problems, Boeing still had a thriving business producing other models, and therefore there was a large margin of safety in the shares. My analysis fell on deaf ears, and the other manager sold all his holdings. Most investment managers adopt two goals: (1) to earn a good return on their holdings and (2) to keep their clients happy. I have only one goal: to earn high returns. If I earn high returns (without taking large risks of permanent loss), then my clients likely will be happy. If a client is not happy because of any ill-determined reason, then I am happy if the client chooses to leave Greenhaven for another manager.

During February and March 2012, Boeing worked to enclose the lithium-ion batteries on the 787 so that any future fires could not damage parts of the plane exterior to the enclosures. This plan seemed to satisfy the FAA, and on April 19, the FAA lifted its grounding order. The price of Boeing’s shares hit a nadir on January 29 at $73.65, remained in the mid-$70s during February, and then started appreciating in March, when it appeared that the battery problem would be solved. On April 19, the shares closed at $87.96. Six months later, the shares sold at $122.52. The investment manager who sold his shares in mid-January at about $75 made a large mistake. The way I look at it, in the investment business, there are risks in owning securities, but there also are risks in not owning securities that have favorable risk-to-reward profiles. The risks in not owning undervalued securities are the opportunity costs. An extreme example would be an investment manager who purchased only Treasury bills for his clients. After adjusting for taxes and inflation, clients who own only Treasury bills would, over time, experience large erosions in their real wealth. However, if the investment manager had purchased Boeing’s shares for his clients, the clients would have earned large profits that would serve to protect their original capital against losses on any future unprofitable investments. If an investor turns a $75 initial investment into $122, then the investor could absorb $47 of future losses before being underwater on his original $75 investment. Sometimes the best defense is a sensible offense.

Boeing’s shares continued to move higher in the fall of 2013 and finished the year at $136. By now, Wall Street generally believed that the 787 program would be successful and that Boeing would enjoy rising earnings and large cash flows that could be used to repurchase shares. We believed that a large percentage of the company’s intermediate-term potential now had been discounted into the price of the shares, and we started to reduce the size of our holding.

I emphasize that I like to invest in strong and growing companies, such as Boeing, whose shares are temporarily depressed by understandable and solvable problems. However, I usually shy from investing in weak companies that are suffering from problems that stem from their weakness. Managements of weak companies often announce plans to improve earnings and other fundamentals, but my experience is that turning around entire companies usually is a difficult process that rarely meets with satisfactory success.