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:: April 2007 Letter ::

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Dear Fellow Bubble Watchers,

What’s the strangest thing in your house? For me it’s an easy answer—a Steinway baby grand piano. I pass it every night on my way upstairs and ask “how long have we had this piano?” Oh yeah, I remember, my wife won it back in 1999 when she clicked a button on some tech company website. If you want to know why tech stocks collapsed a few years back remember the piano giveaways, and those multimillion dollar Super Bowl ads with sock puppets and monkeys.

That’s not it of course. Tech and coms crashed because of a bubble — too many ideas chasing too few consumer bucks. Investors wanted profits (who knew?) and grew tired of waiting for returns. Panic ensued as they headed for the doors, although AOL nabbed Time Warner as an exit strategy. Impoverished day traders traded bath robes for street clothes and got real jobs. But as a result of this heroic misinvestment by millions of gullible investors (me too—turns out 75 shares of Nortel wasn’t going to fund my early retirement) we’re now living in a better world, with superb software, e-commerce options, communications links, and YouTube (for a new account of this phenomenon, see Daniel Gross’s Pop: Why Bubbles Are Great For The Economy, to be published by HarperCollins in May). Investors got screwed, but now you can link yourself to Jessica Simpson’s MySpace page. Oh, and my wife and I got a Steinway.

Our industry doesn’t currently have many dangerous investment bubbles. Strong airline traffic largely justifies the cash pouring into jetliner finance, although if those Gulf carriers really do buy hundreds of 787s/A350s there will be a serious widebody glut there in a few years. Business jet demand is still strong and even NetJets is showing signs of profitability. There’s been a huge run up in defense, but the US military fleet is largely trashed, so I don’t see much risk of a DoD procurement collapse.

That leaves only one imminent concern: Very Light Jets (VLJs). Specifically, Eclipse Aviation. I’ve written about Eclipse’s crazy business plan before, in my March 2006 and December 2002 letters. For much more on the debate see http://eclipseaviationcritic.blogspot.com. Long story short: they’ve blown through hundreds of millions over the last ten years. They’ve delivered about six semi-functional jets. Their business plan calls for a 500-aircraft/year breakeven point (750 to be “comfortable,” according to CEO Vern Raburn). A few suppliers have jumped ship, but most have stayed with the program. Since Eclipse hasn’t collapsed, we can assume their investors have kept the faith.

I don’t know what Eclipse’s backers are thinking. They seem impervious to bad news or rational thought. The program’s unrealistic production numbers depend on an untenably low price. The untenably low price depends on unrealistic production numbers. Something’s gotta give. You don’t get to build 500 a year of anything in this industry. Unless it blows up when it hits its target.

If VLJs are a fantastic growth market, how do they explain the pile of failures that tried to enter this niche? The CenturyJet, SafireJet, Avocet ProJet, Visionaire Vantage and others use similar technology and address the same or a proximate segment, yet they are quite dead (you can still visit Century’s cyber-crypt at www.centuryaero.com for details and 1998 pricing). Eclipse by contrast is expected to surf a massive wave of pent-up demand that the other guys just couldn’t satisfy. Meanwhile turboprop planes costing $3-5 million keep reaching new heights, with record delivery numbers. As our British pals say this gives the lie to the notion that VLJs offer an aeronautical killer app, a breakthrough rendering earlier technology obsolete.

Those prosperous props raise the awkward matter of air taxis, a key rationale behind Eclipse’s sales forecasts. Given the massive popularity of great planes like the PC-12, TBM 700/850, King Air, and Avanti, do air taxis really need to wait until some new magic machine arrives? The real problem is that operational barriers to successful air taxi services prevent widespread adaptation of the concept, confining it to a handful of regional markets (and a handful of VLJs). Given lukewarm investor response it’s also possible that air taxis will provide no VLJ demand at all. That’s another great example of too many ideas chasing too few consumer bucks.

To my amazement this year the FAA slightly reduced its forecast of annual VLJ deliveries — 6,300 through 2020, rather than last year’s 4,950 through 2017. This came from an agency that worships growth and uses the VLJ menace to bolster its user fees proposal. For comparison, Teal Group forecasts 2,900 VLJs through 2016. But with either forecast, Eclipse needs over 100% of total market demand to survive. Eclipse’s competitors, by the way, include two minor startup companies known as Cessna and Embraer.

What will happen? Here are three scenarios, with rough probabilities, in reverse order of likelihood. There’s a 0.2% chance that somehow the Eclipse business case survives on its current numbers. There’s a 30% chance that the up-front numbers look good enough to permit an IPO or some other financial soft landing that spreads the pain when the business case implodes. That leaves 69.8% for a very unpleasant scenario where the whole thing falls apart.

The AOL/Time Warner merger was scrutinized in a book by Kara Swisher, There Must Be A Pony In There Somewhere. In Eclipse’s case, there is. The Eclipse 500 looks like a neat little plane, and I hope it does well. But for reasons stated in my March 2006 letter, we refuse to give it a production forecast. After the present business case collapses and the plane winds up in the hands of people with more realistic goals (and a more responsible plan), we look forward to issuing an optimistic report. And the backers who generously made it possible will wind up like Pets.com investors, without the souvenir sock puppet dog to console them.

April’s Teal aircraft reports include the annual Business Jet Overview, along with updates of the V-22, EA-6B, Challenger/Global Express, A340, Gripen, Eurofighter, Mirage 2000, EC 135, and P-3. Have a great month.

Yours, Until Those Tech Investors Want Their Piano Back,
Richard Aboulafia

 

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