On October 24, 2016, Rockwell Collins surprised the aerospace community by announcing the $6.4 billion ($8.3 billion with debt) acquisition of B/E Aerospace, the largest manufacturer of aircraft interiors and solutions. At first glance, the marriage between Rockwell, a renowned supplier of aviation electronics and avionics, and an interiors supplier may seem odd. However, upon further review, Rockwell appears to be making three bets, two of which are on the health of the civil marketplace and one more strategic.
Bet #1: Strong Air Travel Demand
The first bet is about as fundamental as it gets. Over the last 30-40 years, air travel demand has consistently grown ~5% annually, despite all the recessions, conflicts, and other macro challenges that have taken place. Today, this growth rate remains true and is being fueled primarily by growth in China and emerging regions where airlines have contributed to an aircraft order book that stretches out to the early 2020s for certain models.
Consequently, aircraft OEMs are increasing their production rates to record levels over the next four years, with potentially more rate increases to come. Many Airbus and Boeing suppliers are poised for healthy growth as they ride the production wave, and in the longer term, the door is open for aftermarket revenues to a diverse and growing airline customer base.
With the strong historical precedent and a strong backlog providing good visibility into the next five years or so, this is a safe bet. For Collins, this means that air transport revenue as a percentage of total sales grows from ~30% to over 50% in the combined entity, thereby de-emphasizing the stagnant government business and shifting the core focus to OEMs and airlines.
Bet #2: Strong Airline Profitability
It is one thing to have strong and consistent air travel demand, but as history has shown us, strong and consistent airline profitability is a whole different animal. Following US airline deregulation in 1978 and elsewhere in the years to come, many airlines struggled to get by in the new era of free market competition. After the 9/11 attacks and the onset of high fuel prices, many US airlines entered bankruptcy protection and consolidated to survive. Since the financial crisis and ensuing recovery, US airlines have restructured themselves, have posted record profits, and appear in a healthy state.
Why does airline profitability matter for this acquisition? Well, B/E Aerospace is not only a supplier of seats and other interior components for new-build aircraft, but also for interior retrofits on existing aircraft (airline sales account for ~20% of combined revenues). Historically, these retrofits are a discretionary spend item depending on the financial health and profitability of the airline. The combination of strong profitability and the need to compete for premium passengers has driven interior retrofit demand recently, and as a result many airlines are restyling their cabins. As ICF consultant Jonathan Berger recently put it, we are in the golden age of aircraft interiors.
However, it is important to note that globally, airlines are still producing returns below their costs of capital, and the record financial figures are largely unique to US airlines. Furthermore, it may take another recession to stress-test the airlines and see how financially healthy they really are. US airlines have so far weathered unit revenue softness with the decline in oil prices, but it’s tough to say what toll a much larger macroeconomic event would have.
Bet #3: Continued Cost Pressure From Aircraft OEMs
The third bet that Collins is making with this acquisition is that cost pressures from the major aircraft OEMs will continue, and perhaps become more demanding. Boeing and Airbus have both initiated programs to accomplish supplier cost reductions, dubbed “Partnership for Success” and “Scope+”, respectively, in pursuit of operating margins in the teens.
As consultant Kevin Michaels astutely observed, many of B/E’s sales, particularly for seats, are “Buyer Furnished Equipment” (BFE), meaning the sales are negotiated directly with the airline rather than through the OEM. In contrast, “Supplier Furnished Equipment” (SFE) is content negotiated through the OEM in order to standardize what goes on an aircraft. As Michaels points out, BFE sales open the door to higher-margin customized work.
However, an additional advantage to pursuing BFE opportunities is that they do not fall under the Partnership for Success or Scope+ umbrellas, and thus do not face the same threat of cost pressures in the future. So while the Commercial Systems segment may post modest gains in margin, it is susceptible to future OEM terms. On the other hand, the new Aircraft Interior Systems segment should be able to show rapid margin improvement with lean operation principles applied.
These bets are not overblown and present manageable risk. The integration will be interesting, especially to see what sales synergies are achieved with the enhanced airline relationships that B/E brings.
What do you think? Are there any other major bets Rockwell is taking by acquiring B/E Aerospace? Feel free to discuss in the comments section below.