Three Things Rockwell Collins Is Betting On With B/E Aerospace

Posted by mikestengel on November 4, 2016
Posted in: Airlines, Manufacturing. Tagged: , , , , , , , , , , , , , , . Leave a comment
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Rockwell Collins Revenue Breakdown, Current vs. Combined. Source: Rockwell Collins

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.

Never Discount the Threat of New Entrants

Posted by mikestengel on April 18, 2016
Posted in: Manufacturing. Tagged: , , , , , , , , , , , , , , , , , , , , , , , , , . Leave a comment

When the renowned Michael Porter published his “five forces” analysis in his book Competitive Strategy, he created a framework that is now ubiquitous in MBA programs, corporate strategy departments, and among management consultants. The concept introduces five indicators that, when aggregated together, form a clearer picture on the attractiveness of a certain industry: threat of new entrants, threat of substitutes, bargaining power of suppliers, bargaining power of buyers, and overall rivalry.

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Porter’s Five Forces

One popular notion from this approach is that consolidation of an industry increases the overall attractiveness by suppressing the five challenges that Porter poses. In other words, by increasing scale and eliminating competitors, barriers to entry would be too high and the competitive environment too strong for any small firm to succeed in. However, as recent events in the aerospace world have shown, that is not the case and the reality is actually more dynamic.

Let’s take United Technology’s (UTC) 2011 acquisition of Goodrich for $18 billion as the first example. UTC, which at the time operated three different aerospace businesses, wished to expand its product portfolio and become an integrated systems provider. By acquiring Goodrich, according to Porter’s framework, UTC would reduce the industry rivalry, increase their bargaining power in supplier and customer negotiations, and supposedly mitigate the threat of new entrants by increasing the barriers to entry with economies of scale. With the upcoming contract to build the 777X landing gear, UTC would be in a good position to secure the lucrative long-term work.

In 2013, it came as a surprise to most industry followers that Boeing awarded the contract to Héroux-Devtek and that UTC lost out. Héroux-Devtek, based in Longueuil, Canada, is a manufacturer of landing gear systems for smaller helicopters and business jets, and the new Boeing contract was the largest in the company’s history. While the contract would require a major investment in capabilities to adequately supply the larger and higher-volume 777X landing gear, it would also represent the opportunity to compete at a higher level amongst larger suppliers.

This month, Boeing pulled a similar move again, this time among seat suppliers. Airbus and Boeing view customized interiors as a large chokepoint in their production processes, and would like to streamline the process. Consequently, the large incumbent seat suppliers, Zodiac Aerospace and B/E Aerospace, have been under public pressure to improve their processes to reduce production delays at Boeing and Airbus plants.

Seemingly fed up with the delays, Boeing announced that a new supplier, LIFT by EnCore, a California-based startup led by former executives of C&D Aerospace (now part of Zodiac), will be the sole supplier of 737 seats to Boeing. By directly purchasing the seats, this also represents a break in the traditional practice of allowing airline customers to select their seats.

The lesson to be learned here is that immunity from the threat of new entrants does not come with scale and size. In both cases, Boeing spurned large incumbent suppliers on significant long-term contracts, and instead chose smaller firms that do not yet have a history of delivering on large scale programs. From a supply chain point of view, this represents an element of risk in the medium term, but also means that Boeing can bring these companies up and keep future negotiations more competitive in the long term.

In this sense, Porter’s five forces analysis should be viewed as more of a system of checks and balances, rather than a framework to achieve absolute power and leverage, particularly in the business-to-business (B2B) world. Once the five indicators appear too strong, it may be time for the large influential customers to reboot and redistribute the balance of bargaining power; hence the title of this article.

In Defense of the Fuel Surcharge

Posted by mikestengel on February 8, 2016
Posted in: Airlines. Tagged: , , , , , , . Leave a comment
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Photo Credit: Airline Reporter

Over the last 18 months, fuel prices have dropped dramatically in the wake of a supply glut after the world’s major oil producers decided not to cut production in an effort to protect market share. Since then, consumers have experienced a major windfall, particularly those who commute to work or live in rural areas.

However, air travelers represent one group of consumers that have not received the same relief in prices. Not only have airfares remained steady, but another pesky element of the total cost has yet to disappear: the fuel surcharge. Travelers are wondering why, in light of record airline profitability and significantly lower fuel costs, the charges continue to be built in. In my view, as unpopular as it may be, fuel surcharges actually continue to make sense for the airlines.

First, the application of fuel surcharges is not universal and varies from market to market. It appears that most domestic routes in the United States no longer have a fuel surcharge, although it’s likely that many routes once had one that has been rolled into the base fare. However, surcharges are still present on a number of long-haul international routes, where fuel makes up for a larger portion of the overall operating cost. A number of outlets have cited New York-London flights with a $458 surcharge, and carriers apply international surcharges on other parts of their network as well, such as to Asia.

Second, the surcharge functions as a sort of insurance policy against volatile fuel costs. Obviously, fuel prices are at historical lows, but they are not quite stable yet. In such an environment, airlines are unlikely to hedge their fuel contracts since it is unclear where prices may head in the near term. However, another way to effectively implement a hedge and “peace of mind” is through fuel surcharges to protect against unpredictable spikes in prices. In fact, this practice is common in the trucking and railroads industries as well, although with greater transparency in some cases.

Third, changes in cost structure do not necessarily imply that savings get passed onto the customer – this concept is present in a number of cases outside of aerospace too. In general, as companies develop economies of scale and go down the learning curve, the unit cost for their product decreases, but only a sliver of those savings, if anything, is passed onto the customer. Using one consumer example, Apple has made tremendous strides in the overall design and manufacturing process for the iPhone. Despite the implied savings across manufacturing and the supply chain that the company has realized, pricing for their products remain firm.

Lastly, with continued strong air travel demand and disciplined capacity allocation, there is simply no reason to change pricing policies for base fares or surcharges. Air travel demand has consistently grown 4-5% annually over the last few decades, even when factoring in recessions and other downturns. Furthermore, flights are fuller than ever, with load factors over 80% due to management’s capacity discipline mentality. This means that even if an airline decides to axe the fuel surcharge, it’s likely to just get rolled into the base fare.

With volatile fuel prices, strong air traffic demand, and full planes, fuel surcharges are likely to remain. Should fuel prices remain low and stable for an extended period, carriers may consider easing the charge. However, in the current environment, no such appetite exists for price relief unless air travel demand subsides.

This article is also available on LinkedIn here.