Richard Aboulafia: November 2018 Letter

Dear Fellow New Org Chart Watchers,

For years, the world has watched for the next emerging jet producer. Will it be in Bandung, Sao Jose dos Campos, Beijing, or Nagoya? Perhaps we should look in Connecticut and Iowa. The new United Technologies, created this month, incorporates Pratt & Whitney, Rockwell Collins, and UTC Aerospace Systems (plus legacy names like Goodrich, B/E, Rohr, etc.). Somehow, this giant collection of businesses has no real overlap and builds everything a plane needs to fly except aerostructures. All they need to make a jet is someone who connects the dots and covers it all with metal or CFRP. And, of course, someone who creates a product the market wants. Bank of America/Merrill Lynch analyst Ron Epstein termed New UTC a Tier 0.5 supplier, or a virtual prime. If it isn’t now, it could be in the future.

Where to go from here? Being bigger may be the only goal, since scale matters. But UTC may also look to create new jets, partly to push back against draconian pricing pressure from Airbus and Boeing. Joke making the rounds: UTC just issued an RfP for a metal tube and wing.

This might have already happened. For ten years I wondered if the CSeries would destroy Bombardier before it could get off the ground, but I was told by people smarter than me that this wouldn’t happen – UTC would bail them out, because UTC needed the CSeries to trigger a wave
of single aisle re-engining. If that was the goal, UTC succeeded in co-creating a new jet. As of this month, they are much, much bigger, and able to wreak even greater jet-creating mayhem.

Since Airbus grabbed the CSeries and Boeing is grabbing Embraer’s jetliner unit, Bombardier and Embraer won’t offer any new jets for UTC to co-create. But there are three other hypotheticals: a UTC Jet, a Chinese jet, and a US defense company jet.

I’d rule out the first two. A UTC-jet would be an all-UTC jet. That means the worst of vertical integration. If there were more innovative and/or lower-cost components to be purchased from other companies, the aircraft’s designers would not be able to purchase them. Each business unit would become a cost center, not a P+L. Mediocrity and high costs would be almost unavoidable. Being a prime is also riskier and less rewarding than being a subcontractor. And a UTC-jet would guarantee retaliation from Airbus and Boeing, who would freeze them out of future jets.

Next, there’s the prospect of recruiting the Chinese to create a national plane which was really all-UTC. Aside from the fact that COMAC continues to stumble on its ill-advised path, there are political considerations. There’s also the issue that China wants to do everything in-country, and UTC would be foolish to give away the technology store. While UTC and other contractors are already transferring know-how to China, there’s strong evidence that they’re holding back on giving away their best. This is hardly the way for a new mega-contractor to shine.

That leaves one intriguing possibility: a US defense prime. A few decades ago, most US defense companies decided on a pure-play defense strategy. They either sold their civil units (like Northrop, Raytheon, and Grumman) or just let their civil products die (like Lockheed, and McDonnell, whose civil unit was coughing blood up to the Boeing merger). Other than Boeing, the only exception is General Dynamics, which has owned Gulfstream as a strong, profitable, standalone unit for twenty years.

And then there’s Boeing, the one big defense company that stuck with commercial. Propelled by the magic of long-term compound traffic growth (and a smart product strategy), the company’s BCA unit is clearly the chief cash generator, and the major revenue growth engine. The company’s recent defense wins – T-X, MQ-25, MH-139 – can partly be attributed to the financial strength that comes from building and maintaining jetliners. Boeing’s 2017 commercial jetliner profits earnings came to $5.4 billion (compared with $2.2 billion from defense). Losing a few billion dollars on aggressive defense contract bids matters much less in this context. And the supplier management muscle that comes with a large jetliner unit really helps control defense supplier costs too.

The primes who are losing to Boeing on these defense contracts may wake up. Being a pure-play defense prime made sense in 1995, when the jetliner market was below $30 billion in today’s money, but it’s another story altogether in 2018, when that market is almost 400% larger. In
1995, there were also three jetliner players. Today, there are just two. There’s clearly room for a new jetliner market entrant. If Lockheed Martin, Northrop Grumman, Raytheon, or GD wanted a long-term play to redress their disadvantage against Boeing, this would be the way to go. In fact, the two military airframers, LM and NG, might be able to create a disruptive transport with innovative structures, one that moves beyond that joke about a tube and wing for UTC.

And now, there’s New UTC, a large company that will create the latest and best engines, avionics, thrust reversers, nacelles, APUs, floor lighting, and seatback tray tables for that new market entrant. They bring everything, including help with customer relations and a massive aftermarket support network. And, this new company is desperate to escape the terror of working for just two big primes that constantly beat them up on price, grab their aftermarket business, demand their intellectual property, and generally don’t clean up after using the office coffee station. They’d cheerfully foot much of the new jet development bill.

There are many obstacles to a US defense company entering the jetliner business, even with the full aid and encouragement of New UTC. Pure-play defense companies tend to be risk-averse, and not particularly focused on commercial considerations. They live in a cost-plus
development world, and don’t spend much of their own money on R&D (compared with the 3-6% of sales a commercial company needs to spend on IRAD). They don’t understand multidecade payback periods for nonrecurring expenses. They also tend to over-engineer stuff. Lockheed’s civil jets, the L-1011 and JetStar, were technically brilliant but expensive and overcomplicated.

The big takeaway: the odds are still against any new jetliner producers emerging. But if someone does want this job, as of this month there’s an out-of-the-box partner ready to do much of the heavy lifting.

Yours, ‘Til Southwest Orders 500 CollinsLiner-3s,

Richard Aboulafia