Premium 2018.21 – Does Boeing’s proposed acquisition of Embraer’s E2 program make sense?

Boeing and Embraer have been in discussions regarding an acquisition of Embraer’s commercial aircraft unit by Boeing, and potentially other elements of the corporation. Let’s first examine some of the reasons why we think the fit may be challenging: Mainline Aircraft and Regional Jet Markets There is a “wall”, so to speak, between what is a regional jet and what is a mainline jet. That wall occurs at 100 seats. Neither of the big OEMs has historically wanted to cross over that wall. Evidence of this would be the fact that Airbus bought into the C Series, but not the rest of Bombardier. The duopoly, Airbus, and Boeing are compelled to compete in every segment to support mainline aircraft customers. This partly because of the way the business works but is also pushed by game theory, which compels them to compete across the board. We see this with almost every presentation they make – with the side-by-side comparison of each other’s models and where they fit in the marketplace. But joint ventures haven’t generated competition. ATR, an Airbus-Leonardo JV, hasn’t generated a reaction from Boeing in the turboprop segment. Since Airbus is not going to compete in the regional market, one might think that Boeing will also want to avoid competing in that segment, which also includes Mitsubishi, a long-time Boeing ally. But as Boeing and Embraer circle each other, what could evolve? Embraer has developed a fine family of commercial aircraft with the E-Jet range. By far the best-selling model is the E175, soon to be replaced by the E175-E2, which will join the E190-E2 and E195-E2 that are mainline sized aircraft. But if Boeing isn’t interested in regional jets, what happens? How can the E175 and its successor the E175-E2 be separated from the rest of the family? The short answer is that it cannot. If Boeing does not want to be in the regional jet business, that means its interest in the E2 program will primarily focus on the E190-E2 and E195-E2. This allows Boeing to offer competitors to the CS100 and CS300. It makes sense for Boeing to stay away from the E175 from a game theory point of view. But from a practical viewpoint, the E175 and E175-E2 models cannot be separated from the aircraft family. Might the slow dance we’ve seen between the parties be held up as they try to figure out what to do with the E175? While the path for Airbus/Bombardier is quite clear, the path for Boeing/Embraer is more difficult. Separating the C Series from the rest of Bombardier is easy. Separating the E175-E2 from the E2-Jet program is most definitely not. If Boeing acquires the E2 program, they will be forced into the regional jet market. This will be an interesting element to watch, as selling regional jets is a different game than mainline jets. The Culture Gap One of the major differences between Boeing and Embraer is culture, particularly in the way engineering is organized. Embraer's engineers have moved between commercial, military and business jets seamlessly on projects, leveraging their specialization and experience along the way. Boeing operates in a different manner, with silos that are typically not crossed. As a result, there is a tremendous cultural mismatch between the two organizations. A change to Boeing’s model would likely negatively impact Embraer’s productivity and the ability to continue to produce airplanes on time and below budget, which Boeing itself needs to re-learn after their debacle with the 787. Boeing wants to leverage Embraer's engineering resources for the 797, at a lower cost than its Seattle-based employees. Remember, Boeing's engineers are unionized. If Boeing outsources engineering, the unions have a scope of work grievance. But if Boeing acquires the E2 program, Boeing can claim it is just moving work to another part of the company. So, Boeing does have an incentive to acquire Embraer E2 for access to the lower cost talent. The Business Jet Market Lacks Key Synergies Embraer has come from nowhere to become a major player in the last decade, with multiple new models that are competitive in the small to medium market. It would be a better fit with Bombardier, Dassault or Gulfstream, each of whom has a stronger presence at the high end of the market but don't compete in the smaller side of the market. The only potential for synergy with Boeing we see is the Legacy 1000E joining Boeing's Business Jet Unit as a smaller business airliner. With limited synergy, acquiring the business jet line doesn't make sense for Boeing, and could become a candidate for divestiture, as it culturally doesn’t fit the organization. Defense will be Blocked from a Transaction The Brazilian government doesn't want to divest military capabilities, including the KC-390 (which is jointly marketed with Boeing internationally) and the Super Tucano, a leading trainer and light attack aircraft. Those are off the table, even though they could provide synergies with Boeing Defense. The Brazilian Government’s “golden share” will ensure that acquisition of those programs will not happen. Fit within a New Boeing Culture Our colleagues at AirInsightResearch hold the view that Boeing has evolved from being primarily product driven and is now be more focused on value creation. Value creation includes an emphasis on services, which the E2 Jets might fit because they can generate a long-tail of revenue. Can Boeing capitalize on the E2 and successfully leverage Embraer’s engineering given its new philosophies? The jury remains out. But the challenge is not insurmountable. A New Paradigm? However, we may be viewing the entire deal from too narrow a perspective. Boeing sees air travel as fragmenting. They tout this constantly with the 787 and we expect to hear more about this with the MAX as well. What does fragmentation mean? Essentially it means the industry “de-hubs” with a consequent increase in direct air service with no hub connections. Direct air service does not mean that costs must go up – which was why the hub process was developed in the first place, as it drove down costs and improved system load factors. In fact, right-sizing can bring costs down. If this fragmentation process continues, then Boeing needs to have a “right size” solution for the spectrum of market options. Ergo, it needs the entire Embraer E2 family. An industry expert shared this view with us. “We understand that the essence of the article is that the Boeing-Embraer deal is different from CSeries Airbus. The product positioning is different, and it is right that the E175 cannot be separated from the E190/195. However, we believe the full family makes sense for Boeing. Because the value proposition of the E2 is exactly to bridge the gap between regional and mainline. The E190, in particular, is aircraft that we find on both sides of the wall: COPA, American, JetBlue, Air Canada, Kenya, Royal Jordanian, are good examples of mainline customers while Aeroméxico Connect, BA Cityflier, HOP!, KLM Cityhopper, Tianjin, are very important customers in the regional segment. We believe the main reason why Embraer may be more attractive for Boeing is because the E2 covers a wider spectrum of airlines.” Consequently, if we accept that the air travel paradigm as we know it is changing, then the complete E2 family may be exactly what Boeing needs to fend off Airbus from below 100 seats to over 400 seats. Indeed, with hundreds of E175s in service, with long-term service agreements, the combined venture would have another “hook” to discuss with airlines. And the more hooks one has, the better. The Bottom Line Embraer impresses us as a young, dynamic, and innovative organization, fueled by its engineering and technology-oriented culture. It would be a shame to see that dynamic changed in a merger that on many fronts. There is some risk that a deal might not provide the synergies needed for success. However, the counter to this thinking is that the market is changing and with a new travel paradigm actually drives Boeing and Embraer to combine their offerings into a phalanx that is tough to compete with.

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