Aerospace is a big business but it is an industry increasingly consolidated. Big business yes, but a shrinking industry for sure.

The recent July deal by UTC to sell its Sikorsky helicopter unit to Lockheed Martin for $9bn is an example of how the huge parts and pieces need to shift around to extract value. UTC says it will use the funds for share repurchases. But what about instead making an investment that could really shake up the industry?

How about merging Pratt & Whitney and Rolls-Royce?

This has been discussed in the past, and arguments go both ways.  Also, the experience with IAE drove both sides crazy, and finally ended up with P&W having to buy out R-R to get their GTF technology into Airbus.  There was also a lawsuit over fan designs. There has been a costly and nasty history that left a bad taste on both sides.  Moreover, could a deal even get by the anti-trust regulators?

But even with these hurdles, the timing is propitious.  R-R lacks in the small engine arena and P&W lacks in the big engine arena.  If ever there was a time to give this idea a hard look, now is the time.

  • Rolls issued three profit warnings between 2014 and 2015.  Rolls is trading down. The stock is down over 25% this year. At current prices the company is worth £13.7bn (~$21bn).

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  • UTC, P&W’s parent company looks like to be following a similar path.  UTC is worth ~81.6bn. UTC stock is also down this year.  They are NOT flush with performing units, and are struggling; P&W gets its big revenues when GTF powered airplanes get delivered.

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  • R-R is a strong player in large commercial aerospace jet engines and competes against GE. Whereas GE is Boeing focused, Rolls is Airbus focused.
  • GE has a partner in SNECMA and markets the best-selling jet engine in the CFM.  R-R has no offering in the segment.  P&W has the GTF which has proven very popular.
  • R-R is not in the small engine business where the sheer volumes enable an excellent arena to undertake applied research which can then migrate to larger engines.  Economies of scale are crucial to offset extremely expensive R&D.
  • R-R may have a stiff upper lip, but things don’t look rosy.  Its deal to win the Emirates A380 order must have come at a cut throat price (since we have heard that Engine Alliance offered their engines at cost and still lost).  R-R is betting on the A330neo and A350, both which are not flying off the shelf when compared to 787 and 777.
  • The lower fuel price changes the economics of new fuel efficient aircraft relative to existing aircraft.  For example, key R-R customer British Airways seems happy to keep its 747 fleet in service.  This means spares sales for R-R but fewer new engine sales.
  • It will be between 2025-2030 before Rolls gets a look into the next wave of the single aisle engine business.  By then Pratt and CFM will have built a lead that will cost many billions more to overcome.  It is unlikely Rolls will see that sort of cash from its investments in the A330neo, A350 and A380 programs over the next decade.
  • Morningstar does not see R-R as having a strong defense (see small moat).   RBC Capital also is sanguine about Rolls’ prospects.  In July RBC said “However, with its medium term profit and cash challenges, the question has been raised as to whether Rolls could be an acquisition target.”  RBC then goes on to state: “We think suggestions that could be interested are baseless.” As we said, the idea has come up before.
  • Meanwhile P&W has no big engine business outside of its USAF tanker order and EA for the A380.  Its GTF on the other hand is doing very well and is found on five new aircraft programs.  R-Rs is now looking at geared fan technology for its Ultra engine.  With the ability to upscale the GTF to 100K, does P&W need R-R?  They seem satisfied taking on 13 new aircraft from five manufacturers, and then moving upstream for the next generation of and then widebody aircraft as a strategy,  Would it be as fast?  No. Could it work? Yes, it is quite plausible.
  • P&W (through parent UTC) is more flush and can fund R&D.  It is no secret that P&W is looking at ramping its current GTF design to 40,000 pounds and more.  Its GTF design is capable of tremendous scaling – and R-R has to pay for all its own learning for the Ultra. There might even be more patent hurdles ahead which P&W will enforce with all its might.
  • The segment will require an engine in roughly the 40,000 pound category – R-R might be better off collaborating than going it alone against GE and P&W.  GE and CFM may have to probably considerably modify the LEAP design or come up with something new.   GE hinted at this at the Paris show where it seemed GE might do such an engine itself rather than with CFM.
  • Put the P&W GTF technology together with R-R big engine plans and you have a compelling cocktail of talent and IP.
  • To further demonstrate why consolidation is powerful, Reuters reports that Boeing is using its power to exercise veto approval over supplier consolidation.   This means if R-R and P&W ever want to compete with GE and CFM for Boeing business they had better be very strong. Both firms are reasonable on their own, but together they can face off against GE and CFM.  In this case, probably much to the joy of Boeing who would benefit from competitive offerings.
  • Airbus could also benefit from a combined P&W and R-R engine offering.  It means less dependence on R-R (as Boeing is with GE) which may be running into challenges with the big engines it supplies Airbus.  Moreover, with the A380neo clearly under consideration, the idea of a R-R solution that deploys patented P&W GTF technology almost certainly gets much closer to Tim Clark’s economic goals.  Meeting Emirate’s goals of 10-13% reduced costs per seat mile will depend a lot on engine performance.  P&W, through its relationship with Engine Alliance, knows the A380 just as well as R-R.  The only way the A380neo really moves ahead of the 777-9’s expected economics is to deploy the latest geared technologies and composites.  P&W owns the former space and R-R is a leader in the latter.This is possibly one of the most disruptive moves that could occur on commercial aerospace today.  There are big hurdles to overcome and the two firms will likely dismiss the idea.  It would be the equivalent to two tectonic plates combining to form a new continent.  But that would the landscape.  Big time.

 

 

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