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Rockwell Collins agreeement

Just when it appeared that equipment-supplier consolidation had run its course, United Technologies (UTC) shocked the aerospace industry by reaching an agreement to acquire Rockwell Collins for a cool $30 billion.

UTC Aerospace Systems (UTAS) will be combined with Rockwell Collins and folded into a new business unit named Collins Aerospace Systems with revenues of $23 billion—twice the size of the next-largest equipment supplier. This doesn’t include Pratt & Whitney’s $15 billion aeroengine business. This mega-merger raises three questions:

Why did it happen? First, UTC likes the aircraft systems business. Its $18 billion acquisition of Goodrich in 2012 is perceived as successful, and the acquisition addresses three of the most attractive segments in aerospace: avionics, interiors and defense electronics. Second, Collins is a superb company. It has invested in the future, its operations are lean, it posted 18-19% operating margins over the last five years, and it delights its customers. The Collins aftermarket organization is widely viewed as best-in-class, and its opportunistic acquisitions of ARINC and B/E Aerospace expanded its markets.

The third reason for the deal is a response to a three-front aircraft OEM assault on supplier business models: demands for double-digit price concessions (e.g., Partnering for Success and Scope+), OEM vertical integration and an aggressive push into their aftermarkets. And the pace is increasing. In the last year, Boeing announced plans to expand in-house production of avionics and actuators and set up a new integrated services organization to pursue a goal of $50 billion in services revenue; Airbus plans to bring in-house Pratt & Whitney PW1100 nacelles for the A320neo. These recent actions may have influenced the timing of the deal; it would have been much less expensive to acquire Collins in 2015 or 2016. Financial analysts believe that UTC overpaid, and its stock price plunged 8% since the announcement. Then again, UTC’s stock fell the same percentage after it announced its Goodrich deal. Its market capitalization has increased $20 billion since.

Can the deal be stopped by regulators or aircraft OEMs? Regulators in the U.S. and Europe will justifiably take a hard look at its impact on competition. They will find that there is virtually no overlap between the two companies. Both participate in interiors, but UTAS’s products (evacuation systems, lighting, crew seats) mostly complement B/E Aerospace’s portfolio. Cannacord Geniuty estimates that total overlap comprises 1% of Collins Aerospace Systems.

There is also very limited potential for Collins to bundle systems and distort competition. If anything, aircraft OEMs are moving away from the broad, system-oriented work packages that characterized the Boeing 787 and Airbus A350XWB as they assert more control over suppliers. I don’t anticipate a repeat of the 2001 action by the European Commission to scuttle GE’s acquisition of Honeywell.

Aircraft OEMs could stop the deal by voiding contracts, but the commercial implications are daunting. Canceling a supplier’s contract means costly system recertifications at a time when Boeing and Airbus need operational perfection from their supply chains to meet higher production rates. Airlines do not like the idea of replacing a well-performing equipment supplier, as supporting two types of components drives up maintenance and inventory holding costs. My sense is that OEMs will sabre-rattle to drive commercial concessions and might cancel some contracts but are unlikely to block the transaction.

What does UTC-Rockwell Collins mean for aerospace and airlines? It clearly escalates the competitive dynamic between aircraft OEMs and their suppliers and presages further consolidation—particularly given the herd mentality of aerospace leadership. Midsize suppliers that are not part of conglomerates, such as Esterline and Meggitt, must determine their next move: acquire, sell or stand pat?

Will it be bad for airlines? Probably not. Larger size may yield stronger bargaining power versus aircraft OEMs but does not equate to pricing power with airlines. What about responsiveness? Kelly Ortberg, the new CEO of Collins Aerospace Systems, has shown that he understands how to balance customer-oriented decentralization with the financial benefits of centralization. UTC also learned important lessons from the integration of Goodrich. The challenge will be to create a nimble conglomerate. One upside is that Collins Aerospace Systems can offer fundamentally new maintenance services by combining equipment breadth, health-monitoring capability and communications services.

For aircraft OEMs it is a reminder of Newton’s Third Law: For every action, there is an equal and opposite reaction. The stakes of this grand OEM-supplier tug of war are at a new plateau. Stay tuned for the aftershocks.

By: Kevin Michaels

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