Giant Aerospace Merger30/06/2019
MERGER fever seems to be spreading, this time in aerospace which has witnessed continuous merger and acquisitions (M&A) activity for over several decades as technologies have advanced, R&D and production costs have gone through the roof and even large firms have found it difficult to compete with the bigger players, especially if their main work is in broadly the same market segment.
The latest is the all-stock merger decision announced by two US aerospace majors, United Technologies Ltd (UTL), manufacturer of the Pratt & Whitney aero-engines which power fighter aircraft and large passenger or transport airliners, and Raytheon, manufacturer of many leading missile systems. The combined entity, which is to be named Raytheon Technologies Corporation, is expected to have market value of $120 billion and annual sales of about $74 billion, making it the second largest aerospace company in the US, next only to Boeing with annual sales of $101 billion. The next largest US aerospace major is Lockheed Martin with sales of $54 billion annually. After the merger, UTC’s shareholders are to hold 57 per cent of the combined stock while Raytheon shareholders will hold 43 per cent. The boards of both companies have approved the merger, which is expected to fructify in 2020 after regulatory clearances.
For a variety of reasons, however, the merger announcement has received a rather cool response from the stock market, from major investors and fund managers, and from industry commentators. Immediately after the announcement, US president Trump voiced disquiet at the sheer size of the merged entity and its implications for competition, especially in the defence market in the US. Commentators have drawn attention to the lack of synergy between the two entities and wondered how this would either help reduce costs, increase efficiencies or enhance competitiveness or bargaining power in the market, and have openly wondered what purpose the merger hopes to achieve.
To unpack all this, let us first look at the two entities.
UNITED TECHNOLOGIES (UTC)
Even before the merger decision, UTC had decided to hive off the two other rather incongruous components of the company, namely the air conditioning company, Carrier Aircon, a familiar presence in India too, and Otis Elevators, also well known in this country, so as to leave UTC as a mainly aerospace company with Pratt & Whitney aero-engines as its main product range. Late last year, UTC completed a $30 billion take-over of Collins Aerospace, a large manufacturer of aerospace components. UTC’s space activities range from building satellites and communication systems, and it has to its credit the first ever photograph transmitted from a satellite in the 1960s, and receiving the first ever GPS signal in the early 1980s. Through this process, UTC has transformed itself from a somewhat mongrel company to a mainly aerospace and defence manufacturer.
P&W engines are an optional to power the Airbus 320neo (new engine option), but has encountered many problems with that application as discussed later, and the ill-fated Boeing 737 Max. Other P&W engines also power the Airbus A220-100 and -300 series, as well as the US’ most advanced fighter aircraft, the F-35.
P&W’s most recent and creditable innovation in aero-engines has been the Geared Turbo-fan or GTF engine, the PW1000G and variants, which have been adopted as engine options by both Airbus A320neo and 737 Max, all narrow body airliners. The idea behind the GTF is so simple, it makes one wonder why no one thought of it before.
Many modern aero-engines have a large diameter front fan which, like the propeller of pre-jet aircraft, pushes a large volume of air at low pressure and temperatures. A smaller volume of air flows through the main, narrower jet engine, is heated along with fuel in combustion chambers, then expanded in turbines. These two streams join together in the exhaust stream and that pushes the air flow back at optimum pressure, temperature and velocity, and hence pushes the aircraft forward. These types of engines are called high by-pass engines.
The front fan, compressor and turbine are normally all mounted on a common shaft and therefore have the same rotational speed. The GTF, however, inserts a gear before the front fan, so that its rotational speed can be varied compared to the compressor and turbine, giving more control over the air flow, thrust and fuel efficiency of the engine. The big promise of the PW1000G was its claim to reduce fuel consumption by as much as 20 per cent and noise by a whopping 75 per cent, huge benefits to any airline.
The main rival to the PW1000G is the LEAP (leading edge aviation propulsion) engine by CFM, the 50:50 joint venture of General Electric, USA, and Safran of France, known to Indian readers as the makers of aero-engines for the Rafale fighter. The CFL Leap is the other engine option for the Boeing 737 Max and NG, and the Airbus A320neo. This engine offers 16 per cent better fuel efficiency than predecessors through many innovations including the first aviation standard 3D-printed engine components.
Unfortunately for UTC, the P&W1000G/1100G have been plagued by numerous problems since their introduction, including higher start-up times than its competitors, air seal leakages (mostly in the third bearing due to, according to some experts, excess forces generated by the gearing system) leading to engine failures mid-flight etc. This last led to massive groundings of over 40 Airbus 320neo operated by Indigo and GoAir in India, apart from airlines in Japan, Hong Kong and Europe. UTC had to make a number of design modifications to overcome each of these problems. In 2017, the European aviation regulator refused approval for fresh induction of P&W GTF engines till all modifications are duly completed and certified. UTC ascribed the problems in India to “the hot, humid, salty and polluted environment,” surely common to many regions of the world. UTC has, at least in public, taken all these issues in its stride as teething problems in new-design engines. For its part, Indigo recently at the Paris air show, gave up on Pratt & Whitney and placed one of the aviation industry’s largest orders worth $12 billion for 200 CFM LEAP engines for its fleet of Airbus 320neo of which it has ordered 180 more aircraft. How UTC handles these issues will affect its fortunes significantly in the years to come.
Raytheon is of course famous for its missiles, and is the world’s largest missile manufacturer. It is the US’ third largest and the world’s fifth largest military contractor, derives over 90 per cent of its revenues from defence products, and is the world’s largest manufacturer of guided missiles.
In the 1940s, the company made the first sea-faring micro-wave radar to locate other ships and which spun-off into the world’s first microwave oven. It also made the first missile-mounted guidance system during this period. In the 1960s it made the first working laser and helped develop the ARPANET, the forerunner of the internet, and pioneered the e-mail system. In the 2000s, Raytheon made the first anti-satellite missile.
Over the years, Raytheon ventured into different aviation and electronics related businesses, mostly through acquisitions such as business aircraft (Hawker and Hughes Aircraft Corporation), defence electronics (defence side of Texas Instruments), helicopters, robotics, aircraft and air-war simulators, air traffic control systems etc, gradually hiving off non-core businesses so as to concentrate mostly on missiles and defence systems.
Today it is the manufacturer of the most well-known and widely used missiles such as the AGM-65 Maverick, AIM-7 Sparrow and AIM-9 Sidewinder, AIM-120 AMRAAM (mounted on the F-16), BGM-109 Tomahawk, FGM-148 Javelin anti-tank missile, FIM-92 shoulder-fired anti-aircraft Stinger missile, MIM-104 Patriot anti-missile systems, RIM-131 Standard anti-satellite Missile etc.
On the face of it, the UTC-Raytheon merger is a natural fit between two mainly aerospace and defence companies. However, as the above brief description would show, the products made by each of the companies are really quite different, and there are few areas of commonality or synergy where each company adds value to products of the other. The merger therefore also does not create any scale advantages in any product.
Some investors and business analysts therefore do not see any great merit in this merger and wonder if it has any logic at all. One large investor, Bill Ackman whose hedge fund Pershing Square has $700 million invested in UTC, has formally protested the deal in a letter to the UTC Board arguing precisely that.
On the other hand, other analysts believe the main objective is simply to form a bigger company whose very size would increase strategic R&D investments which amount to $8 billion annually even at current levels, better competitiveness relative to major rivals, and a huge combined research force of over 60,000 engineers to drive further innovation.
For instance, UTC may gain additional clout to face its main rival General Electric (GE) and its CFM joint venture with Safran who, between them, account for 50 per cent of global aero-engine sales. First there are the current problems with P&W’s GTF series of engines, which are presently flying on around 500 aircraft that P&W estimates could go up to over 4500 in future. The GTF engines themselves involved R&D spending of over $10 billion, and it will take sizeable production volumes to recover this initial investment.
There are also several new challenges ahead. Boeing is working on a new mid-sized airplane (NMA) for which P&W offered to develop an engine conditional upon Boeing selecting it as the sole engine choice. If Boeing chooses a GE or CFM engine instead, P&W would be in trouble. P&W is also working on a GTF engine series for wide-bodied aircraft. P&W will therefore have considerable demand for R&D funds in the coming years. UTC expects the new merged entity to facilitate this cash flow, for which it relied on Carrier and Otis earlier, since P&W’s sales of engines for civilian aircraft are not there yet.
In the merged entity, while much of UTC’s passenger aircraft business will fluctuate with market trends, the mostly military products of Raytheon will deliver steady and substantial cash flows that would come in handy. Observers also expect the merged entity to bid more aggressively for contracts like Boeing does since its military business cross-subsidises its civilian offerings.
President Trump is familiar with this aspect of the aviation business, having had close links with Boeing, and known to have pressured foreign governments to buy their products. Trump was quoted in the US press as saying he was worried about the size of the new company and how difficult it was already getting for the US government to deal with large defence manufacturers. In these dealings, size does matter!
President Trump’s other worry about the effects of the merger on competition may not be that serious. Anti-trust regulators are not likely to feel perturbed since UTC and Raytheon have such diverse products and with minimal business segment overlaps. But other aviation majors will be watching the new Raytheon Technologies closely, for there is a new behemoth on the loose.