Planemakers Jet Off to Paris Air Show Under Growth Clouds

(Bloomberg Opinion) -- Aircraft manufacturers and suppliers big and small will gather at the Paris Air Show next week to showcase new products and technologies, trumpet orders (both firm, tentative and recycled) and pontificate on the industry.

This year’s event comes amid concerns that the robust commercial aerospace spending cycle that has fueled record backlogs is getting long in the tooth. Passenger traffic grew 4.3% in April, which was an improvement from a notably weak 3.1% expansion in March but off the long-term average of about 5%, according to data from the International Air Transport Association. The common thinking had been that secular changes like the burgeoning middle class in emerging markets and millennials’ preference for travel experiences would support traffic growth beyond that average rate, and that was what happened for a few years. Whether or not the slackening trend of the past two months lasts, commercial air-travel demand will most likely continue to grow in some capacity, Aengus Kelly, CEO of plane-lessor AerCap Holdings NV, said in a phone interview this week. The question is whether Boeing Co. and Airbus SE are already planning to build more planes than the industry will need and whether some customers may soon realize they’ve overpaid for assets or bought plane models that now look less desirable. “We have a view on the value of an asset, so where we see value and price intersect, we will be aggressive,” Kelly said. “You can’t say I’m going to buy growth at any price. If it’s a great sellers’ market, it can’t be a great buyers’ market.”

Profit margins are already showing signs of wobbling at some airlines amid higher costs and competition for fares. That, combined with a slower economic backdrop and the continued grounding of Boeing’s 737 Max jet, may keep a lid on fresh aircraft orders at the Air Show, write Bloomberg Intelligence analysts George Ferguson and Francois Duflot. American Airlines Group Inc. has pulled the Max from its schedule through Sept. 3, but CEO Doug Parker told shareholders at the company’s annual meeting this week that it’s highly likely the plane will be flying by then. That comment might mean more if the company hadn’t also said it was confident the Max would be recertified by Aug. 19, the previous estimate for returning the plane to American’s schedule. A Federal Aviation Administration official was more measured, saying the plane should be back in the air by December. Once the Max re-enters service, the impact on Boeing’s deliveries may linger for a few years, Kelly said. Boeing said this week it booked zero orders in May and delivered 30 planes,down substantially from the same period a year earlier. When asked whether the Max crisis may present an opportunity to negotiate a discount on the Max, Kelly replied “possibly” but said it’s hard to contemplate much of anything to do with the plane until regulators all across the globe deem it safe to fly again.

There’s also the risk that some of Boeing’s other products get caught in the fray. Europe’s aviation regulator said this week that it would assess  commonalities between the 737 Max and the 777X jet that’s meant to enter service in 2020. Airbus, meanwhile, may unveil the A321XLR — a longer-range version of its largest-single aisle jet — at the Air Show in a bid to undercut the business case for a potential Boeing mid-market aircraft, a decision on which has likely been shelved for the time being amid the Max crisis. Airbus is also reportedly considering making the next version of its best-selling A320neo narrow-body jet a hybrid-electric model. The other hot topic at the Air Show will be the implications of the gargantuan merger United Technologies Corp. announced this week with Raytheon Co. The combined company — dubbed Raytheon Technologies Corp. — is set to have $74 billion in sales spanning missiles, commercial jet engines, airplane lavatories and avionics. That United Technologies felt the need to diversify through more exposure to the defense market doesn’t send the strongest vote of confidence that the commercial aviation boom will continue unabated. The combined company’s $8 billion R&D budget will be multiples above peers, and that has to be spooking some rivals, particularly General Electric Co., whose cash-flow challenges may keep it from responding in kind. Some analysts have pointed to Aerojet Rocketdyne Holdings Inc. as a potential next target, while others have debated tie-ups between Airbus and BAE Systems Plc or Safran SA and Thales SA. 

MEET MEGATRON
Only four aerospace and defense deals in the past decade have been bigger than $10 billion, and United Technologies CEO Greg Hayes has played a role in three of them. The all-stock deal with Raytheon will make United Technologies a more legitimate counterweight to Boeing and would seem to give it a better shot at protecting its margins and market share from the planemaker’s squeeze. Some criticized the deal as effectively turning United Technologies into a conglomerate again, just after it announced a three-way split that will make the Carrier building-controls and Otis elevator units stand-alone companies. I disagree; I think this deal fits perfectly within the anti-conglomerate game theory. Sprawling diversity is out, but sheer scale and focused vertical integration is in. The appeal of the deal for Raytheon is less obvious. The company seemingly has the more attractive growth and free cash flow profile, so it seems a bit odd that CEO Thomas Kennedy was the one who reached out to Hayes and then was willing to accept no premium; a minority stake in the combined entity; and the abdication of his title in favor of an executive chairman post. Maybe Raytheon felt it needed the heft of a bigger company to properly invest in priorities like hypersonics and cybersecurity. Or maybe the company was worried about being sidelined with Harris Corp. and L3 Technologies Inc. merging and Northrop Grumman Corp. and Lockheed Martin Corp. striking deals of their own over the past few years. 

Two people not yet on board with this transaction are President Donald Trump and activist investor Bill Ackman. Trump ruminated to CNBC about whether the deal may squelch competition for military contracts, causing shares of both companies to dip even as they insisted there’s little overlap between them and vowed to share about half of the $1 billion-plus in targeted annual cost savings with the Pentagon. Ackman, who built a stake in United Technologies last year and supported its breakup plan, wrote a letter to Hayes lambasting the use of the company’s undervalued stock as a deal currency and deeming Raytheon an “inferior” business. Those strike me as shortsighted critiques. The one thing you can say about this deal is that it’s another big undertaking when United Technologies is already juggling the $30 billion takeover of Rockwell Collins Inc. and a breakup. Execution risk is high, but if management can pull it off, this deal has the potential to be a game-changer.

TARIFF ME, TARIFF ME NOT
Trump’s latest tariff dance with Mexico ended up lasting only about a week. He announced late last Friday that he wouldn’t impose sweeping levies on Mexican goods after the country agreed to do more to address the flow of immigrants across its border into the U.S. The New York Times reported that most of the actions Mexico agreed to take had already been negotiated months earlier, an article that Trump took issue with on Twitter. Later this week, Trump threatened Mexico with “a much tougher phase” if it didn’t deliver a demonstrable drop in migrant traffic. Mexican Foreign Minister Marcelo Ebrard said his country has 45 days to prove it’s following through on its commitments. Those comments raise the prospect of the tariffs going into effect after all at a later date. So while manufacturers have avoided this particular trade headache for now, the uncertainty this latest spat has introduced isn’t going anywhere. On the China front, Trump said he’s personally holding up a trade deal and threatened to put tariffs on $300 billion of goods if the country’s president, Xi Jinping, doesn’t meet with him at the G-20 summit later this month. There are signs that China is girding for a protracted trade war, even with its economy on shakier ground. So the industrial pressure points continue to pile up. Macquarie analyst Sameer Rathod warned this week that Caterpillar Inc. is likely to face a serious drop-off in demand and margin erosion amid a slowdown in China excavator sales. Research firm LMC Automotive sounded the alarm on a “sustained downturn” in the global automotive industry, while Bank of America Merrill Lynch analyst John Murphy said expectations of an improvement in the Chinese market later this year are too optimistic. Of note, a report this week showed U.S. car brands were losing market share in China to German and Japanese models. The data is from the state-backed China Association of Automobile Manufacturers, so take that for what you will.

DEALS, ACTIVISTS AND CORPORATE GOVERNANCE
Roper Technologies Inc. scrapped the sale of its Gatan electron-microscope instruments business to Thermo Fisher Scientific Inc. after running into “challenges” in getting U.K. regulatory approval for the $925 million deal. Roper management previously expressed optimism that they could overcome inquiries from the U.K.’s Competition and Markets Authority, but the asset sale was announced about a year ago, and the two sides may have just run out of hope and patience. While Roper won’t get the $700 million in net proceeds it was anticipating from the divestiture, it will still have plenty of M&A firepower. The company has said it could deploy about $7 billion over the next four years. RBC analyst Deane Dray said that Thermo Fisher was the most logical buyer for the Gatan business and that Roper may struggle to find an alternative suitor willing to pay a similarly high valuation. This underscores why it can be difficult for Roper to divest even those businesses that no longer fit with its current software-driven identity. On the flip side, Dray now estimates Roper’s 2019 earnings per share could be as much as 25 cents higher now that Gatan is likely staying in the fold.

Avis Budget Group Inc. has a better shot of selling a potential merger with Hertz Global Holdings Inc. to U.S. antitrust regulators as ride-hailing services Uber Technologies Inc. and Lyft Inc. take sales away from the traditional car rental market, Macquarie analyst Hamzah Mazari argues in a report this week. Avis’s and Hertz’s market share each shrinks from the low 20% range to high single digits if Lyft and Uber are treated as commercial-travel competitors, he writes. That’s even after making a conservative assumption about the percentage of Uber and Lyft’s vehicle miles that might have otherwise gone to rental companies. That may make regulators more amenable to a deal that would create a stronger challenger to rental giant Enterprise, which itself has 56% of the U.S. car rental market excluding ride-sharing services, Mazari writes, citing conversations with antitrust lawyers. Mazari says he’s not aware of any deal talks and isn’t outright advocating for them, but he notes scale is beneficial in the car rental industry when it comes to IT systems, car procurement and pricing discipline. 

Ferguson Plc, a plumbing-products merchant formerly known as Wolseley, has attracted the attention of sometimes-activist investor Trian Fund Management. The fund, run by Nelson Peltz, has built a 6% stake in Ferguson and says it will push management to correct the stock’s discount to U.S. peers. That’s sparked speculation about whether Trian could seek to press the company to shift its listing to the U.S. from the U.K. Ferguson derives nearly 90% of its revenue from North America, but its position on a U.K. stock exchange may keep it out of the jurisdiction of U.S. fund managers. My Bloomberg Opinion colleague Chris Hughes points out that engineering a U.S. listing is easier said than done and that it may be oversimplifying things to blame all of Ferguson’s discount on its British address. Worries about a slowdown in the U.S. and lackluster margin improvement could also be a factor, he writes.  

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To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

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