Boeing (BA +5.19%) is continuing its push into areas traditionally dominated by its supply base. Though the company's latest move is relatively small in terms of revenue, it seems likely to further enflame tensions, and lead to even more scrambling, between the aerospace giant and some of its key suppliers.
Boeing on June 4 announced a joint venture with French engine maker Safran to build auxiliary power units, small engines used to start the main engines on an aircraft and for supplemental power when the aircraft is on the ground. The current market for APUs is dominated by United Technologies (UTX +2.69%) and Honeywell (HON +0.81%), with UTX the sole provider of APUs on Boeing's 787 models, and Honeywell the sole provider on the 777 and 737.
A Pratt & Whitney PW980 auxiliary power unit. Image source: United Technologies.
Boeing said the joint venture will allow it to lower overall aircraft costs and open a new revenue stream for the company. The company did not say how much money it was investing for its 50% stake in the joint venture, or specify when the business would begin manufacturing APUs.
Elbowing in
The deal continues an increasingly uneasy relationship between Boeing and its key suppliers. Boeing has been pushing to lower components costs in an effort to better compete with arch-rival Airbus for new plane sales. That, in turn, has led to consolidation among suppliers. United Technologies is buying Rockwell Collins in large part to expand its role on key Boeing platforms, in part to gain efficiencies of scale, but also to give it more clout -- and leverage -- when negotiating future supply deals.
Last year, Boeing cast a skeptical eye on the UTX-Rockwell Collins deal, saying it worried the transaction wouldn't benefit airline customers, and threatening to reshop some of the work the combined company does. Boeing officials have repeatedly expressed discomfort with the idea of any of its suppliers becoming too big, which a cynic might say is a sign that United Technologies has the right idea in expanding.
Boeing has made several moves of its own. The company in January announced a joint venture with Adient, the auto parts business spun out of Johnson Controls in 2016, to develop and manufacture seats for commercial aircraft. That would put it in direct competition with Zodiac Aerospace and soon-to-be UTX-owned Rockwell Collins.
In May, it announced plans to buy component distributor KLX for $4.25 billion, bolstering Boeing's services and aftermarket business. Boeing telegraphed its interest in the aftermarket in 2016, when it ended an agreement with former subsidiary Spirit AeroSystems (SPR +0.00%) that had allowed Spirit to make and sell spare parts using Boeing's intellectual property.
Spirit, like UTX, has turned to M&A to broaden its portfolio and counter Boeing's march into new areas.
The big squeeze
Boeing's push into components and spares could have significant ramifications for the supply base, as suppliers have been using higher-margin aftermarket sales to offset the profit pinch airplane manufacturers have been demanding on parts for new jets.
APUs are a relatively small business for both United Technologies and Honeywell -- well less than $1 billion in annual revenue apiece on a total base of $60 billion and $40 billion, respectively -- and given the long runway before the joint venture starts production, Boeing could be more focused on future models like its planned 797 than it is stealing share on existing jets.
But even if the direct risk to the APU business is manageable, the companies are well-aware of the larger threat. Honeywell enjoyed aerospace margin gains last year, with much of that progress thanks to the aftermarket. Chief financial officer Tom Szlosek told Reuters last October that those gains were "not sustainable."
United Technologies, meanwhile, is expecting the addition of Rockwell Collins will support aftermarket sales, but company CFO Akhil Johri on the company's earnings call in April admitted the focus on cost reduction "is never-ending" due to the constant pressures on the business.
This isn't over
Boeing and its largest suppliers are engaged in a high-stakes game, with the suppliers making moves to consolidate in response to Boeing's aggressive march into their businesses and Boeing aggressively marching into new businesses to counter consolidation. There's no reason to believe Boeing's new initiative to make APUs will be its last, and there is likely more consolidation to come among suppliers.
Investors need to be cautious. Much of the bull cases for UTX and Honeywell involve their exposure to the strong demand for Boeing jets that has resulted in a multiyear backlog for the 737 and 787. But if Boeing's expansion continues, and margins come under pressure, the companies might be forced to take further chancy actions. Activist Dan Loeb has positions in both United Technologies and Honeywell and has pushed for a breakup of both, a dramatic and risky option both companies are trying to avoid.
There's a lot to like about the commercial aerospace sector, and to me, both United Technologies and Honeywell remain tempting buys. But investors need to understand the maneuvering going on beneath the surface of one of the strongest aviation up-cycles in history before committing too much cash to these businesses.
More twists to this story are likely.
