Aerospace suppliers Woodward (WWD -0.84%) and Hexcel (HXL -0.27%) are teaming up in a $6.4 billion combination premised on the belief that the two companies combined can operate more efficiently and devote more resources to next-generation materials, which will allow for greater fuel efficiency and better performance.
But the deal is also a reaction to what's been a difficult period for the commercial-aerospace supply chain, which has been squeezed by customers and is now under pressure due to the continued grounding of Boeing's 737 MAX. Investors buying into the promise the deal creates should be mindful of the pressures that are sparking this round of consolidation and a major reshaping of the aerospace and defense supply chain.
A near merger of equals
Announced on Sunday night, the deal calls for Hexcel shareholders to receive 0.625 shares of Woodward common stock for each share held. Post-deal, current Woodward holders would own about 55% of the combination, with Hexcel CEO Nick Stanage set to be chief executive and current Woodward CEO Tom Gendron to serve as executive chairman for at least one year. The new board will consist of five nominees from each company.
The companies said they expect the new Woodward Hexcel to generate about $1 billion in free cash flow in 2021, ahead of current analyst expectations for about $750 million to $800 million in free cash flow from the two independent businesses. The companies expect to repurchase about $1.5 billion worth of shares within 18 months of the deal's closing and generate about $125 million in annual cost savings within two years of merging.
Post deal, the combination would generate about 83% of revenue from selling components for new equipment and about 17% from aftermarket, or spare parts, sales.
Woodward specializes in components relating to power, motion, and control, including thrust reverser systems on the 737 MAX and cockpit systems and actuators for a range of military and commercial aircraft. Hexcel, meanwhile, is known for its composite materials, which offer the strength of traditional metals without the weight to drive better fuel economy. Together, the companies are at the forefront of providing reduced emissions and reduced noise, two characteristics Boeing and archrival Airbus are focused on, due to demands from their airline customers.
Woodward currently gets about 15% of total revenue from Boeing, its single largest customer. Hexcel's largest customer is Airbus, but generates about 25% of sales from Boeing.
Future promise and current pressure
The two companies, when talking about the rationale of the deal, highlighted the work each is doing on sustainability and making planes more efficient, with Woodward focused on control systems and Hexcel advancing lightweight materials. The combined Woodward Hexcel expects to spend about $250 million annually on research and development (R&D), giving it more resources to develop new products quickly.
"The future of flight and energy efficiency will be defined by next-generation platforms delivering lower cost of ownership, reduced emissions, and enhanced safety -- and a combined Hexcel and Woodward will be at the forefront of this evolution," Stanage said in a statement. "Through our combined scale and strong cash flow profile, we will be even better positioned to accelerate innovation in aerodynamics and propulsion efficiencies and support evolving customer needs."
But there are a lot of current-day pressures driving consolidation. Both Woodward and Hexcel are exposed to the 737 MAX. Last year, Woodward warned that the plane's continued issues would cut into sales growth. By buying Hexcel, with its greater exposure to Airbus, the company is positioning itself to benefit if Boeing faces long-term ramifications from the grounding.
Even before the 737 MAX issues, there was growing pressure on the aerospace supply chain. In recent years, Boeing has been moving to insource more components, and suppliers have complained for years that both Boeing and Airbus have been squeezing them for lower costs as part of the plane manufacturers' campaigns to discount inventory and win new orders.
Pressure from Boeing and the need for scale were among the reasons cited for United Technologies' (UTX) pending deal to merge its aerospace business with Raytheon, as well as UTX's prior $23 billion purchase of Rockwell Collins. And Spirit AeroSystems, a one-time Boeing subsidiary, has spent more than $1.6 billion on acquisitions in the last few years to try to diversify its revenue base.
Don't rush in
The rationale behind this deal made sense, even before the 737 MAX issues, but the current state of Boeing's narrowbody jet likely added to the urgency to get a deal done. The new Woodward Hexcel will have the heft to avoid being pushed around by Boeing and Airbus, as the plane makers look to cut their production costs and the capital needed to invest in future technologies.
But for all of its promise, a deal of this size can be tricky to integrate successfully. There's minimal overlap between the two portfolios, reducing the opportunity for cost cutting, and the lack of visibility surrounding the 737 MAX remains a concern. Even with Boeing's problems, commercial aerospace remains in one of the longest sustained sales cycles in history, and a potential economic slowdown could slow the pace of new plane orders and eat into the merger-partners' growth plans.
The new Woodward Hexcel will begin life later this year with a lot to prove. Investors would be wise to tread carefully while the companies work out the kinks and attempt to demonstrate the combination is living up to its potential.