Boeing (NYSE: BA) has launched a new program to help its suppliers -- in return for a little favor from them. The aerospace giant's offering to work closely with the companies that supply parts for its military and commercial aircraft, helping them redesign their supply chains and improve their productivity. But in exchange, those suppliers will have to charge Boeing less when they renew their contracts. Let's see how this program might affect two of Boeing's most prominent suppliers, Spirit AeroSystems (NYSE: SPR) and TransDigm (NYSE: TDG).
Everything is relative
One easy way of assessing the impact of Boeing's "Partnering for Success" program on a supplier is to find out how much of its revenues come from Boeing. Boeing accounted for 84% and 13% of the fiscal 2012 sales for Spirit AeroSystems and TransDigm, respectively. However, it would be misleading to simply conclude that Spirit AeroSystems will suffer more from Boeing's new initiatives than TransDigm. There are other factors at play here.
About three-quarters of TransDigm's revenues are generated from products, for which it is the sole supplier to its customers. In Spirit AeroSystems' case, it is the only supplier for almost all of the products it supplies to Boeing. Moreover, Spirit AeroSystems' supply agreements with Boeing are typically long-term, lasting for the full length of the aircraft programs. As a result, both TransDigm and Spirit AeroSystems have sufficient bargaining power to resist any unreasonable price reductions, since Boeing may have trouble finding alternative suppliers.
It's tough to switch
Building aircraft isn't child's play; there are thousands of lives at stake with each flight. Aircraft manufacturers like Boeing take a long time to carry out testing and certification for new suppliers, to ensure that the high quality and safety standards are upheld.
Assuming that Boeing is willing to go through this laborious process of qualifying new suppliers, potential rival suppliers still may not be willing to enter certain product segments which incumbents like Spirit AeroSystems and TransDigm already dominate. The huge capital investment required is a natural barrier to entry.
For example, Spirit AeroSystems claims that it will cost $5.8 billion to replace or duplicate all the buildings and equipment that it owns or operates. This is definitely not small change for any new entrant.
There are also other factors specific to the two suppliers that make it so difficult for Boeing to turn to alternative suppliers.
TransDigm's niche aerospace parts tend to make up a relatively small part of the total cost of a plane, which suggest that Boeing should look elsewhere to really bring down its costs. In general, customers are more price-sensitive when a particular product makes up a big proportion of their budgets. It looks like Boeing has indeed given TransDigm greater leeway in its pricing, allowing it to deliver consistent gross margins exceeding 50% since its IPO in 2006.
Business isn't just about hard numbers, either; relationships play a big part in deciding who gets what. Spirit AeroSystems was started in 2005, after Canadian private equity firm Onex purchased what was once Boeing's "in-house" manufacturing facilities for fuselage, propulsion and wing systems. Many members of Spirit AeroSystems' management team are former Boeing employees. Current CEO Jeffrey Turner used to be General Manager of the Boeing Wichita Division, and worked there for more than three decades. It will be almost impossible for another supplier to build such deep relationships with Boeing.
The view from Boeing
Boeing managed to expand its operating margins for the Commercial Airplanes segment by 210 basis points in the third quarter of fiscal 2013, which could be attributed to higher delivery volume and productivity gains. In a response to an analyst query about the "Partnering for Success" program at the results conference call, CEO James McNerney said that tactics such as sourcing in-house or switching suppliers will be less important if suppliers believe in what Boeing's objective of driving the highest margins for both itself and its suppliers. But he did add that "those tactics are available to us."
I don't doubt that many suppliers could potentially improve their cost structure by working with Boeing. However, it never hurts to have a few extra bargaining chips when come to the negotiating table with this aerospace giant.
I'm not claiming that Boeing's "Partnering for Success" program won't affect suppliers at all. There's no denying that Boeing's scale gives it tremendous bargaining power. However, each supplier will be affected to a different extent, depending on a variety of factors which I have touched on above.
In my opinion, Spirit AeroSystems and TransDigm are less likely to be affected. It's too expensive for Boeing to switch to other suppliers, and too difficult for those potential suppliers to enter the market in the first place.
Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Spirit AeroSystems Holdings and TransDigm Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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