RichardAboulafia.com 

:: February 2006 Letter ::

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Dear Fellow Wary Globalizers,

Borders are disappearing in the aerospace industry. But despite globalization, companies on both sides of the Atlantic have serious differences of perception. Consider reactions to the recent Russian decision to merge all aerospace assets into a largely state-owned entity, Unified Aircraft Corporation:

Typical US aerospace company: “Hmmm…central government power grab, planned economy, socialism…sounds risky as hell. Let’s stay away.”

Typical Continental European aerospace company: “Hmmm…central government power grab, planned economy, socialism…what’s not to like?”

The creation of UAC (OAK in Russian) would make Stalin proud and introduces de-privatization and re-nationalization. These exciting concepts are incredibly promising new ideas with the slight caveat that they fly in the face of historical and economic logic and have a legacy of disaster. And when OAK was created, European companies lined up to partner with the reconstituted commies: Airbus announced a $25 billion joint parts/aircraft development venture (its EADS parent finalized a 10% stake in Irkut in December). Safran/Snecma and Thales joined the Russian Regional Jet program as suppliers. Air France-KLM and Lufthansa said they were looking at the RRJ. Most egregiously, Finmeccanica, an otherwise intelligent company, took a 25% stake in the RRJ.

I’ll give EADS/Airbus a pass on all of this. Like Boeing they’re concerned about keeping prices reasonable for Russian titanium, itself targeted for takeover by a state-owned company. Both sides want to influence Aeroflot in any purchase decisions, and make trade barriers to used jets go away. EADS/Airbus is probably making positive noises about Russian industry for political expediency. But European RRJ partners have no such excuses.

Poking fun at Russia’s aerospace sector is easy. There’s a recent history of dismal failure and Value Destroyed (the forgotten doppelganger of Value Added). While the Sukhoi Su-27/30 fighter series is a success, every ex-Soviet commercial program has been a nightmare: An-38, Il-96, Il-114, Tu-204, etc. In a world where goods freely cross borders, no one wanted a second-best plane. As a result the market price of aircraft produced was less than the cost of raw materials, energy, components and labor needed to produce them (these inputs had no cost to the plane builders—they just showed up by magic). The companies behind these planes were systematically destroying value. Has anything changed about Russia’s industry—its technology, its production methods, its funding—that would make the RRJ less disastrous than the others?

Russian companies also have a rich socialist history of market cluelessness. When Mikhail Gorbachev was reforming the old Soviet economy, he toured a farmer’s market in the West. “How do they set prices?” he asked. Well, he was told, the producers bring their goods to market and set prices according to demand, quality of products, and the competition. “Of course,” he laughed, “I know the capitalist party line. But seriously, who’s in charge of setting prices?”

That story may be apocryphal, but it illustrates a mindset. Until recently, none of these companies effectively catered to market demands or faced any real competition. Ironically, whatever they might have learned about the market since the Soviet collapse will quickly be forgotten under OAK’s state ownership. And curiously, the RRJ is the product of Sukhoi, the only ex-Soviet company with no commercial experience whatsoever. If I were cynical, I’d say Sukhoi invented the RRJ as a rationale to dominate any new merged entity. If I were even more cynical, I’d say it was a great way to suck up cash which will then disappear. Thankfully, I’m an incorrigible non-cynic.

Getting back to US/European business culture differences, consider airline reactions to the RRJ:

Typical US airline: “Hmmm…tie our fleet plans to an unknown jet from an unknown provider from a state-run economy with a horrible aviation track record? Let’s shred their proposal into an in-flight breakfast cereal.”

Typical European airline: “Hmmm…tie our fleet plans to an unknown jet from an unknown provider from a state-run economy with a horrible aviation track record? Where do we sign?”

Actually, it’s safe to assume the European airlines are just talking, perhaps to make some EU Government types happy. While it’s easy to poke fun at them, European airlines have left their US counterparts in Chapter 11 dust and are generally well-run enterprises that don’t make dumb purchase decisions. This leaves the Russian market as the sole realistic source of RRJ demand. Good news: state-run economies are more likely to erect trade barriers to imported jets, increasing the appeal of domestic equipment. Bad news: when was the last time any domestic market Russian carrier generated the kind of revenue necessary to buy anything? If the cash were there, the country’s hideous mishmash of Antonovs and Yaks would have been replaced with cheap used Western props long ago.

The RRJ might have made more sense a few years ago when the regional jet market was booming. After all, a rising tide lifts all boats. Even slow, stupid, leaky ones. But last I checked, the small RJ market was imploding, the 70-seat market was coasting, and the 90/110-seat plus-sized market was only tentatively moving forward. The two players were doing well enough, despite Bombardier’s self-inflicted CSeries wound. Is the industry really crying out for a third player?

In conclusion, when it comes to dealing with Russia: trust, but verify, as President Reagan said. I have no idea what that means. But while thinking about that, we’ve updated the Fighter and Special Mission overviews, plus the F-16, 777, A330/350, Challenger 300, and the B-1. Have a good month.

Yours, ‘Til OAK Re-Privatizes,
Richard Aboulafia

 

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