June 2018 Letter

Dear Fellow Critical Mass Critics,

Regards from Nova Scotia, a green, eco-friendly paradise offering tasty lobsters, quirky wine, and lovely hiking. Incongruously, it once thrived as an industrial center. Nova Scotia factories built cars, machine tools, and ships. The province was even served by an extensive railroad network, moving raw materials and bringing industrial products to market.

It’s all gone now, of course, leaving behind scallop fisheries and artisanal cheesemakers. The railways are now delightful multi-use trails. Countless similar industrial hubs and rail networks were victims of a relentless drive towards critical mass. One reason: Capital demands ever-greater returns through scale, seeking a higher ratio of revenue to fixed costs. Another reason: larger businesses have more leverage over their suppliers, thereby lowering costs and making themselves more competitive. That’s why there’s a handful of major players in most industries. And the aerospace world is now taking yet another big step towards gigantism. Farnborough 2018 is at the center of this step change, with big developments at Bombardier and Embraer.

The process began years ago. The regional airline business imploded for numerous structural reasons, many also related to the drive towards gigantism. In 1989, regional aircraft (sub-90 seats) were 10.4% of the total civil transport market by value; last year, they were 4.5%. Reacting to this implosion, the two dominant regional primes developed larger jets that could compete in mainline turf – Embraer played it safe with the E-Jets, while Bombardier nearly bankrupted itself with the CSeries.

Yet with these new jets, they quickly found that their products were being compared with Airbus and Boeing single aisle jet costs, and that it was very hard to compete. The two big guys kept reducing their prices, in real terms, as they scaled up. Airbus and Boeing are now headed to about 60 single aisles per month, and perhaps beyond. Embraer and Bombardier’s large jet businesses have been shrinking in relative terms as Airbus and Boeing ramp up, since so far they can merely dream of building ten CSeries or E-2s per month. The deals they get from their suppliers reflect this reality. Their overhead, relative to their output, is another problem.

Due to crushing development costs and the company’s withering balance sheet (and possibly pushed over the line by the ill-advised US/Boeing trade complaint), Bombardier cracked first. In October 2017 they ceded control of the CSeries to Airbus, creating the CSeries Aircraft Limited Partnership (CSALP). On July 1st, this partnership (acquisition, really) was finalized, giving Airbus a new jet family to sell, and, in a few years, rights to buy the entire program.

CSALP meant that Embraer was no longer directly competing with a niche company. The E-2 was now up against Airbus, a global monster. It also meant that the CSeries now had its development costs effectively written off (thank you Canadian taxpayers and Bombardier investors!). That pushed Embraer into Boeing’s arms, with details of the E-Jet JV between the two companies made public on July 5th. When approved by the Brazilian government (which has a word for mañana, but without the urgency), this JV will give Boeing a new jet family to sell, and control over its supply chain and aftermarket.

This means suppliers will now deal with exactly two jetliner primes. Until recently, suppliers faced Airbus and Boeing, with their Partnering for Success, SCOPE +, No Fly Lists, 120-Day Payment Terms, and Thumbscrews, but at least they also had Bombardier and Embraer. Those two smaller guys simply didn’t have the muscle, and suppliers enjoyed better terms and higher profits. Of course, the resulting high supplier costs made E-Jets and the CSeries more expensive, and less competitive and/or profitable.

This transition to just two primes means suppliers now have more reason than ever to consolidate. They need to scale up, partly to push back against Airbus and Boeing’s terms, and partly to gain the economies of scale needed to survive those Airbus and Boeing terms. The record-breaking United Technologies/Rockwell Collins/BE Aerospace double merger is taking place with all of this in the background. At Farnborough, expect to hear lots more supplier consolidation and merger talk.

The biggest supplier development, however, has always been desirable yet unlikely. Transatlantic politics greatly complicate an otherwise inevitable Pratt & Whitney/Rolls-Royce tie-up. That won’t change soon, but then who can say what will happen after Brexit?

There are many other consequences of the Airbus/Bombardier and Boeing/Embraer developments. For one, we’re going to see an interesting experiment. Historically, 100/130 seats jets have been expensive on a per-seat basis compared with larger jets. Now that both the CSeries and Embraer’s E-Jets will be built with Airbus and Boeing’s aggressive supply chain management and massive corporate power, that may well stimulate 100/130-seat market as prices fall. For passengers, that’s good news – more point-to-point flights, and greater flight frequency. We may see a flurry of CSeries (or, rather, A210/A230) orders at Farnborough. It may take years for supplier contracts to be re-negotiated, but sales prices will drop quicker with the expectation of lower costs in the future.

Another consequence: market barriers are going to get higher. It’s always been somewhat paradoxical: as the market gets bigger, entry barriers get higher too, because the incumbents are scaling up. And now, with these latest changes, the incumbent primes are getting bigger still. Imagine, for example, being Mitsubishi or Comac. It’s one thing to enter a market defended by Bombardier and Embraer. It’s quite another thing to enter a market defended by Airbus and Boeing, with their massive scale and supplier management power. It might resemble a Nova Scotia car company going after GM.

If you want to know more about Nova Scotia’s Industrial Heritage, I recommend David Rollinson’s book of exactly that title. If you like trains – and all good people do – you’ll love the Halifax & Southwestern Railway Museum in Lunenburg. Let me know if you need restaurant recommendations. Happy belated July 4th and Canada Day to all.

Yours, ‘Til Farnborough 2030 Consists Of Airbus, Boeing, and Two Mega-Supplier Chalets,
Richard Aboulafia