Talk to anyone in the commercial jet engine business and they will tell you that in the past two decades Pratt & Whitney has suffered a disaster.
It started with Pratt’s fateful choice in the early 1980s not to develop a new engine for the Boeing 737, which went on to become the world’s best-selling aircraft. It grew worse with each failed effort to curb the growth of General Electric and Rolls-Royce. And it culminated in Pratt’s humbling decision last week to make spare parts for the GE/Snecma engine that powers the 737.
Along the way, Pratt has gone from industry leader, with a 40 per cent market share of new aircraft engines, to also-ran, with under 10 per cent. As blunders in industrial strategy go, Pratt’s shunning of the 737 ranks with IBM’s decision in 1980 to let Microsoft make (and retain the rights to) the operating software for its new line of personal computers.
Like IBM, Pratt had no idea how pivotal the decision would be. It made the engine for the first two models of the 737, which sold poorly. So, when it was asked by Boeing to invest in developing a quieter, bigger engine to replace its cigar-shaped early model, it refused. It decided instead to spend its money on developing an engine for the newer Boeing 757.
Oops. That left the way open for GE to work with Snecma on re-purposing a military engine for the new 737. US airlines needed a single-aisle aircraft to fly hub-and-spoke patterns and Southwest Airlines became the first of many low-cost airlines to adopt the 737. Boeing produced its 5,000th 737 last week and each one since 1982 has carried GE/Snecma engines.
Yet, from the stock market’s perspective, Pratt is not in bad shape. It is still a leading supplier of engines for both military aircraft and small business jets. It has limited the sums it has to spend on developing new commercial engines by entering alliances with both Rolls-Royce and GE. Its alliance with Rolls-Royce makes engines for the A320, the Airbus rival to the 737.
And it has kept its cool. Two years ago Boeing asked GE, Pratt and Rolls-Royce to compete to put engines on its new 787. They would not only fund the $1.5bn cost of a new engine but bear a share of the 787 development budget. Rolls-Royce and GE both paid up but George David, chairman and chief executive of Pratt’s parent company United Technologies, walked away when he was given the whopping bill.
The industry’s curious economics have also worked in Pratt’s favour. Making jet engines for commercial aircraft involves one of the longest cycles of all businesses. Aircraft tend to last at least 30 years: the 737 was launched in 1968 and Boeing is not likely to come up with a successor before 2015. It can take more than a decade to get back the development costs of an engine from selling it to airlines.
Manufacturers sell their engines cheaply and try to get contracts to service them and supply spare parts: these activities now comprise 60 per cent of revenues. This front-loading of costs and back-loading of revenues means that a company such as Pratt, which has many of its engines on old aircraft but which avoids investing too much in new ones, can live very profitably off past glories.
This is fine with most investors. When Pratt did not get a place on the 787, UTC’s shares rose. Shareholders liked the idea that it had avoided a bill for billions of dollars, just as investors in Rolls-Royce became impatient in the 1990s as the company invested heavily in its Trent engines. Only now, as revenues from services and sales come through, have its shares been performing well.
The problem, of course, is that you can only pull off this trick for so long. After a couple of decades, your installed base shrinks as older aircraft that carry your engines get replaced by new ones with others’ engines. That is where Pratt now finds itself. As airlines recover from the downturn that followed September 11 2001, they have ordered many new aircraft, and particularly new 737s.
So, there are two ways to view Pratt’s decision to make parts for 737 engines. One is that it is finally waving the white flag and turning itself into a servicing and spare parts business. Some small companies make spare parts but no original equipment manufacturer has broken ranks before.
On the face of it, there is some logic to making a push into the high-
margin parts business. But it only goes so far. The model of engine for which Pratt will re-engineer parts is old enough not to be covered by many patents. These days, manufacturers are more zealous about protecting their intellectual property as well as getting exclusive long-term servicing and spare parts deals with airlines. If they were not, they would not be able to justify developing new engines.
The other interpretation – the one that Pratt endorses – is that it is building up links with airlines so that it will be in the best position to get its own engine on the aircraft that will replace the 737 and A320. It is preparing for a historic chance to atone for its past mistake. If so, UTC will eventually have to risk its stock market reputation by investing billions in new engines.
As Rolls-Royce has shown, that can pay off even if institutional investors get worried by the size of the bill. The cycle of the jet engine industry is so long that it is beyond the ken of most institutional investors, never mind hedge funds. But failing to invest will eventually catch up with you, even if it takes a long, long time. Pratt has been patient, dogged and disciplined in these bleak decades; one day, it will have to be brave.
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