Wednesday, May 18, 2016

Embraer Cries Foul Over Delta C Series Deal, But It May Be More Commercial Than You Think

Embraer may ask the Brazilian government to file a complaint with the World Trade Organization (WTO) over government support for Bombardier (BBD) for its C Series. The impetus is the deal with Delta Air Lines, which ordered 75 CS100 and optioned 30 more.

The government of Quebec, the province in which Bombardier is headquartered, already agreed to invest US$1bn in the C Series, though it still hasn’t been funded. The Canadian federal government has been asked for another US$1bn, but so far the Feds and BBD officials haven’t been able to reach agreement.

BBD says the Quebec money, and, if it ever comes, the federal investment, will comply with WTO rules. This, of course, remains to be seen. The C Series was already the beneficiary of government funding for “launch aid;” Quebec and Northern Ireland (where the wings are made) ponied up about a third of the original estimated development cost, in keeping with WTO caps. Whether the extra $1bn, or $2bn, is compliant is another question.

Did government money affect Delta deal?

The source of the Embraer (EMB) complaint is the Delta deal. Embraer not only lost the prospect of selling new airplanes to Delta, the airline said it would not induct into service 20 used E190s it agreed to purchase from Boeing Capital Corp., which was part of a deal for new 737-900ERs. BCC took the E190s in on trade from Air Canada in connection with a 737 MAX order.

Delta is going to fulfill its contract to buy the used E190s from BCC. It just won’t put them into service. This leaves open to question just what Delta will do with the airplanes: sell them, lease them or dismember them for parts as a piece of its Delta TechOps maintenance, repair and overhaul business for third parties. Regardless, EMB was proud when Delta announced the BCC deal, since it added Delta as an Embraer operator and Delta is…Delta.

The C Series deal squashed the EMB deal. EMB thinks the government aid may have been crucial to winning the deal, perhaps in a way that is non-compliant with WTO rules.

No one except the parties directly involved know the contract price for the C Series. Market intelligence suggests the nominal airplane price may be between $25m and $30m, with it likely at the lower end of this range.

BBD announced a special charge in connection with this transaction, and those with Air Canada and AirBaltic, of US$500m. But this has more to do with unit accounting and learning curves rather than necessarily pricing C Series at a loss.

Other economic considerations

Airplane contract prices are only one element of a deal. There are integration costs of a new fleet type. There are pilot training costs. There are maintenance training costs. These are all areas where the manufacturer can provide credits or discounts.

Then, in the case of Delta, there’s its TechOps profit center. It’s not uncommon for manufacturers to strike deals with MRO subsidiaries to license MRO capabilities to these companies for third party maintenance. Lufthansa Technik, the MRO operation for Air France-KLM and others have so benefitted.

Delta TechOps may well be a party to the C Series deal. BBD and engine maker Pratt & Whitney, which provides the engines for the C Series, could well have stepped up to the party. The overall economics of such a “global” deal may have been more important than any government aid.

But this is all just my speculation, based on a long-held understanding of the dynamics of aircraft/engine transactions.

Cutting the price

That BBD was likely sporty on its contract price with Delta is a safe bet. But our analysis as Leeham Co. concludes that the US$3.2bn program write off last year shaved $5m off the price of the airplane. The cost-cutting Transformation Plan may shave another $2m off costs by the time Delta is ready to take delivery.

Is the government aid to BBD an unfair advantage? I’m not about to go there, trying to decipher the byzantine rules of the WTO. But I doubt this would be the reason BBD won Delta.

(Scott Hamilton - Forbes)

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