Market Overview

28 April 2020

Wounded Boeing Sends the Deal with Embraer into a Tail Spin

The Boeing Co, whose report for Q1 2020 is expected to be published on Wednesday April 29, withdraw from a deal to buy the Brazilian aerospace conglomerate Embraer after two years of hard negotiations. The information became official after the statement by Mark Allen, Boeing's top manager who was appointed in 2018 as a president of Embraer Partnership & Group Operations, a company created specifically for the proposed merger deal. "Over the past several months, we had productive but ultimately unsuccessful negotiations about unsatisfied MTA [Master Transaction Agreement] conditions. We all aimed to resolve those by the initial termination date, but it didn't happen," he said in a statement published on Saturday. Two companies had planned to create a joint venture comprising of Embraer's commercial aviation business.

The American giant has explicitly stated that it does not intend to buy a controlling stake in the world's third-largest aircraft manufacturer as it is not satisfied with the terms of the partnership. Boeing stated in a press release that "Boeing exercised its rights to terminate after Embraer did not satisfy the necessary conditions". The Brazilian Corporation reacted indignantly, accusing its American partners of almost all deadly sins. Embraer representatives are convinced "that Boeing has wrongfully terminated the MTA, that it has manufactured false claims as a pretext to seek to avoid its commitments to close the transaction and pay Embraer the $4.2 billion purchase price. We believe Boeing has engaged in a systematic pattern of delay and repeated violations of the MTA, because of its unwillingness to complete the transaction in light of its own financial condition and 737 MAX and other business and reputational problems".

Initially, both companies agreed to create two joint ventures at once. The first was supposed to be created on the basis of a division of the Brazilian corporation, which is involved in the production and after-sales service of commercial aircrafts. This business was valued at $4.75 billion and under the terms of the deal it was almost entirely to be taken over by Boeing. Its share in this enterprise was estimated at 80% while the Brazilians had only 20%. This arrangement should have been fixed in the management structure of the new company. The Brazilians retained key positions, including chief executive, but would be directly supervised by the head of Boeing. Moreover, the managers of the American Corporation had to take the helm and all the financial flows of the joint company, as well as make the most important operational decisions.

The second joint venture was designated to promote the Embraer KC-390 Millennium military transport aircraft with a payload of about 26 tons, as well as to expand the scope of defence products and services. The exact structure of these transactions was not disclosed by the parties. But some sources cited by Reuters said that Boeing would most likely just pay Embraer about $4 billion in cash, which at the time roughly corresponded to the American airline giant's quarterly net profit. The Americans were to get at their disposal all the most important aircraft manufacturing assets of the Brazilian corporation, its service centres around the world and a ready-made line of three newly released models of regional passenger aircraft of the E-Jet E2 family. Embraer itself would be left with the production of business jets only, which accounts for just under a quarter of the Embraer's total cash flow.

The second joint venture to develop new markets for the C-390 Millennium still exist and probably could go on. But would it remain this way? Brazil's Vice President Hamilton Mourão already announced that Embraer should consider China as a partner in the commercial aviation division after the fail of the strategic partnership agreement with Boeing. "Every dark cloud has a silver lining. Due to the fact that Embraer remains in Brazil, the government retains the Golden share... Embraer has the technology, the know-how in regional aviation. And China is a country that is currently expanding this type of aviation," said Mourão, whose words are quoted by the Tempo newspaper. Mourão also noted that "there is no doubt" that Brazil should "catch the moment and enter into an alliance with China... it is inevitable, we have the product, and they have the demand."

So, what has happened behind closed negotiations curtains. The American concern in mid-March has asked the government for $60 billion of financial assistance to support the entire aerospace industry, including Boeing itself, its suppliers, airline customers and airport infrastructure, all of which was in a difficult position during the coronavirus crisis. In the end Boeing has managed to allocate only $17 billion, and it can be assumed that the purchase of Embraer just became irrelevant for Boeing due to the actual absence of extra money. Even the conditions for receiving the above amounts of government aid as part of a large government package for all businesses are still in question, as Boeing management has balked at terms that could give the government an equity stake in the aerospace giant. US Treasury secretary Steven Mnuchin said at the end of March that Boeing is refusing to use federal money reserved for its assistance.

Boeing's problems began long before the virus appeared. After two accidents with the Boeing 737 MAX Airliners and the complete halt of operation and production of these aircrafts, Boeing was on the verge of financial collapse. Its direct and indirect losses have already exceeded $20 billion and continued to grow rapidly. Airlines around the world have already cancelled about 500 orders for these aircrafts and filed multibillion-Dollar lawsuits demanding compensation for the damage suffered. By the end of last year market experts in a Reuters poll believed that due to the history with the 737 MAX aircraft, Boeing may lose up to $30 or even $35 billion, but that it will be able to gradually restore its solvency and get out of the crisis by the end of 2020. Later it became clear that this will not happen due to the COVID-19 virus pandemic. Moreover, not only the Boeing 737 MAX program fell under threat, but also the continued existence of the American aviation giant in its current form.

Since mid-February and in just five weeks, Boeing's shares have fallen from $340 to $95. US President Donald Trump clearly said that he would not allow such an important giant company as Boeing to go out of business. He made assurances that the Federal government would provide moderate financial support to Boeing. Thanks to these words and subsequent information about the allocation of financial assistance from the government in just four days by the end of March, the company's capitalisation recovered as its share prices jumped to more than $185 per share. But, obviously, many market participants considered the assistance as insufficient, and the company's financial situation is still difficult, so the share price again slipped into the range of $120 to $150 per share. As of yesterday's close, Boeing was trading at $128.68.

At the end of last week Boeing announced that it will lay off about ten % of all its employees engaged in the production of civil aircrafts. Moreover, the aerospace giant will reduce the rate of production of wide-body Airliners Boeing 787 to 10 units per month and the fate of a new mainline aircraft NMA (New Midsize Airplane), which was supposed to replace the outdated Boeing 767 in airline fleets, is still indefinite.

The supply on the global aircraft market will steadily exceed demand for at least five years, according to many expert polls. Therefore, the price of new airliners may decrease by almost 25%. Paying billions of Dollars for a controlling stake in a stagnant business under these circumstances may be suicidal for Boeing. Moreover, the American giant has already had a negative experience in the production of regional jet aircrafts. After the purchase of McDonnell Douglas Corporation Boeing produced the MD-95 airliner for a while (later renamed the Boeing 717). For eight years, Corporation managed only managed to sell about 160 such aircrafts and Boeing 717 model had to be withdrawn from production. Boeing no longer wants to repeat this experience.

Boeing Co chief executive David Calhoun expects a slow recovery in the global aviation industry. He outlined the sad prospects for world aviation, speaking at the annual meeting of shareholders on Monday. He does not expect the return of air travel volumes to the level of 2019 within two to three years, according to the Wall Street Journal. In his opinion, the revenue of global airlines this year is likely to fall by $314 billion. The airlines are "grounding fleets, deferring airplane orders, postponing acceptance of completed orders, and slowing down or stopping payments," he said. Even when the situation will stabilise, he added, "the commercial market will be smaller, and our customers' needs will be different." The Boeing chief executive, who just assumed the role in January after more than a decade on Boeing's board of directors, says the company will need to borrow more money over the next six months to stay afloat and keep paying suppliers.

In the United States, more than 2,800 aircraft are grounded, and the worldwide demand for air travel has fallen by 95% compared to last year, according to the International Air Transport Association. Most of Boeing's plants have now reopened after pandemic shutdowns, but production cuts are likely as airlines no longer need the new planes they've ordered. Job cuts could be coming too. Further plans to reduce employees could be outlined by the management of the company on Wednesday when Boeing releases its first quarter earnings. In this regard, the resumption of production may be purely an image move to maintain a rather positive view of the markets on Boeing right now. Earnings per share (EPS) for the Q4 2019 were negative and amounted to -$2.33. As for Wednesday's report, the average forecast of experts suggests EPS of -$1.36, but the reality maybe worse, and in this case the market "big short" game with Boeing has a chance to be continued.


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