Regional jets have long been the small end of the airliner market. Now the sector is getting taken over by the schoolyard heavies.

Embraer and Boeing announced their intent Thursday to establish a joint venture, with Boeing agreeing to pay $3.88 billion in cash for an 80% stake in the Brazilian company’s commercial aircraft business. Embraer may have had little choice but to embrace the U.S. giant after rival Bombardier agreed to give Airbus a 50.01% stake in the Canadian company’s C Series program in a deal that closed July 1.

“Airbus doesn’t negotiate with suppliers – they put thumbscrews on them,” says analyst Richard Aboulafia of the Teal Group. For Embraer, which has blazed a remarkable path as the only successful new entrant in the commercial jet market in the last 60 years, “finding an ally with equal if not more fierce supply chain management methods was crucial.”

 

 

Embraer was also facing a strategic dilemma, says Kevin Michaels of the consultancy AeroDynamic Advisory. The company has launched its E2 line of regional jets, it’s built out a solid business jet portfolio, and the military transport it’s developed, the KC-390, will debut by the end of the year.

“They’ve built three legs to a stool, very successfully. What’s next?” asks Michaels. “How do you keep your engineering core warm?”

With the aviation industry coming to the end of an era of heavy development of new models and re-engined ones, no-brainer near-term projects are scarce, as evinced by Boeing’s agonizing over its yet to be officially announced New Middle-Market Aircraft (NMA).

 

Boeing could put Embraer engineers to work on structural elements of the NMA like the fuselage or empennage, says Michaels.

For suppliers, Bombardier and Embraer’s tie-ups with the big two in the aircraft industry promise to further erode margins at a time when both the heavyweights have been squeezing them for cost savings, and Boeing has ramped up in-house parts production. Regional jets only account for about 5% of the OEM aircraft market, but Bombardier and Embraer have taken more of a partnership approach with suppliers, who they’ve depended on to fund more of the development cost on their aircraft, with more financial upside. For suppliers, says Michaels, the dynamic has been, “I’m getting beat up by Boeing and Airbus, but at least I’ve got Embraer and Bombardier. That’s going to shift over time.”

Boeing forecasts the JV will generate $150 million in annual savings by the third year.

Potential losers from the Embraer-Boeing deal include United Technologies, which is making the engines, auxiliary power unit and other electrical systems for the E2, as well as wheels and brakes, and avionics supplier Honeywell.

Will Airbus and Boeing’s leverage make regional jets a better business? “Historically 100- to 120-seat jets have been a backwater,” says Aboulafia, in large part due to their relatively higher costs. “We’re about to test the thesis that they would be more competitive to produce with more aggressive supply chain management.”

Boeing’s sales force may be able to drive more sales of Embraer planes, and its full coffers may provide more runway for the E2 as the JV works to change U.S. pilots contracts' “scope clause” provisions that bar use of the E175-E2 by major airlines' regional partners. However, Michaels doesn’t think the deal does anything for Boeing to counter the threat that Airbus could decide to produce an extended version of the C Series with 160 to 189 seats, which could siphon off sales from Boeing’s top-selling 737 MAX.

The E2, while boasting new wings and United Technologies' fuel-efficient Pratt & Whitney geared turbofan engines, is a refresh of an old platform, and it’s unlikely that Boeing could stretch the longest member of the E2 line, the E195.

But Boeing could use the Embraer planes as the basis for a fresh round of trade complaints to stymie the C Series in the U.S., says defense analyst Loren Thompson of the Lexington Institute. Boeing had petitioned for U.S. duties on C Series sales after Delta placed a breakthrough order for 75 of the jets in 2016, claiming that the plane’s development had been subsidized by the Canadian and U.K. governments. However in February, the U.S. International Trade Commission voted against penalties, ruling that Boeing didn’t have a competing product and wasn’t harmed. After the Embraer JV deal closes – the companies foresee that occurring by late 2019 – and there is head-to-head competition for orders from a U.S. carrier, expect Boeing to go back to the ITC, Thompson says.

One key attractant for Boeing is Embraer’s strength in aftermarket services, an area where Boeing aims to expand its annual revenue almost threefold to $50 billion.

About 60% of Embraer’s E jet customers are signed to Embraer maintenance programs, and the company is aiming for 80% penetration with the E2. “Boeing has a lot to learn,” says Michaels.

And Boeing is also taking a jab at rival Lockheed Martin in a market it was no longer competing in, striking a separate JV to market Embraer’s KC-390, which could steal sales from Lockheed’s C-130 Hercules.

There are substantial risks for Boeing in striking a deal on foreign turf. Politics and nationalist sentiment over a homegrown industrial champion could swing against Boeing, preventing the deal's close, or unraveling it years after.

There’s also the risk that Boeing could kill what makes Embraer unique, including a more creative, risk-taking culture than Boeing’s.

It’s a story we’ve seen in many industries, says Aboulafia: Big guy admires small guy for having low overhead and high agility. Big guy buys small guy, thereby giving them less agility and high overhead.

“The history of large aircraft companies learning from other smaller aircraft companies, that’s unblemished by success,” Aboulafia says.

But for Embraer and Bombardier, there may not have been much choice but to join up with the big guys.

“Giving up control is going to be worthwhile and was probably necessary,” he says. “The risk of not doing it was to get marginalized even more.”