Predicting M&A: Rolls Royce Case
by Louis-Jacques Darveau

While boarding an early Lufthansa flight from Cologne to Paris last August, I was given a complimentary copy of the Financial Times with a curious headline: "Rolls-Royce in $1 billion deal to power high-speed ships: Aircraft Engines to Power Transatlantic Freighters."

My curiosity came from my ignorance of boats being powered by aircraft engines. Although I was unaware of this, it sounded like a clever idea. After all, boats are still using a propulsion technology developed in the late 40's. The fact that, finally, some kind of evolution was hitting transatlantic commercial marine transportation caught my attention, especially since it has more capacity than air cargo while being cheaper at the same time.

The deal involved FastShip Inc., a privately owned Philadelphia-based company, and Rolls-Royce Plc., the British aircraft engine maker. The deal, valued at nearly $ billion, would see Rolls-Royce supply FastShip with 25 engines over a period of three years. The article, quoting Rolls-Royce president Sir Ralph Robins, said the deal would "transform transatlantic maritime trade." While I'm not particularly interested in marine propulsion and aircraft engines in general, this deal seemed to be a significant advancement that would affect the growing transportation industry.

A month later, Rolls-Royce announced its acquisition of UK-based Vickers, the marine engineering and defense group for $935.1 million.

A predictable takeover?

The news of the Vickers transaction made me think of the article that I had read a month before and made me wonder if M&As could be anticipated through a careful analysis of the information supplied either through conventional sources such as newspapers or other sources, mainly found on the Internet.

Soon after, the idea of writing the article on M&As and information surfaced and I thought that the Vickers's takeover was a good case study.

Let's make an analysis in retrospect of the situation in the time period between the publishing of the article on the FastShip deal and the later Vickers acquisition.

First Step: analysis of the industry

In Taking the Myth Out of M&As, we wrote that the first step needed to evaluate the possibility of a merger or an acquisition is a careful analysis of the industrial context of the company for which an M&A is anticipated. In the case of Rolls-Royce, the industry outlook showed the following elements:

The aerospace context:

Demand for aircraft engines had been declining in 1999 and forecasts for 2000 showed no real increases in volume, in part because of lower heavy aircraft orders.

Aircraft orders leveled because of a sluggish Asian economy recovery, although the decline in larger aircraft deliveries has been supported by growth in the mid-sized and regional aircraft business.

Consolidation in the aerospace industry could be a threat to engine-makers, by pushing prices down (the recent merger of Dasa and Aerospaciale to create the European Aeronautic, Defense and Space Company (EADS) was the latest example of this trend) in an already price-cutting industry.

Danger of exclusivity deals for certain types of aircraft, exemplified by the deal between Boeing and the aircraft engines branch of General Electric for the exclusive supply of engines for Boeing's new 777 wide-bodied aircraft, especially after the Federal Aviation Administration's decision to allow Boeing Co. 777 jetliners to fly trans-Pacific routes.

Engine-makers such as GE, Pratt & Whitney and Rolls-Royce have always been concerned with the cyclical nature of the aerospace industry and the difficulties of finding appropriate derivatives for their engines.

The marine propulsion systems:

Marine propulsion was part of Rolls-Royce's portfolio way before it acquired Vickers. Although because of a bullish market for aircraft engines that started in the early 90's until the collapse of most Asian economies in the first quarter of 1998, Rolls Royce's marine division supplied only engines to the Royal Navy, until the company found time to concentrate on the commercial aspect of this business last year.

The turbofan marine propulsion business is far less competitive than its parent aerospace application. The industry shows the following elements:

Transatlantic propulsion is a $30 billion industry.

Demand for fast ships is growing by at least 8% annually.

New economic paradigm (outsourcing, partnerships, ventures, reduced inventory investments, need for supply chain management efficiencies and lower logistics costs) means a boost in transoceanic transportation.

Perishable items traditionally transported via air cargo will become transportable through shipliners.

Shipping company UPS has been shy to buy aircraft and preferred renting them in a move some suggest could be to deviate some of its business to fast ships once they are well routed.

Vickers had previously made the acquisition of Norwegian maritime equipment maker Ulstein and was struggling to integrate it, while at the same time facing an ailing defense business unit.

Vickers, following the Ulstein deal, had a share of between 35% and 85% of the marine propulsion market.

The aging marine engines are vastly replaced by turbofans as they take less space and are less damaging to underwater reefs and give a smoother ride than conventional engines.

Second step: analysis of heavy strategic trends

Despite the good prospects of the FastShip deal in late August, many analysts in London were convinced that Rolls-Royce was going nowhere with its decision to diversify in the marine industry. Instead, they unanimously said that it should focus on its core business and increase its presence in the lucrative aircraft after-market services; to better compete with rivals such as General Electric.

But at the same time, CEO Sir Ralph Robins kept saying that what mattered most was to constantly search for new applications for the group's engines. Considering the pressure he had to improve the company's performance on the markets and despite being criticized for caring more about the independence of the company than shareholder value, Sir Ralph showed no sign of abandoning the company's long-term strategy.

Although in that case Rolls Royce did not follow the heavy strategic trends of the industry, it clearly stated the motives of such opposition, thus giving analysts more hints about its future diversification plans and M&A perspectives.

Third step: analysis of the key business drivers

As depicted in the industry analysis, the aircraft engine industry is sometimes being pushed to the limit of price-cutting. Shareholders, nonetheless, seek growth. In an article published September 21st, Sir Ralph said he had promised double-digit growth for the next year (2000), which is consistent with what other CEOs generally look for. This was a further indication that a transaction was imminent: how to achieve double digit growth in an industry afflicted by lower orders and price cuts without a clear growth strategy most probably accompanied by either a merger or an acquisition?

Fourth step: analyzing the mode of growth

Achieving growth - considering the industrial context of Roll- Royce - was not really possible organically. It was unlikely Rolls-Royce would be able to shift from single to double-digit growth in a stalled market within a one-year time frame. The other two possibilities were alliances and M&As. Knowing Rolls-Royce's intentions of having a stronger presence in the marine industry, the tricky part remained identifying whether it would choose to engage in an alliance or an acquisition.

For some reasons related to the company's poor cash flow, we have to admit that an acquisition was a risky bet difficult to predict.

On the other hand - cash flow elements set apart - very few barriers prevented an acquisition that did not add more inconveniences. Since Vickers was the only viable partner with a business already focused on marine propulsion while being at the same time a UK company, there were fewer concerns about information asymmetry, unfeasibility or indigestibility.

Fifth step: analyzing the direction of growth

In the case in point, the analysis of the direction of growth was less difficult in light of the previous FastShip deal. In fact, the determination of the CEO, in spite of some controversy, to revamp Rolls-Royce's marine business was a clear indication that a related diversification was key to Rolls Royce's ambitions at the time.

Nonetheless, it was at least equally justifiable for Rolls-Royce to explore the ways of a horizontal merger with another engine maker such as Pratt & Whitney, with respect to the strategic trends guiding the aerospace industry at the time. Still today, consolidation in the aerospace industry, in light of the existing duopoly in the heavy aircraft market, makes it tempting for Rolls-Royce to join forces against mighty GE to stop the leaking in profit margins created by too much competition. The quest of British Aerospace (now BAE Systems) for a partnership in North America and the 1996 announcement of an alliance between GE and Pratt & Whitney for the engine supply of the A3XX (Airbus's jumbo carrier is still on the drawing boards) could prove necessary for Rolls-Royce to trigger a move, especially since Airbus is Rolls Royce's biggest customer. In any case, and as far as the A3XX is concerned, the alliance between GE and Pratt & Whitney remains theoretical considering that it would cost an estimated $12 billion to put the A3XX in the sky with no clear market for it. Therefore, it should not prevent a Rolls Royce/Pratt & Whitney deal per se.

Consequently, there were clearly two possible directions of growth. An acquisition in the marine sector was the most probable in the short term, given the statements of Rolls-Royce's CEO, its will to preserve the British identity of the company and the strong results arising from an unprecedented boost in aircraft deliveries in 1999. Obviously, the prospect of a downturn in its core business could change the strategy and talks with United Technologies, parent company of Pratt & Whitney or Volvo Aero could soon begin, if they are not already in progress.

Conclusion

The identification of Vickers as the target - even after reaching the conclusion that an acquisition was probable in the circumstances - was very difficult to predict.

In fact, it is almost never possible to tell which company will be selected. We can only say that it made sense to choose Vickers because of its proximity to Rolls-Royce, culturally and geographically. In fact, anybody who would have come to the conclusion that Rolls-Royce was about to enter the marine propulsion market, would have identified Vickers at least as a possible target, thereafter comparing the advantages and inconveniences of choosing the latter or another company.

Despite the distortion that always remain in terms of precise target identification; it always pays to at least make the exercise of trying to figure out the strategic options of a competitor. As far as M&As are concerned, they will always be bound with some uncalculated aspects for even the mostly skilled outsider. Nevertheless, that shouldn't stop them from being pragmatic about it.

For understandable and predictable reasons, Rolls-Royce did put forward a deal in the marine propulsion industry. The second most plausible option is definitely on the drawing boards, now that the industry has shown increasing signs of consolidation. Rolls-Royce will certainly remain a big mover in the near future. It has to.


Louis-Jacques Darveau was called to the Bar of the Province of Quebec in 1997, and became a member of the Banking and Securities Litigation Group with the Law Offices of McCarthy Tétrault in Quebec City for two years. He was recently appointed by Packard Bell NEC Europe to create the Training and Development strategy for all the production sites and sales offices throughout Europe, Asia-Pacific, South Africa and the Middle East.

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This article was originally featured at www.competia.com in October 2001, and is reprinted with permission. Competia Online is a production of Competia Inc.

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