Developed countries may be opening their economies and loosening social-distancing restrictions, but for aerospace and defense suppliers, the debate is about how much worse things will get.
The dichotomy is spurred by falling demand for aviation-centered manufacturing that will only lessen further in coming years, while supply will see new challenges after COVID-19. But yet to come are decisions on how supply chains get refashioned after cuts of 30-50%—or more—in monthly production rates of large commercial aircraft, the core growth driver for the entire A&D industry.
Aircraft giants Airbus and Boeing and Tier 1 suppliers are contemplating such decisions now, several industry insiders tell Aviation Week. Actions could start emerging by the third or fourth quarters.
- Suppliers await more guidance but are likely still too optimistic
- As many as 20% of lower tier suppliers could exit A&D in consolidation wave
“There are a lot of big questions because first the OEMs need to decide what they want to do next with their coalitions of suppliers,” says Eric Bernardini, AlixPartners managing director and co-head of the consultancy’s global A&D and aviation practice. “I don’t think they have officially answered that question.”
Suppliers are girding for more bad news. In June, Airbus is expected to update its midterm production plans for its narrowbodies and widebodies. While Boeing has not scheduled an update of its own specifically, analysts and advisers widely expect both leading aircraft OEMs to outline further cuts to monthly rates as airline and lessor demand withered starting in March.
At the same time, smaller manufacturers are shelving new projects such as the Mitsubishi SpaceJet regional aircraft. Even the Lockheed Martin F-35, perhaps the single most protected aircraft program currently, will see 18-24 fewer deliveries this year due to the novel coronavirus crisis.
By late May, suppliers still had more questions than answers, according to what executives told Wall Street analysts in first-quarter teleconferences. For many, April program cutbacks announced by Airbus and Boeing had yet to be translated into purchase orders and other guidance for suppliers.
“Everybody is trying to show a good face because, first of all, the first quarter only had barely two weeks or three weeks of impact of the crisis,” says Bernardini. That almost certainly will change by July when second-quarter financial results start being revealed, either fully or in advance warnings to investors. “I suspect that when the second-quarter numbers come up in the next earnings calls, there will be a different conversation when they show and share the damage—first in their top line, and second, of course, on their supplier base.”
As many as a fifth of lower-tier A&D suppliers could exit the sector over the next 18 months, seasoned supply chain experts tell Aviation Week. Some will go out of business, choose to merge into others, or just walk away from A&D for other industries.
“Either through consolidation or attrition you’re probably going to see a number closer to 20%,” says Chris Celtruda, a senior executive at the newly merged Aero Precision and Kellstrom Defense and a longtime partner to private equity investors. “The stress levels, the liquidity challenges grow the deeper you go in the supply base.”
He cites the 2013 federal sequestration as an example, when there was a similar, sudden softening of long-term business plans and 10-15% of smaller suppliers exited the business in the aftermath. But this downturn is worse. “I don’t think we’ll see a snapback. I think we’ll see something similar to after 9/11,” after which it took five years for airlines to get back to precrisis capacity levels.
Tier 1s and OEMs will provide financial lifelines to certain Tier 2-4 providers, especially those with intellectual property and who are critical parts providers. But many insiders expect bankruptcies and asset sales, such as inventory or manufacturing capability, while others may elect to go into other markets completely. One larger consultancy to large A&D clients says there is 30-50% extra capacity in the industrial base for the longer term.
That sober outlook is shared by Kevin Michaels, managing director of AeroDynamic Advisory and an Aviation Week guest columnist. “We’re especially concerned about the Tier 2, 3 and 4 suppliers,” he says. “Suppliers have really faced this whole litany of events that have happened. We had the supply chain squeeze from the Partnership for Success 1.0 and 2.0, Scope-plus at Airbus. Then suppliers were asked to deploy capex for a massive ramp-up in single-aisles. Then we had the [Boeing 737] MAX shutdown, and now we have the COVID-19 crisis. All of this has significantly weakened the supply chain.”
Half of the defense supply chain is seeing cash concerns, Celtruda and Michaels say. There was “massive” idling of Northeast U.S. suppliers, home to engine-making ecosystems, and also in Washington state, Wichita, Dallas-Fort Worth, Arizona and California hubs.
Celtruda and Michaels stress it is not only a commercial aerospace issue, but also a growing challenge to the defense industrial base, as evidenced by recent Pentagon concerns and the Joint Strike Fighter production rollback. Jefferies analysts estimate the Defense Department has pushed $3 billion worth of accelerated payments into the supply chain. Defense officials acknowledge they have learned much more in recent months how the defense industrial base is dependent on the commercial market.
That was not always the case. As Tom Mayor, a KPMG partner and industrial manufacturing strategy practice leader, puts it, around the start of the Vietnam War, the U.S. industry saw roughly equal work on the commercial and defense sides. But since then it has changed to 70-80% in favor of commercial. With the latter suddenly flagging for the next 3-5 years due to the pandemic, the whole industrial foundation will be rocked.
Who is more at risk? Several commenters list aerostructures first, as the segment was fragmented and suffered lower pretax profit margins before the crisis. Maintenance, repair and overhaul and parts suppliers to large civil aircraft also are listed, especially for widebodies and older airliners likely to be favored for retirement. Several publicly traded suppliers are exposed to varying degrees (see chart).
Boeing and its suppliers are seen as more vulnerable than Airbus and its ecosystem, both because MAX production is practically null and because there are around 800 inventoried 737s to be delivered, in addition to customers’ own parked aircraft. Besides reduced passenger demand subduing aircraft needs, lessors eager to rent out their own increased inventory will compete with new deliveries and orders.
“The long backlog does provide some certainty, but we expect a significant amount of cancellations and deferrals to be the story of 2020,” says the Jefferies analyst team led by Sheila Kahyaoglu.
Bernardini has a similar view. “Some of our customers in the airline industry, they don’t want to spend $1 on a new delivery,” he says.
Kahyaoglu’s team forecasts annual deliveries will be “relatively flat” from 2019 through 2023 as deliveries recover following an expected 30% decline this year. Narrowbody deliveries are expected to fall 16% this year, with the return to MAX deliveries offset by lower airline demand due to the decline in utilization because of COVID-19. Widebody production and deliveries are expected to fall 63% in 2020, driven by lower utilization for long-haul flights as international cancellations climb higher.
Retirements are expected to affect up to 3.3% of the fleet this year, the team further says. “We estimate retirements will rise over the next four years to more than 7% in 2023,” the Jefferies group says in a late-May report. “The older aircraft that are currently parked may be permanently retired as airlines look to balance supply with a new level of lower demand.” What is more, the current level of the parked fleet is almost threefold what was reached after 9/11 and fourfold from the 2008 financial crisis.
That all means lower revenue and worsening financial metrics for suppliers, almost all of whom built up staff and fixed assets to meet prepandemic historic levels of A&D business. But in talking with industry customers, consultant Bernardini says he still hears too much optimism and an aversion to worst-case planning. “The first thing you need to make sure is that you have the go-dark scenario,” he says. “The second thing we do is see if they’re short on liquidity.” Next comes how to resize your company and also how to restructure your own supply chain.
According to many industry advisers, the downturn came so suddenly that OEMs and top-tier suppliers did not have time to properly plan new supply bases. Decisions are going to be rushed partly based on liquidity crunches at smaller suppliers. Production rates could hover above delivery rates for several quarters just to allow supply chains to adapt, but eventually they will be lowered further, likely eliminating more suppliers.
“You won’t be able to support everybody,” Bernardini says. OEMs and Tier 1s will make decisions based on supplier reliability and relationships, he predicts. If someone desirable is distressed or too small to survive at lower business levels, OEMs and Tier 1s will be tempted to transfer work—but possibly still demand the same pricing as before.
“Of course, the supplier is going to say, ‘How can I give you the same pricing if I’m doing 25 shifts that you asked for 50?’ The [customer] will say, ‘Well, because I’m giving you more volume or business, so you can absorb all fixed costs.’
Adds Bernardini, “You’re going to have a lot of discussion like this, and it may or may not work depending on the supplier and the segment of the supply chain we’re talking about.”
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