#141- The Stressed Aerospace Supply Chain

Airbus and Boeing are increasing production rates for their single aisle aircraft dramatically. Boeing has already committed to growing the 737 production rate to 47 per month in 2017, and to 52 by 2018. Earlier this year, Airbus announced it was going up to 46 A320-family aircraft per month in 2Q16, and is examining rates between 48-50 should it perceive the need to match Boeing. Combined this means the two big OEMs will be able to deliver 100 narrow-body aircraft per month, an unprecedented increase in supply. The Economist also picked up on the long tail impact of this decision. Once at 100 per month, Airbus and Boeing will deliver more single aisle aircraft in six weeks than Bombardier and Embraer produce in a year. Even the ever-optimistic John Leahy, COO Customers at Airbus, was cautious at the recent ISTAT conference in Istanbul, stating: “...what worries me is the whole ‘field of dreams’ concept, build it and they will come...” in reference to higher narrow-body production rates. Will they be sustainable, and is the supply chain beginning to question the judgment of the big two OEMs? The answers are maybe and yes. Rates for wide body aircraft are also increasing, for 787 and A350, but questions remain whether Boeing can maintain the current 777 production rates prior to the introduction of the new 777-X, which generated orders at the expense of the current model. The good news is that the market for parts produced by the supply chain is growing. The bad news is that it will require capital investment in advance of production rate increases to achieve, placing suppliers at additional risk of capacity under-utilization when the next downturn occurs. No one expects growth to increase forever at current rates, and history shows that just when the industry gets comfortable, a spanner is thrown into the works by an exogenous event, be it 9-11, SARS, wars, or potentially, Ebola. Today, the aerospace supply chain is under stress from several factors, including capacity growth, cost control measures from OEMs, staffing requirements, inventory requirements, and competitive threats. Aerospace Suppliers Have Historically Been Quite Profitable and Cost Control Measures have Arrived to Level the Playing Field Most aerospace suppliers earn a higher than average EBITDA margin, which has caught the attention of both investors and the airframe OEMs. Boeing, in particular, announced its Partnering for Success Program, which in essence is a cost-control program which forced suppliers to agree to 25-30% price cuts to maintain business relationships. The notable sacrificial lamb in that process was the 777-X landing gear, which was moved from the incumbent industry veteran United Technologies Aerospace Services, who wouldn’t accede to Boeing's demands, to Hereoux-Devtek in Montreal, which has never built a landing gear that large. That was the shot across the bow from Boeing that indicated it was serious to the supplier community. Boeing appears comfortable with the additional risk this decision entails. Supplier profitability, for many industry participants, has been trimmed through price cuts to maintain their business with Boeing. Airbus, while not as vociferous on pricing, has focused on capacity and the ability to handle growth in supplier relationships, ensuring that suppliers have the capacity to handle a surge in demand to maintain contracts. That often translates to requirements for capital expenditures that some suppliers loathe funding, having lived through historic industry cyclical upswings and downswings. Those who project current demand as a bubble that will burst may be forced to increase capacity that they don’t believe will actually be necessary in the future. None of the manufacturers want a replication of 1997, when Boeing doubled rates and the supply chain couldn’t keep up, forcing the assembly lines to halt. Supplier Roles are Changing, and with That Change Comes Capital Investment and Staffing Challenges Risk sharing has increased, with Boeing now outsourcing significant design elements down the supply chain to first-tier suppliers. While the concept initially failed miserably with the 787, due to a lack of proper quality control throughout the supply chain, having suppliers invest in design, rather than Boeing, should have theoretically brought higher profits to the OEM. For Tier One suppliers, this entails additional design effort and risk associated with bringing in the projects with high quality and performance, on time, and on budget. And these design efforts are often moved downward in the supply chain, with sometimes unfortunate results in both quality and reliability, as the 787 program demonstrated during its teething problems. As a result, more companies in the supply chain are hiring design engineers and have taken on new subsystem integration roles. This has required new skills, and additional personnel and increased costs. Changing the culture of a small supplier is not easy, and often lessons are learned the hard way, with a difficult learning curve. While suppliers in the aviation industry should remain profitable, the higher than average margins they have enjoyed are coming down quickly. Some remain well positioned for future growth and profitability, while others are teetering on the edge under the new pressures. Demand is Real At the same time, there is no question that demand for air travel continues to increase, and that the industry will double in capacity over the next 15 years. Both Boeing’s Commercial Market Outlook and Airbus Global Market Forecast show significant increases over the prior year projections. Of course, those publications also don’t forecast cyclical downturns. The following chart from consulting firm Price Waterhouse Coopers (March 2014 PwC) illustrates how the supply chain should experience a near doubling of workload between 2009 and 2016. Bearing in mind that the new business model for OEMs is to push development and design down the supply chain, the workload increase is not only through higher volumes, but also much more complex responsibilities. PwC’s research found that one-fifth of the supply chain was not ready for the ramp up. And the OEMs are now ramping up quite dramatically. Given that rising complexity is de rigueur, fewer companies within the supply chain can manage the effort and resources required, particularly as Tier1 suppliers push requirements down their own supply chains, which they, and not the airframe OEMs, manage. Lack of oversight in this regard cost Boeing severely on the 787 program. Have those lessons been fully learned? We believe the jury is still out with respect to the dramatic increase in narrow-body rates. Timing and Potential Disruptions From a timing perspective, the supply chain needs to grow faster than the production line, as components with longer lead times need to be produced well in advance. Industry suppliers are provided with projected production schedules well in advance, and are expected to meet the requirements. Recently, particularly with new aircraft, the supply chain has experienced false starts – gearing up for new programs that are delayed not by months, but years. Suppliers of the A380, 787, and CSeries understand the hurry-up and wait requirements placed on them by OEMs, and have become skeptical about new program timing . The costs of ramping up capacity in capital expense, producing initial units, and then going a year or two without cash flow are significant. A number of suppliers for all three programs have experienced not meeting their business plans on a more consistent basis recently, and have become skeptical of OEM forecasting. Globalization and Risk When the Boeing 707 was introduced, it was virtually 100% made in the US. With globalization and internationalization of the industry, that has changed dramatically. Much of the 787, for example, is made in Japan, and parts from 10 countries are incorporated in the aircraft. One impact of globalization is that the risk of disruption to the supply chain from political or environmental impacts are higher than for programs sourced domestically. For example if, Japan were to experience a devastating earthquake, and Mitsubishi factories were impacted, Boeing’s 787 wing supply could be impacted. This would throw out the carefully orchestrated “just in time” parts flow from other suppliers – probably leading to 787 production being halted. One needs only to recall the impact to the Boeing 787 program from “traveled work” and how the program is still trying to get some early production aircraft delivered to understand the potential impact. Industry consolidation means there are fewer firms in the supply chain to utilize and offset risk, and sharing a program amongst two suppliers isn’t feasible when the design has been delegated to one supplier in exchange for program exclusivity. Mitsubishi doesn’t have another factory in Australia or one closer to Everett in case of a catastrophic event, just as Boeing has only one location for 737 assembly. The aerospace supply chain is truly subject to a domino effect, both on the demand side (9/11 and the 2007 recession as examples) and on the supply side. When could the first domino fall? Sourcing critical materials like titanium from Russia might be one place to start. The fact that the world’s largest supplier is in Russia is of concern, given the current political tensions over Ukraine. Politics will always be a wild card. Suppliers need to build an inventory of critical materials to ensure smooth production. But this means tying up capital. Growing inventory “just in case” as opposed to “just in time” is expensive. Another aspect of the supply chain complexity that speaks to capital deployment is the flow of funds down the chain. Supply chain vendors invest up front and send their parts to the OEMs and then wait to be paid. OEMs try to hold back on payables as long as they can. But this stresses the vendors downstream. These firms are already adding new skills and equipment to work with exotic materials and high tech processes. Laying and baking carbon fiber requires new equipment and people compared to bending and riveting aluminum. Talent and Automation Which leads us to the next item that bears special attention: the demand for specialized skills. The pool of skilled expertise is shrinking – current talent is retiring, and often the first to go as the most expensive workers are laid off, but the new entrant replacements are not coming in sufficient numbers nor with the proper experience for a smooth transition. This means bringing back the newly retired as consultants at higher costs. Clearly the next step is automation. Boeing has a good video showing how they plan to do this with the 777. Airbus is right there also. But automation also doesn’t come cheap. Clearly supply chain management requires transparent access to the whole chain. Firms in the chain need to offer high visibility and also need access to visibility at the OEM level. For a program to work with a "Just in Time" system, all vendors need to see where they are and how they need to change their rates to stay in sync. This creates an entire new set of challenge that requires more secure IT. Where are we headed? Looking ahead it would seem to us that the OEMs need to develop ways to attract new sources of production capacity into their stressed supply chains. That likely means new entrants from emerging, as well as developed countries. The new entrants could provide the additional capacity but also reduce risk from disruptions, while spreading financial risks. Increasingly aerospace programs are globally sourced. OEMs could benefit from making their sourcing even more global, if they can manage the inherent risks. The reduction in one set of risks, in this case, means taking on increasing project management risk. The trade off, in our opinion, favors some additional supply chain diversification and competition for programs, with fewer exclusive awards. The problem is that the airframe manufacturers have not covered themselves in glory with their project management skills, or lack thereof, with A380, 787, CSeries, and other examples. The Bottom Line Without a healthy supply chain, the OEMs can’t build airplanes. This is a co-dependent relationship that appears to be on the brink of becoming unhealthy in several respects. The stress points are showing, and production rate increases into a demand scenario that observers are increasingly questioning may prove to be a poor choice when the current bubble inevitably bursts.

No results