Premium #201 – An Outlook for 2016

2016 could be a year of significant events for the commercial aviation market. Here are some items we are viewing with special interest. Oil This is a crucial input for the industry. Wild price fluctuations drive airline cash flow projections way off budget. In recent years we have seen price spikes cause large losses and then the more recent price decline has brought unprecedented profits. In October 2015 The World Bank estimated in its commodity forecast report that the average spot price for crude oil would fall slightly in 2016 to $51.4/bbl from $52.5/bbl in 2015. The IMF's October report revealed a similar expected decline albeit from a lower starting point of $51.6/bbl in 2015 to $50.4/bbl in 2016. In September, Goldman Sachs Commodities Research slashed its oil price forecast for 2016 to $49.5/bbl for the international benchmark Brent crude oil from $53.7/bbl in 2015, allowing for a short-term price decline to $20/bbl. Global crude oil price forecasts from the Economist Intelligence Unit is shown below. Our view is that lower oil prices are likely to remain. Iran’s oil production is likely to start impacting the market in 2016. Plus, Iraqi production could also start flowing into the markets as ISIS controlled wells are retaken, and then there is Libyan oil that could also start to see steadier production. The market is awash with oil. Airlines are going to keep on benefiting from lower input costs. Aircraft programs If cheap oil is the status quo then we expect to see a slowing down of new orders for expensive fuel efficient aircraft. Last winter at the Dublin Finance Conference airline and leasing executives were all wary of cheap oil being a short term thing. Well, it now looks like it is a longer term reality. Those same executives wanted new aircraft as quickly as possible and were delighted with the short term windfall in cheaper oil. The only airline that ran counter to this was Delta. It turns out Delta’s bet was the best one and now its cash reflects this bet on cheap oil and older aircraft. Economic Recession China is in an economic recession, as shown by record lows in the Baltic Dry Index. The degree to which this impacts Western economies will be a key question for 2016. We’ve already seen a moderate slowdown in Europe and a minor one in the US in the second half of 2015, and expect things to slow a bit further. The question then becomes whether aircraft deliveries begin to be pushed to the right. The good news is that low oil prices are helping airlines remain profitable enough to purchase aircraft. The bad news is that they no longer need them as quickly as they once thought. With slowdowns, will players with several hundred aircraft on order in Asia really take them on schedule? Will Lion Air, Air Asia and IndiGo experience slower growth and need to defer some of the 1,000 plus aircraft on order between them? Time will tell, but we think there is a strong probability that the seven year order books could shrink markedly just as Airbus and Boeing finish their planned rate increases and have the supply chain producing at higher rates. This is going to, potentially, play havoc with the supply chain. Regional Instability We believe the Middle East will continue to be the least stable region, with on-going insurgencies and factions competing for power from Afghanistan to Libya, and most places in between. The current sabre rattling between Saudi Arabia and Iran could plunge the entire region into real conflict; what if the Saudi government falls? What carryover impact will this have on the big three Gulf airlines? An unpleasant question. We do not foresee a major terrorist event in the US in 2016. But another attack in Europe could result in additional scrutiny and perhaps the reopening of border checkpoints within the EU. The impact of the mass migration in Europe is already seeing negative outcomes. This concern is not outlandish. The Outlook for 2016 for Major Players in the Industry Airbus The A320neo program deliveries start early in the year. An engine hiccup late in 2015 meant the GTF powered aircraft are likely to run about a month late at the start. Nonetheless, the A320neo family has generated a huge backlog that should be able to absorb the production rate increases, even with a slowdown in new orders. With US production coming on line, the A320neo family will have four final assembly locations – Toulouse, Hamburg, Tianjin and Mobile. The A330 to A330neo production transition appears to be filled via deals completed late in 2015. The A330neo program will benefit from this stable bridge and could be timed well if oil prices rise again by late 2017 or 2018. The A350 program saw unexpected slow deliveries in 2015 - Airbus has a big ramp up planned in 2016. They need to deliver about three per month in 2016 and prepare the supply chain for another rate increase in 2017. The question is are Zodiac and other suppliers up to the task? Airbus can’t afford late deliveries. The year started with the ANA deal for the Skymark A380s. Welcome as this is, Airbus needs to see more action on the A380 program, as the ANA deal brought no new aircraft into the backlog. While we expect ANA to buy more than the first three aircraft, it will be a while before this happens. Moreover, Emirates has said they will hold off on any more A380 orders until the A380neo situation is clarified. We do not expect to see any decision on the A380neo program in 2016, and that the A380 program to remain somewhat stagnant as used A380s start to enter the market later this year. ATR The past few years have seen ATR pile on orders. This has been welcome. But at year end we saw Nordic Aviation (NAC) take over the portfolio at ALC. This means ATR is now more dependent on NAC than ever. We understand the turboprop markets where ATR has been doing well are softening and the company has to start juggling 2016 production slots. We will be watching this carefully. That said, ATR still has a solid backlog and order book to sustain it. Boeing 737MAX test flights start this year and expectations are for an uneventful program, followed by EIS late in the year with Southwest. The 737-8 will likely remain Boeing’s cash cow. The 777X program should also see significant development progress this year, but unlike the A330, the current 777 order gap until the 777X arrives is wide enough that a significant further rate decrease is likely. The freighter market has not materialized as Boeing had hoped, impacting both 777F and 747-8F sales. The 747 program could be slowed further because the USAF order for new presidential aircraft is on budgetary hold. Plus, pending Russian freighter orders are waiting for a better Ruble. The question is not whether the Boeing 747 program will wind down, but when? Our bet is as soon as the Air Force One replacements are built and delivered. Boeing is studying the mid-sized 757 replacement market and managing to do it very quietly – nobody is talking. That’s normally a sign that something is really going on, but under wraps. Of course, any news on this program will further negatively impact the 737-9 whose sales are already weak compared to those of the A321neo. Boeing is losing the battle at the high, and most profitable end, of the narrow body market, and needs to stem the dramatic market share difference in the 180-210 seats category. Boeing will not give up this market without a fight. With 787s delivering at a good clip, financial pressure is easing allowing for more R&D dollars. Will we have an announcement on the new medium airliner by Farnborough, during which Boeing will celebrate its 100th anniversary, or will that announcement wait until Paris in 2017? While we believe the latter is more likely, Boeing is aggressively studying and talking to airlines about design concepts. But current low fuel prices up the ante for the economic improvements of a new aircraft, especially to overcome the undoubtedly higher capital costs. With $20 fuel predicted later this year, the economic case becomes difficult. It also means less pressure to offer a solution though. Bombardier The much-awaited C Series deliveries will begin in the first quarter, but firm orders remain weak and short of their original EIS goal. Bombardier has had numerous explanations as to the paucity in orders; first it was waiting for flight tests, then it was waiting for certification and now waiting for EIS to see how the aircraft performs in service. Those issues have resulted in the aircraft being nicknamed as the “wait and CSeries.” A smooth EIS with Swiss will enhance the program's reputation, but a difficult one could be a disaster. Once EIS is reached the sales team runs out of excuses. If the program does not achieve new orders this year, the program faces severe difficulties, and by extension Bombardier’s balance sheet and those of its Quebec financiers. The C Series team is hot and heavy in several campaigns, including United Airlines, and Bombardier is being uncharacteristically aggressive, according to sources. But that elusive major order remains to be delivered. The airline industry being what it is, there are lemmings waiting to see what United does. Meanwhile its CRJ program looks better than one would have thought. Although an aging design it still falls within the US-airline scope clause restrictions. This means the recent MRJ delay suits the CRJ well and the 2018 EIS of the E2 helps as well. Besides the US airlines, which are major CRJ customers, are in no mood to tangle with pilots over growing scope clauses. Pilot unions are going to demand big pay increases (Delta's pilots for example) now that airlines are so profitable. Meanwhile the Q400 program delivered its first Combi to Japan. Bombardier has focused its limited cash resources on moving the C Series forward. With that program now complete, it will focus on the two Global models, and can accelerate the additional developments planned for the CRJ and Q400. 2016 needs to remove uncertainty across the entire company’s aerospace division – from business jets to commercial aircraft. With so many management changes and delays, customers are naturally wary and skeptical. The new management has a tough 2016 ahead, with no margin for errors or stumbles. But they now have some cash they can to work with to win orders. COMAC The enigmatic Chinese are going to deliver as many of their much-delayed ARJ21s this year as possible. But the attention and focus will be on the C919. Already outdated, when compared to Airbus and Boeing alternatives, the C919 will see significant activity in China as will the ARJ. Which, as far the state and COMAC are concerned, is just fine. The market is substantial and all of COMAC’s production could be absorbed without a significant impact on Airbus and Boeing business. But look beyond 2016 and the market becomes hazier. China is seeing an economic slowdown. How will this impact local air travel? Will high speed rail continue its rapid growth? How many airports are going to be built? What can China afford? For 2016 we see no big news from China, and changing economic conditions probably impacting the future. Today’s market drop in China, based on numbers reflecting a significant economic slowdown, is not building confidence. Embraer The big news for Embraer is the E2 roll-out in February. The company has managed to stick to its timeline so far. But after roll-out the clock starts to tick. Ground tests and flight tests come after this and will be watched closely. Delays are normal - will Embraer overcome these? Fortunately, the engine is already shaken out from other programs. The E2 has a lot of new technology, much of it internally sourced. We see the E2 program as being on time, and building on the success of its existing customer base. But with new competition from the C Series at the high end of the product line, this segment will become much more competitive. Embraer shared this "...appraisers, banks and myriad of arrangers and advisers continue to rate Ejets as 'investment grade' as we achieve this by delivering a product that does what we promise. Our secret sauce is not so secret...(i) we produce an aircraft that's allowing airlines make more profits per asset $ invested when right sizing and (ii) we support the aircraft fleet post entry to service at an exceptional level." Embraer has had to overcome Brazil's history before. Embraer also has a robust business jet operation that has been very impressive. It has only been in the business for a decade and already has a leading role. We expect continued success in this market, as its innovative new products, including the Phenom, have become best sellers. But despite all the impressive accomplishments at Embraer the horizon is hazy. The Brazilian economy is headed for a sharp decline and it is not clear what the impact will be on Embraer this time, although it should be minimized given Embraer’s international sales profile. Its military freighter program has been slowed even though there has been no official word. Embraer has weathered tough times before – but it was a much smaller company last time. Today’s Embraer is an industry powerhouse and the impacts of what happens within Brazil and beyond will test company management in 2016. IRKUT The 2015 year-end saw an announced delay in the MC-21. This was to be expected as state ownership has seen a crimp in funding. The program is sourcing parts from across the Russian aerospace supply chain and financial weaknesses are being stressed. Meanwhile the aircraft still promises to be a technical success and remains, in our view, the closet replacement to the 757 out there. This aircraft has a state of art wing design, an aerodynamic fuselage, and the P&W GTF engines similar to that used on the A320neo, which together should result in industry-leading economics. If only the Russians could get the project completed quickly, and produce them rapidly, they could have garnered more international success. We do expect to see the MC-21 make its first flight before year-end 2016, but do not expect a major western order. The small order from Egypt is what it is. SUPERJET The Sukhoi SSJ is being delivered at a leisurely pace. We have heard that relations between the Italians and Russians are fraying. While this is not good news for Superjet, Sukhoi can sell its SSJ version in the Russian market. But, recent positive language from Russians officials about sales to Iran have been dismissed by the Iranians. Is this real? The Russians would not be careless about this. Is there something else going on with respect to Russia’s involvement in Syria? Reports suggest that Iran has started to withdraw its military support from Syria since the Russians intervened. The outlook for Superjet has become a bit more cloudy. Once again global politics impacts an OEM. Mitsubishi At the end of the year, when most people had gone on vacation, Mitsubishi announced another delay. The program is now seriously late. On the one hand this suits its largest customers in the USA that would have struggled to use the aircraft in regional markets subject to scope clause restrictions. But on the other hand, MITAC is looking clumsy and ill prepared for the big time. Japanese manufacturing is known to be excellent. But program management has suffered because of what appears to be poor planning and execution. Certification documentation fell way behind and this might be overlooked because of the lack of current experience – it has been fifty years since MITAC delivered an aircraft. But to then admit the aircraft needs structural reinforcement is a whole other issue – this speaks to fundamental design. Customers have made positive noises. But we suspect the aircraft will be need to gain weight and thereby go further out of line with existing scope clauses. What are the two key US customers going to do? We would not be surprised if they order CRJs to ensure they have the lift they planned for as MITAC struggles to find solutions and delivers to customers outside the US. If there is no pressure they can wait for the E2, but that too is beyond scope limits. GE GE continues to be successful in its engine business, both through its JV in CFM International for narrow-bodies (LEAP) as well as its successful family of wide-body engines. The GE-9X for the 777X will be on schedule for its first test flight in the middle of the year. The GEnx for the 787 and 747-8 continues to perform well in service and has a market share lead, as we reported here. The major challenge for GE and CFM will be the ramp-up of the LEAP engine in the narrow-body arena for the A320, 737 and C919 families. GE has also introduced a new technology turboprop for the general aviation market to challenge the dominance of the Pratt & Whitney Canada PT6. GE is also introducing additive manufacturing at a faster rate. This means better engines at lower weights. We anticipate continued strength at GE. CFM The LEAP engine will dominate the narrow-body market, as it is exclusive on the Boeing 737MAX and shares the market with the P&W GTF on the A320neo family. With the two majors roughly splitting the neo program, and production rates similar between the MAX and neo, CFM should receive about 75% of the combined market. With both programs set to move to 60 aircraft per month, that translates to about 180 engines per month for CFM by the end of the decade. That’s a major transition undertaking from the existing CFM-56 (which enjoys a similar market share) and the key focus for CFM, which has the strongest order book for new engines. First deliveries are expected later this year for neo and MAX, with EIS this year for both. P&W Pratt & Whitney is reaping the benefits of a bet the company made to develop the geared turbofan, or GTF, engine for the narrow-body market. This technology enables higher bypass ratios and better fuel economy when compared to non-geared engines, enabling them to gain the equivalent performance with lower thermal efficiency (fewer parts, lower temperatures and lower maintenance) or gain higher performance with similar hot section designs. The question is whether and how quickly P&W can take advantage of this design breakthrough. Early on, issues with the engine for the neo program have caused delivery delays, with issues P&W believes will readily be solved without any performance impact in short order. To some degree, the market is waiting to see how reliable the new technology engines are in service, and whether theoretical maintenance cost advantages will be actually achieved. With about half of the neo orders, plus the C Series, E2, MC-21 and MRJ, P&W has a new aircraft EIS about every six months through the remainder of the decade. P&W is busier than it has been in many years. Rolls-Royce Rolls-Royce is well positioned in wide-body engines, with its Trent series as standard on the A350 and A330neo, and in competition on the 787 and A380. But with a slow A380 program, slowed A350 deliveries and a smaller share of the Boeing 787 market, R-R is not in the position it hoped it would be. The company has missed planned financial performance, changed CEOs, and the industry rumor mill indicates a potential transaction may be in the future. The obvious partner is P&W. But there is some history which makes this awkward. Meanwhile R-R looks like they are over exposed to the widebody market which is not looking especially robust. P&W Canada Pratt & Whitney Canada continues to thrive, with the venerable PT6 being continually improved and installed on the vast majority of turboprop programs. The regional manufacturers, ATR and Bombardier, both use PWC turboprops, and its new PW800 turbofan powers the Gulfstream G500 and G600. PWC, with more than 52,000 engines in service, remains the market leader in general and regional aviation. The new GE ATP is putting pressure on PWC to become more aggressive. With Sikorsky no longer part of the UTC family, PWC also needs to bolster its helicopter business. The move by GE is going to make PWC a better company as it will have to stretch to stay the leader. AirInsight wishes all our readers a healthy, happy and prosperous 2016.

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