Premium #313 – The Coming Supply Chain Squeeze

The big two OEMs are facing an interesting situation. Wide-body demand is down for several models, causing production cutbacks, while narrow-body backlog is at record levels. The result is that the OEMs are relying on narrow-body sales for cash flow in the near term, and both OEMs will increase production rates to levels we believe will be unsustainable through the next decade. Our forecast of aircraft production is shown in the chart below. But this may not be enough to provide the returns Wall St. is looking for, and the OEMs will need to improve their top line and margins in a declining market. How will they be able to achieve this? The answers are to lower production costs and gain a larger share of the aftermarket. Lowering production costs will likely result in another round of pressure on suppliers, similar to Boeing’s Partnering for Success (PFS) and SCOPe+ programs, each of which sought to reduce costs by 10%. It appears that another round of supplier initiatives will soon be underway at Boeing and Airbus to extract an additional 10% in cost by early in the next decade to provide better margins for the OEMs. Of course, with dramatic price competition between the OEMs, the cuts may simply be passed on to customers, rather than contribute to margin, as nearly every order is now the subject of vigorous price competition. This is particularly true in the narrow-body market, where Airbus and Boeing do not want to allow Bombardier a foothold and are aggressively pricing every competition. For airlines, the magic words are “we’re considering the CSeries” to obtain the best pricing from the big two. This places suppliers in a somewhat difficult situation. Airbus and Boeing each want to move to 60 aircraft single aisle deliveries per month, a level we believe is unsustainable over the next two decades. This means suppliers need to increase capacity, ramp-up production, and incur capital expenditures that may not produce a desired long-term return. In addition, when it becomes clear that rate 60 is unsustainable, the cost of layoffs and restructuring are difficult, particularly for European suppliers. Facing PFS2 and SCOPe++, industry supplier will find themselves under pressure to increase productivity and lower prices to Airbus and Boeing. The need for additional revenues at Airbus and Boeing will also impact suppliers, as the OEMs want a bigger slice of the aftermarket. Today, Airbus and Boeing are relatively minor players in the OEM and spares worlds, with most of the margin taken by suppliers, who build and sell spares, and MRO facilities that repair them. Airbus and Boeing would love to take a larger portion of that pie, likely through aircraft level by the hour maintenance programs that cover spare parts and overhauls. Today’s programs at Boeing and Airbus rely on outside contractors for maintenance, for example, the 787 Gold Care program contracts with AirFrance Industries for most component maintenance and overhaul. Many suppliers have their own component maintenance programs, some with by the hour pricing, that Boeing and Airbus would love to roll into an all-encompassing program for the entire aircraft. For example Rolls-Royce's SelectCare. Of course, that would come with a revenue stream and margin to cover administrative costs at the OEM level, and likely requiring OEMs to maintain higher inventory levels for spare parts at key locations around the world. More cost for the suppliers, and more revenues and margins for the OEMs. Intellectual property may be the key to decisions of who does what. If the part was designed by the OEM, the IP rights will likely enable it to control maintenance. For specialized parts designed by suppliers, such as avionics, the aftermarket will likely remain with the avionics OEM, and incorporated into an overall aircraft level program. Today, many airlines without internal strong engineering and MRO operations would support such programs, as would leasing companies if a residual value premium could be obtained for an OEM controlled program. Boeing’s recent hire of Kevin McAllister from GE and appointing Stanley Deal as head of a new combined services business provides a strong hint at the direction the OEMs will be taking. This focus on aftermarket growth could come at the expense of third-party MROs and the supply chain. The Bottom Line: Suppliers traditionally enjoyed higher profit margins than the airframe OEMs. Recent efforts to level the playing field at Boeing and Airbus have moved levels closer, but a second round is likely to fully level that differential. Suppliers, expect to be hit with a double-whammy, another demand for cost-reduction and losing some aftermarket revenues to the OEMs.

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