Premium #176 – Our Assessment and Thoughts: The PAS in Review

This year’s Paris Air Show was expected by many industry followers to be a quiet event. No mega orders were expected, but Boeing did win one mega-order for 100 MAXs from AerCap. The typical big sources of news were tamping down expectations. By the show’s end there were some decent sized orders but from a breaking news perspective, it was business as usual. However, there were several undercurrents that we observed that warrant more attention as leading indicators. Air shows are a lot about messaging. The big players want to send messages to their customers and ruffle a competitor’s feathers. The Paris Air Show can sometimes be examined from the perspective of game theory to better explain behavior. Here are the special issues that caught our attention. Item 1 – The Single Aisle Bubble The key problem we see is that the planned levels of single aisle production will exceed total demand. Boeing and Airbus each issued their new market forecasts. But if we take their planned production increases and extrapolate them through the period, virtually all of the forecast demand is met by the big two OEMs. This leaves no room for Bombardier, Embraer, COMAC, or UAC. That’s unlikely to happen, particularly in Russia and China, and Bombardier and Embraer aren’t going to roll over either. As the witches from Macbeth said, “Double, double toil and trouble; Fire burn, and caldron bubble”. We still see a bubble forming that should burst about 2020, just after the increase in production rates. The supply chain is currently wary of over-investing in capacity – and rightly so. Item 2 – The Middle of Market Airplane The Middle of the Market (MoM) is often thought of as the replacement for the Boeing 757 – which was larger and had better range than the best selling narrow-bodies of its day, with better economics than larger wide-body aircraft. If the Boeing 757 was the MoM airplane in 1982, the question is what is the middle today? Is it 20% larger with 25% more range, as Boeing’s Ray Conner suggested, or is it the A321LR, only slightly smaller but still with transatlantic range? Today this is a battle between Airbus and Boeing, but within two years we might add the UAC MC-21 to the mix. There was a lot of messaging going on from Airbus and Boeing manufacturer in their briefings (watch our Boeing and Airbus videos) and they are sending different messages to the market. The following chart illustrates how the Boeing 757-200 and today’s aircraft are situated in terms of capacity and range. The 757, the baseline point of the chart, could carry 189 passengers 3,900 nautical miles, and with the addition of winglets, range has increased to 4,100 nautical miles. The green box indicates the capabilities of the Boeing 757. Boeing says that it is in discussions with customers for a new MoM aircraft; they see a need for 25% more range and about 20% more seats, which would mean about 220 seats and 5,000 nautical miles range. This is shown in the blue box on the chart. This is near the capabilities of 767-300. The 787 is capable of over 7,000NM and therefore vastly too much airplane, and too expensive, for MoM. Of course, with the target a new narrow-body for the MOM, passengers might ask if they wanted to fly in a narrow-body for more than 10 hours for a 5,000NM flight. Almost certainly the answer would be no, but the airlines don’t seem to listen to passengers in defining aircraft seating configurations these days. Airbus would argue they offer the 18-inch wide seat and therefore are more passenger friendly. Competitively Airbus is now approaching the capabilities of the 757 with its A321 alternative. The A321 has grown steadily more capable, and since it is relatively young, Airbus can continue to tweak the design. The A321LR, a long-range version of the A321neo, promises 4,000 nm range and seating nearly equivalent to the 757. It comes up just short on each category to the 757-200W, and also has limited cargo capacity beyond baggage, but it is a lot closer than anything Boeing has to offer. Coming the other direction, with a larger wide-body, Airbus A330-800 will be exceptionally flexible – it can handle the capacity/range combinations at the projected 20%/25% growth levels and also be produced in quantity at lower costs that Boeing’s 787-8. Boeing needs a new MOM airplane, as its MAX9 simply can’t compete in this battle, and its poor sales reflect this. The smaller MAX8 can’t effectively compete either. And with the 787-8 simply too expensive to produce for this segment, Airbus has an advantage. In the near term, the A321 appears to be the most viable 757 replacement, and those aircraft are rapidly aging. Without a MOM model from Boeing coming soon, the 900 plus aircraft replacement market is likely to favor Airbus. Boeing says the MAX9 is fine as a 757 replacement, but the reality is otherwise. While Boeing is conducting many studies, are these simply straw-men to sow seeds of uncertainty around the Airbus offerings? Moreover Boeing indicates there are “thousands” of aircraft needed – Mike Sinnet’s own words. But there were only around 1,000 757s built. Has this market suddenly grown, and how many of those 1,000 757s fully utilize its payload and range in routine operations? Or is Boeing looking at an entirely new narrow-body family? Boeing was dealt a blow when its Yellowstone strategy timing was negatively impacted by the 787 delays and mismanagement. Had the 787 been on time, a new narrow body might have been the next program to replace the 737. Airbus seized the opportunity to re-engine its younger A320, which has higher ground clearance and could more easily accommodate the larger fans on the new engines. Boeing, without a viable answer, needed to quickly develop the 737 MAX to compete with neo, and developed an overnight response for the American Airlines campaign. But with a re-engining program going on, Boeing needs at least 10 years to get a return its investment, and its new narrow-body has been relegated to the back burner. That new narrow-body would have likely been sized slightly larger than today’s models, and offered a true 757 replacement in a growth variant. At this point, Boeing has few options. It could develop a 757 replacement and all-new narrow-body, but that would require sizing the aircraft to replace both the 737 and 757 to generate volumes large enough to warrant the investment in an all-new airplane. Our assessment is that entry into service before 2028 would likely limit the economic success of the MAX, and result in a potential sales gap in the 2025-2028 time frame when customers would wait for the first all-new Boeing narrow-body in 40 years. If Boeing were to limit a new model to the 757 replacement and growth market, is there enough of a business case to make sense? GE’s David Joyce threw cold water on the concept, as they don’t currently have an engine in that size category, and reading between the lines, may not believe that the market will justify such a development. P&W, with a scalable GTF, and Rolls-Royce with its advantage concept, could be likely candidates were a program launched today. The limitations in engine growth may be a contributing factor pushing Boeing to consider a new model. The A320neo uses both the CFM LEAP and P&W GTF, whereas the MAX only uses the LEAP. We believe the GTF, with a simpler core and gear, has more growth potential than the LEAP. Already on the A320 family, P&W has announced an additional 2% fuel burn gain, and is predicting on average a 1% per year potential gain over the next decade. The LEAP could be hard pressed to compete in terms of growth potential. If, five years from now, there is a 3-4% gap in fuel economy between the models, Boeing will be forced to either heavily discount the MAX or launch a new program to remain competitive. While this feels like a Boeing straw-man campaign to sow uncertainty about any decision an airline fleet manager or lessor might consider, it serves two purposes. One is that Boeing has to delay customer decisions that might go to the A321LR to buy itself time, given that the reality is that only Airbus currently has products to accomplish the equivalent 757 MoM missions. The second is to ensure that Boeing has time to develop the technologies to “leap frog” its competition and at a competitive cost. While it is one thing to engineer a carbon-fiber aircraft, it is another thing entirely to build it cost-effectively. So is Boeing, absent a serious offering, sowing doubt? This is very clever, but as a strategy, only has limited life, probably no more than a year. Problems for Boeing in the MoM segment are straightforward - capital cost & ramp up. They have no inexpensive or low risk options. Airbus doesn’t face this problem in this market and can keep pushing A321LR & A330-800neo (and even the A330R). For Airbus, the cost of keeping these products current is low and their basic airframes are easier to tweak. Boeing is unlikely to stretch the MAX9 or add additional fuel tanks, as stated in Paris. If this were chess, Airbus could say “Check”. But it’s not “Checkmate” because Boeing will come up with something. Look at how they pulled MAX out of what appeared to be thin air. Boeing does multiple studies all the time – they ran the 7E7 at the same time as the Sonic Cruiser. When the latter failed after 9/11, they came forward with plan B as the 787. Tectonic plates shift slowly but leave lots of disruption when they move. Airbus now has the advantage in the narrow-body end of the market, while Boeing has outflanked them in the wide-body market, particularly with the 777-X providing capacity that Airbus cannot match without resorting to the A380 (and now talking about a double stretch A350). The game of leapfrog and the associated what-if scenarios are often played out at Air Shows. The MOM segment is this year’s candidate for speculation, and “floating trial balloons.” Item 3 – New Entrant Aircraft Two new entrants caught our attention. The first was Canada’s Viking, which is not quite a new entrant but beginning to gain momentum. Viking owns the rights to what was once the domain of de Havilland, the Twin Otter. This aircraft appears to have an amazing future, even though the original design is 50 years old. For many, this aircraft handles flights for the “last mile” of a journey – be that to an unfinished runway or waterway. They signed a deal at the show with China-based Reignwood Aviation Group for 50 Twin Otters. History shows us it is prudent to be wary of China, as they liberally “borrow” IP to copy and produce their own aircraft. Fortunately Ringwood operates aircraft and does not build them. With both land a sea versions, the Twin Otter occupies a unique market niche. Next was Sierra Nevada’s 328 setting up a joint venture in Turkey called TRJ (Turkish Regional Jet) – what we might euphemistically call Turkey’s COMAC. The idea is to restart building of what was the Dornier 328 and then add a stretched 628 model. Their strategy will be to offer each model with both jet and turboprop. They plan to initially focus on 328 Jet and should see aircraft coming back in production within 18-36 months. We would bet on closer to 36 months, but initial aircraft will be built at the old Dornier facilities near Munich. The challenge here is to prove there is a market for turboprop or jet with 32 seats. And if there is, how they can take market share from ATR and its ATR-42. Our thinking is that the market doesn’t justify this on the commercial side. But the Turkish government has ordered 50 aircraft. And as happens in China, we expect to see Turkish airlines place orders too. But will this be enough? The answer is probably not, but remember that Sierra Nevada is expert in “special mission” aircraft. The 328 aircraft platform, with a high wing, could be excellent as an electronic surveillance and other military missions. We don’t for a moment believe the business case for this new venture is built only on commercial sales. As a military platform, the 328 and potential 628 could be effective platforms. Item 4 – Execution, Execution, and Execution One word that was overused at the 2015 PAS was “execution.” But for many of the big names in the industry, that is indeed the challenge. With airframe and engine manufacturers increasing production to record levels, leveraging a strained supply chain, the focus is on bringing the record number of orders from the last three years to reality. This is not an easy task, as David Joyce at GE, Paul Allen at Pratt & Whitney and Ray Conner at Boeing all emphasized. The word execution echoed as the key challenge for the industry in 2015. Airbus needs to execute on its A320neo and A350 programs. The A320neo appears on schedule, albeit the recent engine difficulty could result in a small delay. The A350, while in production, has had slower than expected initial deliveries, and while now increasing the production rate, might still fall short of expectations for 2015. Similarly, Boeing needs to execute on the MAX development, which was launched later and is about 18 months behind the Airbus neo program. Boeing also needs to execute on filling the gap between the end of the current 777 series production and the beginning of the 777-X in late 2019 to early 2020. The question is whether Boeing can generate enough sales to keep the production rate at today’s levels, or whether it will need to be cut prior to 777-X entry into service. The jury is still out, but we believe the latter might be necessary. For the small duopoly however the word execution really applies. Bombardier has to execute on C Series marketing like never before. As we started in last week’s note, there are no more excuses. The plane is flying, its numbers are truly impressive. Now the sales team has to deliver – and quickly. The lack of new orders being generated at the show was earlier telegraphed by management. We expect to see the C Series demonstrated frequently on "show and tell" trips. Bombardier needs to secure orders from big name customers within the next year. There is really very little margin - and they promised 300 orders by EIS. That could, and should, happen before the year is out. But the sales team has to work 24/7 and pull out all the stops to complete deals. The billion-dollar question is whether the appearance at the air show is a momentum changing moment for the program. The new management team needs to ensure that the positive momentum continues. Embraer also has to execute with respect to their E2. People can see how impressive the P&W GTF engine is – you could hardly hear the C Series. Airlines want these smaller airplanes to serve smaller markets. Embraer does not want to stumble now because the A320neo will be delivered soon, followed by the C Series EIS. Any schedule stumble by Embraer puts their market position at risk. Management is fully aware of this and has implemented strategies for “de-risking” the development cycle. The E-Jets have proven that Embraer can quietly accomplish what it must to deliver a market leader. Despite Brazil’s economic woes, Embraer is once again in a position that requires it to execute flawlessly. Item 5 – Engine Wars On the face of it there was no big engine news. But a few noticed a subtle comment from GE’s president David Joyce. It was about the MoM and he said that they will need to study the market, it will be in the CFM thrust class (40-50k lbs.) and that a new engine platform would be needed. This is potentially a big issue, as it indicates that the LEAP may not be scalable. Then it turned out that CFM said they would like to see Airbus not rush their ramp up. Airbus’ John Leahy reacted to a question about the ramp up by saying something like “we’ll use Pratt engines then”. To a non-industry reader this may all sound silly word games. But they are most definitely not. Is this a sign of GE/CFM confusion, or a potential difficulty in executing a massive ramp-up for both the neo and MAX? The stunning silence tells us new messaging is being developed because there should have been an explanation or clarification in reaction to Leahy’s comments by now. P&W had a very good show. Their engine proved itself on the C Series. It was the quietest jet engine probably ever flown at any air show. Amazingly, little mention was made that the GTF for the A320neo is currently not flying after a technical issue. The media have been very effectively managed by Airbus to keep the story out of the news. When a similar event happened on a C Series, the media were screaming. Yet the A320neo situation has been whisper quiet. Consider the first customer is Qatar Airways - so the silence is deafening. We understand the faulty part was deep in the engine core; it has now been replaced and future engines have been fixed. The A320neo with GTFs should be flying again shortly. Incidentally, if the engine disruptor for the MoM needed is to be 40K thrust, then P&W could prepare a scaled up GTF even before an aircraft is defined by Boeing. Nobody else even has an engine in this segment to show – but P&W does. Their GTF is also the only available engine right now for the 35K requirement for the A321LR. P&W is all smiles. Rolls-Royce is reported to be seeking ways to offset R&D costs. They are as tied to Airbus as GE is to Boeing. Airbus is now talking about a double stretch A350 that presents a further challenge. Can the Trent XWB handle this? How much growth is left in the engine? We understand the A350-1000 is already pushing the Trent XWB hard. Consider that Rolls is strong in big engines and R&D for these is high. Rolls-Royce is working on refinements to their current engines, with new composite fan for the Advantage engine due for EIS in 2020, and even a gear on the Ultrafan due in 2025. But they are way behind P&W with respect to gears, and just inked a joint venture with Liebherr for gear production. A key victory for Rolls-Royce was the recent win at Emirates for the A380. The question is what exactly did Rolls offer Emirates? They needed an order for the Trent 900, as their backlog was down to about 30 engines, and Emirates A380 deal is perhaps a short-term band-aid while Airbus ponders A380 improvements. There is a strong case to be made that Rolls bought that deal. Equally we think that perhaps Emirates decision might have been too hasty. Engine Alliance (EA) lost to Rolls at Emirates. We understand that EA cut its price to the bone and still lost. Rolls must have made an exceptionally attractive offer to win this deal. Did Emirates make a mistake? We think perhaps they did. EA’s GP engine currently offers the best economics according to Airbus' Orange Book. Emirates has been happy with the engine to date and their use of the A380 speaks for itself. Why risk this great combination? We had a private briefing with EA and found out that they have plans to bring the GP to near A380neo configuration. Moreover as president Dean Athans explained, they do not have a shortage of skills or resources. The challenge is only economic – how much is an extra 0.5% or 1% from a technology worth? To add credence to their case, EA can easily improve the GP7000 even more readily because they no longer face any technology transfer limits from GE and P&W. Think about that for a minute. That cocktail of IP is unmatched anywhere. Was the Emirates deal a message to Airbus to support the A380neo – since Rolls was offering an engine while EA was hesitant in making a commitment? Or did Rolls-Royce simply give away the engines to keep its line running? Item 6: The Mood The mood at the show was positive in our view, but with a degree of doubt creeping in. Orders were in the hundreds rather than thousands for the big two, and while backlog is a record levels, some participants in the supply chain have doubts that narrow-body production rates of 60 per month at Boeing and 63 per month at Airbus are sustainable, given the cyclical nature of the industry. With 11 years of growth without a major downturn, in an industry with traditional seven-year cycles, some are waiting for the other shoe to drop. Nonetheless, the focus now is clearly on taking care of orders and commitments already achieved, and with record backlogs, participants are happy with their good fortune. But the question in the back of their minds is how long will it last, and for the supply chain can they afford to build capacity that they may not need? Risk hasn't disappeared.

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