Since March, global passenger demand has declined by more than 90% versus the same period a year ago. In July, demand “recovered” to a level 80% lower than July 2019, resulting in more than half of the global commercial fleet being parked and airlines laying off tens of thousands of employees worldwide, right-sizing operations, and filing for bankruptcy at an alarming rate. The maintenance, repair, and overhaul sector (MRO) has seen revenues drop more than 50% as airlines carefully manage maintenance expenses. Major aerospace manufacturers, including Boeing, Airbus, and Embraer, have followed suit by significantly curtailing output and preparing for a new normal marked by demand for new aircraft that will likely be more than 50% lower than in 2018 (before COVID-19 and the Boeing 737MAX debacle).

Where do we go from here?

There is tremendous uncertainty surrounding the recovery of global passenger demand—the key driver of revenue growth for the commercial aerospace ecosystem—but experts predict demand won’t reach pre-pandemic levels until 2024, with airlines and MROs following the same gradual revenue growth trajectory. With those passenger growth rates, it will take several years for the existing commercial fleet to regain normal utilization rates, which will undermine demand for new aircraft. Original equipment manufacturers (OEMs) have reacted by reducing production rates more than 50% in 2020, which will dramatically impact revenue and valuations within their supply chains. Members of the supply chain should expect production rates to begin a slow but steady climb back to peak rates, which may not be until 2025 (or shortly thereafter), depending on the specific program and market niche.

Down market investing

Prior to COVID-19, the average commercial aerospace transaction was approximately 12.5 times trailing 12-month EBITDA. Given the uncertainty in the market and the rapid decline of revenues, earnings, and free cash flow, however, it will likely drop dramatically this year, giving investors a rare opportunity to purchase quality aerospace assets—particularly manufacturing and MRO businesses—at more reasonable valuations.

So, what should investors look for in a potential acquisition? It is important to examine the following characteristics when trying to find an asset that can be purchased at a reasonable valuation and produce outsized returns.

• Find companies with a “technical reason to exist” in their served market segment. This can be something as obvious as a manufacturing process or product patent or a more subtle competitive advantage in manufacturing process capability or trade secrets. Generally, the more obvious the competitive advantage, the more it will drive up valuations. Being able to discern undocumented process advantages is paramount.
• Understand programmatic exposure. The commercial aerospace market has dozens of programs and program variants currently in production. Understanding the prospects of these programs is vital to unlocking the future revenue trends of the target. It is important to evaluate the overall prospects of the program to accurately assess risk. For example, I evaluated a potential acquisition in 2007 that was a risk/revenue sharing partner on the Airbus A380 and that program figured prominently in the overall growth and profitability forecast of the target company. I did not think the program was going to be a commercial success, which was reflected in the value estimate, so we did not get the deal done. It worked out well for us; the airplane never achieved widespread commercial success and was cancelled in 2020 after only approximately 250 aircraft were produced.
• Identify oversized balanced sheets relative to revenues. Current receivables and active inventory are great, but the ideal target has a heavy asset base anchored by unique manufacturing equipment, such as casting lines or forge presses. Unlike machining equipment, these assets have long useful lives, are in short supply, and technical development tends to be much slower keeping technology competitive for decades—all things that lenders love to see as collateral for an asset-based loan.

Looking ahead

COVID-19 is a “black swan” event: unforeseen, unpredictable, and completely devastating to many segments of the global economy. But although commercial aerospace has been one of the hardest hit industrial sectors, its long-term growth prospects are still there. Passenger demand will inevitably return and manufacturing activity will recover. For the savvy investor, this represents an incredible opportunity to enter the industry or expand at very attractive valuations. The key is to distinguish between a commodity asset and one that has a competitive advantage, which may not be readily apparent to potential investors.