Factors Influencing the Aerospace Supply Chain
Explain the market factors influencing restructuring trends in the aerospace supply chain:
David Nolletti: Echoing other panelists’ sentiments—when I look back over the last year and we see how the market the entire commercial aviation ecosystem has gone from record levels to 65 to 70% lower passenger demand and you look at how all the facets of the supply chain or the industry are interrelated, I chalk up a lack of restructuring and insolvency inside the aerospace supply chain to four factors:
- First, PPP loans and CARES Act money has provided a tremendous amount of liquidity into the supply chain.
- We saw Boeing and Airbus both continue to build at very high rates into the COVID-induced downturn and the Max grounding. The suppliers were still producing at peak or close to peak rates, after the Max had been grounded and after the downturn in demand.
- The third piece: we do know that there has been a lot of liquidity put into the marketplace by major players in the space, keeping suppliers up and running and at some level of demand and providing liquidity to the supply base to keep it solvent.
- Last, the regulatory agencies and the lenders have not pressed on non-performing loans; revenues are probably down 50-60%. So, if a business has a fixed charge coverage ratio, or if it has some kind of EBIDTA-to-debt ratio, or some covenant like that—busted because revenues are down—lenders are taking a hands-off approach, not pushing on technical defaults.
Those four factors have allowed the supply chain to continue without mass restructurings and without the wave of bankruptcies that some were expecting.
What is coming for the aerospace market in 2021?
DN: Start with the balance sheet of the industry when thinking about what is going to happen this year. Because of the continued procurement of components for aircraft, the supply chain inventory situation has become robust. Boeing’s balance sheet has increased in size; Spirit AeroSystems has seen a dramatic increase in inventories; and that is a result of this continued production with very little demand for aircraft in the near term. Currently, we see about 30% to 40% of the global fleet still parked, and the fleet that is active is tremendously underutilized. So, demand for new aircraft in the near term is very low. I would expect deliveries to be a fraction of where we were two years ago for the next 12 to 18 months. It is going to take a lot of time for Boeing, Airbus, and the Tier 1 manufacturers to burn off that excess inventory.
So, for single-aisle and wide-body aircraft manufacturers in 2021, I would expect very low demand. Demand for single-aisle aircraft will pick up in 2022, when domestic travel recovers in most markets. And then for wide-body aircraft, it will be several years further out before we start seeing a real increase in demand for Tier 2 and Tier 3 suppliers in the commercial supply chain.
Big lessors are probably going to be okay, having the balance sheet to withstand it. But for the midsize and smaller lessors, it is going to be very challenging…in a post-COVID environment.
What about commercial aerospace deal flow?
DN: Activity for healthy companies probably will pick up in Q3 and Q4 of 2021, as we gain more clarity on what the future looks like. … How the demand is going to play out for the suppliers, …the timing, and how quickly the recovery will take place is an educated guessing game. In terms of distressed suppliers, that activity will likely pick up quickly, because—while there have not been massive waves of distress—the longer the downturn goes on, the more companies will feel the pressure, and the more perhaps non-core divisions of companies will get spun out, if they are dragging down overall performance. We are going to see that pick up substantially in Q2 and Q3 this year ahead of the return of more healthy company transactions.
Provide insight into supply chain globalization.
DN: Looking at the globalization of the supply chain, and when considering comments about the underutilization of fleets, I think the Original Equipment Manufacturers (OEMs) are competing with existing aircraft to get new aircraft placed in the market. We have seen a lot of repricing of leases in the market since the crisis began. And for the Boeing and Airbus both to get aircraft into service, they will have to compete with the market pricing for very similar aircraft, which has dropped dramatically in the last year.
That leads to more price pressure on the supply chain—the primes and the OEMs are going to put more pressure on their suppliers to be more competitive. And that will likely drive a lot of overseas competition, as they try and lean out the cost structure and continue to drive efficiency into their own cost structures. All these things relate together. I will be interested to see how the global strategy plays out from the supply chain standpoint, if it becomes more important, or if perhaps there is operational risk that the OEMs would like to reduce or eliminate from the supply chain and bring more back regionally or domestically. But my gut tells me, we will see a big push to drive work overseas, for reasons of cost competitiveness.
Are companies willing to invest in mandates such as newer technology to avoid becoming industry laggards?
DN: At our company, we have seen a tremendous interest in industry 4.0 engagements, having performed several in the aerospace industry, and focused on the suppliers, the Tier 1/Tier 3-type suppliers. To get the benefits of technology, it does not have to be as expensive as what an OEM might invest—whether it is understanding:
- The utilization of its work force (such as real cutting time on a machine tool),
- The real capacity utilization in a factory, or
- Work force efficiency in a composite production facility.
We have helped several clients invest in that kind of technology to improve performance. I think we will see a lot more of it in the supply chain, because the cost of implementation has come down dramatically from where it was five and 10 years ago. Businesses can do it very efficiently, and there is money to be saved, and efficiencies to be gained by making relatively modest investments.
Predictions for distressed situations? Will many sales take place?
Bill Alderman: … 2020 was obviously a bad year for the economy… distress is probably coming back to the country. Commercial aviation is going to show its weakness and its pain and suffering … it has not really felt it, but it is going to, finally … Another market, though, I call “the voluntary M&A,” … will not just be distressed sellers (but also) voluntary sellers. It is going to be a tight market. There will always be exceptions, but I really believe that the voluntary founder—who is at retirement age and wanted to exit a year or two ago but could not—now is saying, “when the market recovers, I’m going to sell.” There is going to be phasing, all based on the recovery of the market.
David Nolletti: When looking at the bankruptcy rates, at the reserves that are currently on banks’ balance sheets for potential losses, and looking at the Fed’s balance sheet, that tells the story: it is coming. And it is going to be interesting to watch it play out, because we have not seen reserves this high since 2008 or 2009. In terms of credit, reserves, or credit loss reserves, we watch that with some regularity in our business, and the numbers are startling. The fact that we have not seen the traditional insolvencies to go along with it says—unless this cycle is going to play out in a dramatically different fashion—that the insolvencies are coming. It is just a question of time.
How will lessors fare through the current downturn?
BA: My comment to leasing companies: it is going to come back. It is going to be slow, painful … (but given) a strong enough balance sheet, (companies are) going to work through this (and to get out of this pandemic is), I think, almost going to be a straight line to recovery. And then leasing companies are going to be one of the first beneficiaries. I would rather the leasing company in this market than making wide body landing gear.
DN: I have a contrary opinion on that. … A lot of lessors are under pressure to keep aircraft placed right now, because they really have no alternative if they take a plane back. And they are agreeing to long-term “power by the hour” type of arrangements—and there are commensurate lease extensions go along with that—but pricing has come way down. And those terms are going to extend for quite some time. So, a big lessor tends to have access to capital and the ability to withstand some disruptions in cash flow. For the plethora of smaller lessors that have popped up over the last 10 years—lessors with 50 or fewer planes that are highly specialized or highly focused—are going to have a very tough couple of years, as those “power by the hour” agreements stay in place, cash flows are low and lumpy, and they still have lots of looming debt maturities to deal with. Big lessors are probably going to be okay, having the balance sheet to withstand it. But for the midsize and smaller lessors, it is going to be very challenging…in a post-COVID environment.
Note: All excerpts edited for brevity and clarity.