Listen in as business editor Michael Bruno and analysts Richard Aboulafia and Rob Epstein discuss aerospace's big problem.

They sat down after the Aviation Week A&D Supply Chain conference in Beverly Hills, California, which brings together aerospace and defense supply chain leaders.

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Joe Anselmo:

Welcome to this week's Check 6 podcast coming to you from Aviation Week's Aerospace and Defense Supplier Conference in Beverly Hills, California. I'm Joe Anselmo, Aviation Week's editorial director, and joining me are Michael Bruno, our Executive Editor for Business, special guest Ron Epstein from Bank of America and Richard Aboulafia of Aerodynamic Advisory. So Michael, let's get going with you. Talk about the general sentiment of the industry and what you're picking up here at our event.

Michael Bruno:

Yeah, maybe I shouldn't be surprised, but I was a little surprised to show up today -- and yesterday at our M&A conference -- and hear what is essentially an optimistic take on where the end markets are going everywhere across aerospace and defense and aviation. On the commercial aerospace or aviation side, you see rising commercial traffic. Obviously, you see orders coming in. You see increasing production, and we can debate it as to how much and how fast it'll increase, but at least it's up and to the right to some degree. On the defense side, you have record defense budgets and expectations for rising defense budgets in the rest of this decade.

The aftermarket, people are talking about positive results there. Space, exciting as it ever was, no matter what's happened with the SPACs, those special purpose acquisition companies. So just a whole lot of optimism across the board, which is a really nice, I think, change for this industry, certainly, coming out of the pandemic, but also the production issues with 737 and 787. That doesn't say there aren’t challenges and there are plenty of those and that's why we have this podcast here, but a lot of optimism on where things are supposed to be going.

Joe Anselmo:

Ron, you're the managing director of aerospace and defense at Bank of America, do you share Michael's impressions?

Ron Epstein:

Yeah, absolutely. I would say a couple things that Michael actually left out that even add a little more optimism. Business aviation is also doing quite well. Really the only end market that doesn't seem to be killing it right now is commercial helicopters. So, we'll see what happens there, ultimately. But yeah, across the end markets things are quite well. Richard sitting here has said in the past, it's sort of a market turned upside down. It's not a demand issue right now, it's really a supply issue. So being at a supply chain conference right now is very timely.

Joe Anselmo:

You gave an opening address to the conference this morning and you laid out the macro picture, which wasn't as encouraging. I talked about growth sort of Bank of America forecasting growth, sort of taking a dive this year. You talked about layoffs coming and young people not having seen them. Is aerospace different from that macro picture because of all these things you just said?

Ron Epstein:

That is the perception right now, for sure. If you look at how things are trading in the market, the perception for sure is that aerospace is a "late cycle industry,” that it's going to do better as we go through the cycle. And it was also, if you think about industries that were impacted by the downturn, was uniquely kind of smashed. So, we were coming off of a really low-low for the industry. So, I think the prevailing view is, yeah. If you look across aerospace and defense and the supply chain, everybody's looking for labor, which is a lot different than the tech industry where people are currently laying off staff. And I think today even, the Boeing CEO said that they're trying to hire folks from Amazon, which might make a lot of sense given where they're located.

Joe Anselmo:

Richard, you haven't given your presentation yet, you're giving it tomorrow morning, but give us some clues of some of the high points of what you're going to say.

Richard Aboulafia:

Well, it's the easiest forensics problem ever to be confronted because as Ron and Michael say, the markets are all looking great. Yes, we are I guess a late cycle industry. I've never seen things so good. I would add to Ron's commercial helicopters, I would add twin aisle jets, which are kind of still feeble, but jetliners in aggregate are, they're great. So why do things not appear so good from the standpoint of my true love? Output.

The one thing I love to do every year is to show that matrix of industrial output. I want to be that geek from the economics club who looks at output and boy, it's feeble for a strong recovery driven by powerful markets, things were feeble last year. And that of course is a function of the supply chain. And this is the first time in my 30-something years of looking at this industry that I've had to deal with the whole, oh gee, what can supply allow? How quickly?

And one fascinating point that Ron made, and I'm going to take it and run with it, is to what extent as a late cycle industry that still has quite a lot of tailwind behind it, to what extent are we welcoming bad macroeconomic news? A part of it, of course, as Ron said, is to reduce the impetus for higher interest rates that are not good for jetliner finance, but it's also to free up labor and productive resources and to lower the prices for productive resources for us.

So, per the comment about Boeing hiring from Amazon, well, when have we ever heard that? The tech sector firing people and aerospace hiring it, there's something frankly refreshing. I feel sad for these people's lives are disrupted, but there's kind of an interesting, I guess from our standpoint, happy story here too.

Joe Anselmo:

Yeah, talking about turning things on their head, I was lamenting that the Boeing CEO was saying they're not going to launch a new clean sheet airplane for another 10 years, which would be 30 years after the 787, the last clean sheet was launched. One of the suppliers said, “yeah, but that's actually not such a bad thing for us. It'll give us some room to breathe and time to catch up.” There's a lot of things turned on their head a little bit, aren't there? And we're also hearing when you talk about supply and demand, this industry's problems aren't demand, it's supply, it's the ability to keep up.

Michael Bruno:

It is. And it's great to have trajectories that are in the right direction up into the right again. But there are plenty of clouds on the horizon. As both Ron and Richard alluded to, supply chain is seen as the biggest break on everything that's happening in the production side of this industry. And there are other challenges too. If you have slowing GDP around the world, that's inevitably going to come back and hit everything from commercial traffic volume to the ability of governments to continue raising their budgets.

So, lots of things to be worried about. Plus, you have this lingering what seems like amazingly long-term problem with workforce, and it's a combination of not being able to hire enough people, not being able to have and retain enough skilled workers to complete the jobs. And at the same time, while it may be that it's great that you don't have a new airliner to take all of Boeing's future cash flow away from shareholders and workers, on the other hand, it's kind of worrying that they don't have a new aircraft program brewing because new is what this industry really likes, whether it's a new business aviation aircraft or a new rocket. New is what drives interest and ultimately business.

And when you don't have that new, you don't have anything to turn to in the future, and that sets you up for disruption, it sets you up for malaise, it sets you up for inefficiency. And Richard and Ron know that a lot better than I do because I follow their reports to learn about this. But I do want to say that while things are turned on their head, there are a lot of things to watch out for at the same time.

Joe Anselmo:

And just to explain to our listeners, when we say Boeing doesn't do anything, well that cascades, because Airbus is sitting really pretty right now, so they have no reason to act if Boeing doesn't act, and we Embraer just put their advanced turboprop on ice. So it's sort of a cascading thing where this industry, everyone's saying they want to be green, but there's part of the industry that's just in inertia, isn't it?

Richard Aboulafia:

Yeah, that's exactly right. And you look at the most optimistic expectations for some sort of alternative propulsion. It's what? It's 2040s if there's a miracle, hydrogen or whatever, not likely. But look, it's going to take way into the 2040s and realistically the 2050s before we do something that doesn't burn hydrocarbons. So, it stands to reason that A, there's going to be another generation of conventionally powered aircraft. There might be two generations.

And the idea that Airbus does nothing because Boeing does nothing and therefore people don't, that basically means we'll be decarbonizing at a much slower pace. It'd be great if someone launched a scaled up Geared Turbofan or Rise, if you prefer, or UltraFan. Everybody has in the engine world a plan to make another double-digit step change in reduction in the fuel burn and carbon. And if the airframers don't take advantage of that, that's going to be a pity. And you saw the Pratt presentation about how many gallons of fuel on emissions were saved by the Geared Turbofan. Of course, the other engine folks are saying the same thing. Well, the sound you hear in the background is people not replicating that for this decade. That's not good.

Joe Anselmo:

And Ron, you're the Wall Street guy. I mean you were pointing out this morning in your address, Boeing is doing what Wall Street wants it to do, they're focusing on the numbers, getting the ship in order, returning cash or generating cash, but if they don't do anything, their share of the narrowbody market by Glenn McDonald's, I think projection from Richard's firm is going to shrink down to 30-31%, right?

Ron Epstein:

Yeah, 30, 31% by 2031, which I agree with completely. And that's the catch 22. If you return the cash now, it doesn't come without a price later. And that's the whole thing. And ultimately, even if Airbus sits on the sidelines right now, they have more optionality with their current fleet than Boeing does. They could do an A220-500, which we've all talked about. Or they could do something else with an A 321, an A 322. So, they have a lot of optionality that Boeing just doesn't have for the 737.

Michael Bruno:

A real quick follow up, Ron, why is it, and I think we know around this table why it's important, but I think the audience often may lose the importance of why it is so critical that Boeing and Airbus went from basically sharing the market at almost a 50/50. And if Boeing is at a third and Airbus is at a half to two-thirds, why is that important in the long term?

Ron Epstein:

That's a great question. Because you could say, Hey, a third of a big thing is still a big thing.

Michael Bruno:

Right, it’s a lot of money.

Ron Epstein:

It's a lot of money. However, where it becomes an issue is if you have two-thirds of the market, your incremental cost to get that next airplane off the line, so say it's your airplane number 80 off the line, your incremental cost to deliver that airplane is much less than Boeing to deliver incremental airplane number 45 off the line, or whatever it is. And then that just builds on itself, because when you go into sales campaigns, you can offer more for less or a lot more for the same. And that really becomes the issue. It's a volume issue around incremental cost and spreading overhead.

Michael Bruno:

And for both of you, Richard or Ron, it's also about you can attract suppliers, you can get more interest from your supplier base. They're going to have more confidence in you, they're going to want to strike bigger deals, long-term agreements with you. You're just in a better place altogether with your supplier base.

Richard Aboulafia:

Yeah. And you also become sort of a collapsing empire vulnerable to predation. The optionality in product line futures that Ron correctly identifies means vulnerability. It's not just an A220-500, it's a significant chunk of the 737 MAX 8 being taken away by the A220-500. It's not just an A322 with the resin transfer infusion wings and new engine, it's the end of the MAX 10 and for that matter, a big chunk of the bottom of the 787 market.

In other words, they can use this optionality to go after, and then a slip becomes a slide. You go from a 31% market share to a 25% market share by the middle of that decade, or less. And then of course you have this track record of failure so that investors and your board say, ‘Wait, why are we investing? Why are we putting money into a new product at all?’ And that's of course what happened to McDonnell Douglas, we all remember.

Joe Anselmo:

So guys, this is a conference focused on suppliers. It was a tough year for supply chain last year. Airbus missed its delivery targets by a good margin because of the supply base. So what is your sense on the health of the supply base right now at the beginning of February, 2023? Is it improved from last summer?

Ron Epstein:

I would say yes, it's improved from last summer, but it's not where it needs to be. And we've already talked about probably the single biggest issue across the supply chain in North America -- U.S. and Canada -- is labor, is getting skilled labor. My understanding is, it's less of an issue in Europe for a lot of reasons how they kind of handled what they did during COVID and the workforce in Europe. But in North America, it's a giant problem. And if you look across the supply chain, I think you'd be hard pressed [if you] find any supplier who's being honest about it, they'll all say they probably need 20% more workforce.

Richard Aboulafia:

Of course, a lot of it is, the issue of working capital to make the ramp has been with us for some time. And so far, things are holding together reasonably okay, but there is that rising cost of capital thing. That's a concern. Hence, Ron's point about maybe it's good news if the economy slows so they don't raise rates and capital stays reasonably priced. But this is all concerning because of course through the pandemic, they did everything they could. They loaded up their debt, they sold off everything that wasn't nailed down. It's tough.

Ron Epstein:

Yeah, and the refinancing costs are I think something that gets overlooked. Spirit [Aerosystems] had to raise some debt recently and the last time they raised debt, it was around 5% rate. This time it was around 9%. That's a big difference for them.

Michael Bruno:

And it was a big chunk of money that they raised. And I'm not sure that completely gets them out of the woods, right, because they’ve got to pay more off in 2025 or so, after 2024. So, great example of a company that has gone through the pandemic and probably been more resilient than I think the average person might have expected, to be considering all things that were happening in the aerospace industry. But at the same time, it's hard to say that it's bluer skies ahead.

And I think the case for a lot of supply chain is, the good news is it's more resilient and there were far fewer failures in the pandemic and the MAX crisis and 787 crisis than people expected a couple of years ago. Certainly at the beginning of COVID-19, we had very widespread expectations that we could see like a fifth of the supplier base just exit the industry, whether it was going out of business, bankruptcy, for sale, just choosing to go to some other industry.

And that didn't seem to be the case yet. Now the problem is while we're in a growth phase, that growth is going to require a whole bunch of investment, as Richard and Ron talked about, in everything from new technology to labor force. You're going to be under stricter terms with the OEM and Tier One customers to strike better priced deals because they need to get their prices down to compete because it's still a really harsh duopoly when you get to the top of the commercial aerospace business. So, it is not a lot of clear runway, I think, for the supplier base, but they're not as bad off as people feared when COVID initially hit.

Joe Anselmo:

We've been talking a lot about commercial, but Ron, in your address this morning, you also talked about the outlook for defense, and that's a bright spot for suppliers of the defense industry. You're really bullish on defense. Tell us why.

Ron Epstein:

Yeah, for a number of reasons, and probably the primary driver is just look what's going on in the world. The U.S. is on some level kind of at war on two fronts, one in Eastern Europe and one in the Pacific Rim, and that has expense tied to it. So if you got to, A, replenish, everything that's been sent into the Ukraine, that drives defense spending. And B, more importantly, from a spending perspective, projecting power in the Pacific Rim is expensive.

Michael Bruno:

You had kind of a mic drop moment in your speech at our conference. You reminded the audience that we're very well facing a trillion-dollar defense budget by the middle of the decade. And nobody blinks an eye at that number because we all know it's coming. You wrap everything up; costs, new technology, new production you got to pay for, a trillion dollars, that's where we're going to be in 2025, 2026.

Ron Epstein:

That's right. Yeah, exactly.

Joe Anselmo:

And Richard, you live in Washington, you have a bird's eye view of the dysfunction in Congress, and yet it seems to be the general sentiment that there's going to be bipartisan support for defense no matter what.

Richard Aboulafia:

Yeah, obviously the mechanics are fiendishly arcane. If you could remove the so-called freedom tea, whatever the [Rep.] Matt Gaetz’s of the world and their great intellectual contribution, then you're left with 85%, 90% consensus. That's extraordinary -- about China, about the defense budget, that's about Ukraine. It's just a question of this remaining 10% throwing a spanner in the works. It doesn't seem like they'd be able to, but who can tell? Right? Who the heck can tell?

But I agree completely with everything that Ron said. I'd also add to it that it's incredibly complimentary, these two forms of threat that the U.S. is responding to. The central European front, of course, very much a land front, a tactical aircraft front and helicopters, whatever else. Whereas, if you go to the Asia-Pacific pivot, then it's all about naval and strategic air systems. So, it is really kind of a something for everything defense environment.

Plus, on top of that, it's another surprise that just like we faced in Korea in 1950 and the Arab-Israeli War of 1973, it's just, ‘Oh wow, you go through ammunition really fast, we’d better stock up. And oh, by the way, we better turn Taiwan into a hedgehog island because it's the first day of war, might as well be the only day of war in terms of resupply.’ And then as Ron put it, there's so much happening all at once to make good dilapidated force structures in Europe. This is a recipe for just an avalanche of cash that again, the supply chain just can't cope with.

Joe Anselmo:

So Ron, Michael talked to you about your mic drop moment talking about the defense budget, but another moment that the audience loved was when you brought up a chart of historical interest rates that went back 5,000 years. But, I think your point was everyone's ringing their hands over interest rates, and you're saying that 5% historically is not the end of the world.

Ron Epstein:

No, not even close. And the point of that chart is, we're coming off a period where it was the lowest in 5,000 years, not just 5,000 years of rates, we're coming off the low of 5,000 years. So, if you go back to 5%, 6%, 7%, that's just kind of normal from a long perspective and the world will adjust. And one of the things I think the financial markets had to digest last year is, are we in a higher interest rate world? And it does seem like we are at least for a while and a while, meaning not a month, not a quarter, but for a couple years.

Richard Aboulafia:

I'll bet you two cubits and a shekel that you're right, going back. But on the other hand, I'm kind of a glass half empty sort of fellow. So even though the cost of capital so far hasn't been ruinous and probably won't be, I still can't help but wonder about the end of all this cheap money and God knows it hit the tech sector. You've been pointing out for some time that all sorts of goofy things are possible with cheap cash. And if that goes away, there will be failures.

I remember the very wide jet air taxi days, and it took years for that to unwind 5, 6, 7 years, whatever. This could happen a lot faster. I'm not saying it'll all go away. There's going to be some interesting experimentation in technologies and some companies are going to do fine, but ultimately the better part of 200 startups are going to die, and that's going to be a bit difficult to digest.

Joe Anselmo:

Michael, we're running short on time, but I wanted to note Aviation Week also hosted an M&A conference here yesterday that was just focused on M&A. Can you give us your takeaways from that? What's hot, what's not? What's the forecast for M&A and what are some of the drivers of M&A?

Michael Bruno:

Yeah, so M&A really interesting year. I think 2021 was mind boggling in a way that I find people are still challenged to put into words just how amazing the business activity was that year for mergers and acquisitions. And we've covered that before on this podcast in an Aviation Week, so I won't rehash all of that. But 2022, if you were to look at it compared to the long term, any other year, 2022 would've been very healthy, but it was a drop-off from 2021.

And so, people are trying to put that in context. Not as high as the record year before, not disastrous by any stretch of the imagination. Looking at 2023, the expectations right now at the beginning of the year is that it's still a healthy year. Whether it'll surpass 2022 remains to be seen, probably won't be that far from when you look at the number of deals and the value of deals in the end, people are expecting a relatively good year, so that's good.

Now, it does of course depend on where do you look? There are some sectors, defense, space, hypersonics, things that have to do with new technology such as artificial intelligence, machine learning, and how you can bring those into companies in the aerospace and defense manufacturing sector, are expected to be hot places. Engines potentially might be one sector where consolidation kind of takes off. We have one of the speakers and sponsors of our conference, Michael Richter from Lazard was talking about an engine deal he helped put together at the end of 2022 that he thinks could be a trigger kind of deal that makes a whole bunch of others in that sector come together like what happened in aerostructures about a decade ago. So remains can be seen, but Michael's got experience there, he could be, right.

Where are the places that aren't hot? Well, one of them is very near and dear to many people's hearts in aerospace, and that's aerostructures. It just, that's not an area that seems to be like it's going to see a lot of hot activity unless there's distress. And then you've got other things like new space where once upon a time there might have been mergers and acquisitions if all the SPACs had done well, that doesn't seem to be the case now. And so that'll probably slow down as well.

Joe Anselmo:

Okay. Well, we are unfortunately out of time, but Michael, Ron, Richard always appreciates your insights. We always come together at this event and record this podcast and it's always great to do it with you. So thank you. Thank you for taking the time to do that.

That is a wrap for this week's Check 6 podcast. Special thanks to our podcast editor in London, Guy Ferneyhough and special thanks to our onsite technical editor, Michael Bruno, here in Beverly Hills. If you have any complaints about the quality of this podcast, Michael Bruno's the guy you want to go to. We will see you again next week for another Check 6. Thank you for your time.