The aerospace and defense recovery after the pandemic is expected to continue, but the industry faces several headwinds and not everyone will benefit equally.
Recorded on the floor at the Aviation Week Commercial Aviation Suppliers Conference in Los Angeles, listen in as Senior Business Editor Michael Bruno talks with Alex Krutz, managing director of Patriot Industrial Partners, about why Tier 2 in the supply chain warrants close scrutiny as a point of concern in coming years.
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Rush Transcript
Michael Bruno:
Welcome to Aviation Week's Check 6 podcast. I'm Michael Bruno senior business editor at Aviation Week, and I'm at the Aviation Week Commercial Aviation Suppliers Conference and I have Alex Krutz, managing director of Patriot Industrial Partners. His unofficial title is chief guru there.
Michael Bruno:
So I'm really excited that he is talking with me here for the podcast about what we're hearing at the conference this week. And Alex, I want to start off with you, not in the obvious topics, which are Ukraine and what's happening there, we'll touch on that maybe by the end of the podcast, but you and several others have been pointing a spotlight on areas of concern that we expect are going to emerge in the supply chain in the near future, if not already. And you've identified tier two as a crunch point or a breaking point. Can you explain a little bit more about why you see tier two suppliers as the place to watch in the next year or couple years?
Alex Krutz:
Absolutely. Thanks Michael, for having me on this podcast and another great Aviation Week event here with the team having to put it together. So to answer your question on the tier twos, I think that we're going to see that crunch when it comes to the operating margins, because the tier two suppliers can't push up to the tier ones and OEMs. It's very hard to do that pushup because of the contractual misalignment, or maybe the leverage that those larger firms and companies have on the tier twos.
Alex Krutz:
And then, where we have also seen in the tier threes and fours, slightly downstream, there's some liquidity, some financial health issues, lower volumes, some pressure points in the supply chain. So it's harder for those tier twos to push that down. And we'll also remember that those tier twos were bigger than what PPP was able to be provided to because of just thresholds of the size from that.
Alex Krutz:
So they've had to go to the market to get more debt, to get those. And some of those are maybe on the smaller side where the market is maybe a little bit, maybe more risk adverse, right than a tier one or the OEM. So they're in that kind of $500 million to maybe that $1.5 billion range or maybe $2 billion range of that tier two size that is going to be under some pressures because they're not the small guys and gals, but they're also not the big tier ones in OEM. So, that's where we see some pressures.
Michael Bruno:
I want to unravel that onion a little bit, because it's very interesting to me. I don't think most people, maybe outside of aerospace, understand the multiple tiers involved and how they interplay with each other. But at tier two, you've got some key suppliers who have parts and maybe even subsystems that go into the commercial aircraft and they're feeding up either directly into an OEM possibly, but most likely to a tier one, like Spirit AeroSystems for instance.
Michael Bruno:
And we know that the OEMs and the tier ones are implementing price control regimes. We just had Airbus here yesterday, acknowledging the 15% procurement cost savings effort they've got going through 2025 on narrow bodies. So, tier twos face that, but at the same time in tier threes, they can't pass down the price. Why? I mean, we're living in an economy right now where everyone's passing on the cost inflation of everything and everyone seems to be willing to pay, but not tier threes and below.
Alex Krutz:
Yeah. So just for everybody, the way that I see the world and I think most people do, the tier fours are your kind of raw materials, processing components, tier threes are your kind of machining components, businesses that start to mill it out, do-
Michael Bruno:
Owner, founder shops.
Alex Krutz:
Yeah, owner, founder shops in those tier threes, sub-$25, $30 million, maybe 50 million or less in kind of revenues is in that tier three where they're just components. And then into the tier two, you're starting to get into small sub-assembly, small systems that do go to those integrators, those tier ones, even some tier twos go directly to the OEM.
Alex Krutz:
But the challenge that they have is usually those tier twos have a long term agreement or an LTA, as we say, with those tier ones or those OEMs where they get that cost pressure coming because of, in this contractual misalignment. But when you go down below them, they usually don't set up LTAs not typically with the tier threes or tier fours that they're getting material or components from.
Alex Krutz:
Usually those tier threes are putting in a spot buy purchases maybe for a month, six months, a year at a time. When we say spot buy, it could even be annual per purchases, but they're not long term agreements. So when those come due or come expire for those tier threes, typically they'll go back and look in their estimating and quoting process and say, well, my material's gone up this way and my labor's gone up this way.
Alex Krutz:
And so here's your new annual contract or purchase order right, response to that. And so when they're escalating materials from 10 to 14%, and they're looking at their overhead rate that's gone five to 7% up with 7% inflation, which has been the highest in 40 years, when you're doing that and they have a three to five year contract with maybe a tier one or OEM, and they're doing spot buys or year contracts with the tier threes below or the tier fours, that's where that contractual misalignment's going to come into play, where they're going to start saying to those tier one says, my costs are going up because the person that's qualified and makes it has said now, it's a 12% increase, whatever it is. And they maybe get it [crosstalk 00:05:58]-
Michael Bruno:
And if I want it, I have to buy that at that price in order to meet my delivery to you,
Alex Krutz:
To the tier one or the OEM, that's saying, well, you need to still give that to me. And oh, by the way, where you have those spot buy POS and that contractual misalignment down below that's the increasing cost, then you have the Airbus and Boeings coming and saying, we'd like a cost down because we're going to give you volume, right? Which theoretically makes sense in a perfect environment, but in this environment, right, the cost structure isn't going down, it's going up, right? And it's just, that's where I see that crunch that the tier twos that they're going to have that misalignment.
Michael Bruno:
So today we were hearing from Bill Alderman, a principal at Alderman & Company, the M and A mid-market advisor-
Alex Krutz:
Great banker.
Michael Bruno:
... that he founded. And he was talking about, it's reasonable to expect a lot of turbulence in the tier three. And he hit upon something I've heard a lot from you about, which are concerns over working capital at that level. So what are these concerns? Why is this something that we're going to probably hear more about in the future?
Alex Krutz:
So, if you start with kind of the purchase orders, right? Payment terms are 90, 120 days, sometimes even more on those. And then you talk about the working capital needed to have it in WIP. That's the second, and then even further to order it. So if-
Michael Bruno:
Which is work in progress.
Alex Krutz:
Work in progress, right? So, there's really three stages that consumes cash or the cash conversion cycle. So when a company has to order the material, let's say it takes three months to order 12 weeks right, for some type of metal, titanium or aluminum is probably in that 12 week. And then you have, let's say it takes them 12 weeks to make it in their shop, right?
Alex Krutz:
So that's three months, three months, and then they have 120 day, maybe even say 90 day, another three months, a small tier three has nine months tied up in that product, right from the-
Michael Bruno:
Cash spent.
Alex Krutz:
... from cash spent to cash receipt, right, is nine months. And so, cost cutting, I'm going to say this, I'm not trying to be callous, cost cutting is easier to do. You can tighten the belt and trim down the team, what you do, your expenses, right? And I'm not trying to say that loosely, but going down is a lot easier than up. So as you start going up in rates, then you're expending more cash out for material, work in progress or your WIP, and then your payment terms to your customer, right?
Alex Krutz:
So there's going to be a point, everybody wants more volume, right because theoretically higher volumes mean higher margins, but it also means more cash flow out the door, right? And so that's that liquidity crunch that I think as well as other consultants on the industry, myself included thought that 2020 was going to be a very challenging year, but thankfully there's PPP, loan covenants were relaxed and also, there was a lot of liquidity in the marketplace.
Alex Krutz:
So what didn't happen, what a lot thought it was is that maybe going to happen now because the PPPs expired, everybody's extended their loans or have new loans or have their credit lines maxed out? And now they have these increasing costs and the cash conversion cycle for increased rates. That's where I think Bill was also saying, and I think a few of us have been talking about that cash crunch, right from that standpoint.
Michael Bruno:
So as an advisor in the mid-market working with many of these companies, what is your advice to them, both now and looking as the ramp rate increases?
Alex Krutz:
So one thing that smaller companies don't typically do is lock in some pricing, right? So, that's probably number one is what materials. I just had a supplier here yesterday, chat with me about nickel based alloys, right? Should we lock it in where it's at an increase? Is it going to go up more? It's almost kind of like the Southwest locking in oil really low, right? Where people said, why would they do that?
Alex Krutz:
So I would say, look at some type of agreements, even if it's a year or two years then kind of buy in spot by, but you might have to make some more volume commitment to that. Also, I would say don't go to distributors, those are kind of very high price, short term delivery.
Michael Bruno:
And we heard from Boeing yesterday about potential concerns with distributors not being able to provide, nothing against them, it's just that they're struggling with the workforce and other issues too.
Alex Krutz:
Absolutely. And so, kind of think about some long term or midterm contracting, I would say. Number two is, still continue to a look at your cost structure where it makes sense. And I think those two things, that's your kind of working capital where you're spending a little bit less going out or have some predictability, the cost structure. And then I think number three, we talked about this a little bit yesterday, which is kind of the quoting and estimating process, right?
Alex Krutz:
Out there in the industry, everybody does it, but it's the undiscussed item that says typically tier threes and a lot of tier twos will have an estimating team or quoting and contracting team that says, well, this material six months ago when we did a price check was this. And so they keep on using that. They need to really hunker down every month and revisit that.
Alex Krutz:
And also overhead rates are going up, right? So if you have a wrap rate on the business and if it was $75 per hour, because it's about what it costs for your employees, what benefits, keeping the lights on, all that it might actually be $85 now, right? Because all the costs are going up, whether it's energy and oil. Oil I mean, oil's what, $111. I didn't see it this morning.
Michael Bruno:
No, 113.
Alex Krutz:
Oh, okay.
Michael Bruno:
When I walked out of my hotel room.
Alex Krutz:
So, I'm two hours behind, right? So, you have oil and energy going up, you have your material cost going up, you have your labor cost going up, right? So that means companies, they're wrap rates. And that's probably, so that would probably be one of the things that I would work with companies on is what's your overhead rate, right? Do you do a good job of calculating that and how do you then put that into your costing and estimating and the pricing strategy for the work that you, whether it's LTAs or spot IPOs, right?
Alex Krutz:
So I think that's the theme is, working capital on kind of materials that's stable, look at your cost structure and then what's your overhead rate. And how do you view your estimating, quoting would be, I think the three things that I would be talking to people about right now.
Michael Bruno:
All right. So last question for you. And I'm going to catch you a little off guard here and I just try to broaden everybody's mind, but we're hearing a lot of interesting information and to be honest, not all of it is wonderful and welcomed. We're hearing some, not gloomy, but certainly some foreboding talk about the rise in inflation and workforce difficulties and whether the OEMs really are going to build all the aircraft they say they're going to build and all this.
Michael Bruno:
A lot of new investors have come into aerospace and defense over the past few years and could very well over the next 10 years, as somebody who's knee deep or chin deep, actually in this industry with a career as many years as you have, what do you tell people now about the prospects of being involved, either as an owner or an operator in the mid tier of A and D or, just getting involved in the industry itself? Is it a good time, bad time, they're all the same, what do you see?
Alex Krutz:
I think it's a great time, however, right, there's a caveat to that, right? It's going to be a little bit bumpy, right? And we're going to get to a good destination, but I think that the supply and demand misalignment has to kind of smooth out a little bit, that has to converge again. I think that the rates have increased a little bit, but I think there's other bonuses that we may have not had in the past that aerospace and defense in the space segment, when you put that all together, there's attractiveness for things that fly, right?
Alex Krutz:
So some years ago, F35 wasn't really ramped up, B21 wasn't on the horizon and there's some European fighters. So I think that there are some opportunities on the defense side, also in the space side, right? I mean, you have SpaceX, Blue Origin, so there's some attractive and lots of things about satellites, 5G, some of those type of things.
Alex Krutz:
So I think companies have to look at kind of maybe getting out of their comfort zone, portfolio rebalancing is things that we talk about with clients is, what programs, where does your product kind of go? So I would say generally aerospace and defense is good and oh, by the way, right, General Dynamics built a lot of tanks that are going to Poland. So defense side, even if it rolls on the ground, I think we see now, even on ships, right, with steel and everything that's needed on ships that we have to be ... Atlantic Pacific, there's that number 355 ships.
Alex Krutz:
So I know that's a bit of not flying, but I think aerospace and defense generally has a very positive kind of outlook, right? But I think there's going to be some bumpy aspects and understanding cost structure, what programs are you on? Where are you headed? Are you investing in future technology? Right? Because being competitive is going to be another thing. So I see a generally very positive path, but-
Michael Bruno:
So, still up and to the right, but maybe not as straight.
Alex Krutz:
It's not as straight, right? So, absolutely.
Michael Bruno:
Well, terrific. Thank you very much, Alex Krutz of Patriot Industrial Partners joining me at the Aviation Week, Commercial Aviation Suppliers Conference. Appreciate you time.
Alex Krutz:
Great. Thanks Michael.
Michael Bruno:
Thank you for joining us here on the Check 6 podcast. Don't miss a single episode. Subscribe to Aviation Week's Check 6 podcast in Apple Podcasts, Google Podcasts, Stitcher and Spotify. Have a great rest of your day.
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