The dream still alive for urban air mobility. We will need to succeed in aligning everybody to one single standard. We need to be coaches in the corner. Those of us in aviation. Our aerospace industry is strong, is resilient. Some of the fastest growing segments within USM will be expensive to overhaul parts. It’s a great marketplace where we need to invest in the future. We're looking at domestic markets recovering faster, shorter routes that are higher demand. Our aerospace defense companies to view and assess the opportunity to build.
Dennis Santare
Welcome everyone to the Velocity Podcast brought to you by management consulting firm, Oliver Wyman. I'm Dennis Santare, a New York based partner in our Aerospace and defense practice. The Aerospace industry has faced the most acute shock in its history. As COVID-19 spread across the world in the industry lost over 118 billion dollars in 2020 and it saw dozens of airlines seek bankruptcy protection or stop flying entirely. There's really no sugar coating the fact that the industry has been through a major crisis. Although there is more work to do in order to get through to a full recovery as our current forecast show, the recovery is indeed happening and commercial aircraft activity is poised to return. It is now time to design a resilient next chapter for Aerospace in a post-pandemic world. Key characteristics of our market have changed dramatically from pre-COVID to post COVID, these include but are not limited to market growth rate, volatility, cost of capital, outsourcing trends and capacity shortages. Today's discussion will focus on the Oliver Wyman next chapter design elements focus on market and portfolio choices that aerospace companies can make as they design their next chapter. In general, strategic sustainability for A and D players will be critical post covid. Business design needs to be founded on where and how you play, i.e market in portfolio choices and optimizing to your operating model strengths and weaknesses while guarding against risks presented by the move to the new normal in the next chapter. This brings me to our host for this episode. We have quite the international cohort today. I'm being joined by my colleagues, Ken Aso based in Seattle, Jerome Bouchard joining from Toulouse and David Stewart who is based in London. Together, we'll be examining the key aspects of a pre and post COVID market and which design elements will position aerospace companies to win in 2021 and beyond. Let's jump straight into the discussion. Ken, can you offer our listeners a view on the platform portfolio typically thinking in terms of widebody vs. narrow-body choices.
Ken Aso
Absolutely, after many years of rapid growth in general, aerospace is now entering its most unprecedented period of uncertainty in the history of modern commercial aerospace. We saw pre-COVID, a high rate of growth intense production ramp-up across the entire commercial manufacturing industry, effectively scaling the global supply chains to have the capacity to produce over 2,000 aircraft per year, but on the other side of COVID, with the industry significantly impacted less than 1200 aircraft were actually delivered. We're going to see a slow production ramp-up, not a snapback for sure with an emphasis on narrow body over the next few years. And so, as we think about the aircraft types, there will be a difference. We've been looking at a number of different ways where we can see forward indicators, leading indicators around the growth of industry in terms of narrow body were looking at domestic markets recovering faster, shorter routes that are in higher demand and we're seeing airlines downgauge their aircraft for a number of different point-to-point route, shrunk routes and even on international routes from the standpoint of international routes, crossing International boundaries. We're seeing a lot of pandemic related challenges, you have international regulations, you have higher risk factors on the flights themselves, and then you have customer perception leading to airlines to favor the accelerated recovery of the narrow-body market. On the Airbus side, 321 XLR is a well-positioned aircraft to recover in general across the narrow body portfolio, being more well poised to respond relative to wide-body. As we think about wide-body the A380 and the 747, we’re accelerated in terms of what was an already kind of planned phase of going out of production. In terms of the medium gauge aircraft, we’ve seen negative net orders reduction in production scale and no real demand for medium gauge wide-body aircraft. It's really wait and see with the exception of some cargo specific route and for cargo specific carriers. Boeing 787, and the a350, they're very good aircraft, but production has been cut by 25% or more 25% or so for Airbus and even more on the 787 is they’ve consolidated from two production facilities down to one. And so we'll need to see those international routes rebuilt overtime. Jerome, do you have any perspective in terms of cargo as well as the rise of regional traffic in particular regions?
Jerome Bouchard
Yeah. Thank you, Ken. Nice to meet you again on this podcast. Regarding the cargo, I think that has been a very stable driver for certain sustainability of the airline industry over the past years. So many cargo aircraft have been flying a lot. And when I mean a lot, much more than before, okay, and in majority, those aircrafts are vintage aircraft, I would say. We have seen a rise in utilization of old Airbus a300, for instance, and that generated an interesting dynamic, especially on the aftermarket because all of these vintage, aircraft are needing, some very specific piece and part for maintenance. And obviously the number of cycles in utilization has gone up a lot beyond the cargo, there was also a very good momentum on the regional jet fleet, especially for regional aircraft in some regions of the world. We can think about India, we can think about China, but still also in the US and Canada. So, very large countries where domestic flights are very important and can be operated from point to point with a smaller jet and in fact smaller regional jets
Ken
Yeah. It's clear that regional has been affected much less than International traffic and long-haul point-to-point domestic traffic. That's a good point.
Jerome
Yeah and I think we can see it in the very good older book than the a220 is actually having this plane has quite a success. I would say with some airlines, very few cancellation, a good commercial traction on the market and a good ramp up perspective, besides of course or despite the COVID trend.
Ken
Yeah. That's right. As we're seeing recovery in varying degrees across the different markets. As we look to see the Aerospace industry, build the resilience production posture, aerospace companies need to pinpoint and diagnose which areas of the business will need to be restructured to adapt to this post-pandemic market. Jerome, what does this mean if we're approaching the recovery from the standpoint of the specific air framers?
Jerome
Maybe before talking about the recovery Ken, and let's take a look on what was happening during the 2010s. These particularly decade was growth decade for both Boeing, Airbus but also ATR and Briars and others, especially in the second half after 2015, production rates have been skyrocketing and very fast evolving towards the record years such as 2018 which was, I would say the peak year before the 737 Max and industrial problems. We recorded more than 1,800 commercial aircraft actually delivered and produced that year. I would still say it's in a balance market to the advantage of Boeing over these decade slight advantage, but still advantage both in terms of orders and overall production. But in 2019, the problems with 737 Max arise. And unfortunately, we had a big gap, in terms of production between Boeing and Airbus. It’s of public knowledge that Airbus started the COVID crisis in much better shape than Boeing did because of these 737Max issues. So, at the very beginning of this COVID crisis, if I'm taking the true leader framers, we had on the one hand Airbus that had a very good backlog, a very strong commercial pipe, and a growing capability to deliver and produce aircraft. And on the other hand, unfortunately, Boeing, that was already facing some big issues with the 737Max, many aircraft on the tarmac in Seattle. So taking a look in front of us we see in 2020 or very strong year for others in terms of delivery and production with five hundred sixty-six aircraft and this very good production and delivery rate are putting the Airbus fleet much ahead of the Boeing production that was close to one hundred and seventy aircraft in 2020.So, of course, we're not talking about the same aircraft and the Boeing fleet is much more on the long-range side and the Airbus fleet on the single range, but overall this has created a big discrepancy in the financial results and also in on the fleet mix slowly, but surely the short hauls will take over a large portion of the total fleet. If we take a look at our Oliver Wyman Fleet MRO forecast in 2020., in the overall commercial fleet, there was one long-range aircraft for three narrow-bodies. Well, in 2030, there will be one long-range aircraft for four narrow-bodies. And that’s, of course, a huge shift in change in 10 years, showing both the retirement of the long-range aircraft. But as well, the increasing market share of the narrow bodies and within this narrow body fleet, there will be one winner in the next decade, which will be A321LR or XLR where we can see. I would say a very strong progression in the mix. We also know that starting in 2022, the 321 family, will already represent more than 50% of the total A320 family production. And that particular proportion will only be growing over the decade to come to a very large majority of A321 produced in the end.
Dennis
Jerome, what do you think restores the duopoly? Does the Max help, I just flew in one last night, and it felt great to see that aircraft back in operation. It’s been ungrounded by both the FAA and IASA. Is that going to help? Is that going to get Boeing there? Or does it really take something external or something dramatic like the MMA aircraft coming back, or the Embraer JV being reinvestigated and put through, or what gets us back there? Or is Airbus just too far ahead?
Jerome
That's a very fair question, Dennis. I think, first of all, 737 Max back in the air, is a very good news for the industry, overall and recertification FAA and IASA is clearly a very good sign, not only for Boeing, but also for it's whole supply chain and for the clients in terms of US airlines in majorly. Having said that, I don't think that having the 737 Max coming back into the race will be an actual game changer. These aircraft that has been produced will take, we believe up to two years to be reintroduced and redelivered to the market. So, that will be relatively slow in terms of comparison with the rate of production of A320 family, for instance that we all sat around 43, 45 a month, but still it's a good news for the industry overall. Talking about the middle of the market program for Boeing, Ken, maybe I should turn this question to you. What are the perspectives regarding that particular segment and what could be Boeing’s positioning in the middle of the market?
Ken
It’s been debated hotly around the opportunity for Boeing to participate in that middle of the market. It’s clear that there's a trend of up gauging aircraft on the narrow body side, it’s clear that there's been a need, Boeing was studying it very, very heavily around launching and then unfortunately, because of some of the challenges around the Max, maybe some other quality issues, along the production system. It seems like a lost opportunity. The market is a little bit smaller now, in general, Airbus has a fantastic product with the XLR, very efficient aircraft. There is the need of course for Boeing to launch a new aircraft on the narrow body side. There's just a challenge right now in terms of investing that level of capital for that airframe. And of course, it's a team sport when you're launching a new aircraft, you need to align and you need a partner with a number of different tier one’s, most notably on the propulsion side and so, you have to work closely with the engine OEMs. And they need to be ready to launch around a particular specification. It just takes time in this and I think that's the challenge that Boeing has.
Jerome
I agree with you, Ken. I think it takes time and it also takes money. I think that a rule of thumb we can assess that development cost for a new aircraft of that kind would be between 2 and 3 billion dollars a year. So, knowing that, with the best effort it will take at least six to seven years for a full redevelopment. We are here talking about an investment of approximately 18 to 20 billion dollars. And in this particular COVID situation that has been consequent to the 737 Max issues, there would be a huge financial pressure if Boeing had to fund such a new program, don't you think?
Ken
Yeah. And let’s remind ourselves that air framers have been spectacularly sanguine about the amount of time to develop new aircraft programs and spectacularly wrong in terms of under estimating, the sheer amount of time that requires to get an aircraft designed, engineered, prototype tested and then launched right hand approved. And so, if you're thinking about a realistic time frame, I think that points to the need to frankly, think comprehensively about the narrow body portfolio.
Jerome
Commercialization far exceeded the difference pre-pandemic something which we have seen the significant shift in the post-COVID market. Dennis. How can I aerospace companies design the right approach to tackle that change?
Dennis
Thanks. Jerome. Obviously, defense is something that's near and dear to my heart and thinking short, I'll just cut to the chase. Coming out of COVID, we think that defense is going to lead. Companies should seriously consider a lean towards incorporating more defense work into their business models, even with the apparent talks about the flat budget under the new administration and headwinds overall from a US context, in general. First of all, not going to see major budgetary impacts in the US for at least a year or more as the new administration gets their heads and hands around the defense department in the budget itself. And then furthermore, I think we're globally , you know, trends are pointing towards a sort of a frothy defense market and a bullish take on where defense is going really, again, across the world due to geopolitical instability, on going conflict, competition, and the need to maintain parity with what country is considered to be their pure threats,. The commercial OEM market, so folks, that produce parts and systems and components for production and aftermarket that market is going to be severely curtailed with a full recovery, not really expected. And if you look at our forecast until around 2024 and beyond, and then, when you think about some of the data, we're putting out around the total value, destruction in the market, over the next ten years vs. where we thought we would be in 2019 is sizable. And so for companies that are heavily invested in commercial aerospace production and supply chain, we just think it's a really good idea to take a look at their capabilities and whether they can leverage invested capital, leverage supply chain relationships and capabilities, and leverage their engineering teams to going essentially build products meant for defense or change products so that they may have more of a defense application that takes time. It may be a little tricky to turn on a dime. It's probably a lot easier to say but at the end of the day, it's about taking a hard look at our operating model, taking a hard look at our commercial operating model and take a pivot towards more defense.
Ken
Dennis, for those that are thinking about defense right now, obviously, over the last couple of weeks. We've seen the US usher in a new administration, the Biden Administration. It is potentially going to usher in a set of new priorities for this defense spending. How are you thinking about that for the medium term implications for defense sector growth?
Dennis
It’s going to be a bit of a wait and see and where we’re coming out right now, Ken, is that this Administration can affect the 2021 budget for the most part. There's some things they can do around execution, but budget itself is intact. The 2022 budget is largely going to be attacked again, very little they can do. It’s really around 2023, fiscal year 2023 and beyond, lots of talk about force reductions. So that area of the budget where we've been money on, people may experience some headwinds, perhaps in the area of investment RDT&E and procurement. There may be some programs that are on shakier ground than other programs. I think programs that have established, you know, programs of record have established funding, have established infrastructure, established supply chains, I think they are probably safe for the longer run. But I'd say that a few of the emerging programs might a little bit shaky ground, but then when you think about where a lot of OEM play in terms of OEM spend the operations and maintenance spend it within the budget that is sort of legacy aircraft, legacy weapon systems and maintaining those. We feel at least for the currency least point to that level of spend being relatively intact, flat to maybe in real terms of a percent or two of growth, we’ll have to see how that goes. But it's really about keeping the current weapon systems up and running, keeping them healthy, keeping them sustained and I think there is a lot of room for organizations who are not yet entered to get in and again, leverage their capabilities to try to take some market share within that section of the budget.
Jerome
For the previous years, I believed that the defense market for most of the tier 2 and tier 3 supplier was some sort of very stable, nice to a diversification, but most of them were attracted by the high ramp up in the commercial aviation. And now I feel that defense is bringing a lot of resilience in the supply chain. And I think it's even I would say, key success factors for tier 2 to tier 3 suppliers to actually survive through the crisis. Would you share your opinion on that topic with us?
Dennis
Absolutely. We always used to say Uncle Sam pay your bills on time, right. He pays his bills and he pays them well and that steady predictable revenue, the steady predictable cash flow, that is attractive in the defense market and it trickles down, of course, from the government in the US through the primes and the tier 1’s and down into the tier 2’s and 3’s. You can count on the business once you’ve won it. A little bit of a challenge to win business. Deal cycles tend to be long, relationships have to be built and made, past performance has to start to build on itself. It's not an easy task to just decide one day I'm going to go work in the defence market and then go win it and it takes some time. But once you're there, it can be a nice resilient sustainable source of predictable revenue. You look at the programs of record, the big aircraft programs, a big weapon systems programs and ships and submarines, etc. They tend to have long tails and long life cycles. For example, the B-52 is a B-52 because it was first flown in 1952, right? I mean, it's got a long, long tail and the weapon systems we’re building today are designed to have that long tail as well. So it's important to work real hard to get on those programs. And once you're, there you stay on you perform well, and then you reap the benefit of that. steady predictable revenue, you position yourself for aftermarket, you position yourself for retrofit campaigns as aircraft in systems, become modified and upgraded again. It tends to be a nice counter-cyclical source of revenue to commercial. And it also tends to be far less volatile than exposing yourselves to the ramp-ups and ramp-downs of the commercial air framers.
David Stewart
One other interesting angle which might provide some stability into the commercial side of the business but interested in your view would be, do you suspect that any of the strong defense OEM might consider the distress in the commercial world, potentially enter into the commercial world, take advantage of the distress and in the knowledge that some point is going to recover some of that growth we have had over the last few years will come back. And do you see maybe the defense industry actually being a part of the solution for commercial?
Dennis
That's a great question David. I think for the OEMs that already have commercial exposure, we might see that where they seek out more commercial capability as clearly the play there is to buy low, during this dip and invest in companies or outright purchase of companies that have commercial exposure. For the purer play defense primes it’s tougher for me to see that, where I do see it is in software and high-tech systems. Lot of acquisition activity in the software space, quite a few of those companies that are being acquired by the Lockheed's and the Northrop Grumman's, etc, are face value, commercial software and commercial technology companies, but that can be purposed for defense, cyber, artificial intelligence, all of those are really hot sectors in terms of investment from financial sponsors and of course from strategic owners, like the defense primes. Thank you all for joining us for this episode. Join us for part two as we continue the conversation about optimizing your operating model for the next chapter including our design elements around things like supply chain agility, IP control, positioning and footprint. Thank you to my co-hosts and thank you to our listeners at home. If you have any questions around what we have discussed today, please write into us at Oliver Wyman on Twitter and LinkedIn.
