Mark Odendahl
Welcome to the Industries in Motion podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast moving markets and industries, to help you stay ahead of the curve. Please listen to the end of this podcast for important disclaimers. My name is Mark Odendahl, and I am head of US Capital Markets Research here at RBC. Let's get into today's episode.
I'm happy to introduce our next guest, Ken Herbert.
Ken is new to RBC and joined RBC in 2021 as our aerospace and defence analyst. He's not new to the sector, though. He's been on the street for 15 years. And we welcome his industry knowledge and thought leadership to our industrial team.
Ken is well known for his coverage of the original equipment manufacturers, the OEMs, as well as the aftermarket side of the aerospace sector. Ken is well known for his 13 year running MRO survey, maintenance, repair, and overall survey, which plays quite a bit into his commercial aftermarket calls in the sector.
Ken, thanks for joining us today. And I look forward to going over the aerospace industry with you.
Ken Herbert
It's great to be here. Thanks for having me, Mark.
Mark Odendahl
So let's kick it off. Ken, where are we in the aftermarket cycle, the aftermarket recovery, etc, if you could address the space from both the OEM side of the business as well as the aftermarket business.
Ken Herbert
Great, thanks, Mark. Well, as you know, the recovery has been led by domestic travel, we've seen domestic travel globally running up about 90% relative to pre-COVID levels, with international traffic running up about 70% or at 70% of pre-COVID levels. Now, as you know, the recovery has been led by markets here in the United States and in Europe, with some puts and takes in the Asia Pacific region, China in particular, trying to remember back in 2020, led the industry in the recovery both in flight activity as well as spending on their aircraft as they pulled forward maintenance. But because of various variants of the coronavirus they've taken a more mixed approach in their philosophy and regulations towards traffic. So we've seen a bit of a mixed recovery there. But broadly speaking, we're currently running at about 80% of pre-COVID levels.
Mark Odendahl
So I don't think we could do a podcast on the aerospace sector without some thoughts around Boeing, the timelines around Boeing and where we are with Boeing and the 737 MAX as well as the 787. So where do those programs stand? And what are your expectations for deliveries as we look out over the next one to two years?
Ken Herbert
So heading into the COVID crisis, the 737 Max was grounded. This grounding happened in the first quarter of 2019. So that aircraft was already in a bit of a tough situation. Deliveries have slowly ramped up with the recertification of the Max starting in November of 2020. Most recently, the Max has been recertified in the last major markets, notably China, and then of course some of the other markets in Southeast Asia.
Deliveries have been slow to recover as the supply chain has been gradually increasing their output and production levels. Boeing currently sits on approximately 350 Max aircraft in inventory. We expect Boeing to work down its inventory on the Max this year and through much of next year with an expectation this year that we get about 500 deliveries. Now, the majority of those will come from new production, as the supply chain ramps up and ideally hits the 31-a-month production rate in the first half of 2022 that Boeing has been guiding to.
So the 737, while we're still waiting for the official deliveries to resume into China, they have largely recertified the aircraft and things look to be moving in the right direction. The 787, however, is a bit of a different story. Boeing has been forced to pause deliveries of that aircraft while they work out issues dealing with some conformance issues in the manufacturing process. And we're still waiting for final FAA approval to resume deliveries of that plane, which is expected by the summer of 2022.
Mark Odendahl
So because of Boeing's issues, how has that impacted market share between Boeing and Airbus? Could you give us a snapshot of current market share? How's that different from historical market shares? And any thoughts around that going forward?
Ken Herbert
Yeah, that's a great question. So historically, the industry was roughly 50/50. Now, it was never quite along those lines. But more recently, Airbus has clearly pushed an advantage in the narrowbody marketplace.
Airbus’ A320 family of aircraft right now are running at about a production rate of 45 a month and the company plans to increase that to 65 a month by the by the second half of ‘23. Compare that to the approximate sort of mid-30s a month that Boeing will likely be at for this year. So you're looking at almost a 60/40, maybe even two thirds, one third split on the narrowbody deliveries here for the next several years. We recently attended a very significant supplier conference and suppliers’ confidence in the production increases out of Airbus remain relatively high with mixed messaging out of Boeing. So I think the narrowbody marketplace is structurally advantaged for Airbus for the near term.
On the widebody side, which is the larger aircraft, Boeing has historically enjoyed an advantage in this marketplace, partially due to its position in the cargo markets. Boeing has dominated the cargo markets for many years. We do expect Boeing's dominance in the cargo market to continue, although Airbus does have a competing product here in the A350. It's important to keep in mind that production output on the wide body aircraft, which are predominantly used for international travel, are lagging the recovery and narrowbody. The narrowbody marketplace, which is predominantly for domestic travel, is seen as capacity-constrained right now with airlines looking to bring lift back into these markets, which incidentally is a real positive for the aftermarket, which we'll talk about in a few minutes.
On the widebody side, however, as international travel has continued to lag in the recovery. We've seen significantly slower demand for the larger aircraft. And in this marketplace cargo has clearly been a real benefactor of the crisis and demand has remained very strong. But we are looking at still a roughly sort of 50/50 split in the widebodied marketplace between Boeing and Airbus, at least for the next several years.
Mark Odendahl
How important is that cargo market to the OEMs? And does the acceleration of ecommerce represent a structural shift in the cargo markets?
Ken Herbert
Yes, so cargo markets do represent about 10% of the active fleet. They tend to be older aircraft, which again is positive for the aftermarket. And we do believe the shift to ecommerce, especially compounded by a lot of the supply chain bottlenecks and constraints you've seen more recently, has favored air cargo markets in particular. And we do think that market is expected to continue to thrive and benefit as hopefully the economies do start to normalize. You're seeing a shift and a lot more confidence in at-home delivery for goods of all sorts, and a greater importance on near-time or shorter delivery cycles.
So we do think the shift to cargo does represent a structural shift that certainly benefits air cargo markets, which again is why Airbus is getting into this market in a more aggressive way. And it plays to the historical strength of Boeing.
Mark Odendahl
And then just the last point on OEMs and the cycle there. How does the supply chain look today in terms of labor costs, material costs, inflation, bottlenecks, etc.?
Ken Herbert
Yeah, so we've seen significant pressure on the supply chain, as we've seen across industries. I guess one thing I would say is the industry benefits from the fact that right now the production levels are still you know, 50 to 60% of pre-pandemic levels. So we're not seeing the, in an absolute level, the type of pull that we would see certainly pre-crisis.
Having said that, suppliers are facing significant challenges in hiring, they're facing significant challenges or escalations in raw material costs. Good examples would be, you know, key inputs to aircraft production are materials like steel, aluminium, titanium, and other metals, which have certainly seen a significant increase in prices. And then, of course, to your point, there's significant bottlenecks from supply chain constraints. I would say the supply chain is relatively confident about their ability to execute the planned rate increases from Boeing and Airbus through this calendar year [but] you're hearing a lot of pushback from suppliers, about the price increases and what it's doing to their cost structure.
The outlook in 2023 remains a bit of a wildcard just with the uncertainty today. But what I would highlight again, is as a point of confidence in the supply chain, Airbus has just come out to its suppliers with a proposed 15% price cut across all of its programs through 2025. And I think this points to their confidence, at least in the near term, in the supply chain stability to support their planned rate increases.
Mark Odendahl
Talk to us about the aftermarket space right now and give us an example of some of the leading players.
Ken Herbert
Yeah, so the aftermarket historically represents the highest margin or most profitable business for a lot of the suppliers in the marketplace. So companies tend to work very hard to get on a Boeing aircraft or an Airbus aircraft, because it gets very difficult to get displaced off of that program, considering the regulatory and certification requirements. But then, you know, the typical model is that particular product will generate three to five times the revenue stream as it's in operation, as a company is able to sell spare parts and services to the airlines or the lessors over the life of that product or that aircraft. So it's a very important slice of the marketplace for suppliers and a big part of the economic value chain. As we look at this marketplace you know, the OEMs, Airbus and Boeing, are certainly big in this marketplace, just considering their position as OEMs. But a number of suppliers, most notably, companies like Transdigm and Heico, have a very unique position in this marketplace and tend to do very well as the aftermarket continues to recover.
So the aftermarket saw some of the first recovery as air traffic started to come back and airlines started to fly the planes again. Much of 2020 and much of 2021 was about inventory reduction in deferred maintenance as airlines continued to conserve as much cash as possible a nd we faced a very spotty recovery. But as we look into this year, we're very confident that we'll continue to see upside in the aftermarket relative to expectations as flight activity continues to come back and the airlines continue to now spend to catch up on maintenance and look to more aggressively bring their fleets back into service.
Mark Odendahl
So I'm hearing deferred maintenance, I'm hearing lack of retirements. We're hearing about Boeing's issues, so less new aircraft in the system. What's that mean for aftermarket growth over the next one to two years, and how that how does that compare to historical numbers?
Ken Herbert
Sure, so when we look at the aftermarket, I think this year from an MRO standpoint, we're looking at profit approximately, in our most recent survey, about 20% growth for calendar 2022. It will be the first quarter where we sort of anniversary the easier comps again and the comps get tougher as we go into the rest of the year. The aftermarket results for the publicly traded companies will exceed the MRO results, largely because of the benefit from pricing which tends to be a real tailwind, and then, to your point, catch up on deferred maintenance and some of the other dynamics.
Much of what we heard about through throughout the second half of ‘20 but especially in 2021 was just smaller work scopes than typically what airlines would do. So when an airline would be looking to get a part repaired, considering the financial pressure they were under, they would do the absolute minimum. Now they're having to play catch-up on a lot of that deferred maintenance. We estimate the deferred maintenance was about a 10% to 15% headwind to aftermarket growth in 2021. So you've got that going for you.
The OEMs and their ability to scale up is unlimited. So airlines, as they look to bring lift capacity back are having to look at some of the older aircraft. A great example is Delta's just indicated that their 717 aircraft will in fact be coming back into service. Now, these are 30-plus-year-old aircraft that a year ago, they announced they would really like to be retiring, but because of the demand right now, they are pulling these aircraft back into service, which is very good for the aftermarket.
Retirements, if you go back to the beginning of the pandemic, we all assumed they would be up significantly as airlines looked at, at bringing significant capacity out of the marketplace, well retirements have been very low relative to expectations for a number of reasons. But as we look forward, we're not expecting a significant surge in retirements. One of the wildcards, of course, could be fuel costs, as it maybe pushes airlines to look to bring the less efficient capacity out of the marketplace. But the reality is, they are competitive, there's capacity constraints. And as we continue to see the recovery in domestic travel, there's growing scarcity around the smaller narrowbody aircraft, which is leading to fewer retirements, which is leading to an incremental positive for the aftermarket because again, it's these older aircraft that tend to be much more important when you think about aftermarket spending.
Mark Odendahl 16:34
So you put that all on a blender sounds pretty constructive for growth rates and aftermarket over the next one to two years. What are you hearing from investors in the aftermarket space right now, in terms of their views?
Ken Herbert 16:49
We think sentiment right now is for aftermarket growth of about, call it, 25% to 30% this year. We think the setup could push growth rate higher than that. Historically, the aftermarket grew at sort of one and a half times traffic growth and if you think of traffic growth over the last 50 years in aggregate, growing about 5% a year, air passenger traffic growth aftermarket was a mid to high single digit growth marketplace. We think moving forward structurally, we could see at least through ‘23, double digit growth, even as the industry continues to recover, for a lot of the reasons we talked about. But we are structurally in a situation where the airlines will be restocking material as we go through this year, addressing deferred maintenance, continuing to spend on the older aircraft and the capacity constraint from the OEMs is not likely to alleviate anytime soon. So we do think we're in a prolonged period of better-than-the-historical-model of one and a half passenger growth for the aftermarket, at least through 2023.
Mark Odendahl 21:12
Also, if I could talk about some of your checks with recent industry meetings, there has been different camps forming around alternative fuels for commercial aerospace. Could you talk to us about those?
Ken Herbert 21:30
Yeah, of course. So the commercial aerospace industry represents about two and a half percent of global carbon emissions. So on an absolute level, that might not seem like a lot [but] it certainly is an issue that the industry is grappling with and I think the industry is trying to be very proactive on looking for ways it can reduce its carbon footprint significantly.
So as you know, there's a number of ways to address this. Airbus has been leaning significantly out in front on the use of hydrogen as they look at alternative fuel sources that can burn cleaner. And that can be a way to help reduce emissions. Boeing, for instance, has recently made a significant investment in what they call sustainable aviation fuel or SAF. Most engines in operation today can operate on SAF. The real issue there is the supply of SAF and it clearly is not where it needs to be to meet demand for the sector.
There's a lot happening with investments around electrification and battery technology. And I think you're going to see, over the next several years, a lot of smaller aircraft incorporate battery technology as a primary source of power for a primary source of propulsion.
So there's a significant amount of investment happening, we think this investment will naturally increase substantially. It's been led by some of the companies out of Europe, where ESG, and environmental issues have been a bigger issue for the aerospace industry. But certainly here in the United States, it's catching up and this will be something to watch very closely over the next several years.
Mark Odendahl 17:55
And then if I could just pivot a little bit… you contributed to the department Imagine report that we published at the end of 2021. In that report, Preparing for Hyperdrive, you discussed the outer space market, how could that develop in the coming five to 10 years for the sector?
Ken Herbert 18:25
So it's a great question, we've certainly seen significant investor interest in space increase and bring a range of companies now that are publicly available in this marketplace. There's two fundamental drivers.
The first is access to space. The cost to access space has come down significantly. And this has been led by SpaceX, but more broadly, the ability to reuse rockets, and that has significantly opened up a lot of markets as the cost to put satellites and other hardware up into space has come down significantly.
Second, the capacity of those satellites, it's very similar to computing capacity on any other device like your phone. The amount of weight and mass and computing capacity you need to launch to achieve certain objectives has continued to move aggressively down the curb. So you put those together and it's opening up a range of commercial markets that previously were very dormant.
Historically, space markets were prominently government markets, both civil and national security. We're seeing a very significant commercial market slowly start to emerge. Now this, of course, involves areas around Earth observation, when you think about predictability for weather, weather systems when you think about just other observation opportunities. And then of course, there's the whole communications marketplace, which is opening up. Starlink is perhaps one of the best examples, which is SpaceX’ satellite-based communications infrastructure. And so this is expected to see significant growth and there's a number of companies pushing up into this area.
So while it's a very relatively niche and small market today, when you think about exposure for the companies we cover, it does represent significant growth both on the government and the commercial side and we expect that to continue.
Now, obviously, space is notorious for being a very long-cycle business. It still entails significant risk that we're maybe a little more cautious on markets around space tourism. But when you think about infrastructure and space, communications, navigation, Earth observation, some of these core markets, I think the demand is going to grow significantly over the next several years.
As a great example, the International Space Station is expected to effectively end its useful life in the next five to seven years – NASA has led a number of contracts to private companies to effectively replace that. And then there are a number of companies looking just independently to launch their own space stations, as the cost of accessing space continues to come down. There's a lot happening in this marketplace, not every company is going to survive, but a lot of very interesting things happening.
Mark Odendahl 23:05
Ken, that's excellent. This has been a great discussion today. I think it illustrates your industry knowledge, your in depth, industry knowledge, and we really appreciate your thought leadership in the aerospace sector. Thank you very much for your time today.
Ken Herbert 23:34
Thanks, Mark. It's been a real pleasure.
Mark Odendahl 23:37
What else lies ahead in today's ever evolving markets and industries? We'll be keeping track right here on Industries in Motion. Until then, thank you for joining us on this episode, recorded February 22, 2022. Be sure to subscribe to Industries in Motion wherever you listen to your podcasts. If you'd like to continue this conversation or are interested in more information, please contact your RBC representative directly or visit our website at www.rbccm.com/industriesinmotion for further insights. Thank you very much.