Mark Odendahl
Welcome back everyone to industries in motion podcast from RBC Capital Markets. Reminder, this is 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. Again, my name is Mark Odendahl, Head of US Capital Markets research here at RBC and I'm really happy to bring on Ken Herbert on the line. He is our aerospace analyst here at RBC. Now before we get started, I’d thought I’d give a little more background on Ken. Ken joined RBC in 2021 as our aerospace analyst and has initiated a full list of both OE original equipment and aftermarket companies in the aerospace sector. He recently initiated on Airbus. So by covering Boeing and Airbus, he's become our global aerospace analyst. And we're really excited to have him start to help investors globally understand the trends in the global aerospace sector.
So let's kick it off. Ken. Let's start talking about the commercial aerospace sector. And we got to break that into two parts. The first part is the original equipment manufacturer, the OEs. And that's Boeing and Airbus. Could you just kick it off by telling us a little bit about where we are in the cycle for the OE sector and some of the trends that you're picking up recently?
Ken Herbert
Yes, thanks, Mark. I think a couple of things I'd highlight. First, the recovery in passenger traffic continues to be stronger, I think, than any of us expected. And this has been a consistent theme over the last two to three years really, as you've seen significant pent up demand of travel coming out of obviously, the pandemic. So if you think about domestic travel globally, we're effectively back to where we were in 2019 levels. And in some regions, notably here in the United States, we're even ahead of where we were in 2019. In terms of domestic travel. International travel has seen a real acceleration in the last six to nine months, as we finally seen a lot of the opening up of borders and a lot of the restrictions that prevent an international travel, we still see slower growth in terms of Asia and Asia and parts of Asia, in particular and in China. But I think we're continuing to be surprised by the strength of traffic that's coming back. And that's translated to extremely strong backlogs. When you think about Airbus and Boeing and very robust order activity by the airlines and the leasing companies. It's important to point out as well that I think coming out of this crisis, many airlines have better balance sheets than I think we would have imagined just considering a fair amount of stimulus that the industry received and the strength and traffic the strength and air fares, and all the other fundamental indicators. So we are we are in a very healthy position in terms of the demand environment right now, as it relates to the global aerospace industry. And I'm sure we'll dig into this but, but clearly the big issue continues to be the supply chain and the ability, the industry's ability to meet the demand, which continues to be very strong.
Mark Odendahl
You recently attended the Paris Air Show. Could you let us know a few things that you heard and how that marries with what you explained as it relates to the aerospace sector?
Ken Herbert
Yeah, very, very good order activity at the airshow. I think in particular, at Airbus. We saw a finalization of the order with Indigo, one of the largest orders ever, of course, the Indian airline. And we saw the finalization of some orders for both Boeing and Airbus out of Air India. So a couple things I'd highlight the or show really highlighted the strong demand environment with the order activity, especially on the narrow body or the smaller aircraft. The second thing I would highlight is we saw really strong order activity out of India and India has become a very strong emerging market for the industry, many believe, almost replacing China in terms of the strength and the outlook for air travel in that particular region. The third thing we learned, as I highlighted was, we continue to face pressure on the industry's ability to produce aircrafts to meet the rising demand. So the supply chain has gone through very significant dislocation over the last two to three years and continues to struggle to support the growing backlogs. We've seen it both Boeing and Airbus.
Mark Odendahl
So can you know supply chain issues was a huge topic during the pandemic and COVID. Intuitively, you would think that we'd be moving past this, we've moved past supply chain issues and a lot of different industries in the economy. Why are we still talking about it with the aerospace sector?
Ken Herbert
That's a great question, Mark. I think I'd highlight a few reasons. One, the industry is very long cycle. So the supply chain, when you think about 2020 2021 2022, was very, very slow and measured in its push to recover production rates, the industry obviously was capitalized at much higher production rates than we're at now. But the industry lost a number of people. And it's really struggled with pulling those people back. I think the consistent commentary coming out of the air show was the industry is staffed now to support higher production rates. But the industry issue now remains training, productivity and efficiency of the workforce. If you think about a very experienced workforce, many of which retired in her COVID, coming back with perhaps a more junior workforce, that's certainly an issue. The second point I'd make is you've also got other competing industries. So commercial aerospace, obviously a very strong and growing industry. But we also have very strong pull within the defense market. So you've seen a number of companies, suppliers, or other companies shift, maybe emphasis on defense. And we've also seen very strong growth in business jets. So you've had simultaneously all the end markets growing, which has pulled talent into other areas away from commercial aerospace, perhaps. But then I would also just highlight the long the long nature of the cycles in that, you know, a lot of these, you know, to spool up a supply chain, considering incremental disruption we've seen as a result of the war in Russia and Ukraine, as a result of some of the trading or changing geopolitical issues between the United States and China. We've seen some other significant disruptions in the aerospace supply chain, which contributed to some of the delays. And then of course, like we talked about, the demand came back much stronger than expected. So you've had a number of factors that have contributed to the issues in the supply chain. And you're right, a lot of other industries seem to be normalizing now and putting these issues behind them. But we are seeing production rate increases out of Boeing and Airbus, I just think the pace continues to be slower than that many would hope or expect at this point in these issues. You know, when you're talking about lead times of up to two years, on many on different parts of the aeroplane, it obviously takes more than just quarter to quarter to work out. And so we're very much in the middle of still sorting some of these issues out.
Mark Odendahl
And I don’t think we can spend as much time on Boeing without giving an update on some of their recent products. So, the 737 MAX is heavily debated in the investment community. Could you give us on some of the product initiatives at Boeing?
Ken Herbert
Yeah, of course. And I should mention that the max contributed to some of Boeing's issues, as they of course stop production of that aircraft at the end of 2019, heading into COVID. So that the two or three key issues for the MAX. So first and foremost, it's China. China, Boeing had approximately 100 aircraft in China when the aircraft was grounded. Those all of the Chinese airlines that had MAX aircraft in their inventory have returned the max to serve us. And of those 100 aircraft. The latest numbers are out there approximately between 70 to 80 of those aircraft have in fact returned to service. So, and that's just happened in the last six months, we've seen a nice uptick in the utilization of the MAX aircraft though we're in China. We're still waiting for Boeing to resume deliveries of Max aircraft into China. As a heading into the pandemic Boeing had approximately 140 aircraft and inventory slated for Chinese airlines. Boeing has successfully remarketed, you know, approximately, you know, 40 to 50% of these. So, we are optimistic that as geopolitical issues continue to ideally improve between the United States and China, we could see a resumption of deliveries of the MAX into China at some point this calendar year, it's important to keep in mind as well that the recovery in China has been very, very spotty and inconsistent. So there hasn't been as much of a demand for the lift or the MAXs in China, as you would have seen here in the United States or in Western Europe. Final point I would make on the MAX is Boeing has it's intended to be a four class aircraft, the dash 789-10. The dash eight and the dash nine variants are approved and that is what Boeing is delivering today. We're still waiting for final certification on the dash seven and the dash 10 variants. So that continues to be an issue we watch very closely, as those have continued to slip to the right largely as a result of issues around timing at the FAA, and revamped and more stringent certification requirements, largely as a result of some of the issues associated with the max and the grounding back in 2018 and 2019.
Mark Odendahl
So let’s now turn towards Airbus. Can you give us an update on some of the trends they’re seeing specific to that company as well as their delivery trends?
Ken Herbert
Airbus took production rates down about 50 to 60% across their portfolio when we went into the pandemic. So they're in a better position today on the narrowbody side. They're delivering their A320 family of aircraft they call the Neo the new engine option. Airbus is out delivering Boeing today about by about 30 to 40%. So they are in a better position. Today, Airbus is currently running at approximately 50 aircraft a month in terms of their production and delivery schedules Boeing currently delivering in the low 30s on a monthly basis. So Airbus was in a slightly better position, obviously, heading into the pandemic. Has had a better success in ramping up the supply chain but continues to face issues similar to what Boeing is facing as well. But Airbus and Boeing, neither company is talking about a new aircraft or a new clean sheet aircraft in the near future. So the focus continues to remain very much on Airbus and it's a 320 family and of course, Boeing with the 737 MAX.
Mark Odendahl
All right, let's shift gears, we've talked about the OE trends. Now let's move to the aftermarket. And just a reminder, folks, Ken covers a significant list of aerospace suppliers. And so primarily, a lot of these suppliers supply the aftermarket for the OEs. Ken has conducted a long-running MRO survey (maintenance, repair and overall survey) of a lot of shops that consume these aftermarket components. And he's also a keynote speaker at many industry events as it relates to the aftermarket. So, Ken, just as we kick it off on the aftermarket, give us a view of where we stand in that cycle. And when I hear you talk to investors, you talk a lot about pricing, deferred maintenance, retirements, inventory, kind of give us a view overall for the aftermarket?
Ken Herbert
So the aftermarket, as you indicated, most companies that sell up into Boeing and Airbus, because of regulatory requirements are also the sole source provider of that particular part into the aftermarket. And the aftermarket tends to be where many suppliers make a disproportionate amount of their profit and earnings. So it's a market of considerable focus. And what I would say is for a lot of the same reasons, a lot of the reasons that we're seeing some delays out of Boeing and Airbus, those tend to be those tend to be tailwinds for the aftermarket. So as traffic has continued to surprise to the upside and be stronger than expected, we've seen increased demand for spare parts and maintenance and repair services around these aircraft to meet the rising traffic demand. Also, as supply chains have been an issue, and turnaround times and maintenance shops, airlines have built greater inventory and greater buffer stock. And as a result of some of these disruptions in the demand, many of the suppliers have been in a position to pass on or get much better pricing on spare parts than is then it's typically normal. We're hearing about many suppliers; you know getting price increases into the mid-teens. which is two to three times higher than what you would normally expect. Obviously, a lot of that reflects just higher costs from an inflation and cost and labor standpoint. But certainly, the industry is in a better position today to get pricing. So the aftermarket has been very sound. Our most recent quarterly survey pointed to about 22 to 23% growth in the second quarter in MRO spending, which is which is very strong. And the outlook for the second half of 2023 was about 500 basis points better than our first quarter 23 survey indicated. So we continue to see a strengthening. The risks to the aftermarket are certainly a broader economic recession, which could have a negative impact on passenger flying, which we haven't really seen yet. And second, many of the tailwinds could eventually become headwinds as growth eventually would normalize, and eventually we would see, you know, Boeing and Airbus deliver more aircraft, which would give airlines the opportunity to retire more aircraft or to decrease the utilization of some of the older aircraft today, which tend to be very intensive from an aftermarket standpoint. But we're just not seeing that yet. We continue to see you know, the disruptions on the supply side continue to equate to very good opportunities and a very positive outlook for the aftermarket.
Mark Odendahl
You know, you recently published an MRO survey. You know, what did that show you? What were some of the trends that you've seen over the last couple of years in that survey?
Ken Herbert
Yeah, so it clearly pointed to a couple of things. One, demand on the engine side remains very robust. And if you think about the aftermarket, we tend to look at it in three or four buckets. You of course, have the engine, which accounts for about 40% of all the aftermarket spending. And as aircraft get older, the disproportionate amount of spending on the engine goes up. You’ve then of course got what we call traditional components, which is everything from avionics, and landing gear. And then you've got, of course, the airframe. And you've got interiors, as well. So as you think about the aftermarket, we've clearly seen greater strength on the engine side recently. And that's companies, for example, like General Electric, and like Saffran, and like Pratt and Whitney, part of Raytheon Technologies. Engine spending by the airlines has been very robust. The airlines have utilized a lot of what they call green time in the industry, which is in airlines ability to swap out engines to continue to defer maintenance, and a lot of that act, those behaviors have largely been used up. So we're seeing a real strong demand for engine spending. We've also seen a very strong demand for alternative parts, as you think about the recovery. And you think about supply chain disruptions. Airlines are looking very aggressively at alternative parts. And these tend to be around what they call PMA parts, which are substitute for OEM parts, or used parts that have been repaired what they call USM or used serviceable material. So we've seen a real structural shift towards the airlines looking for alternative parts coming out of this crisis. And then the third thing I would highlight is, we continue to see very strong demand out of Asia and China in particular, I think a lot of us were concerned that with the pandemic demand in China could slow and it's been spotty, obviously. But we get a sense now that the airlines in China are really starting to spend in anticipation of a step up and growth into this year, and certainly in ‘24, and also the recovery of international traffic. So engines, alternative material, and Asia continue to be some of the key themes in the aftermarket.
Mark Odendahl
Ok, Ken. So if I just digest some of the things you’re saying about the OEs as well as what you’re saying about the aftermarket, is there a situation where they both can work?
Ken Herbert
No, it's a great question. And they're both seeing positive trends now, but to the extent to which the OEs continue to do better, and maybe improve their execution. That would be an incremental headwind for the aftermarket, because clearly what the aftermarket and what a lot of these suppliers have benefited from, have been the fact that Boeing and Airbus have struggled to meet their delivery commitments to airlines, which has forced airlines to continue to fly older aircraft that by now they probably would have expected to retire. And of course, those older aircrafts tend to be much more maintenance intensive. So they don't have to be working against each other. But I think and because we do expect to see continued struggle on the OE side, while obviously things are getting better. It shouldn't be a significant headwind for the aftermarket. So they can both they have been working and they both should continue to work for the near future.
Mark Odendahl
Ken, are there any catalyst that investors should know about these sectors going into the fall of 2023?
Ken Herbert
The next big air show upcoming will be the Dubai air show this fall and a lot of the Middle Eastern Airlines have continued to preference or prefer to use the Dubai air show for major order announcements, or other announcements. So look for the Dubai air show, as it relates to demand for international traffic and larger aircraft as a as a potentially very important catalyst for the industry. The second, we would just call out continued, you know, monthly production and delivery rates, and the cadence out of Boeing and Airbus, as particularly important. And then finally, you know, management at Boeing has been talking about perhaps seeing a resumption of deliveries into China, perhaps a little sooner than then into 2024. So if we if we see any resumption of deliveries of the MAX in particular into China, before the end of the calendar year, that would be better than expected.
Mark Odendahl
Well thanks a lot, Ken This was an amazing update on both the OE side, the original equipment side, as well as the aftermarket and really shows your thought leadership across the commercial aerospace sector.
Ken Herbert
Thank you, Mark. Have a great day everybody.
Mark Odendahl
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 July 24, 2023. And also please be sure to subscribe to Industries And Motion wherever you listen to your podcasts. If you'd like to continue this conversation about aerospace or interested in more information, please contact your RBC representative directly or visit our website www.rbccm.com/industriesinmotion for further insights. Thank you very much and look forward to seeing you and look forward to the next Industries in Motion podcast.