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Introduction

By Judson Rollins, Bjorn Fehrm & Scott Hamilton

Sept. 21, 2020, © Leeham News: Commercial aviation is facing a lost decade due to COVID.

Yes, most forecasts target 2024-2025 as returning to 2019 passenger traffic and aircraft production levels.

However, LNA in July published its own analysis indicating full recovery may not occur until 2028. Breathless headlines notwithstanding, it will take years for vaccines to be widely available and considered safe by enough of the world’s population. Growing concern about vaccine production and distribution capacity through 2024 underscores this view. Even Southwest Airlines CEO Gary Kelly said earlier this month that business travel might not fully return for a decade.

Indeed, the 2020s may well be a lost decade for aircraft manufacturers and their supply chains.

Summary

• Debt-laden airlines will have little money to order new airplanes
• Interest in re-engined 787, A350 likely nil this decade
• Airbus, Boeing, Embraer have little interest in launching new programs
• Engine makers too financially stretched to develop new designs
• Engineering talent, knowledge will be decimated by inevitable job reductions
• OEMs must “play the long game” at a short-term cost to safeguard their futures

Discussion

Debt-laden airlines will have little money to order new airplanes

Be skeptical of the “recovery” data emerging from China. Schedules are back to nearly 90% of pre-COVID levels – but Chinese airline capacity is dictated by the government, not demand. Load factors are boosted by extremely low fares, meaning most restored capacity is still loss-making.

In the US, federal aid funding expires Sept. 30. Beginning Oct. 1, airlines are free to cut schedules even further – and lay off tens of thousands of employees.

Data from OAG shows additional capacity cuts looming in many regions.

Airlines around the world have taken on billions of dollars in new debt to avoid bankruptcy. However, as LNA’s latest monthly update shows, the list of airlines in restructuring or liquidation continues to grow.

Airline trade association IATA says airlines have issued $204bn in new debt this year, with just $41bn coming from credit markets. Even frequent flyer programs are being pledged as collateral, most recently by Delta Air Lines. IATA notes, “While the availability of capital market financing is positive, reflecting some confidence in the industry, the credit downgrades have raised the cost of borrowing in an era of low treasury yields. As a consequence, airlines will exit the worst of the crisis not only with higher levels of debt but also with a higher cost of debt.” [Emphasis LNA’s.]

This combination raises the specter of a “lost decade” for aviation. The term refers to Japan’s 1991-2001 recession, which brought the country’s previously bustling economy to a long-term crawl. The primary cause was interest rates rising at the same time a credit crunch was unfolding in the aftermath of an asset bubble – precisely the industry scenario IATA describes in its analysis.

Interest in re-engined 787, A350 likely nil this decade

The re-engined 787 and A350, which LNA thought could launch in 2025, now seem far off. Network carriers like ANA, JAL, United, Lufthansa and Singapore Airlines would be key customers for such concepts. However, airlines dependent on long-haul traffic will see demand return slower than short-haul carriers and have the heaviest debt loads. On the other hand, airlines with sustainable cash flows during the downturn – mostly low-cost carriers like Southwest – are the least likely to order long-range widebodies.

A lack of customers, combined with an inevitable surplus of lower-time 777s and A330ceos, means the addressable market for any re-engined widebody will be too small to address profitably. “Lower for longer” fuel prices won’t make the business case any stronger.

Engine makers too financially stretched to develop new designs

It’s well known that engine manufacturers lose money on engine production. Their profit comes from spares and maintenance. The latter bring high enough margins to justify developing and selling new engines.

The business model has traditionally depended on in-service engines developed 10 to 20 years ago and were sold in decent numbers. If these engines aren’t flying, they don’t consume spare parts as there is no wear. Engine makers dependent on “power by the hour” (PBH) agreements, notably Rolls-Royce, are not only stuck without cash flow but also carry the value of those engines on their balance sheets.

With near-zero cash flow and limited borrowing ability, engine OEMs have little-to-no liquidity to invest in a next-generation engine. They need to wait for spares volume and PBH cash flow to return before investing in any new designs, which seems unlikely for the next several years.

Airframe makers also burn cash on each produced aircraft, but typically only on the first ~200 airframes (the infamous “learning curve”). For engine makers, cash losses on a new engine often continue beyond 500 aircraft, or 1,000+ units – often a decade or more. It’s a warped “jam tomorrow” business model which has evolved over the last few decades. Will this remain viable through a COVID-induced downcycle of a half-decade or longer?

Airbus, Boeing have little interest in launching new programs

Heavy debt loads will force most airlines to wait a few years after supply and demand stabilize before they have the cash flow to justify new orders. Conversions and delays will be unavoidable in the meantime – and the resultant lack of cash flow to OEMs will crimp a key funding source for new programs.

Neither OEM has much incentive to move first, especially for twin aisles, which are hit hardest by the downturn. Boeing dominates the “hottest” twin-aisle segment (below 300 seats) with its 787, so it’s unlikely to launch given its recent strategy of waiting for Airbus to move. Meanwhile, Airbus will try to sell the A330neo as long as possible; it will likely wait until a recovery to see whether airlines order the type before deciding whether to pull the plug. The A350 family lacks a smaller member to compete against the 787-8 and -9. Simply shrinking the A350-900 isn’t viable, as proven by the now-defunct -800; giving up seats without a proportionate weight reduction results in an airplane with unattractive economics.

Airbus thinks single-aisle deliveries will resume from its existing order book, even if new orders aren’t forthcoming. However, many of Airbus’s and Boeing’s largest orders are from carriers with questionable futures: Lion Air Group, Norwegian, AirAsia Group, AirAsiaX, and American. Europe’s IAG, while not in existential danger, has an outstanding MOU for 200 MAXes that it seems unlikely to firm in the foreseeable future.

One need only look at the announced cancellations to date and Boeing orders categorized as doubtful under ASC 606 to realize that the horizon will almost certainly get even darker before the dawn of any recovery.

With no JV and a thin sales pipeline, Embraer is in worse shape than most

Embraer’s failed joint venture with Boeing cost it not only cash but precious momentum, as key potential E2 customers deferred their buying decisions in anticipation of the JV closing. The E190-E2 and E195-E2 are struggling against the A220-100 and -300 due to Airbus backing of the latter, and the E175-E2 can’t capture the critical US market due to being too heavy for the US Scope Clauses.

Airbus A320 deliveries are down 40% YTD, but A220 production is virtually unaffected. The latter’s production ramp-up has a flatter curve, and there have been few cancellations and only limited deferrals to date.

The pandemic’s effects on airline traffic, plus a lack of cash flow from E2 sales, will also probably hamstring Embraer’s hopes to launch a clean-sheet turboprop design any time soon. This leaves the Brazilian manufacturer with slow-selling products for the foreseeable future.

Mitsubishi’s SpaceJet limbo likely to become long-term hibernation

MITAC’s latest public statement was that it expected the M90 to enter service next year. However, the certification process by Japanese regulator JAA was already painfully slow before COVID-19 hit. Now, most M90 customers are likely to find themselves in long-term demand slumps and thus looking to cancel or defer orders.

One customer told LNA in July that parent Mitsubishi Heavy Industries (MHI) said the M100 program is not dead, but on hold until April 2021 – the start of MHI’s next fiscal year. This customer said it was told the SpaceJet budget for the current fiscal year had already been spent before the pandemic essentially shut down both airlines and manufacturers.

However, in a July interview with the Financial Times, MHI’s CEO was ambiguous about the M100’s future. COVID-19 impacts and production cutbacks on the Boeing 787 and 777X hurt cash flow at MHI, limiting funding for the program. This seems likely to worsen, not improve, in the next couple of years – calling into question MHI’s ability or willingness to fund a probably loss-generating program. LNA believes the odds are great that MHI will use COVID as the excuse to terminate the M100 program.

Geopolitics will limit development, sales of Chinese and Russian aircraft

COVID-19 has already led to an increase in geopolitical tensions, notably between China and the US. Any new Boeing order from China seems unlikely until tensions are reduced. The Chinese government wants to decrease its reliance on foreign technology imports, which include commercial aircraft.

In this context, China will likely accelerate its C919 and CR929 projects to completion. However, it is not clear whether COVID-19 will lead to budget cuts in Russia that could delay the more ambitious CR929 project. More delays seem likely. Further restrictions against collaborating with Western suppliers would delay the program further.

Meanwhile, geopolitics and market skepticism will limit Russia’s MC-21 to airlines in Russia and its satellite countries. These markets are too small to make the program successful.

Suppliers are in much greater danger than OEMs

Hard times for OEMs also hit the supply chains for aircraft projects. A modern airliner has hundreds of suppliers and sub-suppliers that develop and manufacture all the essential parts and systems.

These companies often have weaker balance sheets than their OEM customers even in the best of times. In tougher periods, banks and investors are careful not to put additional money into companies they see as weak. While OEMs are too big to fail as financiers and governments will give them money to survive, this does not apply to suppliers.

Commercial aviation’s supply chain will struggle to adapt to lower production, and a growing number of suppliers will face existential financial problems as this crisis grow longer. OEMs are aware of this problem; they are shortening payment periods or even paying upfront in some cases. However, with widebody deliveries falling more than 50%, the situation is becoming critical for suppliers deeply dependent on just a handful of aircraft programs.

Engineering talent, knowledge will be decimated by inevitable job reductions

Order cancellations and deferrals, combined with a lack of new aircraft development, mean that OEMs and suppliers will have let go of tens of thousands of people. Talented young engineers and knowledgeable older hands will inevitably be lost.

This is especially troubling for Boeing and Airbus, which haven’t launched clean-sheet designs since 2003 and 2006 respectively. After a 20+ year gap, how many people who worked on those projects will still be around by the time another new program is launched? This loss of institutional knowledge is sure to increase development times and costs, as seen with MITAC’s now-mothballed SpaceJet. Such inexperience will also give regulators even more reason to increase scrutiny of future programs in the wake of Boeing’s MAX scandal.

OEMs must “play the long game” at short-term cost to safeguard their futures

Faced with the loss of a generation of engineering know-how and the potential destruction of a swathe of key suppliers, OEMs must make the difficult choice to invest in future programs if they wish to preserve their strategic futures. Otherwise, there will be no new aircraft or engine technologies to drive manufacturer demand, airline profitability, and environmental sustainability – even after customer airlines have recovered and are able to buy again.

Saving the future requires immediate choices which are not in the interest of quarter-to-quarter shareholders but will maximize value for long-term investors. Any government support should fund new aircraft designs and innovations that keep engineering talent and suppliers in aviation, not merely keep the lights on. This trade-off is not a breach of fiduciary duty – it is a deliberate choice to value investors who wish to stay around for future profits, not merely reduced cash burn today.

OEM directors and shareholders, are you listening?

Vincent Valery contributed to this article.