“Uncertainty is the worst of all ills, until reality makes us regret uncertainty.” Alphonse Karr
Year of Doubt
Was 2018 a sign of things to come or just the second year of a much large disruptive series of interesting events? For the commercial aerospace industry, it is probably a year that gave participants their strongest taste of what’s to come in the years ahead (production surge, economic slowdown, trade, and supply chain restructuring) and also perhaps, a year that took the polish of a somewhat artificially inflated , and speculative, financial market.The major surprise of 2018 is the disconnect between market fundamentals and stock market performance in a vast majority of cases. Estimates for the 2018 World GDP at 3.4% is strong, markets are however anticipating persisting uncertainty issues, either from financial regulators or politicians’ chaotic protectionist policies, perhaps with the notable exception of what is currently going on in the city surrounded by reality. Even if the market shows definite signs of stress, there is no panic, and no real reasons to. Tightening by the Fed, although not the core issue, was a contributor to this general sentiment of uncertainty but the market suffers simply from an excess of pessimism. Global trade tensions stemming from US geopolitical and trade policy corrections are fundamentally at the root of this uncertainty, together with emerging doubts concerning the US and Chinese economic outlooks. A potentially volatile mix.
As we had been anticipating earlier in the year, there has been a significant slowdown for commercial aircraft orders, although the final numbers won’t be available until January 2019 as is customary, it is clear that we are likely to witness book to bill ratios floating around 0.75/0.85, very much in line with our initial estimates. Both the A320NEO and 737MAX have witnessed a slowdown in orders, which was to be expected at these products’ life cycle stages, and with both programmes likely to end the year at around 450-500 orders. Boeing is however likely to finish comfortably ahead of Airbus in total orders, thanks to the 787, which continues to perform strongly and has indeed reached a strong programme maturity level, although in-service aircraft reliability has declined lately.Deliveries for both OEMs should come close to estimates but are unlikely to exceed them. Boeing was affected by a major series of supplier issues that significantly impacted FAL output during the summer primarily. While the then issues are being resolved and production has climbed back to stronger levels, new issues could reportedly be around the corner, and present new challenges that may have a detrimental effect on 2Q 2019 delivery timings. Airbus also experienced slower than expected deliveries for its A320NEO family, and the main bottleneck has been the Pratt & Whitney PW1100G engine delivery rate, very much like in 2017. The A321LR has suffered from cabin customization issues currently being remedied.2018 bore very much all the signs of a transition period, as one would have expected. Whether or not the ramp up can further accelerate in 2019 remains to be seen. While the fundamentals of the US economy remain strong despite an uncertainty driven series of fluctuation towards the end of the year, demand is solid and any economic slowdown are likely to have a controlled effect on output.Mergers and acquisitions continued apace, driven by aircraft OEM strategies and suppliers need to gain more leverage against these contractual cost pressures. We will expand on what to expect in 2019 in our next note on this very issue. We are however concerned that the Transgdim acquisition of Esterline could compromise the company’s chance to maintain its strong position as a Boeing supplier for future programmes.
Business aviation is recovering moderately, our forecasts for 2018 and 2019 suggest total deliveries of 1,100 and 1,120 aircraft respectively. The market has entered a period of stable growth which will continue over the next 5 to 10 years, and will be characterized with fairly overall stable shares between jets and turboprops. All participants have adjusted their goals and segment footprints and are looking to grow in established markets with newer generation solutions. The market will primarily be characterized by a focus on replacements as its primary growth engines and dynamic systems upgrades. Financial market uncertainties could, however negatively impact growth in 2019 and 2020.
Defense markets in the United States have witnessed the resurgence of Boeing as a prime, with three major contract awards that will primarily support the St Louis facility well into the mid 2030s. The T-X award was the most significant win and presents strong services opportunities for Boeing as well. Although this award was not a total surprise to us, we expected Lockheed Martin to edge Boeing based on risk reduction factors and price. It remains to be seen how Boeing will be able to meet its financial targets based on such a low bidding price. We however disagree with the Boeing leadership, the total T-X market including aircraft for the US Air Force, US Navy and exports should total less than 950-1,000 aircraft, not 2,600. This low ball and long term strategy is risky, and perhaps fails to capture the changing realities of the lower spectrum of the TACAIR/Training markets. This is greatly influenced by geostrategic considerations and the emergence of China and India as suppliers. We also expect Europe and Airbus not to remain passive in this segment. Boeing’s T-X export estimates clearly resembles dinosaur thinking on this issue. The KC-46 “should” be delivered by the end of the year but problems remain with over 150 category 1 and 2 deficiencies to be addressed by the Boeing team.Internationally, F-35 deliveries have continued apace, although it is still too early in the operational life of the system to pronounce a firmed-up opinion about its capabilities. F-35 has the advantage of being the programme “blessed” by the US DoD, and it is therefore the solution that partner nation customers will need to accept for now. Rafale deliveries to Qatar and India will begin in 2019, and we expect Dassault to be the team to beat in India again following the rejection of a complaint about the selection of Reliance as Dassault’s local industrial partner. This was clearly politically motivated and supported by internal and external actors at business and government levels. Such parties would have been the main beneficiaries of a Rafale order cancellation. No need to mention names, you can guess yourself.We continue to be impressed with the apparent capacity of the Chinese military to develop a variety of advanced air systems in a relatively short amount of time (less than a decade). Some would argue that so-called hacking and theft of US & EU IP has contributed to Chinese advances in this domain, however programmes don’t suddenly materialize simply by copying, far from that. The Chinese industry continues to develop advanced designs that stand on their own, not only from an airframe standpoint, but also from a systems development angle. The maturity and true efficiency of those air systems is still a matter of debate, but the foundation is probably more solid than some corners of DC would like us to believe. As with commercial markets, China is just about getting to grips with military engines development (WS-10/15/20) but remains clearly behind with commercial engine programmes. This is unlikely to change until the mid 2030s.On the issue of China, the C919 flight test program has been slow and should accelerate in 2019 with the first flight of the 3rd prototype taking place either before the end of 2018 or in January. Following a major event during test flight last year, the C919 team had to suspend flight testing and modify the airframe to prevent a recurrence of a serious condition. We expect the C919 certification and testing to accelerate in 2019 with the move of a significant part of the test fleet to Yaohu Lake Airport near Nanchang in Jiangxi province.CR929 is beginning to shape up with RFPs and industrialization planning studies well under way. The first flight should take place in 2025 with an EIS in 2027. The Russo-Chinese team is working on a new wing production facility, with closer maritime access to the Pudong assembly line. It is likely to be located in eastern Russia and provide easier port access than the current AeroComposit facility in Ulyanovsk. The fuselage production will be located 100 km northwest of Shanghai in Zhangjiagang and will likely be transported by boat to the Pudong FAL.
Supply Chain Uncertainties
The supply chain is exposed. Liquidity tightening in 2018, plus cost reduction pressures exerted by OEMs and other partners are a dangerous mix that risks creating unpleasant conditions for 2019. OEMs cannot expect all tiers of the supply chain to graciously concede on cost reduction efforts without some levels of guarantees on programme participation in particular. If some OEMs chose a path of diversion towards new entrants, they might indeed find an unstable mix of competence and ignorance. No doubt that there is significant potential for suppliers with strong aerospace background to execute well, but there is a more volatile mix of companies moving up the value chain that lacks exposure in particular to the stringent regulations, supply chain access and processes that often accompany the aerospace markets. We will expand in January on these clearly critical issues.
Geopolitical & Trade Uncertainties
Geopolitics were at the core of the violent and uncertain roller-coaster ride of 2018. A stable relationship with China and European trade partners are essential to maintaining positive economic outlook; once that balance was disrupted by President Trump, for geostrategic and short term political gains, the market initiated a chaotic downward trend that had initially been partially hidden by the President’ tax stimulus. A big tree in the forest that hides all sorts of issues. Trade tariffs on European, Asian and South American steel and aluminum were particularly damaging in our opinion for two reasons. Firstly, it redirected cheaper material flows towards Europe and thus heavily penalized an already stressed European materials supply chain. Secondly, it accentuated the negative sentiment of disconnect with the United States among European investors, government and suppliers. In short, while we could somewhat agree with the premise of President Trump’s effort to strengthen the US industry, its delivery is particularly violent and fundamentally undiplomatic, and can thus only be leading to tension, disrupted partnerships and negative sentiments. There is therefore a risk of long term damage to several critical geopolitical partnerships.The big risk is China. When the US administration shifted its focus on trade sanctions towards its primary trade partner, investor sentiment began an accelerating downward spiral. Doubts were amplified further by the Fed pronouncements on rates, and a mild slowing down of the US economy. Pessimism may still have some ways to go, and current negative sentiment in Beijing will have a definite effect on the first 6 months of 2019. President Xi Jinping will likely stay the course on geopolitical issues but may decide to make small concessions to the United States in terms of Chinese market access for US goods and services.
On the commercial side, much was said about the 737MAX and A320NEO supply chain issues and delays associated with production ramp ups. 2018 was another year of hesitation for Boeing to develop a potential counter to the A321NEO/A330NEO middle of the market stronger positioning. While we do not doubt that Boeing will launch the aircraft in 2019, we are however slightly concerned about its post 2030 market traction. While we anticipate strong demand for the aircraft over its service life, there remains uncertainties about its eventual market share against a strong Airbus product development strategy, and a rising Chinese industry after 2035. While we generally estimate NMA to be a 2000+ aircraft over the programme life, it is likely to be weakened by competitive responses in the 2030s.A380 remains on life support and is definitely not out of the woods. While orders received in 2018 support the aircraft production into the 2020s, there is much to be done to ensure that operating performance and costs continue to improve. We are reservedly positive about the aircraft outlook in Asia and China in particular.
Oil dominates the second half of the 2018 roller-coaster. It has a near term positive impact on consumer spending, but it has had an effect on bonds which are anticipating a reduction in inflation, and a possible economic slowdown.If 2017 was strong and stable, 2018 was a year of disruption and realignment at the global trade level. Company earnings will be the main indicator for positive or negative perception in 2019. 2018 was chaotic and masked several important issues but if company financing access deteriorates next year, the outlook will be highly volatile for markets and the aerospace supply chain. Credit tightening and its impact into real market issues are the primary risks. Financing options will become more selective unless credit becomes more accessible. The market needs consistency of policy, which it does not have either from the US President or the Fed at the end of 2018. Without a stabilization and positive resolution of geopolitical and trade issues, 2019 could be a very unpleasant year for investors and the aerospace segment. Those issues, especially access to financing and rising labor costs, will begin to impact the lower tiers of the supply chain negatively, no matter how vibrant our market segment appears to be.