This Just In: The Aviation Aftermarket Cycle has Turned

The Market’s prevailing bias shifted out of neutral on September 1. Since then, a steady stream of economic indicators point to diminishing chances of any sort of meaningful slowdown. Setting aside the question of how these crude measures of vastly complex activity got to be so important (it reminds me of when “money supply”, at 4:05PM every Thursday, held the Market in its thrall. Then one day, no one talked about it anymore), it is sure starting to seem that there is at least enough traction to get us out of the soup eventually. The talking heads for the most part seem unaware that recovery lived a day at a time and referent to individual hardships that have entered our personal sphere of awareness is always painfully slow. I have not lived through one where the question, “How is it ever going to get better?” did not hang like a dank cloud over our thought processes for what felt like a very long time. And thus it ever was. The 1936 classic comedy, My Man Godfrey, opens with “forgotten men” sitting around their shanties in the city dump joking through gritted teeth about prosperity being “just around the corner”. (Many of the films of the late Thirties did a great job of portraying the crushing weight of Depression on the human spirit.) The recession that officially ended 15 months ago is certainly taking its time in edging toward the memory hole, but global economic growth is clearly sufficient to sustain appropriate (and bullish!) investment theses.

One such thesis for High Road would be that we have a heck of a commercial aerospace cycle stretching out just ahead of us. The big drivers are of course the well advertised order backlogs for aircraft both new (B-787) and not so new (A-320, 737). For well situated suppliers, these volumes will in time be nicely supplemented by defense programs like the F-35, the A-400M and who knows, maybe even a new refueling aircraft to replace the antique KC-135. These programs have slipped out in time even more than those of us who have gotten used to the way that “stuff comes up” in developmental programs had expected, but they will get here in the not too distant at all future (certainly not in terms of the number of years that some of us have worn ourselves down observing such goings-on.) There has been decent recovery in most of aerospace related stock since the dark days of Q1 09, but uncertainty prevails. Among the most troubling and least well understood of issues facing aircraft parts and service providers has been what we take to be a disappointing slow recovery in aftermarket demand. Here is the good news: not only is the inflection point in the commercial aviation MRO cycle upon us, but it is my belief that the very factors that caused the “trough” phase of the cycle to drag out in time will add strength to the recovery over the next two to three years.

There is a part to this MRO cycle (which drives demand for all manner of spare parts) that is relatively easy to understand and even predict, but there are also factors that defy quantification and might only be recognizable after the fact. It is a huge market that grows as a function of demand for air traffic, which is driven not only by global GDP but also by innate human predilection for novelty and adventure. It will tend to grow as long as economies are growing larger and more robust. Travel becomes a consumer good as more basic needs are secured. One does not have to be an art scholar to glean from artwork past that however fraught with danger and discomfort, people will travel when they get a chance, and for all kinds of reasons. Making it quicker, safer, and otherwise less stressful (i.e., bringing down the all-in cost) only make it that much more desirable. What the aviation industry has done to bring down the all-in cost to travel in our lifetimes has rendered it a luxury-bordering-on-necessity in all but the most meager of households in the developed world and for going-on-countless millions of others elsewhere. Such expense categories definitely take a hit in times like we just went through, along with dining out, outsourcing lawn care, etc., but they do come back, often in a “pent up” sort of way.

These factors (GDP, the LT growth in demand or air travel) account for the LT growth in MRO and its related parts consumption, but timing (how long, how deep a downturn before growth resumes) will be driven by a more nebulous set of circumstances. In every downturn, the owners and operators (O/O) of aircraft have a lot to sort out as to what the operating economics and so value of the aircraft are likely to be once they are out the other side. Only a few of the factors they have to consider are readily predictable (i.e., each A/C will be X years old in Year Y; demand for lift will recover). The O/O of all but the very newest and very oldest aircraft have to weigh likely fuel prices 5-10 years hence, increasing maintenance costs as aircraft age and the relative economics of newer technologies made increasingly available to marginal operators thanks to a proliferation of wannabe lessors (until maybe they don’t wannabe anymore). They then apply this tenuous stack of assumptions to a “manage through the downturn” game plan.

As I understand it, aircraft operators are bounded by somewhat absolute limitations in their ability to defer maintenance (cross that line and lose your business, or worse), but there is a significant “margin of safety”, or cushion, between these hard lines and normal practice. It is well understood that operators will eat into the cushion in response to a cyclical slowing or downturn, which makes MRO activity more volatile than air traffic. Less well understood is the role of fleet decisions involving aircraft that have been deemed surplus to current requirements and thus “parked in the desert”. Here, an O/O faces an interesting call. If after weighing a raft of factors it is deemed likely that the aircraft will have decent economics 5-10 years out, that plane might be “mothballed” in such a way that it can quickly be brought back into service. However, every program reaches a point where out year economics have dimmed to the point that more value can be realized by effectively using the aircraft up. This means cannibalizing some for spare parts to operate some others right up until they need a (very expensive) D check. Such a course of action, a liquidation of assets to hold down cash outlays through a downturn, would obviously have a depressing effect on demand for both spare parts and MRO services. However, it would also stealthily burn up capacity that might otherwise eventually return to service. How extensively this has gone over the past three years will definitely affect demand for new aircraft as well as replacement parts over the next three years, and in ways that will surprise analysts who are not thinking about it in these terms. (Bear in mind that while the owner of each individual parked aircraft probably has a pretty good idea how far from good-to-go that aircraft is, no one has a handle on how actually “available” the entire parked fleet is until well after the fact, if ever.)

This time around, the O/Os had an unusually tall order to deal with in making this call. First, there was that step change in fuel price assumptions that accompanied the same change in oil prices, c. 2007, to north of $70/bbl.. This all by itself is a real game changer for vintage 1984 aircraft. Then there was the most precipitous economic downturn in our lifetimes and its still lingering hit to the sense of well-being in so many households throughout the developed world. All of this is well followed and reasonably well understood. What’s not so well understood, I suspect, are a couple of factors distinct to “this time around”. One would be the sheer magnitude of programs that are of a vintage that the “liquidation” option is in play. For example, the 737 Classic. Produced between 1984 and 2000, there are 1984 of these “in service”. Am not sure if this is actually in service or also parked but assumed serviceable, but it is a very big program relative to past programs at a similar point in life in, say, 2003 or 1990. This venerable workhorse faces tough economics up against both the A-320 (the oldest of which is now 22 years old) and the 737-NG. The Classic was designed to improve upon the 737-200, mainly to use the CFM56 engine v. the JT8D, but other improvements were made. (Remember the 737-200 that was Aloha Airlines Flight 243.) We should not be surprised to find, a few years hence, that many of their operators have been squeezing all the juice they can get away with here, in this program and in other of similar vintage as well. This would translate into depressed demand for replacement parts of late, but also a diminished ability for an operator to accommodate growth without writing some big checks once the upturn is underway.

Another factor that I believe has protracted the “trough” but has probably reached its limits is improved capacity utilization by domestic operators over the past several years. Load factor (RPM/ASM or thereabouts) was for most of my years considered pretty high in the upper 70% and normally not quite there. 80%+ seemed like asking for trouble. All that has changed, with mid to high 80% looking to be a genuine “new normal”. Somewhere between better software, code-sharing and firm resolve on the part of managements, the airlines “found” additional capacity while managing through the cyclical downturn. We can never prove it, but that seeming increase in how often flights were overbooked sure looks to me like the airlines probing for just how far they could push this productivity step change. This adventure added to the pain of their parts & service providers (as well as not a few travelers), but the good news is that it appears to have run its course. Going forward, additional capacity to accommodate growth will have to come from more aircraft flying more frequencies.

The past few weeks have provided a few more glimmers that the aftermarket has started to turn. Esterline (ESL) noted on its July Q earnings CC some improved aftermarket sales in the Asia Pacific region. Parts and services titan AAR (AIR) opted on its call to reinstate its long term 10% operating profit goal (a goal that is only worth articulating during the growth phase of the cycle.) Airlines are showing improved traffic figures, with demand for premium seating starting to lead the way. Also telling, in my estimation, is the serial bump-up, contra the expectations of all but a few of us not so very many months ago, of planned narrow body aircraft build-rates at Boeing and Airbus. The fleet planners have seen the writing on the wall, as it were, with respect to wringing more capacity out of their existing fleets.

In June 2003, within weeks of the very bottom of a much uglier industry downturn, Musings described why demand for air travel would inevitably recover. The title said it all: Not Going Back to Greyhound. In the intervening 7+ years, the number of ready, willing and eager consumers of air travel and other goods made available by air transport has grown by many millions. Their manifold interests and relationships have spread out accordingly, in ways that buses, trains and even free-at-the-margin telecom simply cannot satisfy. A long and salubrious cycle for aviation parts and service is only now getting underway, and it will draw surprising power from activity rendered necessary by the actions that made the trough phase seem so numbingly long.

Sharpen the Teeth, Hold the Gravy

So nine years have gone by since that awful morning. In some respects, it has come to seem very long ago and far away, yet for many of us it still bears the stamp of visceral reality. I don’t think I am particularly unique insofar as how easily imagery from that morning can stir me, as in feeling my hair stand up. The interminable “conversation” about its evolving meaning, the quixotic proposals to turn it into a Day of Service, will continue as a part of the background noise of life in our times, but it will a generation at least before it no longer freighted with meaning that is deeper than words can express.

As well it should, for who among us was not deeply touched by this monumental affront? We did not have to be there, or lose a loved one. This was one of those things that simply should not happen. It was in an important sense far worse than any natural disaster, for it involved the cold blooded marshaling of God’s great gifts, will and intellect, with the express purpose of inflicting as much pain and suffering as possible on innocent victims. It was an act that demanded, and got, a powerful response, a reordering of national priorities into actions whose results will only be understood in the long light of history. The passage of nearly a decade brings to light the question of how much longer expenditure for its prosecution (i.e., defense spending) might be expected to grow or even be maintained. This is especially pressing in light of competing claims on the national wealth that have seemingly exploded in the past few years. As we pause to reflect on losses suffered at the hands of a few who so resolutely hated us and everything we stand for, it would be prudent to consider, as objectively as we know how to, how that segment of the economy that is about responding to and deterring threats to our national existence is likely to fare going forward. This will be the subject of the bulk of this Musings, but first I want to expound on an idea that is about comparing, and making sense of, 9/11/2001 and 9/11/2010.

If it seemed at the time that an action such as the 9/11 attack was made possible by technological advances making the world a smaller place, the lead-up to the anniversary has reminded us of how inexorably this trend has continued. The cheap and easy transportation and telecommunications, not to mention that “connectedness on one’s one terms” we once called the World Wide Web, were all but certainly necessary to plan and execute such a grandiose scheme. Nine years later, the smallness of the world wrought by nearly cost-free connectedness is even more apparent. As recently as, well, 2001, garden variety tragedy and scandal was pretty much the purview on “local news”. As the “pipe” got fatter, the bit rates exploded and the number of channels grew beyond measure, we find it increasingly challenging to hide from a flow of “information” seemingly skewed to all that’s not well in the world. The climate isn’t changing so much as we are hearing about really bad weather in places we almost never thought about before this great “shrink”. The same holds for crime. So in 2010, a publicity seeking preacher, whether deep in bowels of lower Manhattan or way out in the weeds of exurban Florida, can command the global stage. Who would have imagined, twenty or so years ago, that a rube pastor of a tiny church out where gators roam could piss off so many adherents to the object of his stunt way off in upcountry West Asia, and get so many “dignitaries” (such a capacious term, no?) so lathered up in protracted bout of moral posturing? A more sensible, realistic world would have ignored him if they had noticed him at all. But such sense and connection with the real seemed to be irretrievably gone.

This brings to mind another recollection about 9/11/01 that was not about shock, grief or anger. There was the silver lining part of it, not the least of which was that sense of reconnection with reality. Much was written in the weeks that followed about change for the better in people all over the country but in and around NYC in particular. It was as if that spirit of our age that is not-so-enlightened self-interest got tamped down. It only lasted for a while, but it really did happen. Stark, brutal ugly reality can indeed blow away the unreality that pervades a culture that has been rolling along relatively unchallenged for the better part of a lifetime. We saw a side of humanity that gets hard to come by when peace and prosperity come to be taken for granted. One element of this is something we can call “neighborliness”. It is how people learn to get along when they have to live in close proximity without having to involve cops, lawyers or duels. It was much more in evidence in early 2002 than it was a year previously or in the years since. This is apropos today because its paucity explains the controversy around what some parties want to build a couple of blocks from Ground Zero. Simply put, such an act is a very unneighborly thing to do. It is not the act of someone trying to just get along and get through life. However subjective the “hurt” inflicted by the 9/11 attack might be, it is a very real pain, and not just for those who suffered personal loss. Even a modicum of neighborliness should be enough to sensitize us to this. But, no. So it seems that technology is bringing us ever closer together, and so ever more in need of that attitude or ethic of neighborliness, and yet there is little if anything the popular culture or the spirit of the age that prompts us in that direction.

If this is so, conflict is inevitable, be it flaring or just simmering. So as we look back on nearly a decade of warfare and contemplate how the priority that is national defense spending will evolve, we can be sure that the underlying “need” that drives demand is not going away. The question, if we are at all disposed to investing in those enterprises whose products and services address this need, is how much of a change is about to take place, and how much does it really matter to any specific company? Admittedly, from an investing point of view, this War on Terror has been the gift that keeps on giving. We knew that it was in a sense just a flare up of a centuries old conflict, but who expected that “combat operations”, as opposed to a still ongoing presence in Iraq, would stretch into 2010? Or that the war that in a model of Special Ops execution we seemingly won so quickly would flare back up again, with no clear end in sight? Still, however committed one is to meeting the threat of force with a poised and proven threat of even more force, a downshift in effort and so expenditure is eventually inevitable. While yet another conflict is always possible, it is increasingly unlikely, given the tremendous toll that has been taken on that sub-set of the so-called Arab “street” that might actually go and stand in harm’s way as opposed to just standing around talking about it. In other words, the ranks of those who are both susceptible to the promise of seventy virgins and man enough to act on it have had ample opportunity to do so. So a downshift in the tempo of this centuries old conflict is quite likely upon us, and priorities are changing accordingly.

This would seem to be an indication for investors to look elsewhere, but at this point in time it not quite so simple. To start with, it appears that the Market has been anticipating it for the last two years at least. The survivability of all but a marginal few of the publicly traded, defense related companies is hardly at stake. What matters is whether price appreciation, which as we know is a function of money flowing into a stock faster than it wants to flow out, is at all possible given the likely flattening if not outright decline in US defense spending. That the “pie” looks to shrink seems among the safest of bets and strikes me as something of an overwhelming consensus. Less well considered, however, is the degree to which evolving priorities might spell opportunity. Even if we assume a declining budget, there are programs and requirements that will grow and go forward. There is also plenty that can and will be cut to free up funds for priority programs. For example, reducing our presence in Iraq means no longer having to maintain an home away from home for tens of thousands of soldiers and contractors. And speaking of contractors, there is a ton of spending that got authorized before we took the measure of and then abraded the current threat that has been a a major driver of the booming Beltway. Not all of it was ever really necessary in the first place. This miles long gravy train will be trimmed back.

So what is likely to grow? The metaphor to keep in mind is the “tooth to tail” ratio. This construct describes how many assets, including people, military planners figure need to be in place to support one warrior who might actually engage the enemy. It tends to be a very high and nebulous number, varying from service to service (lower for the Marine Corps, higher for the Air Force) and over time as technology evolves. As such, when the tempo of engagement slows, cuts to “tail” will tend to vastly outweigh reductions in “teeth”. In point of fact, a conflict that has gone on longer than expected has caused the teeth to be badly in need of repair, if not replacement. Moreover, as planners work to anticipate if not deter the next threat, be it next year’s valedictorian of some Wazzupistan madrassa or the super power China intends to be in 2025, they will give top priority to sharpening said teeth. This brings us down to trying to identify those companies that can help the military do more with less, including repairing and upgrading a plethora of assets that have already performed more rigorously than they were designed to do.

My preference at this juncture is to avoid those entities that are predominately defense as opposed to having a good balance with commercial aviation. They might survive and the stocks are certainly cheap, but what is going to get the money flowing in faster than it trickles out? This dynamic (relative money flow) is especially pertinent with the larger companies, where the underlying commercial viability changes so little over time. (This notion has served to be the best way to “time” BA, but with that company there was a relatively predictable commercial cycle that prompted the marginal money flow. And its not just the inflows but the prospective diminution of inevitable outflows that matters.) Better to own those companies that have been waiting for the upturn in the commercial cycle, the pushed out 787 cycle that sucker punched so many investors in 2007. But won’t the dim prospects for defense spending offset this cycle? Not likely, in my estimation. Investors at the margin have been fretting about both for 2+ years already. The one gets better, a lot better, the other turns out not as dreadful as expected. The next cycle might run longer than 2003-07 (a big maybe), but it probably won’t be as huge, appreciation-wise. That last one started from a much scarier place and the defense side of demand went longer and stronger than could be reasonably expected in 2003. So maybe a punk outlook for defense outlays will take some zip off the ball, but there will still be outsized appreciation for those aerospace companies who have correctly positioned themselves with respect to evolving priorities (i.e, fix the teeth we have worn down, make them last longer with retrofit programs or replace them with more cost-effective teeth.)

With respect to the latter of these actions, it should be remembered that there are some very large and, owing to the wear and tear of the past nine years, badly needed aircraft programs in the not so distant future. Owners of defense stocks will be alarmed from time to time by program cuts, but such is the normal course of events. Not every program lives up to its billing, and sometimes the DoD gets it right when they pull the plug early. The question should not be, “What if they cut the JSF program?” It should be, “How much could they cut it so it’s not a great big program anymore, and how likely is that?” We dare not enter the next decade not being well along in transitioning away from reliance on antiques such as the F-15.

If we pause for only a moment to relive what overwhelmed and violated our very sense of decency nine years ago, we know that we cannot escape the burden of being the world leader capable of deterring such evil. Redirection and refocus are clearly in order, and this is the stuff of great opportunity for those investors willing to take the time and think it through.