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.
No comments:
Post a Comment