Actively Speaking Podcast
Steve Bleiberg, portfolio manager and thought leader at Epoch Investment Partners, Inc. (TD Epoch) takes on current topics and issues facing today's investor.
Actively Speaking Podcast
Grounded: COVID-19's Impact on the Aircraft Industry
The pandemic has brought air travel to a grinding halt in 2020, leaving many airlines struggling to adapt. But what about the aircraft manufacturers? What about their suppliers? Epoch Senior Research Analyst Chris Wolters joins Actively Speaking to share his insight on how are they fairing amid all this uncertainty. (August 7, 2020)
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Hello,
Speaker 2:And welcome to Actively Speaking. I'm your host, Steve Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 1:Welcome back, everyone, to another episode of Actively Speaking. One of the more visible casualties of the Covid pandemic that we're all living through has been the airline business that we've all seen how the number of people flying has declined precipitously. I know I myself have not been on the airplane in months, and that's had an obvious effect on the airlines, but how about the suppliers, uh, of the airlines, the, the companies that make the aircraft and, and the suppliers to those suppliers? And that's what we're gonna talk about today. My guest is Chris Walters, who's an analyst here at Epic. Welcome Chris. Thanks for joining me.
Speaker 3:Hey, Steve, how are you?
Speaker 1:Good, good. Thanks for joining us. So give us a sense to start off with, uh, of the scale of, of the industry that we're talking about. So this is the, the commercial aircraft industry. How big is it in terms of both, you know, revenue, how much revenue does it generate, uh, around the world or, or in the us or both? Uh, and how many people, uh, are employed in this industry?
Speaker 3:Well, Boeing and Airbus split the large aircraft industry, roughly 50 50, while providers of regional aircraft include Bombardier, the Canadian company, now owned by Airbus and Embr Air, a Brazilian company. The supplier base has consolidated over the last decade or so with Raytheon Technologies, a company which was actually created through the recent merger of United Technologies. And Raytheon is the largest aerospace supplier through various subsidiaries. The company provides avionics, landing gear, interior seats and gals along with Jet engines through their wholly owned subsidiary, Pratt and Whitney. Other jet engine suppliers include General Electric Rolls Royce and Saffran through a joint venture with ge. Honeywells also, uh, competes in avionics. And then you have other smaller, uh, suppliers such as Woodward, TransDigm, and Hel a company which makes carbon fiber based composite materials used to build fuselages and engine the cells. And there's Aerostructure companies such as Spirit and Triumph Group, which are also important players producing major sections of a new aircraft, annual revenue generated through the production and maintenance of commercial aircraft totals 300 billion worldwide. This excludes the airline industry. And then the US would account for about 50% of that, or 150 billion of sales and has 500,000 employees. The commercial aerospace industry, including the a, uh, airline industry represent 8% or so of of us G D P and employs, uh, 10 million people worldwide.
Speaker 1:Wow. This is a big, uh, this is a big industry we're talking about. Now. Historically, it was an industry that had pretty steady growth and, uh, uh, also it was an industry that Epic had some, you know, sometimes sizable investments in some of the companies in the, in the aircraft industry. Talk about what were the drivers of that growth historically, wh why was it, uh, a growing industry? And, and, and then, and then we'll turn to after that to talk about how, you know, COVID has affected that. But what, historically, what were the drivers of growth in this, in
Speaker 3:This business? Well, we invested in commercial aerospace for several reasons. One, as you point out, the industry is large, as we noted earlier. Two, for thir. Over 30 years, the industry has consistently grown at four to 5% annually or rate faster than world gdp, and there's long runway to further penetrate developing countries. The previous B Boeing CEO would often say that less than 20% of the world's population has ever flown on an airplane. And three, there are significant barriers to entry. The industry is highly regulated. Safety provides a significant barrier to entry a plane, and all of its parts need to be certified by the faa, the Federal Aviation Administration. And once certified, the plane parts cannot be upgraded or changed without a costly re-certification process. In essence, parts on a plane are like little monopolies that have a long annuity stream attached to them for the life of an aircraft platform, which can last for upwards of 40 years or more. And as we all know, monopolies are businesses that have above average profit models, which is the case for the aerospace supplier base. Also, logistics create a be a barrier. Think about the turnaround time for a Boeing 7 37 at an airport. This can only be accomplished if each airline has maintenance crews and spare parts available to enable that turnaround in airports all around the world, this is extremely costly to develop and support. So even though the Chinese may want to, and it will ultimately be a player in the industry, realistically, it will be 30 to 40 years to accomplish meaningful market share outside of mainland China. Similar to Airbus taking 40 to 50 years to gain its current market position and beyond these industry characteristics. Over the last decade, the OEMs, Boeing and Airbus had eight years of revenue visibility created through a backlog of firm orders of 10,000 aircraft to be produced and delivered to its customers at a production rate of roughly 1600 aircraft per year. About 50% of this demand was to support growth in developing markets and the balance for replacement demand. This backlog is getting refreshed every year, as both OEMs consistently realized the book to bill above one times. So for all these reasons, we at Epic were investors in a broad group of commercial aerospace stocks.
Speaker 1:Okay. So let's talk now about how Covid has affected the industry. We, we've all seen how the number of people flying has dropped off quite a bit. And you know, one has to wonder, is this causing the airlines to reconsider their plans for both future growth, just in terms of roots, but also obviously the number of planes they need. So what, uh, tell us something about what's happening today. Like where are, is production dropped off or are, I mean, like, because the workers are sick, you know, right. So, uh, are they able to be producing at full strengths? Are airlines canceling orders? What's the, what's the extent of the backlog these days?
Speaker 3:Well, simply put, COVID 19 has been devastating for the industry. As an equity analyst, having filed the industry for the last 25 to 30 years, pandemic has always been listed as a risk factor in the s e C document. And now we can see why, for obvious reasons, which are quite apparent today, realizing that flying in an airplane in close quarters with strangers that could infect you causes changes in behavior quickly, not only by individuals themselves, but also mandated by governments. So that historic traffic growth of 5% a year has just fallen off the cliff. The levels today that are un uneconomic for airlines who are the ultimate end customers for new airplanes, as you pointed out, this observation led me to recommend we dramatically reduce our investment exposure to the industry, which have been so vibrant for so long. And so, given this backdrop, Boeing and airbrush have reduced their production rates by roughly 35% to reflect the current reality. Cancellations and other factors have led to a 10% reduction in the firm backlog. These backlogs may come under further pressure over the next six to 12 months, depending upon how much cash the airline industry burns. Given the size of the commercial aerospace and airline industries, government support has emerged worldwide. Nonetheless, layoffs have been announced by most industry participants shrinking the employee base by 10 to 15%. Simply put, this is an industry that really needs a vaccine to turn the corner and a vaccine is needed before we would return to become meaningful investors.
Speaker 1:Well, we've just come through, uh, uh, earnings announcement season in recently, in recent weeks. So I, you know, there's the old joke about making predictions as hard, particularly about the future. But, uh, do the companies themselves, when they went through the earnings announcements, what are they saying about the outlook? Do they have any insights? It's pretty hard, I guess, but what, what are they saying?
Speaker 3:Well, they're, they've been consistent with kind of what we're, what I just mentioned there, where, you know, they've reduced their production to try to get more in line with the existing demand. They have gone out and, you know, spoken to their customer base to try to get better visibility in the, into the airline's needs. And as a consequence, they're reducing their production. Furthermore, you have Boeing, which has 450 planes in inventory on the tarmac given, uh, they're waiting for approval for the 7 37 max to become airworthy again. And, uh, Airbus also has about 150 planes in inventory as airlines. Were not really accepting airplanes or very many airplanes over the last four or five months. So that's definitely caused, you know, issues for both the OEMs. And if you look at what's happened as a consequence on the commercial aerospace side, you know, the governments have tried to help out the airlines pre, which I had previously noted. Uh, you know, I've been completely devastated by the pandemic in the us. You know, some 25 billion of aid has been extended to the airlines through grants and loans. And similarly, 25 billion euro of aid has been extended in Europe, and this aid will likely be passed through by the airlines to help with payrolls well as purchase of new aircraft and beyond what the industry from the OE standpoint then the supplier base is talking about on the quarterly calls you have the, uh, international Air Transport Association, where I had a, the trade organization that provides detail on the industry. And recently I had a disclose that it expects the airlines to lose 85 billion globally in 2020 on a revenue base that's cut in half from 2019 levels to 420 billion in 2021. Further losses by the global airline industry are expected to total 15 billion as global airline revenues recover to 600 billion. So there's a long way to go here for the industry to get back on, on its footing.
Speaker 1:Okay. Well the, these companies, I know they don't just make, uh, commercial airliners. Some of them are also involved in, uh, you know, defense contract in military planes, et cetera. Is that side of their business big enough to, you know, to keep them going here? Or is there some risk of, you know, of these companies really being in serious trouble with survival? Cause that would seem to have some national security implications?
Speaker 3:Well, clearly the, uh, governments can support their defense contractors, of which Boeing participates, and now almost 50% of the total company is defense, given the reduction on the commercial aerospace side. AirBoss on the other hand, has only, uh, 15% exposure to defense related sales. And then obviously all the airlines are just the commercial providers. And so, while not national defense is obviously a key priority for governments, I don't think this approach would be how the commercial aerospace industry would make it through this downturn. You know, I would say nonetheless though, the, in the us you know, the Department of Defense has its accelerated progress payments to the defense primes, which in turn, you know, accelerated payments down to they're smaller but broader supplier base. And that certainly helps with national security. But as I mentioned prior, I believe that this, the support will come through governments providing loans and grants to the airline industry to try to keep the commercial aerospace industry afloat.
Speaker 1:Oh, in all, it sounds like a pretty, a pretty grim situation. I mean, how would you, how would you sum this up in terms of where things stand for this industry
Speaker 3:Financially? Uh, 2020 will go down as the worst year in the history of aviation. On average, every day of this year, we will see 230 million of additional global airline industry losses, and the industry won't get back to 2019 levels until 2024. And that's why this industry needs a successful Covid 19 vaccine more than any other industry. However, present, you know, the visibility is still murky and there appears to be more downside risk than upside to these, uh, forecasts. It sees observations that ultimately guide us at Epic to be extremely cautious toward investment in the commercial aerospace industry today, despite what was clearly one of the best industries for investment over the last decade.
Speaker 1:Okay. Well, thanks for joining me, Chris. And, uh, hopefully we'll be able to check back with you, uh, in better times in the future and, and hear about the spectacular recovery that the, uh, commercial aircraft industry has made. Thanks again for joining me.
Speaker 3:Absolutely, Steve. I look forward to, uh, doing a follow up when things are, uh, in a much better position.
Speaker 1:Okay, well thanks for listening and we will, uh, talk to you again soon.
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Speaker 4:The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur, and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.