Charles Edwards

Experience. Insight. Results.

Earning roundup

Quarter ended June 30, 2019

HEADLINES

Although the lead story in the industry continues to be the 737MAX grounding, Airbus faces challenges of its own. Engine delays are impacting deliveries of the A320. (Engine issues are also delaying 777-X’s entry into service). And Collins Aerospace is poised to grow to be a $75B a year company per their earnings call (i.e., roughly the size of Airbus). Buyers of Arconic product and suppliers to Lockheed, Spirit, and Bombardier need to understand how changes at these companies may impact their businesses. 

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Program Highlights

737MAX


The 737MAX grounding has impacted companies differently.   Spirit has reduced costs and labor hours (more below).  Some companies are relatively unaffected because their content is low (TriMas, Triumph, Hexcel and MOOG).  And some companies view it as a small impact because their margins on the program are so low (Parker Hannifin).  When it will really fly again is unknown but the pause has given the supply chain a chance to reload.  The question that remains is, once it begins ramping up, will the same supply chain bottlenecks reappear?  We have not seen significant capacity additions in constrained areas.  And the ramp up itself could be quite a challenge.  Boeing has indicated a desire to go from the current rates to 52 by February assuming an early Q4 return to service.  We believe that is ambitious.  


F-35

  

Lockheed Martin and the Joint Program Office of the Department of Defense have a handshake deal on a Block Buy for lots 12-14.  The contract has incentives in it for further cost reductions in the supply chain (many of which are already negotiated, e.g. Northrop Grumman on the fuselage center section) and supplier performance.  This, though, will not be the end of the pressure on supply chain cost.  When the program matures into a Firm Fixed Price program after the Block Buy, Lockheed Martin will return to the bargaining table to get lower prices from its suppliers since that contract structure allows them to retain 100% of the reduction rather than share it with the Department of Defense.  The program is also having to deal with moving parts from Turkey back to US suppliers. Companies need to be careful though about giving Lockheed Martin too many price concessions to take this work on if the belief is the cost will be recovered in the out years


A320 Family


Airbus said that their engine suppliers had concerns about supporting a rate of 60 per month.  Nonetheless, they have plans to move to 63 per month and are looking at even higher rates. They continue to have problems ramping up the A321ACF (Airbus Cabin Flex).  This variant has more cabin options and, therefore, more complexity in the build cadence.  We are skeptical about getting beyond 63 per month any time soon.

Company Highlights

Not surprisingly, Boeing took a massive hit to earnings, booking a $4.9B after tax charge for the 737MAX.  But that is not cash and although they did record a $600M reduction in cash flow from operations this quarter, they still have $9.2B of cash on the books so they are positioned to continue easing the impact on the supply chain.  A bigger concern might be the drain on resources.  For example, Boeing has established a Board level committee to “review Boeing's policies and processes for the design and development of airplanes.”  Care and feeding of such a committee takes resources as does implementing any resulting recommendations.  Layer on top of that all of the resources actually engaged in the fix for the 737MAX and the FOD problems on the 767.  The business has to be distracted.


Spirit also had to take strong action in response to the 737MAX grounding.  Spirit announced actions that include reduced levels of overtime and fewer contractors, a voluntary retirement plan, 10 unpaid furlough days for certain employees, including the entire senior leadership team, a hiring freeze, and deferred capital spending and working capital improvements.  Spirit continues building at 52 month (although their shipments fell nine short of that in the quarter).  They believe that will continue at least through 2020.  So, companies that are suppliers to Spirit on the program (rather than to Boeing) will not be experiencing an increase in demand until 2021 at the earliest.  In the near term, expect pulls from Spirit’smin-max system to decline and potential reschedules to the right for their discretely scheduled parts on the program.


Spirit is experiencing delays in integrating Asco.  The European Commission required a complicated split of data from Asco prior to the sale.  While that was happening, Asco suffered a cyber-attack, setting the process back further.  Amazingly, an acquisition announced May 2, 2018 still has not closed.  This alone may discourage Spirit from making a run at another European company like Bombardier’s Northern Ireland operation.


TriMas Aerospace recently announced that they added two new major European based Tier 1 customers, Sonaca and Safran.


Bombardier expects to consume $1.5B of Free Cash Flow this year.  They also took a charge on the Global 7500 that they purchased from Triumph Group earlier this year.  Suppliers should expect considerable pressure to deliver on the 7500 as the cash is badly needed.


Arconic continues to disclose their major restructuring plans.  They had previously announced that they would split into two companies.  The Rolled Products Group (that now includes Extrusions) will be called Arconic and the Engineered Solutions Group will be called Howmet Aerospace.  Next quarter they will announce which one will be spun off.  They expect to complete the process of splitting by the second quarter of 2020.  They also continue to reduce heads – 1,127 employees have been cut through the end of the second quarter.  CEO John Plant also indicated that they would aggressively pursue higher pricing.  Companies should expect price increases from Arconic, particularly on those products where alternatives are not readily available.


Embraer reported a free cash flow consumption of $664 million year-to date.  They also are planning to move most of their Fort Lauderdale, FL operation back to Brazil.


Thyssenkrupp had their restructuring JV plan with Tata turned down by the European Commission.  Instead, they will execute a massive restructuring that includes eliminating 6,000 jobs over the next three years.  They continue to review operations to see if they meet the “NewTK” goals of “high value add business with significant margin”.  We suspect TMX Aerospace will be one of the units reviewed. 


Airbus is yet another company falling short of its cash generation goals.  Their first half free cash flow before M&A and customer financing was minus €4.0 billion. This means they need to deliver about €8 billion of free cash flow in the remaining six months.  That is €1 billion more than in the second half of 2018 on about the same number of deliveries.  Airbus also faces the threat of tariffs levied against US sales in a recent World Trade Organization ruling and disruptions to supply if there is a hard Brexit.  With regard to Brexit, Airbus ramped up their purchases in an attempt to build a 30 day buffer inventory in case there was disruption. Hexcel did the same.  A more orderly exit then would cause a temporary slow down in deliveries from the affected suppliers.


General Electric is in the midst of what they term as a “reset year”.  They are pushing control from corporate to the business segments and have brought on quite a few new executives.  They have hired the following executives: Digital CEO, Power Portfolio CFO, Healthcare China CEO & Healthcare USCAN CEO, Appointed Operational Transformation champion, Power Conversion CEO and are searching for a new CFO.  There may be some changes in the decision makers that companies deal with at GE.  With regard to the 737MAX, it is currently impacting GE’s cash by $300M per quarter, ramping up to $400M per quarter.  But GE has $16B in cash on the books.


Hexcel ramped up its push into the Asia Pacific region announcing the official opening of a new joint venture laboratory and materials testing facility in Shanghai and, most notably, a permanent sales office in India.


The formation of L3Harris and the merger of Collins and Raytheon will likely cause both new companies to review their portfolios for companies that do not fit well.  At L3Harris, that might include L3 MAS.   At the future Raytheon Technologies, might it include the Aerostructures operation in Chula Vista given Airbus has chosen to do nacelles in-house? 


MOOG is another company undergoing transformation – in its Aircraft division.  The transformation is particularly focused on supply chain.  So, if they are a customer, engage closely with them as they go through their changes.  We expect one likely outcome to be a rationalization of their supply base.


Transdigm, while not admitting to, nor being accused of, any wrongdoing, refunded $16M to the Department of Defense.  Despite this, the Inspector General is now conducting a broader investigation.  Transdigm’s highly decentralized operating model has delivered exceptional results but an IG investigation can require significant resources and smaller entities may not have the bandwidth to adequately deal with the demands.  For the business units affected, this could prove to be a distraction.  Meanwhile, the Esterline acquisition is exceeding expectations so far.

Closing thoughts - The 737MAX

With Spirit building at 52 a month and Boeing consuming at 42 a month, a surplus of fuselages is accruing.  Spirit had approximately 35 stored at McConnell Air Force Base in Wichita as of August 1st.  If Boeing successfully gets to 52 per month by February, there would be more than double that many stored by then.  That is a considerable inventory. 


Why then would Boeing continue to have Spirit build?  We think that there may be two good reasons.  First, the selling price to Boeing might rise as the rate decreases.  The deal last year (Collective Resolution 2.0) between Spirit and Boeing had price step downs built in as rate increased.  It likely works the other way as well.  Given that the profitability of a block of airplanes depends on the average cost to build the planes, an increase in cost results in a reduction in margin for all planes in the block.  Second, Spirit’s collective bargaining agreement with the IAM expires in June of 2020.  This buffer is a prudent reserve for both companies should there be a work interruption or an impairment to delivery while negotiations take place.  What this also means though is that the stakes are higher for Boeing if the re-entry into service is delayed. 


Would Boeing consider pausing production of the MAX if recertification drags on long enough?  Anyone ever involved in structural assembly would say that nothing is harder than stopping and starting a line.  So, why would Boeing consider “pausing” work?  Their contract with Spirit would let them do so without a cost claim whereas a rate reduction results in a price increase.  Spirit by the way has the same rights in their contracts.  Many subtiers do not.  There is greater risk in the lower tiers should the unthinkable happen.