Is commercial aerospace starting its descent?
Commercial aerospace has delivered strong profits in the past decade, but over-capacity issues are beginning to weigh on the sector.
Commercial aerospace has been one of the strongest-performing industrial sectors since the global financial crisis. Relatively strong passenger growth - aided by the boom in budget airlines, increased demand from emerging markets and a desire to upgrade to more efficient aircraft - has fuelled demand for new aircraft.
Around 13,000 commercial jets were ordered over the five years to the end of April 2016, according to Flight Ascend Consultancy, while the backlog of commercial jet deliveries stood at US$952 billion in mid-2016, enough to keep production lines busy for many years to come.
Yet there are signs that the commercial aerospace cycle has now peaked and the outlook might not be as bright for the main aerospace manufacturers, according to John Harzich, Senior Security Analyst at Aviva Investors.
“There is evidence that the likes of Boeing and Airbus have been overproducing aircraft recently - with production reaching high rates at both manufacturers, just as order books appear to be slowing,” says Harzich.
Over 2,050 new aircraft were ordered in 2015, yet just 540 net new aircraft had been ordered in 2016 by the beginning of June, according to Flight Ascend Consultancy. The Farnborough Air Show, held in July 2016 and considered a flagship event in terms of new orders, proved disappointing for both Airbus and more particularly Boeing with orders well down on the numbers racked up at last year’s equally prestigious Paris Air Show.
Reports that Airbus will announce a new restructuring and cost-cutting programme in October support the view that the commercial aerospace cycle has peaked. Losses on the A380 superjumbo, as well as costly delays in other aircraft programmes, are hurting Airbus.
Tougher times ahead
The downturn began in the business jet sector. “Until recently, the sector enjoyed strong demand from emerging markets but that has started to wane because economic growth has slowed; particularly in oil-dependent economies such as Russia, with the Middle East and some countries in East Asia also affected,” says Harzich. “The economic slowdown in China is also biting, while US companies are bearing down on costs and this is hitting demand for business jets.”
Departures and arrivals of these aircraft fell by nearly two per cent in the US during the year to July 2016, according to the Federal Aviation Administration.
Slightly more than 700 corporate jets were delivered in 2015, down from more than 1,100 in 2008, according to figures from the 'Wall Street Journal'. But orders appear to have fallen sharply this year. Canada’s Bombardier and Brazil’s Embraer dominate the business jet sector and both have released gloomy market updates. Shipments of Bombardier business jets, for example, fell by almost a third in the first quarter of the year due to declining demand. The company, which accounted for 34 per cent of global business jet sales in 2014, said in September it expected a 10 per cent decline in total industry deliveries this year compared to 2015.
Meanwhile, falling demand for business jets is also hurting Embraer, according to Anton Kerkenezov, Emerging Markets Debt Portfolio Manager at Aviva Investors. “The executive jet sector, which accounts for around 30 per cent of the company’s total sales, was the worst-performing area according to the company’s second quarter results,” says Kerkenezov. “A decline in deliveries and revenues in this segment was the major factor in the downward revision of overall guidance for this year. The company’s management was cautious on the executive jet sector and unable to say when the downward trend will end.”
Passenger growth slowing significantly
Slower-than-expected economic growth, particularly in emerging economies, where demand for new airliners was growing rapidly, and paradoxically falling oil prices, are driving weaker demand in the passenger sector. Global passenger traffic measured in revenue passenger kilometres (RPKs) grew by 6.6 per cent in 2015, according to Flight Ascend Consultancy, but growth has slowed significantly to a year-on-year rate of 5.7 per cent in July 2016. Yet the consultancy says that “while traffic growth appears to be moderating, capacity is accelerating, leading to load factors falling in several regions, with the Middle East particularly badly hit”.
The table below highlights the recent worsening trend in global passenger traffic growth, with a decline of 4.5 per cent seen in the most recent three months*. Terrorism in Europe and economic weakness in large emerging economies such as Brazil have had an impact, but generally weak global growth suggests the slowdown may not be temporary. At the same time as traffic growth appears to be moderating, capacity is accelerating, leading to load factors falling in several regions, with the Middle East particularly badly hit, according to Flight Ascend Consultancy.
Low oil prices hurting new aircraft demand
Aided by low oil prices, 2016 could be the most lucrative year in history for the airline industry with global profits of over US$60bn, according to IATA. This would mark the fifth consecutive year of improving profits if IATA’s forecast proves accurate.
A profitable airline industry should, in theory, be positive for new aircraft orders but that isn’t necessarily the case.
Low oil prices reduce the incentive to buy new, more fuel-efficient aircraft since the older, more energy-intensive aeroplanes are delivering perfectly good profits. This is particularly the case with the legacy carriers, which have been able to continue flying planes that a few years ago appeared highly inefficient, especially in comparison to the budget airlines that have invested heavily in new fuel efficient aircraft.
Wide bodies suffer in downturn
Within the passenger aircraft market, there is evidence of a sharp divergence in the fortunes of narrow-bodied planes such as the Airbus A320 and the Boeing 757 and wide-bodied aircraft such as the Airbus A380. In its latest monthly update, for example, Airbus said it booked 144 new airliner orders in August 2016, all for narrow-bodied planes.
Various factors lie behind this trend according to Harzich. “Traditionally, when the airline industry enters a weaker part of the cycle, demand for wide-bodied aircraft falls faster than for narrow-bodied,” he says. “This reflects the greater flexibility that narrow-bodied planes offer in terms of the number of routes they can operate on, whereas wide bodied tend to be used on particular missions, notably long haul.”
Smaller jets more profitable
Moreover, according to James Balfour, Portfolio Manager at Aviva Investors, the trend towards narrow-bodied had already become established with these aeroplanes proving particularly popular with budget airlines. “It is more profitable to fly a full narrow-bodied plane on several routes per day than a wide-bodied plane on perhaps one long haul route.”
Balfour points out the outperformance of narrow-bodies supports Boeing’s belief that “passengers prefer to take direct flights on smaller airplanes, rather than fly on big aeroplanes to huge hubs and then make an onward connection”.
Airbus, by contrast, invested heavily in the huge A380 in the belief the future of air travel belonged to big planes flying between major hubs. But by the end of July 2016, Airbus had received 318 orders and delivered 138 planes to just 11 airlines. This is far short of its forecast of 1,500 sales over a 20-year period. It is not just the trend away from wide-bodied aircraft that is hurting the A380, which is expensive to operate. Singapore Airlines’ (SIA) recent decision not to extend the lease on its A380 when it expires next year is another blow.
Harzich identifies another factor supporting narrow bodies. “The slowdown in the pace of growth in international traffic is particularly hitting wide-bodied aircraft because they tend to be used on long-haul, international routes rather than domestic routes.” The international passenger market expanded 9.1 per cent (RPK) year-on-year in February, but slowed sharply in subsequent months, growing by just five per cent in the year to June 2016, while demand for domestic travel climbed 5.7 per cent during the year, according to IATA.
Finally, according to Harzich, “a large number of second-hand wide-bodied jets are now coming onto the market as leases end. Many Boeing 777s, for example, are coming off 10 or 12-year leases. Airlines are looking at these aircraft and calculating that it might be better to buy a 10-year old jet at a much lower cost than a new aircraft“.
The result of all these trends, according to Balfour, is that “Airbus and Boeing should be generating even more cash than they are, given that capital expenditure on aircraft such as the 787 and the A380 is in the past. But they continue to invest heavily in even newer aircraft while the order book for new aircraft is far more likely to shrink than increase in size in the coming years. We are already seeing many cancellations and order deferrals”.
In its latest monthly update, Airbus said order cancellations this year had reached 79 planes, up from 50 cancellations in the prior month.
Further cancellations are likely to be concentrated in the developed markets given rising living standards and increased appetite for air travel in the developing world. US dollar strength could also be a headwind for Boeing and other US aerospace companies.
As a result, Balfour is more interested in getting exposure to suppliers to the likes of Boeing and Airbus. Engine makers such as Germany’s MTU Aero Engines and France’s Safran, which also supplies aircraft engines, should see levels of capital expenditure fall, while margins and revenues pick up. In addition, both benefit from recurring revenue streams from engine maintenance contracts and are supplying engines to new narrow-bodied aircraft such as the Boeing 737 Max and the Airbus A320 Neo. These fuel-efficient jetliners have particular appeal to the low-cost carriers that are wining market share from the legacy airlines.
Moreover, the sector may see some M&A activity given that Airbus and Boeing are keen to encourage consolidation in the supply chain. The aerospace giants prefer to rely on larger, financially-stable companies rather than a plethora of relatively small companies.
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