Why supply chain disruption is still a concern for A&D companies

Podcast transcript: Why supply chain disruption is still a concern for A&D companies

12 mins 22 secs | 10 October 2023

Announcer

Welcome to the EY Advanced Manufacturing and Mobility Business Minute podcast series, where EY professionals explore the critical business issues impacting our industry today.

Mike Cadenazzi

I’m Mike Cadenazzi, I’m the Managing Director of EY Americas Aerospace and Defense practice. I’m joined today by the head of EY Americas’ Aerospace and Defense practice, Raman Ram. Thanks for joining us today, Raman.

Raman Ram

Thank you, Mike. Great talking to you.

Cadenazzi

The last time we spoke for a podcast was in June of 2023, just about three months ago, that was right before the Paris Air Show at Le Bourget in France. We were lucky enough to go over for that week and experience the state of the arc of what’s happening in the Aerospace and Defense sector. At the time, just before then, we talked about what you were looking for in Paris, particularly on the commercial side. One of the things was gauging orders for the major airframers and things like announcements. What actually came out of the Air Show and what were you excited about?

Ram

Thanks for asking, Mike. I thought the air show was great. The crowd there and the excitement indicated that we’re back to pre-pandemic levels and there is a lot of excitement. Particularly, something we were looking for from an industry standpoint is the orders. As you know, at Farnborough (Air Show) there were 450 or so new orders were announced. In Paris, about 1,300 or so new orders were announced. I personally was a little disappointed. I was expecting a lot more orders to be announced. Yes, we do understand some of the backdrop of the debt and the airlines are recovering. So I might have jumped the gun sooner and expected more. But I think we do anticipate more orders to come in, or the industry needs more orders going forward in 2024 and 2025 and so on.

Cadenazzi

Anything besides the orders that caught your eye?

Ram

There were a few things, and these were all related to the emphasis, the increased emphasis, Mike, that I noticed. One is the advanced air mobility unmanned stuff. I think there were a lot of players, a lot of demos, prototypes on display, so a lot of excitement around it. Two, sustainability, emphasis on that. Most of the conference presentation discussions. Third is around the supply chain emphasis. It wasn’t all around demand. There was also some discussion on the supply side. Lastly, I think there was an increased participation of financial sponsors in the conference as well. Those are a few things that I noticed.

Cadenazzi

Fantastic. So on the defense side, I think it was similarly an interesting mixed portfolio. First, Paris tends to be a little less defense-centric compared to Farnborough given the proximity to DSEI and London this year. There are a lot of folks that decided to participate there on the defense side rather than coming to Paris. It was a little more muted. There was less active defense demonstrations from the aircraft side to actual things in the air. But on the ground, as always, just a ton of different aircraft and participation. But I thought it was particularly interesting there was a lot of additional defense capabilities on the ground. So ground-based air defense systems, radars, combined with an international presence. So there were Italians, Turkish, South Korean capabilities, a lot of interesting things that I think have been brought forth as a result of the current conflict underway in Europe. Also there were comparatively fewer major announcements at Paris on the defense side compared to 2022. There were some interesting things going on, but some of the sizable ones, the partnerships between commercial and defense firms and some of the big announcements from 2022 were less muted this time around. There were some financial announcements and some reorgs that were released and discussed. Again, overall maybe not as exciting as last year when we sort of turned up the dial and got back to conference life at Farnborough.

As we pivot from what happened in June to what’s coming down the line, we’re looking at the close of 2023, it’s hard to imagine we’re heading into Q4. What has your attention for the rest of this year and going into 2024 on the commercial aerospace side?

Ram

Yeah, Mike. I look at it in two big buckets. The demand side and the supply side. Maybe I’ll touch on the demand side briefly. Traffic is back. Domestic has almost exceeded 2019 levels and international traffic is back. So I think heading into 2024, overall traffic should be back. So that’s all great. The long-run demand of air traffic is probably expected to grow about 3.5%. We’re going to be doubling. The air traffic demand is going to double by 2040. There is no dearth in demand. Even some of the indicators that we’ve been tracking are tracking well. For example, airline balance sheets and debt. Airlines, major network carriers in both the US as well as in Europe have been trying to reduce their debt or have reduced their debt already. Profitability of carriers is increasing. By end of next year, I think we’ll be at $10 billion, the entire air traffic, airline industry profits.

Per passenger profits increasing over $2. It was negative last year. Business travel in spite of the decline, still the yield of carriers have been increasing. So I think that’s good. Competitive intensity in industry has been staying flat. The number of net increases of change in airline actually reduced. That means the competitive intensity is not dragging the yield down. All those things we believe are actually helping operators and consequently, we expect orders to increase over the next three to four years.

Cadenazzi

That’s a lot of stuff. So as we pivot to the defense side and what we’re looking at going forward, I think the backdrop of everything is the current conflict in Ukraine, which has driven a lot of people to assume there was going to be a bevy of spending increases across Europe and in the US. That really hasn’t played out for a whole series of reasons. First, coming out of COVID-19, economies were strained. Budgets were tight, debt and deficit was already high at the national level. The US in particular, we’ve seen a push with the fiscal responsibility act of 2023 and the budgets caps, which have come in at around $886 billion for the fiscal year 2024 budget and are only set to increase by less than 1% in 2024 and into 2025. So if these numbers carry forward, you’re looking at losses, less than real growth on the defense budget in the US, which is never good for the industry. There is some pressure within Congress to look at, trying to use some kind of work around method, call it a supplemental, much like the OCO supplementals of the Iraq and Afghanistan wars to overcome and work around these limits. It’s not clear that’s the case, but there is some interest on the bipartisan side to go ahead and take advantage of these mechanisms and funnel some more money into defense.

The reason why is there is substantial demand. The US has already invested around $76 billion, most of that in defense capabilities, a lot of that in presidential drawdown authorities compared to say Europe, which has invested more totally. About $167 billion according to last count into Ukraine, but much of that not on the defense side. The US is really bearing the burden of investing in defense capabilities to sustain the Ukrainian army and a lot of that is going to need to be replaced. Things like ammunition where we understand at the beginning of the year, the US was announcing significant investments into ammunition production. But they are not expected to reach 100,000 units of ammunition per month production wise until 2025. Meanwhile, consumption in the conflict is something on the order of 5,000 to 6,000 units per day. That math doesn’t work out well from a stockpile standpoint. We’re also looking this year at the near term, what’s in the news today is the issues around a shutdown in the US versus some sort of continuing resolution, there are a lot of detailed politics that are underway. We’ll be keeping a close eye on that. A shutdown is never good for industry, it stops production, there are delays of payables for firms, temporary layoffs in some cases, we’re still convinced there will be some kind of temporary compromise reached with a continuing resolution likely to sort of carry through until the early part of next year, at least through the holidays, and that may turn into something that is more stable ground for negotiating a long-term compromise for 2024.

As far as actual activity on the ground, earnings have been pretty good this year. A lot of firms on the defense side thought they weren’t going to grow despite the additional demand coming out of the war. But as you look at earnings over the past year or so, it’s actually turned pretty good and most firms are expecting positive revenue growth for this year, despite the lack of substantial additional spending on the budget.

Outlook-wise, a couple big things happening. One is the push on the industrial base in the US. Much like demand on the commercial aircraft side, we’re seeing a government in the US anyway that is interested in pumping more money into the industrial base, several billion dollars directly right now that’s likely to go into the submarine industrial base. There’s talk about additional money, in the tens of billions, for submarine industrial support for the long haul to drive more companies and more capacity, to support things like the new AUKUS program, which is the combination, the partnership of the US, UK and Australia to produce the first Virginia-class submarines that will go to Australia, there are already Australians operating in the US nuclear power, supply chain is going to enable that training pipeline and then eventually a newly designed submarine that the UK and Australia will use to improve our partnerships and capabilities in the Pacific.

So there are some really exciting things that are likely to drive additional demand down the line. Those are things that we’ll likely start to get additional detail on as we approach fiscal year 2024 and then calendar year 2024.

So Raman, pivoting back quickly to commercial aero, is there anything else exciting to you that you see coming down the pipe that is really exciting and would capture industries.

Ram

One last thing I wanted to mention is on the supply side, Mike, similar to what you said on the defense side. On commercial, I think the make or break for the industry is going to be how well the manufacturers and service providers handle the supply side. So the demand for parts and services are actually going to increase. In the meanwhile, we’re seeing quality issues industries are wrestling with, cost pressures are increasing all the way from the airlines. For example, even if you look at the spread for the crew for the jet fuel, that spread is as high as it’s ever been. Then trickling down to aerospace industry, interest rates are high, labor costs are still high. I think those things are posing challenges. Supply chain has still not recovered completely. Labor availability and labor constraints are still prevailing. All these supply side constraints still are prevailing. So how well the industry tackles these things to meet the demand is going to define where we’re going to land in the next two, three or four years down the road. Exciting times.

Cadenazzi

That’s fascinating. The same problem is happening in defense with the challenges around supply chain. There’s been a lot of conversation around the utility of multi-year contracts, long-range sort of three to five-year contracts to stabilize mission production, some other supply chain challenges that we are facing. However, the challenges that a multi-year contract with the Primes doesn’t necessarily lead to multi-year contracts with the sub down in Tier 2, 3 and 4. Therefore, there’s still a need to stabilize the supply chain at the lower level, particularly where there is increasing demand from those commercial aerospace and other industrial players in places like semiconductors, materials. They are suffering the same challenges that you’re seeing on the commercial aero side and so the response of the sector to sort of bring more capability and capacity in and manage things like inflation above 2%-3% percent with limited budget increases is going to be interesting.  

So I think with that Raman, thank you very much for your time today. And we’ll look forward to coming back at the end of the year to wrap up Q4 for 2023.

Ram

Thanks, Mike. Always a pleasure.

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