Friday, December 23, 2011

Aerospace and Defense: 2012- Increased Caution Becoming Self-Fulfilling?Not Yet, but Currently at an Inflection Point

Neelam Mathews
Dec 23, 2011
The watchword is caution. For the most part, the industry fundamentals are holding up well, but there is a much greater sense of caution heading into 2012 on the part of airlines and the parts and service providerssays Wedbush.” We believe investor sentiment may have become too cautious on the aftermarket heading into 2012, while the assumption that Boeing and Airbus will be able to execute on the anticipated production increases without any issues is likely challenged at some point in 2012.
For the commercial aftermarket, the primary positives heading into 2012 are strong backlogs for deferred engine and heavy maintenance, continued growth in the emerging markets, and current expectations that the number of  parked aircraft will not significantly increase in 1H 2012.  Heavy and engine maintenance backlogs remain strong, with many firms selling late-2012 and 2013 slots.  However, the confidence in these backlogs is less than it was 3 months ago, implying that the caution on the part of the airlines is creating a perception of softness in the backlogs, says the report.

The quote activity for parking aircraft does not yet point to a substantial increase in parked aircraft in 1H 2012. “However, our conversations with the parking facilities indicate that there will be a substantial increase in parked freighter aircraft in 1H 2012.  However, aside from the usual retirement of older aircraft, or some select fleet rationalization, the lack of any increase in RFPs by the airlines to park aircraft, in our view, is a substantial positive now for the aftermarket.” 

The original equipment supply chain is very confident in its ability to support the legacy program rate
 increases (737, 777, A320, A330 and 767), but the Boeing 787 is viewed as the primary source of risk. 

Boeing’s planned rate increase to 3.5 787s a month in April 2012 is not seen as an issue, but the planned increase to 5/month in October 2012 is the major question mark.  The supply chain has been ready for 3.5/month for several quarters, but the move to 5/month is unchartered waters.  Moreover, we should get visibility on the potential here as many suppliers are expected to start to ship at a rate of 5 787s a month in 1Q 12. 

Aftermarket Fundamentals Generally Strong, but Airlines Increasingly Cautious

The primary risk to the aftermarket growth in 2012 is an over-reaction by the airlines to potential macro
concerns.  "We believe airlines are taking a cautious approach to 2012, and as expected some initial reductions  in overall capacity, such as from Delta (DAL-Not Covered), have been announced.  However, with fundamentals that continue to look positive, there is a risk that the airlines potential for over-caution will in fact be a trigger for a potential downturn, or in other words, will become a self-fulfilling prophecy.This is reflected by the fact that many of the MROs we spoke with over the past few weeks now have lower confidence in the 2012 backlogs than they did in October."

Aside from macro concerns, the primary headwinds for the commercial aftermarket in 2012
 include the following:

• Continued weakness in air cargo growth
• Pricing (5%-10% lower price increase versus 2011)
• Used and surplus market taking sales from new parts
• Increased airline caution
• Slower traffic growth
• Older planes getting parked

However, these are partially offset by a few positives heading into 2012:

• Strong deferred backlog
• Economic recovery, continued strength in emerging markets
• No unusual parked activity expected, just normal levels with focus on older aircraft
• New airplane parts provisioning

All told, we expect slower growth in terms of aftermarket parts, and we believe the recent guidance
from both TransDigm and HEICO, calling for approximately 10-12% slower aftermarket parts growth in 2012, as not overly conservative.  We do not think we will see a return of the very strong demand we saw in 1H 2011 as many airlines were caught in need of urgent maintenance to support the summer surge in traffic. 

This demand surge enabled many OEMs to push through a second price increase in May 2011.  

Regarding the 787, it is the “smaller” supplier that is cited as the biggest source of risk.  Many Tier 1 and 2 firms are well into their capital plans to support the rate increase, but it is the firms much lower on the supply chain that have them worried.  It also must be noted that material lead times are increasing, labor shortages are starting to appear and wage inflation will also hurt margins, adds the Wedbush report.

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