How are aerospace OEMs surviving the price inflation squeeze?
Maturing generations tend to view price inflation as a symptom of the modern age. With a tear in their eye, they recall the days when a piece of rock candy was a few cents, and the most expensive car a wealthy individual could possibly afford was a fraction of what a Toyota Corolla costs today.
By Dennis Menefee, President and CEO of Partstat.
This is, of course, an oversimplification of the concept of price inflation, but it’s an accurate depiction of how professionals across the manufacturing world feel watching component prices increase year-over-year. Price increases, alone, however, are not enough to blame inflation as the primary cause of financial strain.
The goal of an economic body is to moderate price inflation to where costs rise and fall in perfect proportion to the value of the national currency; in theory, while that Corolla may look more expensive today, buyers should be spending proportionally what they would have at any point in the past. It is only when this ratio is disrupted through other economic factors that buyers begin to feel the pinch.
In today’s aerospace industry, that pinch is feeling more like a MIL-grade vice grip.
According to the Bureau of Labor Statistics, the US Producer Price Index for Aerospace Product and Parts Manufacturing is at 230.40, a net increase of 1.10% from last year. While in itself this is not an egregious increase, look a little further and you’ll notice that this is a whopping 11.7% increase from 2010. This is a significant issue, and one that the aerospace industry has been aware of for years – even if proactive in-house strategies for coping with it are limited at best, and non-existent at worst.
What’s responsible for the rapid price inflation?
Aerospace manufacturing does not operate on the buyer cycle other tech-based industries are known for. It is expected for Apple to release a new smartphone annually, for example, and it is equally expected that there is a Day 1 consumer pool substantial enough to make such a business model worthwhile.
Compare this model to an aerospace OEM such as Boeing, who this year celebrated the 50th anniversary of their landmark 747 model. While updates and enhancements have been made to navigation and electronic equipment since its introduction, the base design has essentially been left unchanged since 1960. As of today, there are 547 of these aircraft still in regular use, and each has a service life of roughly 30 years or 165,000 hours.
A newer model Boeing 777 cost approximately $320 million in 2014, but even a price tag that significant cannot sustain a 30-year buyer cycle for any component manufacturer involved. Instead, Tier 1 and Tier 2 suppliers must focus their year-to-year sustainability on providing aftermarket parts and components needed for OEMs to honour long-term service commitments.
This model, however, is dependent on a consistent, predictable marketplace. As the economy has improved and airlines are posting record profits as a result of efficiency improvements on all levels, Boeing and Airbus are seeing an unprecedented demand for their products. By mid-2020, Airbus expects to ship at least 410 new aircraft to customers, with the intention to maintain regular production of approximately 70 per month (a figure so high studies have been commissioned to measure this expectation’s feasibility). This is good news for aircraft manufacturers, but production increases also require suppliers to ramp up their output to match. When demand is not met, prices skyrocket, and supply chain disruption becomes widespread across the industry.
Not only has component production been slow to react to customer needs, but suppliers have also struggled to implement the infrastructure required to do so, such as integrated software and automated machinery.
These improvements require upfront investments many have been unprepared to make, and as a result, their rollouts have been spread over multiple years. This leaves their OEM customers to procure inventory in a competitive, inflated marketplace their budgets are not prepared to handle.
To cope with price inflation, which is not projected to improve, OEMs have taken to adopting two separate solutions: one for completing current product lifecycles, and another to proactively ensure future ones.
Last time buys
Not long ago, the U.S. military specification controlled the electronic components placed into all commercial and military aircraft. While costly, it ensured the availability of critical components over extended lifecycles. This all changed in 1994, when the Secretary of Defense mandated that defence suppliers seek out commercial-off-the-shelf (COTS) solutions for their designs to give a strategic boost to the economy while cutting costs.
In that respect, the initiative was a success – but in return, this also meant that military and commercial aircraft manufactures would now have to compete with other industries who require the same base components and semiconductors. Where aerospace OEMs were once insulated from the swings of supply and demand, now they run the very real risk of not being able to source the components they require.
Even more concerning is the fact that, despite its size, aerospace does not have enough influence to be a primary driver of the electronic component market. According to Boeing, over 93% of all components are purchased by companies operating in computer, telecommunication, and consumer industries. More recently, automotive and IoT industries have pushed demand to record highs, resulting in a market-wide component shortage that all OEMs are feeling.
The only true solution to this issue, that could be implemented today, is a commitment to securing enough inventory through a last time buy to support their aircraft at the beginning of the buyer cycle.
The sooner the electronic inventory can be purchased in the process, the better; electronic component suppliers are going to concentrate on where there is the most profit potential, and that is in other industries that demand smaller, faster, more efficient components with each new product launch. With component lifecycles shortening by the year, the chances of a critical electronic component being available for longer than three or four years (let alone the lifespan of an aircraft) are almost non-existent. If the inventory is already in hand, however, there is no need to worry about what the market does.
Last time buys used to be looked upon as a last resort, an inconvenient reaction to unexpected electronic component obsolescence. Now, they need to be considered an essential piece of any aerospace OEM’s inventory management strategy.
While last time buys are the choice to overcome inflation today, many OEMs are also looking toward securing the lifecycles of future products, as well. This is exactly what vertical integration could provide, and future strategies built on this premise will play a key role in the future of the industry.
Boeing, in fact, has made strides to take matters into their own hands with a vertical integration initiative designed to bring more component suppliers and distributors under their umbrella, the most recent example being KLX, Inc. in a $4.25 million blockbuster deal – the largest move Boeing has made since merging with McDonnell Douglas in 1997. Back in June, Boeing also acquired auxiliary power unit supplier Safran.
No technology is off the table, and reports indicate that Boeing is carefully analysing the value of each component in their aircraft from wings and seats down to flight-control computers. The ultimate goal, should this trend continue, is complete self-reliance, which allows Boeing to bypass the marketplace entirely in favour of components made entirely in-house and designed specifically for them.
Boeing isn’t the only aerospace OEM prioritising vertical integration. In the defence sector, L3 Technologies Inc. and Harris Corp. recently announced plans to merge and create the sixth-largest defence company valued at approximately $33.5 billion. As of November, United Technologies is finalising plans to acquire Rockwell Collins, a long-time supplier of radio and flight displays to Boeing, for $23 billion. The trend is so widespread that in many markets there is currently a shortage of suppliers for the big names to target.
“The opportunities to consolidate companies of this size are diminishing,” said Scott Thompson, U.S. aerospace and defence practice leader at PwC., to the Los Angeles Times. “I do see the trends continuing, but I don’t foresee it continuing at the values we’ve seen.”
This strategy does not come without its drawbacks. For suppliers such as Spirit AeroSystems and United Technologies who have a strong presence in the aftermarket, this presents something of a nightmare scenario. OEM customers such as Boeing are learning to live without them – and without additional offerings that can match what in-house authorised suppliers can already provide, they run the risk of becoming obsolete as far as aerospace is concerned. A commitment to transparency equal to or greater than their OEM customers is a must, or by nature, the market will leave them behind.
For the OEMs in question, however, this presents an opportunity to curb the inflated component market back in their favour through regulated pricing. This does open significant profit potential (especially in the aftermarket), but it also could be a boon for their customers who have seen their on-hand capital evaporate in the face of inflated prices. Large-scale OEMs are also in a better position than small suppliers to offer customers extended payment terms, which could be beneficial to their customers’ quarterly margins.
Will history look at this trend as an attempt to monopolise the aerospace industry? Only time will tell, but at least in the short-term results have been positive. In a 2018 study published by The Hackett Group, the industry has seen six percent increase in days payable outstanding, and a 17% year-over-year increase in OEM cash on hand.
Not since the early 90s have we seen such a dramatic shift in the basic structure of the aerospace supply chain, but as always, it has been forced to adapt in the face of today’s challenges. With change comes risk on all levels of the supply chain, but it also presents new opportunities just waiting to be taken advantage of. It’s exciting to watch, and one can’t help but wonder how long this trend will continue before the pendulum once again swings the other way.