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Monday, December 1, 2014

Challenges in the Commercial Aircraft Sector

by Raman Ram and Randy Starr

With aircraft selling at record volumes, the commercial aircraft industry faces a production challenge — and this may be only the beginning. A combination of low interest rates and readily available financing, reduced operating costs, and surging demand from emerging markets — to name a few factors — will mean that commercial jet orders are likely to continue driving industry sales to unprecedented levels. The production backlog at Boeing and Airbus, more than 10,000 aircraft, is already at an all-time high. Meanwhile, the surging demand is also lifting regional jet makers Bombardier and Embraer, as well as producers in China and Russia, providing newer players an opportunity to challenge the single-aisle duopoly.

The challenges, of course, vary depending on one’s position in the value chain; OEMs and parts suppliers face different, sometimes opposing hurdles to capturing the immense value coursing through the system. But you can’t capture that value unless you can master a few key challenges first. Below are four imperatives we believe you must understand — and embrace — to thrive in these extraordinary times. For some players, such an understanding will be necessary for survival.

Supply Chain Readiness

The increase in production by major airframers will place intense pressure on every part of the supply chain, portions of which have never dealt with this level of production before. If the situation is not handled proactively, problems are bound to emerge such as parts shortages, out-of-sequence work, defects, rework, and unplanned overtime, all impacting delivery schedules and costs. Supply chain capability and risk assessments are required to identify and address weak links such that production rates can be met efficiently. Trade-offs will be required for investment in capacity, automation, and utilization to ensure readiness and to maintain flexibility. Now is the time to assess and make improvements to operating models, to minimize supply chain complexity, to aggressively manage performance through leading indicators, and to augment the enabling tools and systems for improved visibility.

Importance of “Should Cost” Capability

Over the last 15 years, value and pricing power have shifted from airframers and major subsystem providers to upstream suppliers. To reverse this trend, airframers and major subsystem providers will need to master the ability to estimate the “should cost” for sourced parts — a capability that has atrophied at many companies. Without this capability, OEMs are unable to identify inefficient suppliers that pass along high costs or opportunistic ones that exploit the lack of price transparency.

Although most major OEMs and subsystem suppliers want to recapture value, they struggle with where to begin. One place to start is by segmenting the supply base along two measures: relative economic performance and supplier power ratio. Relative economic performance compares the economic profit captured by suppliers to that captured by customers, whereas the supplier power ratio reveals the concentration of suppliers to customers in a given market. Armed with insights from those relative measures, OEMs have three strategic options for wresting back margins from parts makers: threaten to source from alternative suppliers, collaborate with suppliers to jointly reduce costs, or pursue long-term strategies such as vertical integration. The right path will depend on the specific market structure, the product being sourced, category-specific supply market dynamics, relationships within the supply chain, the extent of the suppliers’ excess profits, and the willingness of suppliers to collaborate.

Growth Options for Suppliers that Missed Out

If you’re a supplier with positions on growth platforms such as the 787, A350, 737 MAX, A320neo or 777X, or niche positions on new regional and business jet platforms, you’re positioned well to ride the growth wave — if you execute. If you’re not on one of these platforms, you’re looking at a dearth of major opportunities in the near- to mid-term, and should look to inorganic growth options. The difficulty here is that most major subsystem markets have already consolidated. Your best bet for acquisition opportunities may reside at the component and assembly levels. It is natural for growth-challenged companies to seek adjacent segments or products for salvation, but unless those adjacencies are rooted in your core capabilities, you risk paying a premium for acquisitions that fail to create incremental value.

Aftermarket Shifts

Finally, the growth in production also presents distinct challenges for aftermarket players. As airlines seek to reduce their operating costs by upgrading to more efficient fleets, they will retire some of the current generation aircraft earlier. This is already proving to be the case with regional jets, as their average retirement age is falling quickly — down to 15 years, in some cases. In the face of accelerated retirements, aftermarket players must move beyond traditional services and provide integrated material support. That includes new, repaired, used serviceable, and surplus parts. It also includes value-added services like kitting, inventory, and supply chain and asset management. Independents may have to consider disruptive approaches, particularly while competing against established scale players. This will require mature pricing capabilities for tailored solutions, and taking into account product-line and part-specific dynamics, the evolution of alternatives, and customers’ usage horizons for the assets they’re buying.

It is a great time for participants in the commercial aerospace sector. Success will require higher levels of operational agility to ensure rate readiness, rethinking of value distribution across supply chain and using targeted approaches to correct imbalance, ensuring inorganic growth strategies are rooted in core capabilities, and determining creative ways to maximize life cycle value in a moderate growth aftermarket.

 

Randy Starris a partner with Strategy& (formerly Booz & Company). He has 13 years experience with the firm where he co-leads the firm’s strategy consulting work in the aerospace and defense and national security sectors.

 

Raman Ramwas formerly a principal with Strategy& (formerly Booz & Company) based in Washington, D.C., focusing on the commercial aerospace area.

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