Kevin Gould, managing director of Alderman & Company, explains how the reconstruction of the aerospace supply chain continues to drive middle-market Merger and acquisition activity in the sector
COVID induced a shock to the aerospace industry, the likes of which had not been seen for decades.
The precipitous drop in airline passenger traffic, combined with service and supply chains seizing up, wreaked havoc on both the supply and demand sides of the equation.
One of the results has been a widespread reset of firms at lower levels of the aerospace supply chain.
Smaller, more vulnerable participants have decided to sell or merge their businesses as they surrender to the risk and financial pressures placed on them.
But to fully understand the story behind this trend, we must look back several decades to the roots of the current situation.
In the 1980’s and ‘90’s, many large aerospace companies engaged in two industry initiatives aimed at increasing the profitability and cash flow of their operations.
The first was ‘lean manufacturing, a concept widely credited to Dr W. Edwards Deming and pioneered by Toyota Motor Corporation.
Using a variety of tools such as just-in-time delivery, waste reduction and continuous flow production, aerospace OEMs streamlined their production processes to require less inventory and speed throughput, thus reducing both production cost and working capital.
(I did this at Piper Aircraft and freed up $7 million of cash which was reinvested in the PA-46R-350T Matrix product development program).
The second industry initiative was the effort to outsource production, often overseas, to access lower labour and other production costs, and reduce invested capital.
In-house manufacturing operations were spun off and major work packages were subcontracted out.
With encouragement from the OEM’s, companies in the supply chain also adopted these practices and enjoyed the cash flow and profitability benefits.
But the OEM’s then made efforts to co-opt some of those benefits, using their market power to extract contract price concessions and extending payment terms, in some cases reaching 120 to 180 days.
The result was the creation of a finely tuned supply chain that was much more efficient and less capital intensive.
But it was also highly dependent upon predictable demand and a reliable supply of components.
Without the layer of inventory throughout the system and having surrendered direct control over production priorities of its inputs, the supply chain was now vulnerable to exogenous external shocks; any disruption in demand or supply and the precariously-balanced production operations set up under lean manufacturing would stall.
Then two unexpected disasters occurred: First, Boeing suffered a series of setbacks, the most notable being the MAX MCAS debacle; and second COVID struck.
The MAX grounding triggered a series of events that led to the stalling of factory production activity and the lowering of future aircraft production rates, the effects of which rippled throughout the entire supply chain.
With COVID, airports became ghost towns virtually overnight. Sizable portions of the commercial airline fleet were parked indefinitely. Airline stock prices dropped by half or more.
Airline orders for new aircraft were cancelled or delayed. Businesses based on aircraft hours flown or takeoff and landing cycles (eg MRO’s and FBO’s) ground to a halt.
Ships delivering assemblies, parts and components were anchored offshore at port, unable to unload their cargo.
Then labour became scarce and doing business became more expensive as inflation set in. Many companies within the aerospace supply chain were caught in the pinch of trying to meet fixed price contract obligations with already thin margins while their costs were rising.
Combined with the effect of Boeing’s misfortunes, COVID’s impact on the aerospace supply chain was devastating and virtually no firm was spared.
As the pandemic subsided, companies struggled to fill open positions and their output was often affected.
Within downstream layers of the supply chain, this frequently manifested as parts shortages creating a waterfall of delays and disrupting the delicately balanced flow of assemblies, components and parts.
Slowly, companies were able to address or work around their labour and material shortages, and the highly integrated supply chain began its recovery towards equilibrium.
Which brings us to the present day. In the world of commercial aviation, passenger traffic is finally approaching pre-COVID levels, although the recovery was much slower in Asian markets than elsewhere in the world.
This restores airlines’ confidence in future business plans and allows them to reinstate some of their cancelled or delayed airframe orders.
This in turn leads to Airbus and other OEMs slowly ramping back up their production rate plans.
For Boeing, the additional loss of production related to the grounding of its MAX models further reduced its output plans, which are only now being revived.
[As I write this article, Boeing is facing yet another threat to its manufacturing plans with the 737 emergency door plug issue].
As the OEM’s raise their production rate forecasts, demand then increases throughout the entire supply chain, but this all has a significant time lag.
The net result is that this massive, interdependent network of companies, large and small, involved in the production of commercial airliners and which constitutes the bulk of the aerospace supply chain, was substantially impacted over the past four years. The aftereffects continue to this day.
Looking at just the middle market companies ($150 million revenue or less) that comprise a sizable portion of the aerospace supply chain, many did receive financial assistance from a variety of government programmes during COVID aimed at preventing a full-scale meltdown of the economy in general.
But the cushion from those programmes has now largely run out and many business owners have had to dig into their own pockets to bridge the financial gap between the COVID downturn and the recovery now underway.
For some owners, the strain has simply been too much, and they have sought, or are seeking, to exit their ownership positions. For others, the experience has driven them to accelerate their own plans for retirement or exit.
As those firms change ownership, either as strategic acquisitions by larger companies in the segment or as financial acquisitions by private equity firms, the outcome is a less fragmented and more resilient supply chain.
The combination of increased vertical integration and stronger capitalisation should restore the companies’ abilities to weather future storms.
It has also created an upswing in middle market M&A activity which we expect to continue in the foreseeable future.
About the Author:
Kevin Gould is a Managing Director with Alderman & Company, a sell-side investment banking firm that exclusively serves middle market companies in the aerospace and defence market.
He has more than 30 years of experience in the aerospace industry, including M&A, strategy, and executive leadership. Kevin started his career in the electrical business unit of Boeing in 1988.
After 12 years at Boeing, he went on to become the chief executive of Piper Aircraft and then president of the Bendix/King division of Honeywell. Prior to his business career, Kevin was an attorney with McCutchen Black Vergler & Shea.
Kevin holds a JD from the University of Southern California, an MS from Stanford University, and an MBA from Harvard Business School. Kevin has over 1,000 hours as a private pilot, with instrument and complex ratings.