Our insight into the commercial aerospace industry

Preparing manufacturing and supply for geostrategic risks

Taking on huge risks has historically been known as 'bet the company strategy'. Geostrategic risks associated with the macroeconomic trends of Demanding Customers, Nationalism and Technology Advancements are adding to risks already inherent in the global aerospace industry, leading to a huge increase in risk. There is every reason to believe that these geostrategic risks will accelerate the pace of change to today's manufacturing and supply chain and put future value chains in a constant state o flux. Yet less than one third of the respondents in a 2017 McKinsey survey have taken steps to develop a wining plan - a very well integrated overall Competitiveness Achievement Plan (CAP) that mitigates these risks and that combines productivity and investment together to unleash a virtuous circle, so that strong growth becomes doable and self-sustaining. As global economies become increasingly interconnected and a chain is only as strong as its weakest link, companies that adopt a 'wait-and-see' attitude towards these geostrategic risks and that fail to reconfigure themselves into an operational alliance network to maximise access to markets and strategic resources and to improve the quality, speed and flexibility of work dramatically are likely implementing a ' bet company strategy'.

United Technologies Aerospace System: Hidden Opportunity

The Honeywell bid for United Technologies Corporation (OTCPK:UTX) may have been opportunistic, but one thing that it has done is to question the pace and size of UTC’s restructuring/ cost saving plans. In December 2015, UTC announced a $1.5 billion restructuring plan, which will run through to 2018. In February 2016, Honeywell’s deal forecasted a saving of $3.5 billion each year by cutting supply chain spending and costs, improving operational productivity and other ways. The delta between these two plans suggests that there may be opportunities still on the table at UTC. One of the key ways to investigate whether this is the case is to look at potential impact of improving inventory turns within United Technologies Aerospace System (UTAS). We believe that if UTAS used a double focus playbook to reinvent its supply chain, then the estimated one off cash benefit by the end of 2020 will be $1.2 billion, with more to come. We have sought to layout how to capture this prize.

Short and Medium Targets

The modern aerospace supply chain is an increasing complex and volatile network that stretches across continents and supports numerous market segments. This complexity and volatility makes it harder to determine the impacts of changes in demand and mix and the risks involved with changing demand and mix. Changes in demand and mix, as well as other operational and environmental parameters, have an impact material flow. As a result, the traditional supply chain paradigm supports the belief that inventory reduction will lead to increase in part shortages and subsequently lower service levels. Some CEO who suggests that more inventory equal growth is constantly reinforcing this paradigm. Our experience of implementing lean in the supply chain suggests that one can reduce inventory and improve service levels simultaneously.

At the end of 2015, we estimate that UTAS carried about $3.2 billion of inventories on its balance sheet. This number represents almost a third of UTAS’s $10.7 billion Total Current Asset. Also, management has guided that sales is expected to grow at 5 to 7% CAGR over the five years. Let us assume that management will expect to reduce each of the following seven core supply chain operational measures by about 1.5% point per year:

• Supplier Order Delivery,
• Demand Forecasting Accuracy,
• Lead-time Reduction,
• Quality, Right First Time,
• Schedule Achievement,
• Velocity,
• New Product Introduction.

This implies setting inventory turn of 7 as a target.

Reinventing UTAS' Supply Chain

UTAS Executives can reduce inventory, whilst improving service levels, either by re-engineering the supply chain process to make it lean, restructuring the supply chain to improve agility or reinventing the supply chain, which is a combination of both. Re-engineering includes redesigning cross-functional process or improving how people make decisions. Restructuring involves changing the supply chain network or scale, improving production assets utilisation, moving suppliers closer to assemble or simplifying material flow. We suggest a double focus playbook to reinvent its supply chain that will achieve future goals in the medium to long term as well as reducing cash needs in the short term. Therefore, improvement actions to achieve short-term benefits must be balanced with actions to capture value in the medium to long term.

Step-by-step Focus Approach

Best practice suggests that the dual modus operandi to reinvent the supply chain works from a simple step-by-step approach:

1. Use Achieving Competitive Excellence (ACE) to diagnose where material flow conflicts are in the supply chain;
2. Rebalance ‘Make vs. Buy;
3. Regulate to prevent congestion, impose sequence, reduce inventory, shorten leadtimes, and focus on customer need;
4. Simplify material flow to make it easier to see bottlenecks and conflict, and to keep control;
5. Automate demand levelling;
6. Integrate supply chain teams and project teams;
7. Improve the operational effectiveness of critical suppliers, which will lead to reduction in batch size.

Room For Improvement

Our experience tells us that there is considerable scope for improvement. Assuming a conservative revenue growth target of 5% CAGR between 2016 and 2020, we assess that inventory will come down from about an estimated $3.2 billon in 2015 to about $2.0 billion in 2020. This implies that inventory turnover increases from about 3 to 7, there will be a $1.2 billion one-time cash savings and there will be a $170 million annual cost saving by the end of 2020. Therefore, a double focus approach for UTAS, we believe, makes compelling common sense. There are, of course, many partial solutions with individual good points on the road to improve service levels and inventory turns. But they don’t solve the whole challenge facing UTAS.

Rolls Royce: More than just tinkering

CEO Warren East has promised to cut Rolls Royce’s cost base by £150M - £200M a year by 2017. The company, which has issued five-profit warning in just two year, is under pressure to take action, particularly from activist shareholder ValueAct, which raised its stake in the firm to 10 per cent. His aim is to simplify the organisation, streamline senior management, reduce fixed costs and improve greater accountability and pace to decision making. He went on to say that the group is entering a period of unprecedented change to position itself to compete for the long-term opportunities before it. Therefore, in the short to medium term, cost reduction is the strategic priority.

Yet we believe that there is a clearly a prima-facie case for restructuring aero-engine business, targeting annual equivalent cost saving of £200m+, which will put it on course to outperform GE Aviation by 2020. The aero-engine business represents roughly two thirds of Rolls Royce overall revenue and it is underperforming its main competitors in key financial measures. Merely tweaking or fine-tuning it is not going to do it. The investor community is seeking significant improvement in the company performance from where it is today. So we have outlined below how Rolls Royce could capture this prize with Cash Sensitive Restructuring (CSR), as many analysts expects cash flow likely to remain negative until at least 2020.

The Prize

The aero-engine business, in the medium term, is in a race to add value in the present as well as in the future faster than its main competitor, GE Aviation. It should begin with setting clear and transparent operating metrics by which the management teams could be judged. We suggest that, over the next 5 years, the business should go back to basics and use: Underlying revenues growth, Operating Margin, Return on Invested Capital (ROIC), and Cash flow from operating activities (CFOA).

These metrics, shown above, allow us to size the prize on hand, if we use the aero-engine 2014 results, as a baseline, and assume that the target will be GE Aviation Division’s 2020-forecasted performance, assuming the division continue to improve at its historical rate, adjusted for Rolls Royce capital structure.

So the investment community is expecting the aero-engine business to improve significantly its performance from ‘Where it is today’. Margin has to be almost doubled to 27%. Return on Invested Capital has to be improved from -23% to greater than 24%. Therefore, the overall improvement sought for the business is huge and the context for the change in priorities is shareholder value.

Recommending a double focus approach

Investors are likely to remain concerned about the potential for additional near-term hiccups, until the company gives more detail on how it intends to blend the different types of business initiatives that will balance short and medium terms with a long-term perspective, to achieve its goal. The different types of change initiatives are as follows:

• Radical Change – These are typically restructuring initiatives where breakthrough levels of performance improvement are sought. The benefits are large, but the risks are high.
• Continuous Improvement – These are on-going initiatives, which seek incremental change. The benefits are modest, but the risks are small in the short-term.
• Quick Wins – Quick win projects eliminate glaring inefficiencies. The problem can be fixed rapidly, but the solution may be discarded when a more complete solution is implemented.

Both Restructuring and Continuous are strategies for effecting change, but in different degrees and pace. As the aero-engine business performance gap with GE Aviation is large, we commend Cash Sensitive Restructuring (CSR) approach, which improves the balance of fixed assets, inventories and cost to the best effect. CSR will provide the right mixture of fundamental and radical change and quick wins to lower the risk profile.

Cash Sensitive Restructuring as a course of action

We believe that there are opportunities for improvement across all of the aero-engine business. The greatest benefits will be achieved principally in five areas of action:

• Action area 1 – Manufacturing footprint and Fixed assets – With a focus manufacturing, operational geographical footprint can be reduced by eliminating spaghetti material flows, excessive storage, functional layouts and outdated traditions. We estimate that reducing fixed assets can provide substantial funding for other investment opportunities.
• Action area 2 – Inventory and Supply Chain Management – Previous successful initiatives to deliver on time in full, New Product Introduction, and demand changes have resulted in higher inventory balances. Yet reducing overall inventory levels annually represents the fastest single opportunity for pumping out cash for restructuring.
• Action area 3 – Overheads and material – The biggest portion of the cost of good sold are in overheads and material. Annually reducing material costs overall and overheads will release the money tied up in overheads and material for restructuring.
• Action area 4 – Capabilities and New Products/Technologies – Companies, seeking competitive advantage, have began to priorities, synchronise, integrate and coordinate capabilities that deliver high performance and value. For example, GE Aviation has transformed itself by increasing its in-house capability, adding Additive Manufacturing capability and acquiring key capabilities in the supply chain. The aero-engine business can reclaim profit margin and restore cash flow growth by investing in the right capabilities and building infrastructure that capture new technologies efficiently and effectively.
• Action area 5 – Organisation and Communication – Successful restructuring is also about investing people and about good communication. Giordano Prandelli, a fellow colleague from a partnering organisation, recently blogged on how to communicate change efficiently, which we have summarised as follows:
  • Make a strong case for why change is necessary;
  • Set out the objectives for change;
  • Describe vision in terms of things that stakeholders will understand and support the case for action;
  • Transit to vision with clear communication and an open avenue for two-way communication.

Potential Benefits/Objectives

We have sought to layout an action roadmap that will restore the Aero-engine business to where the investing community expects it to be. Our financial analysis indicates the following:

Our Board experience in the aerospace industry suggests that if each core operational measure – Demand Accuracy, Customer Order Delivery, Lead-Time Reduction, Velocity, Quality/Right First Time, Schedule Achievement and On Time New Product Introduction – improves by just 1 percentage point annually then this prize, the overall impact, is achievable. This would position Rolls Royce in the right place to compete for the long-term opportunities before it. In a race everyone runs, but only one person gets first prize. So run your race to win.

Rolls Royce: Parking decision whether to enter into single-aisle jet engine market

Recently, Rolls Royce (OTCPK:RYCEY) reported five-profit warning in just two year. The company has attributed this drop to myriad of factors. This has led to intense speculation in the investment community on how the company should eliminate the approximately 10 points profit margin gap with GE aviation and how it should restore ROIC back to attractive levels north of 24%. The company’s battleplanners, who are developing the company’s Competitiveness Achievement Plan (CAP), were exploring how to re-enter the huge market for single-aisle jet engines, as part of their counteroffensive. Therefore, in this article, we will look at the demanding requirements to institute this tricky manoeuvre, as it would carry a high growth reward and a high risk and pose the begging questions resulting from the company’s action to park the decision on whether to enter the single-aisle jet market until early 2020s.

The company is exploring how to re-enter the single aisle/middle of the market jet-engine segment, four years after exiting the marketplace. Its re-entry would carry a high growth reward and a high risk and is so crucial to the company future that the Tactical Action Plan to achieve it must satisfy demanding requirements. These requirements are as follows:

• Objective – Why has the company selected its stated objectives?
• Means – By what means will the company achieve its objectives?
• Force Ratio – How will the company husband its scarce limited resources, as the company cannot outspend GE?
• Intelligence – When will the stakeholders know that the company are on the right road to meeting its objectives?
• Follow through – Who will be responsible for the delivery of this pivotal project?

Emphasising these four key requirements, the company’s battle-planners not only can develop an effective tactical action plan, but also demonstrated to investors how well the company is positioned to perform and compete well in the future.

The investment community believes the narrow-body to be the most profitable. The community presumes that the long-term service agreements on the installed is more profitable than servicing a wide-bodied fleet of aircraft, because the more frequent take-off and landings of narrow-body planes generate more service work. This assumption is true, if the current airline business model remains. But even the airplane manufacturers have differing opinions on the future of air travel. Airbus predicts that the Hub-and-Spoke will be dominant, whilst Boeing foresees the Point-To-Point model taking precedent. Also, the European Commission is in the first stages of an investigation into OEM aero engine aftermarket control.

Depending on whose view of the future you use, Boeing or Airbus expect new narrow-body deliveries to be between 22,900 and 26,730 over the next two decades, of which GE Aviation and Pratt & Whitney have already secured a strong beachhead and COMAC has made no secret of the fact that Chinese plans to enter. This has led many investors to postulate whether Rolls Royce has been too slow to set clear objectives for this huge market. So far, the company has declared the broad objective, to re-enter the single-aisle aircraft segment. The next opportunity for this is expected in mid 2020’s when Boeing and Airbus are forecasted to develop new versions of 737 or A320 respectively. But, by this time, GE/Boeing engine-airframe combination will have become even more ingrained as a de facto standard as consequence of the 737 MAX entry into service. As result as, Rolls Royce’s odds seem impossible.

To compete with GE initially, the company is investing in two core key technologies, additive manufacturing and composite material, and has two estimable technological advantages in the means at its disposal, Advance and UltraFan, which amounts to a fundamental shake-up of its engine architecture and philosophy. In the case of additive manufacturing, the company has announced that it will flight-test what it claims to be the largest 3D printed aerospace component to ever power aircraft. But, GE has already made enormous strides in industrial 3D printing by opening a mass additive manufacturing facility to produce the 3D printed fuel nozzles for it advanced LEAP jet engines. Numerous other highly specialised manufacturers have eliminated the traditionally high costs of sourcing small volumes of unique components. Therefore, 3D printing has demonstrated that it can greatly reduce the inefficiencies inherent in highly specialised, low production components for a relatively modest capital requirement.

Rolls Royce’s roadmap also sees the company introducing composites on a wider scale in new areas. Ceramic Matrix Composites (CMC) represents another opportunity to both lightweight engine components as well as removing high-value add supplier such as Precision Cast Parts. The manufacturing capabilities are far less demanding for CMCs than they are for cast parts such as single-crystal alloy blades. Furthermore, CMC components are typically less than half the weight for their metallic replacements. Light-weighting a turbine blade also means that its disk and related components can be lighter and smaller, completely changing the dynamics of engine design.

According to the company, it has two other means at its disposal. The first is its Advance technology, which evolves the core architecture to off-load the work performed by the intermediate-pressure spool and split it more evenly with the high-pressure system. The second is its UltraFan, which will feature a new-geared architecture. When the UltraFan is combined with elements of an advanced three-shaft core with a fan drive gear system, it will boost the overall pressure ratio to 70:1, closing in on the 80:1 theoretical limit perceived by aeronautical engineers. But even with these means, Rolls Royce will have to tailor its tactical action plan that links all these technologies to the means that it has available to carry it out, as the company cannot outspend GE, to achieve its objective.

Force Ratio is the third critical requirement, which goes in deciding the true balance in opposing competitive forces. At the time of writing, Rolls Royce has the scalability of the above technologies and the company’s technological infrastructure as force multipliers. The technologies mentioned above have been earmarked for the widebody aircraft, but their scalability provides a launch platform for new medium-thrust engines, possibly allowing it to re-enter the narrow market.

The other force multiplier would be the company’s technological infrastructure for marshalling new technologies to maturity. The traditional hierarchical models have been proven to be inadequate. This means that the company might need to invest in a common knowledge space on its IT platform, which can be deployed independently from the organisational structures and processes. This will provide planners with the answers to the following questions:

• What the company is up against?
• Which technologies must be pursued to achieve the objectives?
• How should the company collaborate with outside corporation/institution?

It will also go a long way in allowing the company to monitor how well their tactical aims are being meet. Therefore, the scalability of these technologies and a new company’s technological infrastructure that will focus the company’s attention on the most promising mature technologies will allow the Rolls Royce to husband its precious resources where they are needed.

Follow through! Rolls Royce replaced its under-performing CEO with the former CEO of ARM Holdings, Warren East. Mr East starts at Rolls Royce when it is in the midst of a restructuring programme and is facing several huge challenges such as:

• To synchronise the profitable introduction of additional capacity with the primes ramp-up in production;
• To redistribute capital efficiently from defence to other fast growing areas of the business;
• To execute effectively product development to capture anticipated growth in emerging markets;
• To implement a simple, but effective, Competitiveness Achievement Plan to make up the over 10 points profit margin gap with GE Aviation, given that Rolls Royce derives all of its profit from the exact same market segment, and this gap is the major culprit for the valuation gap between the two companies (Rolls Royce sporting 10-11% profit margin vs. GE Aviation generating low to mid 20%);
• To resolve the company’s massive pension obligation;
• To improve the company’s relationship with the investment community;
• To manage effectively the long-running fraud investigation.

His start prompted Ian Davis, Rolls Royce’s chairman, to announce in the Financial Times that the change of CEOs would not lead to a change in the group’s strategy. The company’s current long-term goal is to be an independent global provider of complex, integrated power systems and services to the aerospace and marine/industrial power systems markets in a way that allows it to maintain its long-term growth trajectory in underling profit. To achieve this goal, the company’s strategy focuses on following:

• Adding value for its customers,
• Investing in technology, infrastructure and capability,
• Growing profitably market share and installed product base.

East with a glorious track record is joining the company at an opportune moment to restore the company’s profit trajectory through the implementation of his Competitiveness Achievement Plan (CAP). At the company’s half year 2015 earning presentation, Mr East said that “there is actually a great deal to be done, both in the short term and in the longer term, and my challenge is to balance those two. Without wishing to become over-short term, so that we damage the future, there are some urgent issues. I will be continuing to review operations and I do intend to come back to you before the end of the year with some thoughts and comments on priorities.”

Against this background, Mr East needs to communicate to the investment community his thoughts on re-entering the single-aisle aircraft segment, which is an important subset of the company’s Competitiveness Achievement Plan. We believe that the battleplanners at the company are faced with 3 options:

1. To continue with current focus on the wide-body segment;
2. To re-enter the narrow-body segment as a part of a joint venture for example with Pratt & Whitney;
3. To re-enter the narrow-body segment without “betting the company” on the capital investment required.

Each option assumes that the company will reduce costs in manufacturing, supply chain and services and each option deliver higher growth with higher risk than the previous option. Mr East decided to focus on the wide-body segment and on the high value end of biz jets and to park the decision to enter the single-aisle jet market until early 2020s. This is because of two principally reasons:

• The company has Trent 7000, Trent XWB-97, and Trent 1000 programmes moving from a cash consumption to cash generation over the next 5 years.
• The company expects that the next opportunity to enter the single-aisle jet market will be early 2030s (Table two: Aircraft evolution by Philip Butter-worth-hayes).

But this begs the questions, what potential profit or cash generation will be put at risk by this decision, how is the company going to shorten the product development time, as GE/CFM took about 10 years to develop their LEAP engine for A320neo and what could be the possible unintended consequences of this decision? We now know the cost to the company of the unintended consequences of getting out of the single-aisle jet market. The company does not want to compound this cost.

Knock-on effects of rescheduling aircraft backlog orders

Aircraft manufacturers face the risk of weakening business case for their new, premium-priced, fuel efficient aircrafts of which there are thousands of orders pending. Low oil prices could last for an extended period. Low borrowing rates could increase. The strong US Dollar could endure for a long period.
This risk could lead to disruption in the industry supply chain. A small change in orders would lead to volatile changes in a supplier’s schedule. This volatility would lead to additional consumption in capacity. Therefore, this increase in capacity consumption could lead to shortages.

As a result, the task of monitoring material flow to predict potential supply chain problems and to trigger corrective actions is rising up the aerospace executive’s agenda. The rescheduling of airline orders would not happen suddenly, but rather slowly as progress payments become due over the next several years. When the rescheduling does occur, many orders will be indefinitely deferred rather than cancelled just to keep a place on the schedule in the event that the pendulum swings the other way.

Boeing and Airbus rate increases are unstabilising the supply chain

The race is on. Boeing, Airbus and other aerospace companies are ramping-up production and introducing new products. As Boeing is behind, the company has made a move to boost output of its 737 jets to 52 per month in 2018, up from 42 currently, and Airbus is likely to match Boeing’s move with its own for the production rate of its competing A320 aircraft. But general consensus is that the combined Boeing’s and Airbus’ rate is unsustainable. Suppliers are already operating at “absolute capacity, and one of the most difficult make-or-break issue facing these suppliers is that of introducing additional capacity, as it is filled with unpredictable challenges and unseen perils. Both Boeing and Airbus experiences demonstrate that once shortages get into the supply chain, it is costly to get out. Therefore, optimising material flows is rapidly rising up the aerospace executive agenda, as it is the essential first step to mitigate this risk.

Airbus vs Boeing: The mutually assured destructive price spiral

If Airbus’s counter-offensive does not include restructuring its supply chain, then it would enter a slugging match that will lead to margins being squeezed at both ends and spiraling downwards. The 737- and A320-market segment is the largest part of the aircraft manufacturing market and the most important to both companies. As a general rule of thumb according to the analysis at Canaccord Genuity, many suppliers cite 100 per month combined production rate for both Boeing and Airbus as a natural limit. Therefore, anything above this level is unsustainable for more than a short period of time.

Airbus, with first-mover advantage, is scheduled to deliver its first re-engineered A320neo in early 2015, whilst Boeing is scheduled to deliver its first re-engineered model, 737 MAX, in late 2017. This first-mover advantage is forcing Boeing to consider increasing the build rate of its existing 737 and perhaps even increasing the discount to compete with A320neo just to keep from losing orders for the current version of the 737. This counter-defensive move is possible by Boeing building capability through its “Partnering For Success” programme. But, this move would very likely trigger Airbus to increase production also.

Boeing: Preparing to compete on price in narrow body market

In the coming decades, the rapid pace of Revenue passenger miles (Air Travel) expansion will drive annual aircraft delivery. A segment, narrow body segment, of this market is a key battlefield for Boeing. A crucial element to its offensive strategy is to develop price, as a source of competitive advantage, because the margin between the company and Airbus in terms of technologies and engine efficiency is likely to be small. One way that the company intends to accomplish this advantage is through the use of a supply chain constellation, groups of key suppliers that will share risk and costs. In this regard, the company has launched its “Partnering For Success” programme. By reaching into suppliers to ensure that certain things happen on time and at the right quality level, the company hopes to realise margin improvement that will provide it with the competitive price advantage that it seeks.

However, this approach is fraught with many dangers. What if it results in a price war? Should a supplier, say, join under these terms if it means being completely dependent on Boeing? What happens when the annual aircraft delivery falls? What about the benefits from the exposure of a supplier to other customers? Who will resolve conflicts when different divisions of Boeing are fighting for capacity on the same critical resources at a particular supplier? How would its programme impact the company’s ability to flex its supply chain? How will suppliers be compensated for degradation in a supplier’s mix performance, due to a very small change in Boeing’s production plan? Etc.

Boeing disrupting the supply chain

Take note of the side effects associated with Boeing’s partnering for success programme. In 1997, Boeing tried to double the production of its 737 family in 18 months, which resulted in supply chain disruptions that cost the company $1.5bn in charges. This time, acting on the lessons learnt from past experience, the company is introducing a new supply chain approach, Partnering For Success, alongside the dramatic production rates increases. But, squeezing suppliers could lead to disruptions in the industrial supply chain, which will be costly.

Competitive price pressures are building for Boeing. Airlines are struggling with cheaper fare rates and high fuel costs, and thereby adopting the hard way of negotiating prices with aircraft makers. Smaller players, Bombardier and Embraer, are stretching to churn out higher jet numbers at competitive rates. Comac, the Chinese state-owned manufacturer, will eventually build large passenger aircraft with a capacity of over 150 passengers to reduce the country’s dependency on the duopolist. Raw material prices will trend higher with geo-political tension and GDP growth in fast expanding economies.

To offset these pricing pressures, Boeing is adopting tactics to achieve double-digit profitability. The first is to increase production rates. The second is to work with suppliers to reduce supplier costs and prices. The third is to pursue reduced labour costs through decentralisation. The forth is to expand service revenue. Etc.
The tactic of squeezing suppliers must be handled with care in the years ahead as it could lead to disruption with the aerospace supply chain. It could lead to the removal of mature suppliers for new risker suppliers. It could ask too much of some small suppliers to transform themselves – bridge that some may not able to cross. Therefore, a combination of these side effects and others could threaten the stability of the supply chain or even hallow out the supply chain, which could be costly to Boeing and other companies in the industry, as the past has proven. Contact us to find out more.