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Welcome to the EY Advanced Manufacturing and Mobility Business Minute podcast series, where EY professionals explore the critical business issues impacting our industry today.

Mike Cadenazzi

Afternoon Raman, thanks for taking the time today to join me to discuss the 2023 Paris Air Show. We’re headed over there in a couple of weeks, and it’s an exciting time. We were both at the Farnborough Air Show last summer, which was an exciting event for industry, always a huge number of commercial firms and government folks and journalists and attendees there to discuss sort of the future of aerospace, this year should be no different. I’m Mike Cadenazzi, managing director within EY Americas Aerospace and Defense sector team. I think we wanted to pull this podcast together to have a discussion around sort of the major themes underpinning change within the aerospace and defense sector. And I wanted to bring my colleague, Raman Ram. Raman, why don’t you introduce yourself, and then we’ll get into discussions with the air show.

Raman Ram

Thanks, Mike. Good to talk to you. Hey everyone, I’m Raman Ram. I’m with Ernst & Young Aerospace and Defense, I lead the Americas Aerospace and Defense sector. Good to be with you today.

Cadenazzi

Good to connect. Let’s just get right into it and talk about in anticipation of the Paris Air Show, which has a large commercial aero segment. Let’s talk about the commercial sector. There are large disruptions from COVID related restrictions and economic changes as a result of the virus and the response to it. We’re thankfully through most of that, if not all of it and well on the way to recovery. But what still hasn’t changed back to normal following the transition in COVID-19?

Ram

I think, Mike, it’s good to remind people, just summarize where we were a couple of years ago when the pandemic hit. Traffic obviously declined significantly, 60+% in variance across the regions. Cargo took a surge, if you will, because of the vaccine transportation, protective equipment as well as e-commerce surge. Production rate of airplanes declined. Aftermarket services declined significantly because there was no intrinsic demand for new aircraft. And since the vast majority of the airplanes were parked, consequently, that led to headcount reductions, at least on the commercial aerospace side, particularly, with airplanes not flying, border closures, all of that. So that’s the backdrop that we are recovering from.

Cadenazzi

Where do you think we find ourselves at now? How is the commercial air industry faring at the moment? What are some of the current drivers of change as we go forward?

Ram

This is great time to be in the commercial aerospace sector. As you know, this is a resilient sector and has been and continues to prove that, recovering from shocks. Traffic is pretty much back, global traffic, air traffic is back. I think it’s about 10%, 12% below the 2019 levels. Domestic traffic is just about a percent down from 2019 levels and by end of the year will be actually exceeding the 2019 levels as a baseline. International is still down. China has just started reopening, so we’re down about 18% compared to 2019. But I think by 2024, we’re pretty much back to and will exceed the 2019 levels. So strong traffic demand, that’s a good thing, and we expect traffic to continue to grow at 3%, 4% rate over the next decade or so, That’s actually that tail wind. But there are a few concerns to keep in mind, but let me hold that, Mike. I’d love to hear your perspective on the defense as well before we get into the details of what are the things to watch out for.

Cadenazzi

Great. I think it’s safe to say the defense industry went through similar change over the past three years, first with COVID related disruptions and now with the rapidly changing situation driven by evolving geopolitical issues of the moment. Certainly, first of all, global spending is increasing, which, coming out of COVID-19, was a question mark. I think there were real question marks about what the drivers are going to be, but really it’s been a consistent set of growth drivers within the US. First of all, to sort of backstop our NATO allies and their support for Ukraine in the current conflict in Europe, then also prepare for higher-level conflicts of potentially the Pacific over time. There’s a lot of discussion here in the DC area regarding what those drivers are going to be, what are the priorities. But it’s very clear there’s general support for defense spending increasing both in the US and Europe, although how it’s going to manifest could change. It’s interesting to note that in the current debt ceiling fight here in the US, the driver is not really defense itself or the investments in defense. It’s more of a macroeconomic issue and the macro finances for the government. DOD or the Defense Department spending is going to go ahead and find some impacts to the spending for the next few years. But it’s not the core of the discussions that are there. In Europe we’re seeing a split between Eastern Europe, where spending is increased directly in response to the events of the last 24 months, whereas in Western Europe, promises for additional growth have been relatively slow. Net net though, we should see in the West between the US and NATO allies a variety of spending increases. We’re also seeing a change in demand, so the scale of demand for artillery ammunition, not just one and two times but four and five times as much as we’re currently producing, is sort of the expected amount of growth. And we’re seeing that in different places where, say, two or three years ago, ground systems, ground forces, enablers, things like tanks, weapons, those sort of things that you’d use in the current fight in Ukraine are expected to sort of see additional demand, whereas in the past sort of expected more moderate growth in those sectors. And collectively, along with the growth in commercial aero, we’re seeing pressure on supply chains and their difficulty to find talent to go out and do this. And then finally, there’s just been — the pace of change is increasing dramatically. The use of UAVs Ukraine has been transformational there everywhere. And what that portends for the future of how armies will operate and fight is pretty dramatic: things around the application of AI and machine learning for targeting, for command and control and also the risks of those structures. You can’t just have a tent with a lot of antennas sticking out of it anymore. So what the services are going to request in the future, how industry is going to organize around that will be very interesting as well. And all this is going to be very different from what’s happened in Europe as to what could happen in the Pacific, the sort of investments that will be necessary to deliver on new capabilities to deal with the distances in the Pacific over tens of thousands of miles of ocean are really quite dramatic as well. So pivoting back to commercial, what are the key factors that you’re pivoting on that are most interesting to you that are driving this change within the sector?

Ram

Mike, it’s interesting to hear you speak on the defense drivers, while the drivers are quite different, we seem to be in a secular growth mode across both commercial aerospace and defense, specifically on commercial aerospace. And like I mentioned, traffic has been growing. 2024 is expected to be a key year for the airline industry. Industry observers expect the airline industry to be free cash flow positive in 2023 — barely positive, and then it’ll continue growing, which is great. We want the airline industry to be profitable and thriving, that’s what drives the commercial aircraft sector. So that’s good. But there are a few things to keep in mind. While the air transport passenger traffic is surging, cargo is reverting back to mean. Cargo had been growing at about 3% or 4% historically and then during the pandemic spiked up quite a bit. So that’s reverting back. So that’s what you would expect. But near term, another good thing that’s happening is also the aftermarket cycle. So we have deferred maintenance that came back, aircraft utilization has gone up. So that’s driving maintenance, a lot of the unconditional spending, driven demand. So that’s happening. So aftermarket is in a great spot. On the production side, as the traffic is growing, you would expect that more airplanes will be produced. Consequently, production rates will go up and consequently it’s beneficial for the suppliers and industry. I think there are some concerns emerging and some that the industry has been dealing with. And let me highlight a few things, to your question. One is we do want to see more orders happen and traffic recovery is happening. Traffic recovery leads to financial revenue recovery for the airlines, and revenue recovery leads to financial recovery. And if the balance sheet is good, then they go and place orders. Well, that needs to happen. So that’s what we’re waiting for. But a few concerns that we need to watch out for; for orders to happen, airlines need to be healthy. And one of the things we notice is the debt levels on the airlines, the debt level that airlines carry has skyrocketed during pandemic and just post-pandemic. So that needs to come down. Last time we saw it during global financial crisis, it took five, six years to unwind. So I think that is something to watch out for. Will the airlines rush to place orders, depending on their capacity and the growth plans? Or are they going to wait to take care of the balance sheet first before they place orders? So that’s something to watch out. The second one is, while traffic is surging, a lot of it’s driven by visiting friends and family and leisure travel. So, yes, the yield has gone up, but still, there is a sustained reduction in business travel. So I think that’s something to watch out for. Will it come back fully, or is this the way it’s going to be going forward? The third thing is the competitive intensity on the airline side to watch out for, because during the pandemic, nine new airlines came into existence. So they are going to compete with the existing carriers. So I think all those things would pose some challenges on yield and profitability for the existing carriers. So how the industry works through that and recovers financially and consequently places orders, I think those are the things to watch out for on the demand side. On the supply side, let me say one thing and then I’ll stop. Supply side, post-pandemic, the production rate, the industry has been trying to ramp up the production rate, but there are constraints that on supply chain and talent that they are working through. So those are actually putting a damper on how the supply side is going. But more to be talked about on that.

Cadenazzi

Speaking of debt levels, I don’t think it’s any mystery that the governments are facing similar pressures, and that’s also having a constraining impact or a guiding impact on what’s going to happen going forward. First on defense, I think there’s a lot of times you can sort of talk about industry without getting too deep in the weeds on geopolitics. This is not one of those times. Geopolitical decisions are actually having a real-world effect on funding flows and decisions to spend money on this and not on that. And that obviously has a knock-on effect to sort of industry plans I would expect going forward. We also see that defense spending generally is going to be pressured by tightening conditions. So that’s in the face of demand for more capability, how do you go ahead and sustain real growth when you’re spending below inflation? How do you go ahead and continue to sort of invest in your industrial base and expand the mix of capabilities you need to do whatever the mission set is going forward. There’s also this balance of modernization vs. sustainment. So the equivalent of, you know, the idea of buying new aircraft and new platforms or do I sustain the force that I have? There’s a huge investment in improved readiness, both in the US and in Europe, to go ahead and increase the ability of forces to respond. The US has talked about increasing readiness of aircraft, ships, having more highly ready forces over in Europe. All that takes money and is in direct competition with buying new gear for in and of itself. Collectively, this is all put a tremendous amount of bits of pressure on the supply chain, not just the primes who are having to go ahead and rationalize what the government wants and how the priorities will flow for the future. But at tier two or three and below, where there’s pressure to disentangle or decouple from China to go out and do more across the supply chain. A lot of those companies are serving both the commercial air sector and the defense sector. So they’re getting increased demand on both sides. And then they’re facing what is essentially a structural change in the availability and costs of talent within the defense sector that we haven’t seen in the past. Traditional cyclical effort of economic downturn means talent comes into the defense industry, and that’s not happened this time in the same way nor do we anticipate it happening that way for the future. I think this will require new changes to look at talent and even at the tactical level, at the factory level, where you’re sort of making ammunition in artillery, we’re seeing individuals able to walk out of one factory, walk into another factory and get 10%, 15% raises at the skilled labor level and doing that successfully over the course of two or three factory hops. That’s a major change in challenge from how this has happened in the past.

Ram

Mike, I think it’s interesting that you talk about the geopolitical stuff. Obviously, we don’t have a crystal ball, but do you anticipate a scenario where the peace evolves in Eastern Europe. For example, we don’t know what’s going to happen with the administration, the threat perception decreases with an improved posture towards Asia. Is that a scenario where all these things could happen and put a damper on defense spending over the next decade or so?

Cadenazzi

Certainly, there’s a downside economic case for industry, which is peace breaks out and everyone decides that they’re okay with the status quo. It seems unlikely. First, in light of what’s happening realistically, that there’s no projected resolution in Europe. But more generally, even if there is a resolution, most observers and commentators would say there’s a need for our NATO allies to go ahead and increase their capability for the future so that as increased modernize binding platforms, increased stockpiles and increased readiness. That’s true on the US side as well, where we’ve depleted stockpiles significantly, ammunition of vehicles, trucks, you know, very fundamental things that enable the military to go do its job. And then there’s a mix of capabilities that have not been involved with the current conflict. So, Navy in particular, and aircraft, that are suffering from lack of attention and overuse. So, to varying degrees in the past, that’s all going to require additional investment. So, it’s unlikely that there’s a combination of events that will result in significant declines in defense spending. Then the downside case is probably flat, but that is negative for the industry, given inflation, and I think there’s enough pressure from the industrial base and local economies to go ahead and prevent that from happening. Let me pivot to the future outlooks as we’re talking about Paris and Paris is really about the future. What, then, in this backdrop is the outlook for commercial aero? How is the industry set to perform in the next few years? Are there any major risks that you’re concerned about that you think will hold back growth or the industry’s ability to position for the future?

Ram

I think Paris, I think a few things to watch out for. I think we’re eagerly looking forward to public announcements at the Air Show as well as during our conversations with the industry leaders there. First one is orders: eagerly awaiting to see how many orders, what’s the magnitude type of new orders, the types of carriers and regions where these orders get announced. So that’s one. The second one is newer technologies and capability advancements. Whether it’s in the unmanned advanced aerial mobility side or supersonic side, I think it’ll be interesting to see what advancements are being announced. Funding partnerships, whether it’s from the venture side or from the traditional airline side. Third is around sustainability: what companies are doing, given the net-zero mandate and the expectation, what companies are doing, not just on the product side but also across sustainable supply chain initiatives that are underway and what’s happening. So that’s a good one to watch out for. The fourth is around investments the companies are making on digital. I think it’ll be interesting. I’m always eager to learn how much advancements because during the COVID-19 pandemic time, I think companies have started ramping up their investment, out of need actually, across a variety of value streams within the company. And so, it’ll be interesting to see if that’s being sustained and are they getting value out of it. Fifth is around the software supply base, whether it’s Tier 1 or Tier 2, are the sub tiers gaining visibility? As we all know, there is a risk element in supply chain that they are working towards. So, I think watching that and also the sub tier has been hampered with the rising cost of capital and the credit tightening by the regional banks. So, all that is how are they going to overcome that to continue supporting the production ramp-up that is expected by the industry. And the last thing is around talent. We’ve always talked about how the entire talent aspect needs to be revamped, not just for a focus on the near term, but also change the type of talent that’s required for the longer term. So, these are all the things I’m excited to learn more about in Paris.

Cadenazzi

Pivoting to defense and sort of what we’re looking at of Paris, and one of big things is always unconventional partnerships. We’re at a time where there’s changing relationships across countries, what’s the impact on economic markets? So traditional export markets are FMS or DCS markets for defense gear. How those relationships evolve will be interesting going forward. There’s also a lot of interesting financial results and transformational results that tend to come out of Paris. So, we engage in this transformation, we want to announce it, we want to sort of highlight our success in doing something different. A lot of times that’s a result of M&A. So, what were the synergies that came out of it or reorgs of some type — that will be interesting to see if any firms come through with that. I think there’s a few that are intending to do that. There’s also some interesting technology pieces. You talked about supersonic and sustainability. Always exciting on the defense side and might sort of in addition to UAVs would be looking at firms that are interested in defense that haven’t necessarily been in it before. So, the launch of a new division of one of the smaller UAV providers is trying to get into the eVTOL space with the military and sort of the capability offering or something that’s space related. Obviously, those would be interesting things to enter the market as well. And then tactical manufacturing technologies or additive or productivity enablers that someone is doing something brand new within the space they think is going to unlock new growth potential for them. It’s always an exciting time to sort of be there and hear folks offer what’s new in the market. Great. That’s fantastic, Raman. Thank you very much for the time and I look forward to seeing you there.

Ram

Thank you, Mike.

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Thanks for listening to today’s EY Advanced Manufacturing & Mobility Business Minute Podcast. We hope you found it engaging and informative. To listen to other Business Minute podcasts, you can find them at ey.com/AM&Mpodcasts.

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