Wish You Were Here: Some Of What You Missed If You Didn’t Make TD Cowen’s 45th Annual A&D Conference

Roman Schweizer:
From DOD to Congress and from the White House to Wall Street, the NatSec Need-to-Know podcast. An unrehearsed podcast presenting insightful discussion and forecasts of the major national security and defense news of the day. Hi, thanks for joining me for a special edition of the NatSec Need to Know podcast. I'm Roman Schweitzer, the TD Cowan Washington Research Group Geopolitical, Security and Defense Analyst, and I'm joined today by my two counterparts in equity research, Cai von Rumohr and Gautam Khanna.
We've just wrapped up our 45th Annual Aerospace and Defense Conference in Washington DC. It was a great conference. We had a lot of insightful discussion and I think we're going to talk about some of our views, what we've learned and where we found out some new items and maybe been surprised a little bit. I'm going to turn it over to the guys in just a second, but what I want to do is go over some of the major themes that I think were meaningful. Some of them may not be surprises, but I think there's some new wrinkles involved that are going to be helpful for the year ahead.
From my perspective, I've got a series of macro bullet points and then want to dive into a couple of program takeaways from our conversations that I think are meaningful. One, we're still optimistic that Defense Appropriations will get done by March 8th. In typical Washington fashion, it will be as painful as possible, but we do think DOD will get its appropriations. We don't anticipate another CR beyond that, but interestingly, there might be a brief shutdown during that first leg of the CR. We also do expect a security supplemental and tax package to pass. We're waiting on the House to take up the security supplemental, the Senate to take up the tax package, but we are optimistic that these all do come together and get wrapped up by early March.
Just interestingly, Congress still does also intend to get work done on FISA, the Intelligence Collection bill, controversial bill that is, and then also the FAA reauthorization. Those are two other pieces of legislation. It's going to be a busy few weeks and you're going to have to stay tuned.
One key takeaway from all of the side conversations is that the fiscal '25 budget, which is due to be released on or about March 11th, we'd probably take the over on that, is going to look pretty bad. There's a lot of published press releases, our published press reports about potential program changes. Most recently, talk about the F-35 program being reduced, the Army's decision on FARA and other aviation programs. That fiscal '25 budget is only up 1% year over year, so that means there's going to be some tradeoffs. It's going to look ugly by design. The one thing we would just encourage people to keep in mind is that that final budget is not going to be up just 1%. I think it's more likely to be up 5%, but that depends on election outcomes and that'll be the next overhang for the following year.
A couple of just quick points to rip through macro. DOD still has significant concerns about supply chain recovery, source materials and critical minerals or supplies. There's also too much of a dependence on China for commodities and electronics and a focus on areas like... Even as specific as seabed mining and processing rare earths domestically.
We published a report earlier this week on unmanned systems and the DOD's replicator initiative. That's a major theme and we think will be a focus area of spending. We've got more conviction after our conversations during the conference. The Air Force's CCA program remains a major area of interest for both traditional and non-traditional players, and DOD is going to continue to use an interesting contract mix of OTAs, fixed price, LRIPs and Defense Production Act authority.
Global demand for foreign military sales continues to be robust across the board in Ukraine, NATO, Asia and the Middle East. Aircraft, unmanned systems, Counter-UAS, long-range fires are all areas of particular interest. And the one thing that I would say is an interesting comment was Ukraine has shown that it's not just the exquisite defense systems that matter, but some of the basics like ammunition 155 are of major interest.
And again, just on the supply chain and sourcing, DOD does have a new National Defense Industrial Strategy. They intend to use Defense Production Act as well as loans and loan guarantees in critical market segments. Again, I mentioned some of those basic raw material and commodity areas. A near-term focus is on microelectronics, semis, casting and forgings, critical minerals and solid rocket motors. I'm going to get into some of the program specifics, but I think for now, what I want to do is I will turn it over to one of my colleagues, Gautam Khanna, so that we could get some of his specific takeaways.
Gautam Khanna:
Thank you. Spent a couple of days with a number of companies at the conference. I thought what was interesting on the commercial aerospace side was both ATI and Carpenter, some of the upstream jet engine billet manufacturers have not seen any destocking, order cancellations, pricing or backlog deterioration despite the change to the production rate on the 737 Max, where it's being held steady for longer given the FAA's more stringent oversight of Boeing's processes. So for those guys, it looks like they're still producing maybe below the underlying rate, and so there's an opportunity for them to continue at this rate and continue to ramp as well.
We met with General Electric as well. It was interesting. They were actually a little bit less positive on the pace of supply chain improvement. They mentioned it continues to be a slog. They've deployed 50% more engineers at their supplier facilities to help debottleneck the supply chain, which just tells you how slow some of the supply chain improvements have been to manifest. They were very positive on the aerospace aftermarket and even the old engine aftermarket, the CFM-56, through as far as 2028, they're seeing an increase in scope at shop visits and pricing also as a tailwind. But as they've said before, profitability faces some pressure for mix within the aftermarket and because of the rising OE delivery mix, especially as the GE9X begins to ship later this year.
HEICO's management team echoed GE's bullishness on the aerospace aftermarket. They noted that initial customer response to the Wencor acquisition has been very positive. On the defense side, both LHX and HII mentioned that supply chain and internal labor attrition and productivity continue to improve. Leonardo said the same thing, but mentioned that certain regions remain tough for labor, specifically Milwaukee is one city where the job market is particularly tight for engineers. All of the defense firms we met with were fairly bullish on the prospects for a DOD budget being passed sometime in Q1, and ultimately for defense funding to be well-supported in an election year given the broader geopolitical threat environment. Cai, I'm going to turn it over to you for your thoughts.
Cai von Rumohr:
So thanks Gotham. So I've got a couple of thoughts here too. So commercial air transport demand and pricing certainly look like they remain robust. China is taking planes from Boeing. 737 and 87 are sold out to '27, '28. Boeing is still working several active campaigns. Airbus targeting 800 aircraft delivery. So demand clearly not the issue.
In the commercial era aftermarket, pricing also remain strong. We're still really bullish on this sector and there are a fair number of reasons. One is still healthy global traffic demand, particularly for wide bodies, challenging OE delivery targets that don't meet really what the airlines want. The impact of the close FAA oversight of Boeing, we think that's likely to impact deliveries in the first half, and the push out of MAX 7 and 10 deliveries due to Boeing's decision not to seek an engine anti-icing certification exemption.
In addition, the increase in A320s on the ground as Pratt fixes the powdered metal issue restrains capacity. So we think airlines are going to have to spend to keep flying what they already have in their fleet. And as a result, while provisioning for some items may be down as airlines have tried to restock in 2023, the pricing environment remains strong and suppliers are getting near 10% price hikes this year and that's close to what they got last year.
On the BizJet side, demand also continues healthy, maybe stronger than some investors think. That's because backlogs have expanded significantly for all the producers over the last two years and lead times now extend out over 18 to 24 months. Unlike the air transport market, this is a constraint. Retail buyers don't want to wait more than 12 to 18 months for a plane, fractionals firm up their schedules 12 months out, and corporates may wait 18 to 24 months, but likely not longer. So everyone expects book-to-bill to be reasonably good, but we think it's going to moderate to 1.0 or maybe a little bit lower.
So commercial demand, broadly speaking is good, but the elephants in the room are the ability to get planes through the FAA certification and the industry's ability to deliver. On the certification issue, the FAA has taken longer than expected to certify the Gulfstream G700 and the MAX 7, even before the Alaska air incident, but the Alaska incident, while it's not a design issue, it's put a spotlight on safety and if anything, it's expected to cause the FAA to be even more careful, i.e. slower in approving new or derivative designs, and probably in lifting the ceiling they've put on Boeing's production rate. This clearly is an issue for all new designs like EV tools, where the FAA has yet to settle on what certification requirements should be, but it's also a factor for derivative aircraft like it's been for the G700.
So the other major issue is supply chain and labor, which have prevented commercial and defense companies from meeting schedules. On the supply chain issue, things continue mixed. Most companies, including Boeing, GD and Lockheed and MOE say things have improved versus 2023, or at least are stabilizing. But many companies like Textron also complain of continuing whack-a-mole situations where shortages can change from day to day. Furthermore, RTX and Lockheed are still struggling with Rocket Motors. Castings generally are noted as an issue among commercial suppliers, although microelectronics have improved. And for example GD has more engineers at its suppliers than it did in 2022.
On the plus side, A&D labor markets generally do look like they're getting looser. Boeing claims no problems in getting workers with an 80% acceptance rate on all the offers they make, although training still remains an issue. Lockheed claims it turned the corner on labor availability in mid-2023. However, Textron continues to see difficulty in attracting qualified labor in Wichita, but that's probably because that's where it and Spirit dominate as manufacturing employers.
On the plus side, Textron needs to hire fewer workers in 2024 than it did in 2023. And on the plus side, there's a uniform agreement that attrition rates have started to decline. So we think there is some hope that the supply chain could get looser as we move through the years and allowing output to hit targets.
Roman Schweizer:
Well, great. Thanks guys. Those are really important insights and thanks for sharing. Before we close out, I do just want to cover four program specific issues based on our conversations and some of the recent things I've published to refresh thoughts on where things are at. So one, on the F-35 program. I've talked about certainly some of the bigger risks in the program, TR-3, Block 4, and some of those other issues. I've changed my view a little bit. I think I'm a little bit more positive. Certainly there are some tough months ahead for the program. Obviously TR-3, they're trying to get that next software batch certified or tested, lab tested, flight tested and then certified and moved into production. It's going to be a busy few months and if they miss that calendar can get extended a little bit.
Obviously, Lockheed is looking at a June timeframe, that could extend depending on how many increments or loops they need to go through on the software testing. But we heard the comment that there's a light at the end of the tunnel. I think that's true. I don't think that light is a train. It might be daylight, but I don't think that's a big issue beyond this year, let's call it that. I think this is software engineering. This is not basic science and discovery. I think they can get over this hurdle, but probably not soon enough for a few people either running the program or in the companies dealing with this.
One of the issues that I'd flag, that I've harped on after the PEO's testimony in December is this concern about Block 4. Block 4 is probably 70 or 80 capabilities that follow on after the TR-3 tech capabilities there, that the PEO's stated risk is in his testimony, and I think I've come away from the conference getting the sense that I think that'll be restructured or phased a little bit better. I think the department realizes it doesn't want to get into a situation like it did with TR-3 where it doesn't have off-ramps and it's a go or no-go decision that's going to impact production. So I think Block 4 is probably going to be de-risked, maybe broken into some components or things like that. That's a TBD, but I think it's probably going to be resolved before it becomes a problem.
One issue that has been perpetual is what's the long-term rate look like? Is 156 sustainable? With a foreign demand coming into the program, it's like 156 or better probably. I think some of that will depend on the finalized numbers in the US budget cycle. Is it going to be the 83 that's currently in the FDIP or is it something less than that? And then how do you start rolling in those foreign buys or those new foreign orders? So certainly demand's going to be robust.
The one interesting comment that I heard though that I think is meaningful is that there's a view that production isn't going to go above 156 until the government and industry can support all of the aircraft it has in the field, that they want to get the mission capability rate, the global sustainment up better, that there's no point in building more planes if you can't support them in the field, which I think is an interesting perspective and might be one of those dual challenges, right? Production is one aspect, but the logistics enterprise, the support enterprise behind it is also another big one.
And then one thing, just a flag to pay attention to, being an acquisition nerd, it does look like the program is on track for Milestone C, sometime to Spring March or perhaps after. That is a big decision. That means that they are technically out of EMD and into full production. That is a major milestone, one probably a long time coming for this program, so pay attention to that. And that does mean that the program would be eligible for multi-year procurement or block buys or something like that. So it's a big meaningful milestone.
I do want to touch on changing gears a little bit to another program of interest really in the Department of Air Force, collaborative combat aircraft. It is a major area of focus both for the Air Force and probably DOD writ large in terms of the incorporation of unmanned wingmen and things like that. Our understanding is there are five companies involved in the airframe piece, and that's been publicly reported. And then more recently, the Air Force Secretary has announced that that will be down selected within the next few months to two or perhaps three companies, depending on pricing and whether there's cost sharing involved and things like that.
We also understand there are 25 or more companies involved in the mission systems piece of the program. We got to understand right now that the Air Force is going to be the integrator for the platform, or for the system itself rather, the family of systems and that there are some government referenced architecture pieces of the program. So that might be sensors or payloads or weapons or things like that that the government is controlling and will require interfaces and use some of those other 25 companies doing the mission architecture. But in terms of the airframe itself, the companies pursuing that will be the prime responsible for integration of those government-directed pieces of it.
So an interesting recall, this first competition is going to go down two or three. Quantity is still TBD, but interestingly, we believe there's a second increment or increment two. This first batch is being called increment one. Increment two will be the follow-on, could be a different mission set, could be a different type of vehicle, so stay tuned for more on that.
Also, just want to touch on the GBSD program, ground-based strategic deterrent. Obviously that program is in a Nunn-McCurdy breach situation. Basically, as we understand it right now, that is going through a OSD or Office of Secretary of Defense mandated review that is not within the Air Force's control. OSD now needs to make a determination of whether the program gets canceled or restructured. We do not believe it will get canceled. We do believe it will be restructured.
The Air Force earlier this week announced some reshuffling, a big effort, a re-optimization. As part of that effort, they're going to set up a new PEO for GBSD and Minuteman III, the ICBM leg of the triad. So certainly, I think even the Air Force understands there's going to be some restructuring of the oversight of the program. I think it's also possible in a restructuring, there could be some changes in the contracting. I don't think necessarily that Northrop Grumman has any work taken away from it. I think there might just be maybe some different contract breakouts or cleanse or different types of contracting vehicles associated with the various elements of the program.
As we understand it, there's a root cause analysis being conducted and OSD and the Air Force will determine where the majority of that cost growth is. Obviously, you've got the missile component, you've got the silo refurbishment, you've got the ground command and control systems. I think it's been suggested that the silo upgrades and the ground command and control systems are some of the culprits in this case. Whether that's a function of inflationary cost pressures or even things of relying on older infrastructure that was built in the 1960s and needs to be refurbished.
And the last program, it wouldn't be a conversation without talking about the B-21 program. Obviously, Northrop has had to take the charge related to LRIP, but we get the sense that the Air Force is still pretty pleased with where that's at. Obviously the Air Force is not covering that charge, so it's not a cost related to... It's not an overrun that the Air Force has to cover and budget. But the interesting thing that was suggested, or at least we think is probably the case, is that the program's still meeting its acquisition program baseline in terms of cost and schedule. So it does seem like that's on track. So that's a very, at least good indicator that the Air Force is probably pretty pleased with that, even if the financial result is not what the desired outcome was or has been for the company so far.
Well, that's it for me. I think I'm going to wrap it there. Cai, Gotham, thank you very much for your insights. Always appreciate it and always enjoy the opportunity to collaborate with you on this great annual event that we hold. If you didn't make it this time, we sure hope to see you next year. We think you're missing out. It's the best opportunity to hear from companies, hear from government policy people, and just rally up and get your head on straight for the year ahead. Thanks everybody. Appreciate your time and look forward to talking with you again.

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