Should Aircraft Makers Bank on Their Huge Backlogs?

The aviation industry is a cyclical business that sees its share of good and bad times. Despite the current global economic uncertainties, aircraft biggies Boeing (NYSE: BA  ) and Airbus (NASDAQOTH: EADSY  ) are loaded with extraordinary order levels from airline operators. According to CAPA. a fleet database firm, orders stood at 12,596, that's equivalent to nearly half the aircraft in service in the world. Both Boeing and Airbus recorded more than 10,000 aircraft in backlog in 2013.

The enormity of the backlog is raising questions about whether the orders are an accurate reflection of demand or merely speculations. Let's assess.


Airbus A-320 waiting to take off from SFO. Source: Wikimedia Commons

Mounting backlog
Boeing's commercial backlog is rapidly approaching the $400 billion mark -- it increased more than 16% year over year in 2013 to 5,080 aircraft worth $373 billion at contract prices. The aero giant recorded net orders for 1,355 planes during the year with top-selling single-aisle 737 bagging the most, followed by the 787 and the 777 fleet. More orders could be round the corner as Boeing's re-engineering the 777, to have a more fuel efficient engine with advanced environment performance -- the 777X. Although caught in technical snags, the 787 Dreamliner could also excite the carriers as the Federal Aviation Administration has confirmed that the fleet's safely designed. 

European aero major Airbus finished 2014 with a bulky backlog of 5,559 aircraft valued at a list price of $809 billion by registering industry wide record orders for 1,503 jets, adjusted for cancellations. There's massive demand for its A320 family jets, the A350, and the A380 jetliners. The plane maker is designing the successor of the A320, dubbed as the A320 NEO, which already has 2,610 orders registered in books.

Even smaller players like Brazilian Embraer (NYSE: ERJ  ) ended 2013 with a backlog worth $18.2 billion at list prices, up from last year's $12.5 billion. In 2012 there was a concern regarding Embraer's shrinking order backlog, which stood at just 185 jet, or less than two years of production compared to Boeing's and Airbus' eight to nine years. But last year the regional jet maker eased concerns when it secured an agreement for delivering 177 E-175s -- 30 to United Continental, 40 to SkyWest, 60 regional jets to American Airlines, and 47 to Republic Airways. This lifted Embraer's firm order to 429 commercial jets. 


American Airlines' first Embraer E-175. Source: Wikimedia Commons

Risk and reward go hand in hand
Adam Pilarski from leading aviation consultancy firm, Avitas, is skeptical regarding the current backlog size doubting if "the existing orders and deliveries" is rational. He believes that the order book is inflated as orders from budget carriers from Asia are vulnerable. It's a "high-opportunity, high-risk space" says Jeff Knittel , President of Transportation and International Finance at CIT, an organization providing financing solutions to aerospace and rail industries.

Ramping up production rate in collaboration with the suppliers to clear the backlog is a huge challenge for aircraft makers especially when we are talking of commitments worth eight to nine years of production. And delivering on time is essential -- for delays, apart from the costs, there's a risk that the airlines could swap their order for a newer version, or even cancel it if business relations deteriorate.

But, he biggest uncertainty is that if future passenger traffic doesn't match expectations, airlines could defer delivery or reassess their purchase plan, and this is what's making industry watchers uncomfortable. In May 2012, Boeing customer Southwest Airlines postponed the deliveries of 30 737s to restrict capital spending. The same month, Qantas followed suit for two A380s.Such situations can put the aircraft manufacturers in a spot as huge investments go in building new plants and augmenting capacity.


Boeing 737-3A4, Southwest Airlines. Source: Wikimedia Commons

Reasons to be reasonably optimistic
Thankfully cancellation and conversion have reduced in the past decade, raising hopes that the demand is largely real, and both Boeing and Airbus are confident that the market is stable and resilient. Airbus senior VP, Andrew Shankland, feels there are "reasons to be reasonably optimistic".

According to World Bank, GDP would grow to 3.4% and 3.5% in the next two years, up from 2.4% in 2013, and growing affluence would spur demand for air travel. Boeing estimates world passenger traffic could rise 5% annually for the next 20 years, with carriers across Asia-Pacific expected to see solid growth.

Replacing the early generation jets burning more fuel with the latest fuel-efficient  ones could be another big driver as fuel makes up a third of the operating charges. Steven Udvar-Hazy, CEO of Air Lease, says that there's massive need for replacement as several aircraft are flying for more than 20 years. This will boost demand for fuel saving fleet like A320 NEO and the 737 MAX that are made of composite material and have advanced engines to reduce the aircraft weight and improve fuel efficiency.


Historical Jet Fuel Prices: Bloomberg Finance L.P.

Airbus COO John Leahy says, the industry demand "doubles every 15 years in seat-mile capacity", and plane makers seated on a current backlog of more than eight years of production are at negligible risk.

Foolish conclusion
The concern that the aircraft backlog's too huge to be real cannot be laughed off, but there are good reasons to justify the number. Unless there's a drastic economic downturn or something severely unforeseen, the current order trend should continue. With rise in passenger traffic, fuel efficient planes, and steadier market conditions, the aircraft makers are poised to benefit in the future.

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