2010 Aerospace and Defense Industry Outlook
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The aerospace and defense industry performed surprisingly well in 2009, compared to other industries. However, OEMs, suppliers and investors should not expect the same results in 2010 and 2011.For A&D companies, the challenges of a long, slow economic recovery in the U.S. and the debt crisis in Europe will be compounded by expected reduced defense spending worldwide and by intensified competition driven by shrinking demand.
Facing uncertain demand outlooks in most sectors, these companies must improve their operational processes, lower their break-even points, and address inefficiencies in product development and the supply chain to succeed in the long term.
CLOSING A CHALLENGING YEAR
Sales in the aerospace industry grew by 2% in 2009—a strong performance compared to other industries. U.S. defense spending contributed to this industry growth, buoyed by supplemental spending authorizations for the wars in Iraq and Afghanistan. Nevertheless, 2009 performance was quite a departure from the five years of strong profitable growth that preceded it (figure 1), with new aircraft orders falling by 70%.
Overall, industry health has improved slightly, as measured by Altman Z-scores. The dramatic 24% drop in overall industry score from 2007 to 2008, was partially offset by the slight improvement from 2008 to 2009 (figure 2). The risk of financial distress in the industry decreased slightly, indicating that companies have executed operational and/or financial restructuring to get out of the red zone.
Still, in 2009, lower sales in the regional, business and general aviation segments, along with program delays in commercial transports, pushed industry-wide EBIT margins down 13% below their 2007 peak. While all geographies and stages of the value chain were impacted, original equipment manufacturers (OEM), particularly commercial and business jet OEMs, suffered most. OEM profitability lagged behind that of suppliers by more than 30%, due mainly to development program delays. In 2009, for the first time since 2005, suppliers outperformed OEMs due to a two-point increase of their cash flow return on invested capital (CFRIC).
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Globally, airlines have reduced capacity significantly, grounding or retiring 7.5% of fleet—just as they did in 2001. Although airline traffic has returned to pre-recession levels for both passengers and freight, profitability remains very weak at an anemic 0.5% margin. Despite underlying long-term growth drivers and analyst predictions of a 5-6% growth in air traffic in 2010, a quick industry turnaround is unlikely before 2011 or 2012.
In 2009, all commercial aerospace segments suffered, with orders down drastically since 2007 and seeing only partial recovery in the first quarter of 2010 (figure 3). At the same time, after three record years, aircraft deliveries are beginning to suffer the delayed impact of the recession, with a nearly 10% drop in the first quarter.
Emerging countries do offer some hope for driving growth, as Middle East-based airlines are placing significant orders of highly efficient large-capacity aircraft. However, this does pose a threat to established carriers. Going forward, OEMs going forward can expect 15% growth in deliveries per annum, with particular strength coming from Asia-Pacific and the Middle East.
BUSINESS JETS
The demand for business jets has dropped drastically. Tied to still-fragile corporate profits, this sector faces the additional hurdle of overcoming the politically-incorrect stigma that was forged during the auto-bailout hearings of 2009 and that remains associated with this mode of travel. While the business jet segment typically mirrors the health of the economy—with growth and contraction cycles impacting compound annual growth rate (CAGR) by plus or minus 20%, respectively—this segment saw an unusually steep 34% CAGR drop in 2009 (figure 4). The fractional-ownership market, which in 2008 comprised 20-30% of total business jet orders, struggled in 2009; after strong growth for more than a decade, the fractional fleet contracted by 7% in 2009 amid decreasing new aircraft purchases and increased used sales and aircraft retirement. Looking ahead, the recovery of this segment will be tied to that of corporate profits, emerging markets, and the fractional ownership market.
Priorities for business jet manufacturers in the next three years are to reduce the break-even point; drive faster, cheaper product innovation; balance standardization with customization and improve after-sales support and profits.
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MAINTENANCE, REPAIR AND OVERHAUL (MRO)
The MRO segment continues to struggle as airlines have retired older, more maintenance-intensive aircraft, deferred-maintenance aircraft and reduced component inventories. Volume has declined and, to restore margins to earlier levels, MROs will not only need to reduce variable costs but also to shed 16 to 22 cents in “fixed” or structural costs for every dollar of revenue lost (figure 5). Excess capacity in North American and Western European will continue to be a problem, especially as airlines expand the use of low-cost MRO shops in emerging markets.Meanwhile, demand in China, India and the Middle East is expected to grow 7-10% per annum over the next decade, due to expected aviation demand growth in those markets.
| SG&A and indirect costs represent a significant portion of a typical MRO provider’s “fixed” or structural costs. North American and Western European MRO providers can erase much of their cost disadvantage through aggressive performance improvement efforts. |
DEFENSE
The steady growth in global defense spending since 2001 (figure 6) is coming to an end. Since the middle of the past decade, U.S. defense spending has represented 45% of total global defense spend.Going forward, double-digit growth in defense expenditures is not sustainable in the U.S., where the interest payments on the national debt alone are on track to equal last year’s defense budget. At the same time, defense ministries around the world are being pressured by budget issues to reduce costs while ensuring that the troops in the field have the resources they need to execute their missions.
| Large prime contractors that operate across multiple sectors will need to adjust cost structures of individual business units in line with expected demand and growth opportunities. For primes and sub-primes that compete in only a few sectors, the challenges are the same but the potential impact is more extreme. In response to the recent announcement by the U.S. Department of Defense that they would be aggressively seeking cost reductions, defense contractors may finally be forced to address significant inefficiencies in their development and program management efforts. |
STRATEGIES FOR SUCCESS
Given the continued uncertainty ahead, all aerospace and defense companies would be wise to re-examine their financial and operational processes for opportunities to increase efficiency. Competitive advantage will be driven by disciplined program management, supply-chain optimization and lean engineering.
On the program-management front, aerospace companies need to implement design-to-cost practices more widely, as the number of recurring cost overruns is now as high as non-recurring cost overruns. Half of these overruns are generated during the pre-development phases, indicating a need for a rebalanced planning and deployment approach with more rigorous life cycle management. Given the pressures in today’s environment, cycle times need to be reduced by 40% or more. The supply chain model is fundamentally changing; beyond getting just the best cost, OEMs and suppliers must work together to achieve increased competitiveness OEMs need to master integrated product development and mutually-beneficial collaboration approaches, while suppliers must be open to cost- and innovation-sharing in exchange for bigger pieces of new programs and earlier involvement.
In engineering, many aerospace and defense companies spend up to 200 engineering hours per component, compared with 21-28 hours for many companies in the auto industry—an industry also building highly complex products. This suggests considerable opportunity exists for aerospace and defense companies to more effectively implement lean engineering programs.
Finally, during the downturn, mergers and acquisitions in this space slowed significantly, but OEMs and suppliers are now driving consolidation. As segments of the industry continue to recover, low valuations in certain segments provide opportunities; we see the greatest consolidation potential in the electrical systems, aerostructures and airframe MRO segments.
The aerospace and defense industry is entering a period that will be governed by budget limitations and cost management, and companies across all segments will need to adopt new strategies to meet these new challenges. Effective management, superior operational performance, and cost control will be critically important differentiators in the fiercely competitive conditions ahead.
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