Record year for aerospace and defense industry driven by continued boom in commercial aviation

11 June 2015

Positive outlook driven by structural and strategic changes in defense, the aerostructure value chain, disruption in the space industry and additive manufacturing, according to AlixPartners study.

The global Aerospace and Defense (A&D) industry is continuing to soar with record profits and civil aviation backlogs at an all-time high, according to the most recent annual outlook for the industry by AlixPartners, the global business-advisory firm.  Civil players are focused on execution of the production ramp-up and ongoing developments.  Meanwhile, defense and space players are in the middle of strategic repositioning to tackle both their cost structure and their offering in response to declining budgets and disruption from new entrants and new technologies.

Said David Wireman, managing director at AlixPartners and co-head of the firm’s Aerospace & Defense Practice: “The global Aerospace and Defense industry has had another record year with civil aviation backlogs at an all-time high.  Key macroeconomic factors such as GDP, falling oil prices, low interest rates and commodity prices have provided strong tailwinds.”

Said Eric Kronenberg, also managing director at AlixPartners and co-head of the firm’s Aerospace & Defense Practice: “In the defense sector, the picture remains positive despite budget cuts in Western economies, largely due to the resilience of the defense primes which are focusing on restructuring and product diversification.  Space is seeing continued disruption, which is likely to result in further consolidation and vertical integration.”

The AlixPartners study confirms that 2014 was another record revenue and profit year for the A&D industry, driven mainly by the continued boom in commercial aerospace. Average profitability of the top 100 companies in the industry reached a record level, beyond 10% EBIT margin.  However, airlines industry margins remain much lower, just above 5% in 2014 but are expected to increase to 6.0% in 2015 and have already rebounded significantly from 2013, principally due to lower oil prices.  The key macro-economic drivers of the industry – GDP, oil price, interest rates, commodity prices – are providing tailwinds, not only for airlines, but for players across the industry.

The civil aviation profit pool jumped to $77 billion in 2014, from $57 billion in 2013, a 35% increase. The focus in civil aviation is now on execution, with significant production rate increases ahead to deliver the record backlogs built-up over recent years. Major players are also focused on the re-engining developments of a good share of their product portfolio (A320 NEO and B737 MAX, A330 NEO, B777X). In the meantime, defense primes are facing a new global environment of declining budgets in their home countries, with the growth mostly abroad or in selected segments such as cyber-security and UAVs.

Record profitability driven by commercial aerospace and the resilience of defense primes
Profitability across the A&D industry improved markedly to a record 10.2% of EBIT margin, up almost 1.0 % point vs 2013 thanks to higher deliveries, fleet in service and better cost control. Suppliers have typically enjoyed 4% higher profits than OEMs, due partly to higher exposure to the profitable aftermarket business.  Meanwhile, European players benefitted from the 20% decline of the euro vs. the US dollar. Decreasing commodity prices and interest rates at historical lows have supported continued demand, profits and investments in the industry.

Airbus and Boeing have a record backlog of 12,000 aircraft, representing between eight and 10 years of production, which will provide a significant buffer against potential turbulence. Both are planning steep production ramp-ups for their narrowbody cash cows. Boeing is planning to increase the B737 MAX rate to 52 per month by 2017 and Airbus to step up A320 NEO production to 50 per month in 2017, and with a rate of 60 being considered.

Commercial airline profits rebounded by 50%, fueled by solid passenger traffic, oil prices and capacity discipline, with revenues increasing by 4.7%, to $751 billion.  EBIT margin improved above the 5% mark, from 3.4% in 2013.  Traffic growth of 5.7%, measured in RPK (revenue per passenger per kilometer) was a key factor, together with a 40% decline in jet fuel from Q1 2014 to Q1 2015 and – so far – capacity discipline. Beyond the 50% rise to $38 billion, in 2014 compared to 2013, airline profits are expected to increase by another 24% to $47 billion in 2015.

North American airlines are already benefiting from past consolidation and restructuring, whilst capacity discipline has been real and are getting the full benefit of oil prices drop which are offset by the euro decline vs the US dollar, for European airlines.  In Europe, airlines are struggling to restructure, apart from IAG, and are losing ground to low-cost carriers on short-haul and Gulf-based carriers on long-haul.  However, the main concern is that lower oil prices – if sustained – will drive key players into price wars and into relaxing their capacity discipline.

The civil aerospace-industry profit pool increased to $38 billion, a 20% rise driven by the steep improvement by aircraft OEMs.  Players along the civil aviation value chain – from aircraft suppliers to aircraft OEMs, lessors, and MRO and aviation-services players – increased their combined profitability to a 12.0% EBIT margin, up from 10.7% in 2013. All segments improved significantly, except MRO, for which profits decreased in absolute value despite fleet and market growth. The aerostructure segment is the least profitable and the only one for which profitability decreased since 2007.

Compared to the 2007 profit pool of $21 billion, the 80% increase to $38 billion was accompanied by a significant change in distribution among the different players. Aircraft OEMs almost doubled their share, to 28%, and have now become the first segment by profits, at the expense of all other players.  Engine OEMs resisted well, with only a slight decline of their share, from 24% to 22%. The same applies for aircraft lessors, down from 23% to 20%.  Other aircraft suppliers (aerostructure, cabin, equipment and materials) saw their share decline from 24% to 21%, with some variance across segments: aerostructure declined the most while nacelle/pylon suppliers maintained their shares. Aftermarket profits through spares remain the key profit driver for engine, cabin and equipment suppliers.

The above virtuous cycle of higher volumes and profits materialized in the stock market: A&D stocks outperformed the market since the crisis by a factor of almost 2, both in Europe and the US.  At the same time, A&D-focused M&A also rebounded in 2014, reaching $41billion in deal value, a doubling from 2012.

Defense is restructuring, focusing on core profitable segments and diversifying geographically and into high growth segments
Global military expenditure of $1.78 trillion (2.3% of global GDP) has only declined slightly since its 2011 peak (a minus 1.7%) with significant differences across regions. The US represents 34% of this total and has declined quickly from its 2011 peak of $711billion, to $620 billion.  However, the procurement, research and development budgets that constitute the bulk of the figure are set to grow by 9% in 2016 compared to 2013. Beyond the US, there are strong budget increases in China (+10%), Russia (+8%) and Saudi Arabia (+17%). China and Russia, which are also the top two weapons exporters in the world, are mostly captive markets, with few opportunities for Western defense primes. 

Overall, defense players increased their profitability to an 11.2% margin in 2014, from 10.1% in 2011, but revenue decline is accelerating, driven by budget cuts.  The five major US defense primes - General Dynamics, Lockheed Martin, Northrop Grumman, Raytheon and Boeing - achieve similar financials with EBIT margins in the range of 10% to 14% and slightly declining revenues (minus 1% to minus 3% revenue CAGR) as they focus on more profitable products and services at the expense of top-line growth. BAE Systems, the only European player comparable in size, suffered more – a 4% annual decline in sales in the last three years - as it is more exposed to the declining land-systems segment. 

Restructuring has been and remains active in the sector, with constant headcount reduction for main A&D players of 2.6% per year 2009-2014, and an even stronger decline for defense-focused companies.  Restructuring is also taking the form of portfolio reshuffling, spin-offs and M&A.  US defense primes have led this wave with several spinoffs in the last few years, such as Northrop Grumman’s shipbuilding business being spun-off in 2011 as Huntington Ingalls. All major European defense primes -- Airbus Group, Finmeccanica, and BAE Systems -- initiated such portfolio reviews, leading to several assets being on sale. This includes the former Cassidian defense electronics for Airbus Group, Finmeccanica’s MBDA stake, and a partial or full sale of DRS, its US defense electronics business. BAE is evaluating the sale of its US platform business and has also initiated offensive M&A with the acquisition of several targets in cybersecurity and software (SilverSky and Perimeter Internetworking).  M&A is also the natural response to overcapacity and slow growth or even declining sales prospects, as illustrated by Harris-Exelis merger, both strongly exposed to the US Army budget reductions.

One way of restoring growth in defense is to get more exposure to the highest growing segments, such as UAVs, which is expected to grow at 9% per year in the next 10 years, and cyber-security. UAVs’ presence is a must for today’s aircraft OEMs, as increasing maturity of the technologies and mission-scope coverage will help UAVs gradually take over manned aircraft missions, starting with intelligence, surveillance and reconnaissance – already well-advanced – but expanding to strike, refueling, combat, and search & rescue.

Consolidation trends within the aerostructure value chain
Aerostructures is a growing market worth about 60 billion euros in 2014, driven primarily by civil aviation, with 2.7% annual growth expected in the next 10 years.  A large portion of the aerostructure market is captive for aircraft OEMs, with Airbus and Boeing performing more than 50% of their aerostructure work in-house.

Although most recent aircraft have a composite share of more than 50%, this share will likely stagnate or decrease for future aircraft, in particular for the next-generation narrow-bodies.  This will continue as aircraft OEMs and all aerostructure players recognize that composites are not the “one-size-fits-all” solution to weight issues. Manufacturing costs are higher than initially envisioned and aluminum alloys keep improving. The aerostructure value chain consists of three main clusters:

  • Materials suppliers, supplying raw materials, forgings and castings. The average 15-20% EBIT margin in this cluster is due to consolidation and high barriers to entry (investments, know-how)
  • Elementary-parts and sub-assemblies manufacturing.  This cluster faces strong competition from LCCs and is still very fragmented, resulting in average EBIT margin of 4-10%
  • Major assembly (or “super tier 1”).  These are the larger players delivering whole sections of fuselages, wing-to-aircraft OEMs. The RSP model has become the norm for them to carry financial risks linked to new program developments. This resulted in one-off losses for specific programs where new technologies such as composites were introduced. Average margin for the cluster is only 2-5%.

The whole aerostructure value chain does not benefit from aftermarket profits fueling cabin, equipment or engine OEMs. AlixPartners sees three main consolidation trends within this value chain:

  • Downstream consolidation of raw-materials suppliers towards elementary-parts suppliers to capture more value
  • Selective consolidation within the parts/subassembly currently fragmented world, driven by the search for critical size
  • Consolidation of major assembly players into super tier 1, with the idea to be able to mitigate key risks in the RSP model: financial and engineering (capability to take on and develop work packages end-to-end)

All of these will increase the bargaining power manufacturers have with their clients.

Disruption in the space sector
Disruption in the space sector has started and affects both satellites and launchers.  In satellites, disruption comes from new propulsion technologies – with the slow, but gradual move towards electric propulsion – and remotely configurable capabilities.  It also comes from the emergence of smaller satellites and constellations to replace part of the functionality provided today by geostationary-heavy satellites. This will change the business and operating model of satellite OEMs, operators and launcher OEMs, and will enable the partial industrialization of satellite manufacturing as production quantities increase with constellations and modular designs.

The launcher market is intrinsically imbalanced, between national players driven by strategic interests and the political will to secure an access to space – resulting in seven to 10 global players - and the rational economic size of the commercial market – the only one accessible as most of the government / military launch market is captive – which justifies the existence of only three players. The imbalance is mostly compensated through government subsidies.

SpaceX is a major disruptor of this legacy launcher ecosystem. This is very clearly illustrated by:

  • A 50% market share of the commercial market achieved in 2014, thanks in part to a launch price of Falcon 9, 30% below Ariane 5;
  • The certification by the US Air Force in May of the Falcon 9 launcher, giving SpaceX access to the military launch market. This market, worth $70 billion until 2030, is in the sole hands of United Launch Alliance, the Boeing Lockheed Martin JV.

To face these challenges, long-time players are consolidating and vertically integrating to address uncompetitive cost structures, as shown by the Ariane 6 JV and Orbital ATK merger. Both are putting together a space-propulsion specialist and a launcher OEM, achieving part of the integration done by SpaceX.  Synergies now need to be embedded into their new product line up with reusable design options and a required restructuring of the legacy Ariane industrial setup.

Strong growth in additive manufacturing to benefit wider industry
Additive manufacturing is becoming a real industrial option in A&D. With a market size of $400 million, it is still small, but expected to grow at a very strong 15% rate annually for the foreseeable future.  A&D companies (e.g., Airbus, Boeing, General Electric, Pratt & Whitney, Rolls-Royce, Turbomeca and ESA) are at the forefront, with investments and parts production becoming real for plastic and metal parts.  Additive-manufacturing processes will bring benefits on many fronts:

  • Tool-less production and single-process-step manufacturing, imply a reduced manufacturing lead time and less working capital
  • Direct production from a CAD model means products can be produced on the spot all around the world: spare parts application is a natural fit
  • Reduced weight: less than half the weight compared to selected machining applications
  • Optimized material usage, with “buy-to-fly” ratios of close to 1, instead of 5-20 for machining
  • Reduced scrap and cleaner manufacturing environment, no recycling needed
  • Reduced part complexity – several parts can be replaced by one

However, further evolution of additive-manufacturing technologies is required to accelerate the penetration of this technology from rapid-prototyping applications to low-volume serial production and/or spare parts application. This includes:

  • Reducing the cost of equipment and material
  • Reducing processing time – expected to improve by a factor of 4 in the next two to three years as well as current size limitations (about 2m in diameter)
  • Expanding the scope of usable materials
  • Improving process control and knowledge about structural characteristics of 3D-printed parts
  • Improving the maturity of the qualification process for 3D-printed parts

This can only be achieved by a major change in the way engineering departments design parts, in order to fully benefit from the possibilities and reduced constraints arising from this new process. Training plans and close collaboration with 3-printing specialists are required to achieve this goal.

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