Top 100 Aerospace and Defense companies posted record profits, but a slowdown in commercial aircraft orders and macro-drivers may create new headwinds

06 July 2016

Sector to face continued disruption from combination of new players and digitalization, according to annual AlixPartners study.

(July 06, 2016) – The global Aerospace and Defense (‘A&D’) industry has seen record profits of 10.1% EBIT for the top 100 companies and sales up 3%, according to the most recent annual outlook for the industry by AlixPartners, the global business advisory firm.  AlixPartners warns that some parts of the sector may face new headwinds from the combination of a tense commercial aircraft supply chain, potential attrition of commercial backlogs, macroeconomic threats, new entrants to the space market and the challenge posed by digitalizing large organizations.

The AlixPartners global A&D study reveals that US companies remain 4% more profitable than their European peers and that suppliers are also 4-5% more profitable than OEMs.  Overall A&D players have outperformed the stock market by a factor of almost two in the last 10 years. 

Mergers and acquisitions (‘M&A’) in the sector has continued its recovery since 2012, with $41 billion in deal value – doubling since 2012. The year has been dominated by Berkshire Hathaway’s acquisition of Precision Cast Parts for $37 billion. Valuations are well above 10x EBITDA with strong variance across segments but positive trends in Defence, Satellites, Engines and Composites.  The six drivers of M&A activity in the sector are:

  • Attractive investment conditions for all players – low interest rates and available liquidity;
  • Defense spending rebounding – expected strong growth in defense electronics, C4ISR (Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance) and cybersecurity;
  • OEM focus on core business – reallocation of capital to core business and new strategies;
  • Consolidation of aerostructure players with a focus on smaller tier 2/3 suppliers lacking critical scale;
  • Attractiveness of composites – vertical integration of material suppliers to capture more value;
  • Fragmentation in Maintenance, Repair and Overhaul (MRO) – global leaders Air France / KLM and Lufthansa Technik outperform independent ones and further consolidation is expected.

The A&D sector as a whole lags behind other sectors such as retail or banking in terms of digital transformation, but some key primes, such as GE and several disruptors (Google, SpaceX) are leading the way.  Digital transformation is challenging for A&D companies, given the massive data flow generated by a steadily increasing fleet of commercial aircraft, coupled with more parameters of modern aircraft and enabled by in-flight broadband connectivity. 

However, we believe one of the key challenges of digital transformation in A&D is centered on the difficulty of transforming large organizations composed of historically hardware focused engineers, into providers of lean open-source, software-driven solutions and services. As a result, new ways of working are required in order to fully leverage the new available technological building blocks. This includes big data, applied analytics, further automation and machine connectivity, excellence in software development, connectivity and improved sensors to achieve better business insights and drive new business.

Eric Bernardini, Global Industry Lead for Aerospace & Defence at AlixPartners said,

“Over the last twelve months, a number of key economic drivers have provided tailwinds for the global A&D sector. The strengthening of the USD against the EUR has benefitted a sector which trades in USD.  At the same time, the oil price collapse has enabled airlines to reach record profits.  However, strong airlines demand, especially for narrow-body aircraft is putting historical pressure on the commercial aircraft manufacturers who are now trying to work through record backlogs.

“A&D has traditionally lagged behind other sectors such as automotive on the industrialization and automation front, and lags behind many B2B industries on digitalization, with paper drawings still prevalent on older programmes. Companies which embrace digitalization will grow faster and make more money than those which don’t.  IT will move from being a support function to a key enabler of corporate strategy, with digitalization bridging the gap between IT and the needs of the business. SpaceX has led the way for major disruption and is well ahead in achieving breakthrough in functionality vs cost.”

A&D sub-sectors

Defense primes have increased their profitability to 11% EBIT margin, but revenues kept declining in recent years at a rate of 2% per annum as a result of budget cuts.  Global military expenditure of $1.77 trillion has slightly declined from its 2011 peak (-1.7%), although there has been a slight uptick (1.0%) in global defense budgets in 2015, which could mark an inflection.  Although there is continued decline in NATO spend, increased security threats from non-nation states and cyber terrorism are likely to result in Western defense budgets increasing again.  China, Russia and Saudi Arabia - historical fast growers in defense spending, saw their budget growth decline from double digits to 6-7% in 2015. This slide will probably continue with falling oil prices and the China slowdown putting pressure on their budgets.

Airlines have seen profitability further boosted by lower fuel costs and healthy traffic growth.  Global airlines revenue is $718 billion, down 4% in value, year-on-year, despite a 7.4% increase in traffic as ticket prices declined 11%. Traffic is expected to double in the next 15 years driven by long-term GDP growth.  Improved financials, even for weaker airlines in Europe and Asia, will potentially delay major consolidation.  However, price competition is likely to further erode windfall profits in the next 12-24 months, potentially triggering distress and driving anticipated consolidation in these regions.  Airlines are taking advantage of low fuel prices, although this is partially offset by FX for non-American airlines and can be delayed by their hedging policy. Some, such as Delta Airlines, are also delaying the retirement of old aircraft, although the long-term strategy and rationale to buy latest generation of more fuel-efficient aircraft remains unchanged.

Aircraft OEMs are facing a global backlog of over 13,400 aircraft (mainly the A320neo and the 737 MAX). Over the next 20 years 32,500 new jet deliveries are expected with 40% of this growth coming from Asia Pacific. By 2034, its fleet will be as large as North America and Europe combined.  OEMs are fully focused on ramping-up production to meet this demand, with most of the growth planned for narrow-body aircraft. Airbus and Boeing intend to increase production to 60 and 57 aircraft per month, respectively. In wide-body programs, the priority is on delivering the B787 and the A350 while preparing to transition from the A330 to A330neo and 777 to the 777X.  The Jumbo aircraft market remains sluggish with the A380 fighting for survival.  The Bombardier C-Series is the only serious contender in the narrow-body field and landed a big order of 75 aircraft from Delta Airlines. The Chinese Comac C919 is expected to come into service before 2020. 

The current backlog of narrow and wide-body aircraft represents seven years of production (at future rates). The 35% fall in net orders in 2015 must be analysed in the context of this strong backlog: airlines ordering aircraft now would have to wait very long to get their hands on airliners. The backlog may face some attrition, especially from emerging Asia Pacific airlines with very ambitious fleet expansion plans, due in part to local currency devaluation and degraded financials, but is not a major risk to aircraft OEMs, who are used to swiftly managing tail allocation to airlines. 

Space disruption has started, led by ‘New Space’ launcher players, and a trend towards smaller satellites and constellations.  The overall market is now worth $203 billion, up 4% year-on-year with 60% of the market consisting of satellite operations and services and 29% from ground equipment.  Several emerging trends will dramatically reshape the satellite industry in the coming decade.   Customer demand and competitive pressures are driving significant changes in the satellite market including electrical propulsion, remotely reconfigurable capabilities and on-orbit servicing capabilities to maintain new constellations and extend the life of existing vehicles.  Similarly, affordable small sats and the commoditization of sensor data will fundamentally change the current space sector’s ‘big rockets / big and heavy satellites’ mindset.

The space launcher market is witnessing unprecedented competitive pressure with the confirmation of SpaceX success in the commercial market and access to the US military market, estimated at $70 billion until 2030.  Historical players must drastically review their business models and reduce their development/production lead time and costs.  With Airbus and Safran teaming up and production of a competitive Ariane 6, there will be face greater efficiency.  However, cost pressures will continue to grow in the future because of technical breakthroughs such as reusable first stage rockets.

Deliveries of business jets are up from 7% from the low point of 2012, driven by demand for larger aircraft, but are still 45% below pre-crisis peaks.  Overall, the market was flat in 2015, with 718 units sold and revenues of $21.8 billion.  There has been a switch in segment mix with a 9% fall in larger aircraft and a 10% increase in medium aircraft compared to 2014.  Over the next 10 years, all markets are expected to increase with a CAGR of more than 4%.

The global helicopter market is in freefall as a direct result of the collapse in oil prices coupled with a contraction of military spending.  Deliveries of both civil and military helicopters have fallen 28% versus the 2013 record of 2,336 to 1,689 in 2015.  Revenue for the top five OEMs has dropped by 13% on 2013 to $25 billion.  The oil price collapse has resulted in Oil & Gas operators heavily restructuring.  CHC has filed for bankruptcy (aiming to reduce its fleet of 230 helicopters by one third), while Bristow has been cutting costs, reducing staff and parking helicopters.  The helicopter leasing market has expanded over the last two years and OEMs are increasingly reliant on MROs for between 40-60% of revenues.  The M&A market is expected to be very active as demonstrated by Lockheed Martin’s completion of the acquisition of Sikorsky from UTC for $9 billion.

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