2013 AlixPartners, LLP

JUNE 2013
2013 AlixPartners, LLP
Pockets of Turbulence
The 2013 Aerospace & Defense
Industry Outlook
INSIDE
Airlines
Defense
Commercial Aerospace
Supply Chain
MRO
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T
he global aerospace and defense (A&D)
industry is continuing its growth in the wake
of the worldwide nancial crisis, yet it
remains an extremely dynamic marketplace,
in which some sectors are booming and others are
experiencing pockets of severe turbulence.
According to the AlixPartners 2013 Aerospace
& Defense Industry Outlook, an indepth analysis of
sector and company nancials and key macro-
economic trends, the A&D industry grew by 6.8%
in 2012. This was up from 2011s sales growth of
5.5% but still not at precrisis growth levels, which
hit 10% in 2008. Commercial aerospace companies
represent perhaps the strongest segment of
the industry: they are expected to deliver more
than 1,300 jets worldwide in 2013a record for
the industryand new orders continue to roll in.
Meanwhile, in contrast to this growth among
airlines and commercial aircraft original-
equipment manufacturers (OEMs), the defense
sector is shrinking. Even though some of the
developing-market countries are ramping up
spending, the increases are not enough to make
up for a sharp decline in spending by developed
nations, primarily the United States, which
continues to face fiscal uncertainties.
According to the Outlook, the defense sector
will struggle to make up for reduced top-line
growth; the commercial aerospace sector will
benefit from a strong increase in deliveries
and will focus on translating that growth into
a bigger share of the profit pool.
Given this challenge, A&D companies need to
become more efficient and wring costs out of
their operations at all levels. In the defense sector
particularly, companies must diversify into new,
more-promising international markets, where the
rules of engagement are also changing. The
industry will likely remain highly competitive for
the foreseeable future, yet there is strong growth
potential in some markets, as well as greater
profits for companies nimble enough to identify
and exploit those markets.
Airlines: Growth returns,
but prots still languish
The airline sector reects the current good-news/
bad-news state of the A&D industry. Steady trac
growth5.3% in 2012is leading to improved
revenue, and the airlines have become much more
disciplined on capacity than they were in the past.
(Capacity grew 3.9% last year.) Still, airlines have
struggled to translate these improvements to the
bottom line, and strong prots remain elusive.
Current projections call for operating margins of
just 3.3% in 2013. Operators are being squeezed
on both sides: high fuel prices have raised
operating costs, and low-cost carriers and new
global competitors have kept pressure on pricing.
Even if fuel costs revert to historical averages at
some point, the competitive factors are likely here
to stay. As a result, the airline sector is in ux.
The formerly strong European and US markets are
in decline, and operators are either restructuring
(American Airlines, SAS Scandinavian, Spanair)
or merging (AmericanUS Airways, Continental-
United, International Airlines GroupVueling).
As growth in mature markets has attened, the
industrys center of gravity has shifed to more-
rapidly-growing markets in Asia and the Middle
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East, which show favorable demographics and
growing middle classes that are more and more
inclined to travel by air. Accordingly, airlines in these
markets are building up their eets and placing
large orders (gure 1). Indonesias Lion Air, for
example, ordered 234 A320s in March 2013the
biggest commercial airline order in industry history.
(Even Africa showed 7.2% trac growth in 2012,
though admittedly from a small base.) By 2031, the
Asia-Pacic region will be the biggest airline market
in the world, receiving 31% of all new jet deliveries.
The second area of ux among airlines is in
operating models, as the line between low-cost
and full-service carriers has blurred. Traditional
network carriers have unbundled their pricing to
give passengers lower fares overall, with a menu of
available add-ons. Meanwhile, low-cost providers
have added new servicesfor example, business-
class tickets and long-haul routesalong with
service innovations like live in-ight television.
The fundamental message for airlines is that the
product they ostensibly sell is no longer mere
transportation. When that product was a
commoditya seat that takes passengers from
point A to point Bairlines could dierentiate
based only on price and schedule. Today, they can
dierentiate using merchandising and marketing.
They can develop innovative product and service
oerings that stand apart from the competition.
And they can use state-of-the-art marketing to
ensure that their brand is clear in the market.
Defense: A painful contraction
and a shif to the East
The defense sector is experiencing a similar shift
from mature Western marketswhere cuts in
defense budgets have made business far more
challengingto faster-growing regions, in Asia.
Global defense spending decreased in 2012 for
the first time since 1998, to $1.7 trillion. That
includes 3 to 4% cuts in most of the major
Western markets (5.8% in the United States, the
largest market worldwide). Asian countries
outspent European NATO countries for the first
timeand will continue to do so (figure 2).
Compounding this transition, two of the largest
developing-market spendersChina and Russia
are eectively o-limits for outside contractors.
Chinese defense spending is projected to increase
at a compound annual growth rate of 18.5% for the
next decade. This is tremendous growth that
Western contractors cannot tap. (By 2016, China
and Russia will account for 32% of all defense
spending among the top ve markets worldwide,
up from only 17% in 2011.) Defense manufacturers
are now ghting to capture the addressable
Source: International Air Transport Association Forecasts Feb 2013;
ASK = available seat kilometers; RPK = revenue passenger kilometers
FIGURE 1: YEAR-OVER-YEAR GROWTH IN GLOBAL
PASSENGER TRAFFIC AND CAPACITY (%, 2012)
7.2%
6.0%
5.1%
9.5%
15.2%
1.1%
5.3%
6.5%
5.2%
2.9%
7.5%
12.4%
0.1%
3.9%
Africa Asia
Pacic
Europe Latin
America
Middle
East
North
America
Total
Market
RPK ASK
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subsegment of developing marketsprimarily
India, Brazil, and Saudi Arabiaeven as Russian
and Chinese contractors increase their exports
to those markets as well.
These issues are not likely to change soon.
Contractors that sell to the United States will be
exposed to a confluence of factors, including
sequestration and a drawdown in military activity
once US forces leave Afghanistan in 2014. The
situation will have varying effects depending on a
manufacturers offering and geographic focus.
Suppliers that have fairly diversified portfolios
minimize their exposure to cuts in specific
programs. Many OEMs, however, are vulnerable:
our research indicates that 80% are reliant on
defense and 75% are dependent on US and
European markets. Similarly, companies that
depend on annual appropriationssuch as ship
repair and the supply of operational consumables
like ammunition and protected vehiclesare
directly exposed to the impact of sequestration,
which requires short-term cuts.
Among European firms, the threats are even more
dire. As major programs like combat aircraft and
shipbuilding ramp down, European contractors
are now struggling to sustain innovation and
industrial capacity. In the absence of a major new
initiative to radically restructure European
defense capacity, the industry is dangerously
close to a point of no return. The situation is not
yet do or die, but it is clearly do or decline.
To succeed in this environment, defense
companies must:
Continue to reduce costs. Companies need
to improve their value proposition to
customersin other words, affordability has to
become a reality, not just remain a buzzword
and increase their returns to shareholders.
Focus on international markets.
Competitions for major programs are
increasingly winner-take-all arrangements,
such as combat aircraf in developing markets;
and OEMs must adapt their offerings
accordingly. Pure oset deals are dying; most
of the developing-market buyers demand
transfer of technology, nal assembly line, or
local suppliers.
Rebalance portfolios. A shift from big bets
on major programs to a more balanced
portfolioincluding, say, electronics and
cybermay also help mitigate exposure to
further cuts.
Consolidate in Europe. Excess capacity in
combat air, defense electronics, and
shipbuilding is currently unsustainable,
requiring a major effort with strong
government leadership.
US
UK
FIGURE 2: GROWTH IN DEFENSE SPENDING
(HISTORICAL AND FORECAST)
10%
5%
5%
10%
15%
20%
25%
5% 5% 10% 15% 20% 25%
CAGR 20072011
C
A
G
R

2
0
1
1

2
0
1
6

China
India
Russia
Saudi
Arabia
Brazil
Italy
France
Germany
Japan
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Commercial aerospace:
Booming with new products
The strongest sector within the A&D industry last
year was commercial aerospace, which not only
expanded but also accelerated its growth,
particularly among OEMs. Boeing revenues grew
18.9% in 2012, and EADS by 12.7%. Current
projections call for that growth to continue, due
largely to a huge backlog of orders ($390 billion
for Boeing and 638 billion for EADS at list price,
a total of more than 9,000 aircraf). We expect that
by 2017, the workload volume of OEMs main
commercial programs will have ramped up by 45%
and will include a signicant surge in major new
programs, with further increases on the horizon.
At the same time, both OEMs and suppliers are
translating those gains into improved earnings
before interest and taxes (EBIT). Supplier
segmentsincluding propulsion, cabin interiors,
and components and materialsbuilt on their
EBIT momentum from earlier years, with strong
performers such as Precision Castparts, Safran,
Rolls-Royce, UTC, Parker Hannifin, and Zodiac.
Among OEMs, EADS has shown significant
growth in EBIT; other competitors are still slowly
returning to 2007 levels. Overall, suppliers
remain more profitable than OEMs by a gap of
nearly five percentage points (figure 3).
That said, other indicators show that the gap in
nancial performance between OEMs and
suppliers is starting to close. For example, OEM
revenue growth is now acceleratingfrom 1.6% in
2011 to 6.7% in 2012and supplier growth seems
to be slowing down: from 10.2% in 2011 to 6.6%
in 2012. Similarly, an analysis of cash return on
capital invested (CROCI) shows that suppliers have
trended downward since 2007, whereas OEMs
have improved their CROCI performance. In part,
this is because the backlog in orders has allowed
OEMs to build up stronger cash positions.
Moving forward, the commercial aerospace profit
pool will continue to grow at a rate of 5% per
year, driven in part by both airframe and engine
manufacturers new technologies intended to
improve aircraft operating efficiency. Aircraft
deliveries will increase 2.3% a year for the next
decade. As the profit pool gets larger,
commercial aircraft OEMs will fight to increase
their share, by developing new aircraft designs
and ramping up production for both narrow-
body and wide-body aircraft.
ppt = percentage point
Sources: Capital IQ, AlixPartners analysis
FIGURE 3: EBIT MARGIN GROWTH (%, 2005-2012)
8.8%
2006
7.6%
2005
7.7%
7.4%
2008
8.8%
2007 2012
9.2%
2011
8.7%
2010
8.6%
2009
2012
11.3%
7.6%
2011
11.0%
7.0%
2010
10.3%
7.4%
2009
9.6%
5.9%
2008
9.6%
8.2%
2007
10.7%
7.5%
2006
9.8%
6.3%
2005
9.0%
6.7%
OEMs Suppliers
+0.8 ppt
1.4 ppt
+ 1.8 ppt
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Supply chain: Challenges
on the horizon
The coming increase in sales volume is a positive
sign, but it will create significant challenges for
A&D supply chains. As noted earlier, we project a
45% ramp-up in workload by 2017, with new
programs like the A320neo, Boeing 737 MAX,
and Bombardier C Series that will tax engineering
and industrial service functions. These new
programs also involve more-technologically-
complex designs aimed at increasing aircraft
operating efficiency by 15 to 20%. Such advances
include composite materials, fuel-efficient
engines, and new systems, including avionics,
fuel, braking, and electric systems.
The current industry supply chain is not entirely
ready for this dual challenge of delivering a
greater volume of more-sophisticated aircraft.
In fact, there is a real and growing risk of supply
chain disruptions. Certain suppliers have only
limited expertise and modest engineering
capabilities for implementing and sustaining
several programs, especially in the detailed-parts
and aerostructures segments. Some suppliers
and OEMs have taken early steps to handle those
limitationsfor example, by more directly
involving and closely monitoring tier 1
aerostructure suppliers in new programsbut
those measures represent a new risk-sharing
model for which neither side is yet mature
enough to implement and monitor.
FIGURE 4: SUPPLY CHAIN EVOLUTION
Raw
materials
Make-to-print
parts
Large-scale
integration
Aircraf
assembly
Small-scale
integration
Value-added parts
and assemblies
OEMs
OEMs
Current
OEMs
Future Past
Many supply paths
Many direct suppliers
Limited role for integrators
Some role for value-adding
suppliers
Fewer supply paths
Far fewer direct suppliers
Extensive role for integrators
Still-larger role for value-
adding parts suppliers
Few risk-sharing partners
Unbundling of modules
and systems by OEMs
Tier 2/tier 3 supplier
nomination by OEMs
Small supplier base in each
segment
Reduced supplier base managed by OEM and tier 1
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More and more, OEMs will have to lead
operational improvement programs at their key
suppliers, and tier 1 suppliers will have to develop
similar measures further down the supply chain. As
tier 1 responsibility shifs to include not only
full-system but subsystem specs and integration,
OEMs will have to work with those specs and that
integration to ensure the OEMs have the sucient
competencies in place. In addition, OEMs will
have to continue streamlining their supply chains
through restructuring and integration eorts (gure
4). Consolidation is especially needed in the
detailed-parts-supplier segments, and OEMs must
actuate that process.
MRO: Solid growth and a
shuing of competitors
Worldwide, the maintenance, repair, and
operations (MRO) market grew 11% in 2012, from
$50.9 billion to $56.8 billion.
The civil air transport fleet, including regional jets
and turboprops, is currently at about 26,000
aircraft, and that number will grow sharply in the
coming decades: in 15 years, the in-service fleet
will be about twice as large as todays. That
growth will lure new entrants to the MRO field
and realign the competitive landscape, and we
are already seeing evidence of the shuffling. For
example, Goodrich merged with Hamilton in
2012 to form UTAS, a megaplayer in the
component flight-hour-services (FHS) field, with a
strong intellectual property position on several
new platforms like the Boeing 787. In other shifts,
the US market saw several bankruptcies, and the
component MRO business of Aveos was taken
over by A J Walter Aviation.
We expect that airlines will continue to outsource
their maintenance segments in greater volume,
such as Finnairs deal with SR Technics, and
Americans outsourcing of its 757 and wide-body
maintenance.
More broadly, aircraf OEMs are extending their
reach into the MRO business. Airbus FHS and
Boeing Edge could become major players in the
segment in the next three to ve years. The two
companies can build on their unique access to
airlines and can challenge component OEMs such
as cabin equipment manufacturers by implementing
major new programs and platforms.

Another trend affecting the MRO business is that
next-generation aircraft and engines simply
require less maintenance. For example, the
Boeing 787 requires C and D checks at half the
frequency of the 767. And profits remain elusive:
only a few premium players can reach an EBIT
margin of 10%.
In sum, there is a clear growth opportunity in the
MRO segment, but to win, operators will have to
navigate a dynamic market. Key requirements will
be access to capital, willingness to invest long term,
and a footprint with operations close to the eet of
tomorrow, including strong coverage in Asia.
Thriving in an unstable market
The compounding effects of the growing markets
in Asia and the Middle East, rapidly evolving
technologies, and fiscal strains on mature markets
in Europe and the United States will likely lead to
instability for the A&D industry over the coming
years. Successful companies in the industry will
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focus on several priorities. First, profitability is an
ongoing challenge, and companies must
redouble their efforts to reduce costs. Those that
can achieve more-efficient operations and greater
EBIT margins can give themselves the head room
to pursue future opportunitiesand endure
future downturns.
Second, companies should accelerate their
diversification into new and faster-growth
markets. This entails more than a mere
geographic changewith the inherent supply
chain challengesand involves the tailoring of
products and services for customer segments
with varying priorities and requirements.
Last, innovation is a major theme across all
segments. The ability to identify and anticipate
demand for new products and servicesoften
driven by new technologieswill be a clear
differentiator in A&D companies.
These are sizable challenges, yet they also point
to clear opportunities. A&D operators that can
get these three areas right can give themselves a
clear, competitive edge in a volatile industry.
FOR MORE INFORMATION, PLEASE CONTACT:
Eric Bernardini
Managing Director
ebernardini@alixpartners.com
+44 20 7098 7492
David Fitzpatrick
Managing Director
dfitzpatrick@alixpartners.com
+1 (415) 848-0307
ABOUT ALIXPARTNERS
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To learn more about our publications, please visit www.alixpartners.com/en/whatwethink.aspx.
AlixPartners, LLP is a global business advisory firm offering comprehensive services in four
major areas: enterprise improvement, turnaround and restructuring, financial advisory services,
and information management services. The firm was founded in 1981 and can be found on the
Web at www.alixpartners.com.