Aerospace & defense 2012 year in review and 2013 forecast

Transcription

1 Aerospace & defense 2012 year in review and 2013 forecast How are aerospace and defense companies performing today? What challenges and opportunities do they face? PwC takes a look.

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3 Contents Aerospace and defense year in review 1 Commercial aerospace 7 Defense 15 Trends 20 Mergers and acquisitions 31 In summary 33 Top 100 list 34

4 Methodology Our analysis is based on the fiscal 2012 data for the largest 100 aerospace and defense (A&D) companies, by revenue, with publicly available financial reports. Our cut-off date for publication was April 25, Consequently, several companies were not included because they had not reported results by the announced deadline. A&D companies include those that generate the majority of their revenue from aerospace and defense activities or, for diversified companies, those reportable segments that derive a majority of revenue from aerospace and defense activities. The results are reported in US dollars. Foreign currencies are translated at average exchange rates for the years ending December 31, 2012 and December 31, 2011, respectively. Our report also offers PwC s point of view on topics affecting the industry. Our viewpoints have been developed based on our interactions with our clients and other industry leaders and analysts.

5 Summary table (US $ billions) Change Revenue $695 $666 4% Operating profit $59.8 $58.4 2% Operating margin 8.60% 8.77% -17bps Source: PwC analysis Aerospace and defense industry delivers a third consecutive year of record revenues and profits The aerospace and defense industry reported its best year ever in 2012, in terms of revenue and profit. The uptick came on the strength of a surging commercial aviation market that more than offset a soft defense performance. For 2012, the top 100 A&D companies reported a recordsetting $695 billion in revenue and $59.8 billion in operating profit. Revenue was up 4 percent compared with 2011, while operating profit was up 2% over Operating margin decreased 17 basis points to 8.60 percent. We report only full fiscal year results, so these statistics slightly understate the strength of commercial aviation earnings as a result of the acquisitions of Goodrich and Avio. The Goodrich deal closed at midyear, so United Technologies Corporation (UTC) picked up about half of Goodrich s annual revenue, meaning that the year over year statistics do not take into account more than $4 billion of revenue from Goodrich. Similarly, Avio was acquired by GE Aviation at the end of the year, so the year over year statistics do not include about $3 billion of revenue related to Avio. While these types of anomalies occur every year, they were particularly pronounced in Commercial aerospace companies continue to be optimistic about the future. Air traffic is robust and steady, driving the lucrative aftermarket business. The industry increased large commercial aircraft output by 18 percent in 2012 to a new record, and captured more A&D 2012 year in review and 2013 forecast 1

6 Aerospace and defense industry delivers a third consecutive year of record revenues and profits than 2,000 large aircraft orders for the second consecutive year and the third time in history. As a result, there s a record backlog more than seven years at current production rates. And the industry is anticipating another record output in In the wake of modest revenue declines reported for 2012, defense companies face an uncertain Despite efforts by the industry and others, sequestration went into effect on March 1, Companies now are bracing for the consequences and waiting for details regarding the impact on specific programs. Defense companies face more pressure than ever to improve productivity, increase transparency, and respond to increasingly complex government regulations and oversight. There are also significant challenges associated with tighter schedules, and generally higher expectations. Persistent security threats, the Iranian and North Korean nuclear threats, and geopolitical instability underscore the need for increased global security and could rapidly affect defense priorities. For more than a decade, the industry has enjoyed steady growth in defense spending and, simultaneously, the longest up cycle in commercial aviation history. The industry, having well managed the growth and achieving record results, now must effectively weather the down cycle. Despite efforts by the industry and others, sequestration went into effect on March 1, Companies now are bracing for the consequences and waiting for details regarding the impact on specific programs. Defense companies face more pressure than ever to improve productivity, increase transparency, and respond to increasingly complex government regulations and oversight. 2 PwC

7 Aerospace and defense industry delivers a third consecutive year of record revenues and profits Some highlights from our analysis of 2012 results Largest increase in revenue (dollars) Boeing $12,963 M Largest increase in revenue (percentage) AVIC Aircraft Company 82% Largest increase in operating profit (dollars) Finmeccanica $2,731 M Largest increase in profit (percentage) Dyncorp 700% Highest operating margin Transdigm 41.2% Largest increase in top 100 list AVIC Aircraft Company +19 to 51 Largest decrease in revenue (dollars) BAE Systems -$2,482 M Largest decrease in revenue (percentage) ThyssenKrupp Marine -27% Largest decrease in profit (dollars) General Dynamics -$2,993 M Largest decrease in profit (percentage) Engility -458% Largest decrease in top 100 list ThyssenKrupp -12 to 68 Deleted from the 2011 list Goodrich Avio Barnes Group Loral Space & Communications Titanium Metals Volvo Aero Indra Security & Defense Acquired by United Technologies Acquired by GE Aviation Segment reporting change Acquired by MacDonald Detwiler Acquired by Precision Castparts Acquired by GKN 16% decline in revenue Added to the 2012 list #66 Engility Spun off from L-3 Communications #72 Korea Aerospace Did not make reported date cutoff in 2011 #77 Cytec Engineered Materials and Umeco Business combination #80 Kratos Defense Acquisitions #92 Nabtesco Aircraft and Hydraulic Equipment #93 Wesco Aircraft Holdings #99 Sumitomo Precision Products Source: PwC analysis A&D 2012 year in review and 2013 forecast 3

8 Aerospace and defense industry delivers a third consecutive year of record revenues and profits The amount of revenue that Boeing added in 2012 would be equivalent to the 15th largest A&D company. Another year of record deliveries and backlog for commercial aerospace Boeing again was the industry s largest company, with $81.2 billion in revenue, a 19 percent increase, on the strength of commercial aircraft deliveries. Boeing reported the largest revenue growth, $ billion. In fact, the amount of revenue that Boeing added in 2012 would be equivalent to the 15th largest A&D company. EADS increased revenue by 15 percent, from 49.1 billion to 56.5 billion (6% when translated into US dollars). Predominantly commercial aerospace companies generally reported strong revenue growth. United Technologies, GE Aviation, and Honeywell Aerospace all reported growth between 5 percent and 8 percent, thanks in part to acquisitions. Precision Castparts, Spirit, Babcock, Triumph, and BE Aerospace, among others, reported double-digit growth. AVIC Aircraft Company reported the largest revenue percentage increase 82 percent. AVIC also made the largest jump on the list, advancing 19 places to #51. BAE Systems reported the largest revenue decline but improved operating income through a 100 basis point increase in operating margin, the largest of any defense contractor. Boeing was also the industry s most profitable company, with $6.311 billion in operating profit, an increase of 8 percent. Finmeccanica reported the largest profit increase $2.7 billion due to the absence of large program charges recognized in Companies with operating margin > 20% #19 Precision Castparts 25.1% #46 Hindustan Aeronautics Limited 23.7% #49 Meggitt 24.5% #64 Transdigm 41.2% #69 FLIR Systems 21.65% #93 Wesco Aircraft Holdings 20.5% #97 Crane Aerospace & Electronics 22.3% Source: PwC analysis 4 PwC

9 Aerospace and defense industry delivers a third consecutive year of record revenues and profits Industry operating margin decreased 17 basis points to 8.60 percent. Despite the record results, the industry as a whole continues to be eluded by double-digit operating margins. The industry s best operating margin belongs to Transdigm, at 41.2 percent, up slightly from 40.4 percent the previous year. Globalization The A&D industry is becoming increasingly globalized. Companies are reporting more foreign direct investment, with the rate more than tripling from a decade ago. For investments in manufacturing, China and India have been the top targets. The United States is third, on the strength of its market size and capabilities. Fourth on the list is Mexico, which has developed an aerospace manufacturing niche. India was the top target for R&D investments, while China came in seventh, presumably because of concerns over intellectual property protection. The United States was the second most popular target for aerospace and defense R&D investments. Investments by top 50 global A&D companies in international markets R&D Manufacturing Source: Company reports A&D 2012 year in review and 2013 forecast 5

10 Aerospace and defense industry delivers a third consecutive year of record revenues and profits 2013 forecast and risks The A&D industry has reported its third consecutive year of record revenue and profit, as the growth in commercial aviation more than offset a soft defense market and multi-billion dollar impairment charges at large defense contractors. The principal risks related to 2013 performance are familiar, and sequestration is certain to have a negative impact on defense industry revenue and profit. Given the significant uncertainty in the US defense market, it is difficult to predict what s ahead for Commercial aerospace growth is expected to slow to a rate of between 4 percent and 5 percent, which is approximately the percentage defense revenue is expected to decline. As a result, industry revenue is expected to be flat in However, operating profit could set new records, if the industry avoids the large impairment charges of recent years. While there is a risk of some impairments resulting from the decline in US defense spending, the magnitude of those charges is likely to be less than in recent years. The growth in commercial aerospace should approximately offset declines in defense spending. Accordingly, operating profit performance is expected to be flat, with the potential for improvement in the absence of large impairment charges. While there is a risk of some impairments resulting from the decline in US defense spending, the magnitude of those charges is likely to be less than in recent years. 6 PwC

11 Commercial aerospace In 2011, the industry set a record, for the first time delivering more than 1,000 large aircraft; in 2012, the industry beat the previous year s record output by 18 percent, delivering 1,189 aircraft. Boeing delivered 601 aircraft in 2012, the second best in its history and close to its record of 620 deliveries in In 1999, Airbus recorded 294 deliveries, less than half of Boeing s tally the same year. In 2012, Airbus delivered 588 aircraft, exactly double its output of 1999, its eleventh consecutive year of record production. It was the first time Boeing delivered more aircraft than Airbus since was also the third best year for orders. Orders exceeded expectations, surpassing the 2,000 mark for the second consecutive year and for only the third time in history. The industry book-to-bill was 1.7:1, pushing backlog to another record of more than 9,000 aircraft, or approximately seven-and-a-half years at current production levels. In 2012, Boeing aircraft programs achieved several milestones. The company booked 1,124 orders for the 737, the most for any Boeing model in a single year, bringing cumulative program orders above the 10,000 mark. In addition, Boeing exceeded 1,000 cumulative orders for the 737 MAX, approximately 18 months after launch. Those orders included Boeing s largest order ever: s for Lion Air. The 777 also achieved a program milestone, exceeding 1,000 deliveries since inception. A&D 2012 year in review and 2013 forecast 7

12 Commercial aerospace Boeing s backlog is at a record $319 billion, and Airbus backlog is at $638 billion (at list price). Backlog (US $ billions) 12/31/12 12/31/11 12/31/10 12/31/09 Boeing $319 $293 $256 $250 Airbus* $638 $679 $480 $459 *At list price Aircraft backlog (units) Boeing Airbus Total Backlog at December 31, ,771 4,437 8,208 Net orders 1, ,036 Deliveries ,189 Backlog at December 31, ,373 4,682 9,055 Source: Boeing annual report; Airbus annual report For 2012, the International Air Transportation Association (IATA) reported revenue passenger growth of 5.3%, a level of demand boding well for the 20-year forecast of approximately 34,000 new planes at a value of $4.5 trillion. IATA statistics Revenue passenger miles 5.30% 5.90% 8.20% Load 79.10% 78.10% 78.40% Cargo freight ton miles -1.50% -0.70% 20.60% Load 45.20% 45.90% 53.80% Source: IATA 8 PwC

13 Commercial aerospace Order activity continued to be driven in large part by the new single-aisle aircraft, 737MAX and A320neo. Both offerings are re-engined versions of the existing models, offering at least a 15 percent improvement in fuel efficiency. To put this in perspective, aircraft engines have achieved a 49 percent fuel efficiency improvement in more than five decades of the jet era, or about 1 percentage point annually. Consequently, a 15 percent improvement in one generation constitutes a significant advance in fuel efficiency. Some larger orders from 2012, with approximate value Lion Air, MAXs and ERs Norwegian, 222 narrow-body split between Boeing and Airbus United, MAXs and -900s Pegasus, 100 A320neos GECAS, MAXs and -800s Air Lease, MAXs $22 billion $22 billion $15 billion not disclosed $7 billion $7 billion To put this in perspective, aircraft engines have achieved a 49 percent fuel efficiency improvement in more than five decades of the jet era, or about 1 percentage point annually. Consequently, a 15 percent improvement in one generation constitutes a significant advance in fuel efficiency. A&D 2012 year in review and 2013 forecast 9

14 Commercial aerospace Regional aircraft Mitsubishi reported its largest order yet for the MRJ in 2012 from SkyWest, which ordered 100 firm and 100 options of the jet. That more than doubled Mitsubishi s backlog to 165 aircraft, pulling ahead of Bombardier, which has received 148 orders for C-Series. Embraer will formally launch its secondgeneration E-Jets during Among the improvements will be Pratt & Whitney PW1700G and PW 1900G geared turbo fan engines, fly-by-wire, and new wings. In a complete turnabout in the regional engine market, Pratt & Whitney, once absent from the regional jet space, now dominates new production platforms, with engines on the Bombardier C-Series and Mitsubishi MRJ, and its recent selection for Embraer s second-generation E-Jets. Business jets Business jet deliveries and cycles experienced a flat year and remain more than 10% below the prerecession peak. Business jet cycles are roughly the same as a decade ago. Business jet growth looks favorable for the long term, with strong growth in the international markets, as well as improvement in the United States, driven by an improving economy and growing demand for replacement aircraft. During 2012 the number of business jets in China increased 40% to 336. Long-term estimates exceed 2,000, according to the Aviation Week Intelligence Network. Aviation deliveries Global business jet deliveries Global turboprop deliveries Global piston aircraft deliveries Source: General Aviation Manufacturers Association 10 PwC

15 Commercial aerospace All graphs represent business jet data Industry orders and deliveries Units, ,800 1,600 1,400 1,200 1, , Total orders Total deliveries Sources: Actual deliveries from GAMA. Orders estimated from competitive intelligence, OEM guidance. Excludes Very Light Jet and Large corporate airliners segments. Seasonally adjusted business jet monthly cycles 250, , , ,000 50, Source: FAA and UBS estimates A&D 2012 year in review and 2013 forecast 11

16 Commercial aerospace Commercial aerospace 2013 forecast For 2013, Boeing is forecasting between 635 and 645 deliveries, a 6 percent to 7 percent increase, and Airbus is expected to achieve another year of record deliveries of 600 to 610 units, a 2 percent to 4 percent increase. While these growth rates are more modest than the 18 percent growth in original equipment manufacturer (OEM) deliveries in 2012, the industry continues to establish new records for output. These record output levels create considerable strain on an industry that arguably has the most complex supply chain and the one with the longest lead time. The challenge will be to avoid previous supply chain issues while increasing production rates. The industry previously has faced raw materials shortages, late deliveries, out-of-sequence work, overtime, and rush shipments throughout the supply chain, all of which erode the economic benefits of higher volume from dropping to the bottom line. The industry will face these challenges in 2013, and in the longer term, as capacity constraints bump up against record backlogs. OEMs and suppliers are encouraged to perform thorough supplier capacity and readiness assessments. While it is difficult to predict orders, it is unlikely that orders will maintain the manic pace of 2011 and However, 2013 is already off to a strong start. In the first quarter of 2013, Airbus booked 431 orders and Boeing recorded 220 orders, a combined rate of 2,600 orders annually. Lion has ordered 234 A320s, Ryan Air ordered s, Lufthansa ordered 100 A320s, and Turkish Airlines has ordered 82 A320s. We do not expect this pace to continue or for orders to exceed 2,000 for the third straight year. But we certainly expect orders to exceed the approximately 1,250 deliveries predicted for 2013, pushing backlog to another new high by the end of PwC

17 Commercial aerospace For the past three decades, leased and financed aircraft have steadily grown to represent about half of the commercial airline fleet, and leasing companies have about 16 percent of the current backlog, a historic high. Aircraft lessors will become even more important as their more stable business models, diversified portfolios, and comparatively higher grade ratings ease their access to capital markets. Economic risks include the potential for slowing global growth, resulting in part from government spending declines. In addition, the European sovereign debt crisis has the potential to disrupt aviation financing markets. However, any disruption may be mitigated through increases in private financing. As we discussed in our recent report, Aviation Finance: Fasten your Seatbelts, as global risks are re-priced, the competition to obtain financing for aircraft may intensify, and the cost of financing may rise. We expect the industry as a whole to be able to attract funding, but new sources of finance will need to be tapped. Export Credit Agency (ECA) financing, traditionally a backstop, has become the funding source of choice for many airlines. However, the new Aircraft Sector Understanding (ASU), which governs pricing of ECA financing, will go into effect in 2013, resulting in considerable premium increases for this financing stream. Overall, modest growth in commercial aerospace is expected for Space Space-related initiatives are expected to increase significantly in SpaceX will continue its cargo missions to the International Space Station (ISS) and Orbital Sciences is scheduled for its first berthing with the ISS under the Commercial Orbital Transportation Services (COTS) program. In addition, research and development continues under the Commercial Crew Development (CCDev) program. Boeing, SpaceX, United Launch Alliance, and Sierra Nevada are among the companies receiving NASA funding for CCDev. The impact of sequestration on these and other space programs remains to be seen. Long-term forecast The long-term forecast for commercial OEM aircraft is about 34,000 deliveries valued at about $4.5 trillion over the next 20 years. While some observers have questioned whether these forecasts are overly optimistic, they are nevertheless based on well-founded assumptions about global economic growth and the rate of aircraft replacement. In fact, the significant improvements in efficiency for new aircraft may accelerate the demand for replacement aircraft. With long-term demand at more than 1,500 aircraft per year and current production rates at about 1,200 per year, the industry can look to future growth and a lot of cushion between forecasted demand and current production to absorb any softening in demand. Perhaps a key competitive advantage will go to the company that can effectively raise production rates fastest to shorten delivery times. At the same time, new competitors are trying to take advantage of the growing market. Commercial Aircraft Corporation of China (COMAC) has launched its C919 aircraft. COMAC is projecting to sell more than 2,000 planes, capturing about 7 percent of market share. In addition, Irkut of Russia has launched a narrow-body aircraft, and Bombardier is marketing its CSeries. Embraer is expected to launch its next-generation E-Jet in 2013, but it has not announced any plans to compete in the narrowbody market. A&D 2012 year in review and 2013 forecast 13

18 Commercial aerospace The business jet rebound remains elusive and slower than was expected at the beginning of the year. Companies are reporting that business jet backlogs have been cut approximately in half since the start of the recession. Growth in business jets The business jet rebound remains elusive and slower than was expected at the beginning of the year. Overall cycles for 2012 were still more than 10 percent below the 2007 peak. Companies are reporting that business jet backlogs have been cut approximately in half since the start of the recession. The recovery in business jets is expected to align with the overall Western economic recovery, which continues to be slow. In addition, residual values for aircraft remain challenged, given the lack of demand, leaving many owners, operators, and their financiers exposed. Therefore, business jets should expect another year of modest improvement. In the medium to long term, business jets should see significant increases, driven by economic growth and adapting regulations in Asia and the Middle East, particularly in China. These longer routes favor the larger segment of the business jet market. 14 PwC

19 Defense Defense contractors brace for sequestration The top dozen global defense companies reported revenue decreases of about 4 percent, and an increase in profits of 2 percent (the profit statistics exclude the results of General Dynamics and Finmeccanica, which reported large impairment charges in 2012 and 2011, respectively). Only 3 of the top 12 companies reported revenue increases, with Boeing up 3 percent, Lockheed Martin up 1 percent and Safran up 7 percent. Revenue at Thales and L-3 was essentially flat. Five of those companies reported increased profits (Lockheed Martin, 10 percent; BAE Systems, 2 percent; Raytheon, 6 percent; Thales, 18 percent; and Safran, 13 percent). Northrop Grumman reported the best operating margin, at 12.4 percent. Four other companies reported double-digit operating margins (Raytheon, 12.2 percent; Safran, 10.5 percent; L-3, 10.3 percent; and UTC- Sikorsky, 10.5 percent). Operating margin for the group was 9.4 percent, an improvement on 30 bps. The best improvements in operating margin were reported by BAE Systems, at 100 bps; Thales, at 90 bps; and Lockheed Martin and Raytheon, at 80 bps. However, some investors are asking whether the margin improvements are sustainable or are a temporary result of cost reduction preceding a revenue decline. Sequestration went into effect on March 1, 2013 and provides for $85 billion in spending cuts in FY13, half from defense. The defense cut represents about 8 percent of the Department of Defense s FY13 base budget request. The DoD is taking actions that include reduction and furlough A&D 2012 year in review and 2013 forecast 15

20 Defense Backlog (US $ billions) 12/31/ /31/2011 EADS Defense $64 $73 Lockheed Martin $82 $81 Finmeccanica $57 $64 BAE Systems $67 $58 Boeing Defense, Space & Security $71 $60 Thales $32 $33 Northrop Grumman $41 $40 General Dynamics (exc. Gulfstream) $36 $40 Raytheon $36 $35 L-3 $11 $10 Total $497 $494 Source: Company reports of civilian staff and cutbacks in base support services. Much uncertainty remains about the impact of sequestration on specific defense programs, but the defense industry should expect a proportionate reduction. During 2012, European defense ministries began responding to the consequences of budgetary reductions by cutting and reprofiling programs and reducing platform numbers. This process is still unfolding, and it is driving significant uncertainty in the supply base as companies struggle to manage both the impact of known reductions and the risk of uncertain future reductions. Initiatives to preserve capability at the same or lower cost have burgeoned in Germany, Sweden, Norway, the UK, and elsewhere. Globally, there is a growing appetite for capability and cost-sharing between nations initiatives that remain at the discussion stage. The NATO Secretary General s Smart Defense initiative seeks to achieve this for the Alliance, and bilateral arrangements such as the Anglo-French Defense and Security Cooperation Treaty encourage collaboration in a range of activity, from military operations to acquisition to asset sharing. NATO s operations in Libya highlighted the importance of having the capability to respond to unexpected events the return to contingency and of a strong blend of European capabilities able to be deployed at short notice. Though the Libyan operation was relatively short-lived, it highlighted significant capability gaps (e.g., in intelligence and surveillance systems) that European nations will find difficult to fill while under the current financial pressures. European defense companies are responding to declines in their traditional markets and are simultaneously pursuing opportunities in growth markets, including the Middle East, Brazil, Turkey, Southeast Asia, and India. The challenges in those regions are strong competition and in-country barriers to entry. Exports The growth of defense export deals has led to a record backlog of $327 billion at mid-year We have in excess of 13,000 active cases with more than 165 countries and institutions, adding up to about $327 billion, said Vice Admiral Bill Landay at a Pentagon news briefing ahead of the Paris Air Show. 1 1 Bloomberg, Gopal Ratnam, Pentagon Has $327 Billion Export Backlog, Sees Drone Demand, June 10, PwC

21 Defense US defense export authorizations spiked at $264 billion in 2011, the most recent year for which data is available. It represents an $84 billion increase, 48%, from 2010, and a 394% increase compared with The export backlog, which was disclosed at $327 billion at mid-year 2011, is now estimated at around $500 billion. The significant growth in defense exports should help soften the impact of US defense cuts. Much of the growth during this period has been in Asia, due to concerns about China s growing military power and tensions between North Korea and South Korea, and in the Middle East, due to concerns about Iran s military ambitions. And the United States is not the only country benefiting. Western European countries, Israel, South Korea, and Russia are all gaining from increased defense exports. On March 7, 2013, the White House sent its export control reform proposals to Congress for approval. The reforms redefine restricted categories on the US Munitions List (USML), with oversight responsibility for some categories moving from the State Department to the Commerce Department. These reforms, which have been supported by industry, are designed to simplify and streamline the export process and may lead to further increases in export authorizations. US foreign military sales (FMS) agreements and direct commercial sales authorizations 2,3 USD Billions Foreign military sales (FMS) agreements Direct commercial sales authorizations 2 US Department of Defense, Fiscal Year Series, Fiscal%20Year%20Series%20-%2030%20September% pdf, Sept. 30, US Department of State, Section 655 Annual Military Assistance Reports, A&D 2012 year in review and 2013 forecast 17

22 Defense Market contraction, coupled with increasing certainty about the nature and amount of defense budget cuts and the impact on specific programs, is also expected to drive significant industry consolidation. Defense forecast Due to sequestration, the initial effects of which will be felt during 2013, our expectation is that defense revenue will decline by about 5 percent, based on our calculation of the defense portion of sequestration for about seven to eight months. But the impact on profits may be mitigated, because as the industry contracts, many of the costs to reduce capacity and restructure or terminate programs will be absorbed by the federal government. The industry drove a slight increase in margins in 2012, despite modest declines in revenue. According to our estimates, the industry will likely hold operating margins flat, before considering potential impairments. As the industry contracts, expectations are that some companies will be susceptible to impairment charges, similar in nature, although not necessarily magnitude, to those reported by General Dynamics and Finmeccanica over the last two years. Market contraction, coupled with increasing certainty about the nature and amount of defense budget cuts and the impact on specific programs, is also expected to drive significant industry consolidation. In recent years, the trend has been toward spin-offs and divestitures. High-profile spin-off transactions have included the Huntington- Ingals split from Northrop Grumman, Exelis from ITT, and Engility from L-3. In 2013, SAIC is scheduled to complete a spin-off to be known as Leidos. The period of spin-offs looks to be nearing its end, to be followed by a period of defense consolidation. The defense industry is already highly concentrated, resulting from consolidation 18 PwC

23 Defense during the post-cold War era. The Defense Department has opposed any further consolidation among major prime contractors, but that position could soften, depending on market conditions. Regardless of whether the major prime contractors consolidate further, expectations are for significant consolidation of the supply base. Contractors may also continue to respond to market conditions in other ways. The current focus remains on affordability, and the Defense Department now lists affordability among its procurement criteria. Contractors should stay focused on improving productivity, as the industry is beginning a period of fewer new platforms. At the same time, there is a need to recapitalize equipment. So the focus will likely shift from new platforms to platform upgrades and sustainment. Electronics and C4ISR, including unmanned aerial vehicles and cybersecurity, will likely be among the areas of growth. Many companies are exploring commercial applications for their technologies. Most defense contractors, and their investors, have approached commercial markets cautiously because of mixed experiences, weighted toward the negative, in the past. Much of that experience, though, is dated; defense contractors have had ample opportunities in their core markets for more than a decade. However, many of the industry s largest commercial markets have their roots in defense and space technologies, such as computers, computer networking, and telecommunications. Going forward, defense contractors are expected to seek commercial applications for their technologies, even if it means licensing or supplying technology to commercial entities. The future of the defense industry is difficult to predict, as developments in North Korea s and Iran s nuclear weapons programs, instability in the Middle East, and other factors could bring rapid changes in defense priorities. During 2013, the European defense markets will likely begin to stabilize as defense ministries address the budget cuts initiated two years ago. Budgetary increases are not expected until 2015, and it may be necessary to pare some defense budgets, specifically procurement budgets, still further if the Eurozone s austerity measures need to be tightened. According to the London Times, the United Kingdom has announced plans to roll out a balanced defense program for the first time in a generation; the program will provide clarity for OEMs after some years of uncertainty. At the same time, accelerated transition in Afghanistan will likely start to manifest itself in rationalizing in-theater equipment and logistic support and an increase in logistic movement as military materiel is redeployed. As a result, the next few years will likely bring an acceleration of equipment refurbishment, although the extent and its effect on the industry has yet to be quantified. European nations will likely continue various transformation programs aimed at preserving capability at lower cost and will import many of the ideas and concepts pioneered in the United Kingdom a few years ago; expectations also are for an increase in availability contracting for land, sea, and air platforms, plus an increasing appetite for industryled solutions in the provision of training, infrastructure, and backoffice shared services. Programs for industry will likely take on more complex and broader roles, and the United Kingdom s Advanced Materials strategy may prove to be a pioneering approach. The drive for exports will also likely continue and remain fiercely competitive as the global defense industry competes in growth markets. So while the traditional, platform, and equipment-based defense markets in Europe remain under intense pressure, opportunities exist for industry to more broadly deliver service-based capabilities in many countries. In the United Kingdom, the whole of the defense support services market is projected to be worth an estimated 16 billion per year by 2020, or approximately 75 percent of total MoD spend with industry; these trends will accelerate in Europe. (PwC assessment based on public domain sources, 2012.) A&D 2012 year in review and 2013 forecast 19

24 Trends Eight trends to watch in A&D for 2013 and beyond 1 Strategy While strategy is continually evolving, the pace of significant strategic decision making is expected to accelerate due to a rapidly changing environment, particularly in defense. With the advent of significant reductions in US defense spending, companies will likely make strategic decisions regarding prioritization of markets and technologies. Going forward, defense spending is expected to emphasize: Lifetime affordability Fewer new platforms Upgrades and sustainability of existing platforms Command, control, computers, communication, intelligence, surveillance and reconnaissance (C4ISR) Energy and efficiency Many strategic decisions have been made in anticipation of these changes; many actions have been in the form of spin-offs and divestitures. But the market is expected to shift toward industry consolidation as spending cuts take hold. The failed merger between EADS and BAE Systems might be viewed as a harbinger of things to come. Whether the governments involved will allow mergers among any of the major prime contractors may depend on the extent of defense spending cuts. Regardless of whether major primes merge, significant consolidation of the supply chain is expected. 20 PwC

25 Trends In addition, companies are expected to have a greater focus on international markets, in order to help compensate for the decline in US revenues. In recent years, exports have increased significantly. However, companies will increasingly focus on international strategies, which may include a more significant international footprint. These efforts may be aided by export control reforms proposed by the White House. Additionally, companies will likely focus on adjacent technologies and markets. While many organizations are expected to approach commercial markets cautiously, they are expressing greater interest in commercialization of their technologies. 2 Innovation Innovation is another area that is steadily evolving. For many companies, innovation is the single most important success factor, as confirmed by a PwC survey of more than 20 executives from leading A&D companies, who collectively ranked innovation as the highest business priority. Innovation, therefore, is a major risk to be addressed when examining enterprise risk. Yet many companies do not view innovation as a top risk. They are focused on financial and compliance risks, when a failure to innovate may pose the greatest risk. Perhaps innovation is not understood as a risk because companies are more adept at measuring financial and compliance risks, including operational risks that have financial consequences. In comparison, it is much more difficult to evaluate opportunity cost and the effectiveness of research and development and the innovative culture. With reduced government funding for research and development, defense companies look to be making greater investments in independent research and development (IR&D). The challenge for the defense and space industry is to become more commercial in its approach to innovation. Commercial aerospace is enjoying its longest up cycle in history. Not only is demand of the end markets strong, but successful innovations with dramatic improvements to efficiency, reliability, and safety are helping drive the boom. The challenge lies in gaining the resources, both human and economic, to keep up with the accelerating pace of innovation and product development. As one company executive described it, We have more opportunities with good business cases than we can afford. Commercial aerospace and defense companies should gain greater productivity from research and development activities as well as prioritize investments. The solution depends partly on viewing innovation as a business process. To learn more about PwC s perspective on achieving innovation excellence, please visit A&D 2012 year in review and 2013 forecast 21

26 Trends 3 Talent management Demographics The A&D sector continues to face two significant challenges related to talent: steady losses of experienced senior personnel and the need to attract skilled talent. While retirement levels for 2011 remained low, retirement eligibility double-digit in most job categories is growing by one to two percent annually and estimated to reach 18.5 percent in And while attrition rates show small decreases, as well as possible declines among the youngest workers, more than 45 percent of workers under 35 plan to switch employers within the next five years, portending a significant talent drain. With defense spending cuts on the way, expectations are for declines in employment levels. The industry faces a challenge similar to that faced by companies during the post- Cold War era: How can businesses avoid losing the next generation of A&D talent? 4 A skilled work force The number of US graduates within the critical fields of science, technology, engineering, and mathematics (STEM) remains low. Shortages in the pool of scientists and design engineers are particularly pronounced, with demand expected to show continued growth in Furthermore, a majority of industry jobs are in defense and security, where US citizenship is required, further limiting the pool of available talent. According to the Aerospace Industries Association, only 44,000 of the 70,000 engineers that graduate each year in the United States are qualified to work in the aerospace sector, suggesting the need for stronger partnerships between universities and A&D in order to identify the skills required within the industry. A&D companies also face competition from organizations and other industries for the available talent. This trend is mirrored in other developed aerospace nations. The resulting pressure has HR playing an increasingly strategic role in the talent supply chain. Mentoring programs and training initiatives, designed to help retain key knowledge and skills, are growing in popularity. Additionally, succession fosters early identification of top talent, and recruiting partnerships are being developed to deliberately attract talent from universities. Two other areas important to talent management are knowledge capture and organization design. Knowledge management programs are increasingly critical in minimizing the effects of turnover. And firms are paying attention to the organizational design elements that compromise project execution and cross-functional collaboration, which may be particularly important to younger workers. 4 Aviation Week, Carole Rickard Hedden, Aviation Week Workforce Study, Aug. 13, PwC

27 Trends Engineering talent and US citizenship The pinch is also evident abroad. In Europe, for example, only about 10,000 graduates from technical universities choose to work within A&D, while the industry needs at least 12,500 graduates every year. 5 Global/US citizenship The search for qualified talent forces US companies to focus increasingly overseas. And while organizations have historically attracted engineering talent from countries such as India and Russia, several forces have slowed the promise of an international labor pool. The growth of international markets for A&D has resulted in increased competition from countries like China for skilled labor. Another concern is the US government s restrictions on the number of H-1B visas, a special designation letting firms hire temporary high-skilled workers. Additionally, US talent is typically preferred in organizations like the US Defense Department, where security clearance requirements rule out international talent, while laws such as the US International Traffic In Arms Regulations (ITAR) prevent sharing technical data and knowledge with foreign nationals. Still, the foreign labor pool is significant, making immigration reform a major issue for the A&D industry. According to a 2007 study by the Woodrow Wilson School of Public and International Affairs at Princeton, two countries in particular, India and China, with their vast, educated, low-wage workforces, attracted more than 100,000 H-1B visa holders in a single year. Stricter immigration controls may serve to constrict this supply of talented workers. For more information on talent management, please visit us online at The growth of international markets for A&D has resulted in increased competition from countries like China for skilled labor. 5 Aviation Week, Carole Rickard Hedden, Aviation Week Workforce Study, Aug. 13, A&D 2012 year in review and 2013 forecast 23

28 Trends 4 Productivity and affordability The Pentagon has emphasized affordability, including it as a criterion for procurement decisions. Accordingly, defense contractors have strategized to reduce costs and improve productivity. We compared defense companies with companies in the Dow Jones Industrial Average (DJIA) on the basis of revenue per employee, using data from company earnings statements and company profiles. We acknowledge that revenue per employee is an imperfect measure and that a better measure would be value added per employee, but since that data is not available, we have used revenue per employee as a reasonable surrogate. In this comparison, we see that defense contracts are about half as productive as the DJIA. We believe there are some valid reasons why defense companies have lower productivity, including: Limits on profitability Much of defense revenue is under cost-reimbursable, or costbased, fixed-price contracts, with revenues limited based on profit limitations. Defense contractor profitability is typically a little more than half of the DJIA. Development of leading technologies Defense contractors are frequently developing cuttingedge technologies, which are inherently manually intensive and involve some degree of trial and error. Extremely low volumes Many defense contracts are for single units or quantities measured in the dozens or hundreds, compared with commercial enterprises that typically measure volumes in the millions of units. The low volumes result in manually intensive manufacturing and assembly and low absorption of fixed costs in a capital-intensive industry. Regulation The industry is highly regulated, which can increase compliance costs, including compliance with federal acquisition regulations (FAR), cost accounting standards (CAS), and export controls (ITAR). The industry is highly regulated, which can increase compliance costs. 24 PwC

29 Trends Despite these inherent limitations, the industry recognizes there is room for improvement in productivity. Many companies have been taking action to reduce overhead costs, including workforce reductions, early retirements, and facilities consolidation. Direct product costs will likely be more challenging. We believe the following areas offer opportunities: Program management/shortened development cycle Supply chain management Information technology Knowledge management Improving the speed and effectiveness of program development typically produces the biggest gains in affordability. Schedule delays are the biggest factor in budget overruns. While contractors take pride in their program management abilities, the industry should seek continuous improvement, including unbiased, independent assessments and benchmarking. The defense supply chain has become extremely complex. Typically, 50 percent to 80 percent or more of the total value of production is rooted in a technically complex, multi-tier supply chain. Accordingly, any productivity improvement initiative should address suppliers, the most significant component of costs. Defense contractors can no longer accept long lead times and marginal supplier performance as industry norms. The industry should challenge itself to get much closer to just in time delivery. The industry might consider adopting leading-edge risk management practices to regain visibility into the supply chain that has been lost through outsourcing. Information technology represents one of the biggest areas for discretionary spending at most companies, including defense firms. Many A&D companies have invested millions in systems implementations but haven t yet realized the full capabilities and productivity enhancements that these systems enable. Many IT organizations are still spending most of their time in legacy system maintenance and enhancements. Companies should unlock the full capabilities of their IT platforms, become leaner, and migrate the IT organization away from costly maintenance toward strategic initiatives and competitive advantage. Finally, improved knowledge management will likely become more critical. Talent drain, already a factor due to demographics, has been accelerated by early retirements and workforce reductions. Companies should identify the key people and knowledge in their organizations and capture that information using searchable technology tools. Organizations should also create a knowledge management culture that promotes and rewards the effective capture and use of knowledge. A&D 2012 year in review and 2013 forecast 25

30 Trends 5 Supply chain In 2013, two major trends are expected to have a significant impact on the supply chain: Commercial aircraft production rate ramp-up Previously, we discussed the commercial aircraft production rate ramp-up of historic proportions. In 2012, the industry delivered a record 1,189 large commercial aircraft, an 18% increase over the prior year, which was also a record. In the long term, demand is projected to be about 1,700 aircraft annually, meaning that annual production rates may continue to increase by another 40 percent. The current and projected production levels will likely strain a supply chain that can be considered to have the most complex and longest lead time supply chain of any industry. Defense spending reductions For the defense supply chain, the concern is that significant defense spending cuts will drive small suppliers out of business. Some of these suppliers may be sole source or produce unique components. Accordingly, the supply chain could be left with a shortage of critical parts and long lead times to qualify new suppliers. Both commercial aerospace and defense contractors should reevaluate supply chain strategy and evaluate supplier performance risk. To learn more about PwC s perspective on the supply chain, please visit 6 Globalization Globalization is driving the boom in commercial aviation. The Asia- Pacific region is expected to take more aircraft deliveries, in units and value, over the next 20 years than North America and Europe combined. Why? Developing economies, particularly in the BRIC countries (Brazil, Russia, India, and China) are growing faster than developed economies. The economy is becoming more knowledge based, with businesses increasingly relying on the global deployment of human capital, a requirement for operating a twenty-first century business. That new paradigm is driving strong demand for aviation, as well as resiliency for the industry. Aviation once was a hyper-cyclical industry, overreacting to business cycles. Now, that dynamic has fundamentally changed, as demonstrated during the most recent recession. While aviation demand did take an extreme downturn during the 26 PwC