POINT OF VIEW THE EUROPEAN A&D INDUSTRY. Leaning against de-industrialization trend. Clouds in the sky bring new challenges.

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1 POINT OF VIEW THE EUROPEAN A&D INDUSTRY Leaning against de-industrialization trend. Clouds in the sky bring new challenges. NOVEMBER 2014

2 The success of Airbus Group, Safran, Zodiac or Rolls Royce enabled the aerospace and defense industry to enjoy a continuous growth of 4.8% p.a. up to c. 158 Bn revenues, leaning against the de-industrialization trend in Europe. However, despite its strong growth, the European A&D industry is not immune to challenges faced by industry in general: decline in profitability, rise of new competitors and an insufficient level of investments. Building on its success, it must address the evolution of its industrial model and investment effort, while European Governments have a bigger role to play in bolstering A&D integration. Roland Berger A&D team p. 7 2

3 The A&D industry is one of the few sectors where Europe has performed in line with the World's industrial trend The European industry has been losing ground for two decades. It now accounts for 15% of European value added. Except for Germany and part of Eastern Europe, EU states live a daily de-industrialization, partly linked to insufficient productivity gains. Factories close down and companies even those with local roots prefer to invest overseas. French, British or Spanish industries have seen their market share shrink drastically since The growth in Germany hardly compensates the decline elsewhere; the overall European manufacturing industry has underperformed worldwide growth by 2.4 pts p.a. (+1.6% vs +4.0% p.a.) over A Aerospace and Defense is an island of success among this depressing landscape in terms of both sales and value added. Since 2000, growth of A&D value added has outpaced the European manufacturing sector by 36 pts (+47% vs. +11%), while global A&D value added growth was closer to the global manufacturing value added growth (+57% vs. +37%). This strong performance of the A&D industry is undoubtedly a European success story. An early exposure to the fast growing economies of the emerging markets in general and to Asia Pacific in particular has brought a rapid growth to the commercial aircraft market. 45% of Airbus order book stems from emerging markets (16% in the BRIC, 13% in Middle East, 10% in the rest of Asia). Then, the massive investments, the cutting-edge technologies and the high-skilled workforce specific to this industry have all translated into barriers to entry for competitors. Finally, the A&D industry has secured on-going product innovation: the A350 aircraft, the Leap-X engine, the Storm Shadow missile or the EC225 helicopter are the most recent achievements of this innovative dynamic. A Europe A&D sales vs. Europe manufacturing sales [rebased; 2000=100] Manufacturing Aerospace CAGR Source: IHS Global Insight, Roland Berger analysis Global A&D sales vs. global manufacturing sales [rebased; 2000=100] % % % +4.7%

4 B German A&D vs. German manufacturing value added [rebased; 2000=100] French A&D vs. French manufacturing value added [rebased; 2000=100] UK A&D vs. UK manufacturing value added [rebased; 2000=100] % -0.8% -2.2% % +3.0% +2.4% Manufacturing Aerospace CAGR Source: IHS Global Insight, Roland Berger analysis Yet, these drivers also apply to other manufacturing segments such as Automotive or Consumer Electronics, albeit with less success. There is an additional factor: the A&D industry is, above all, one of the finest illustrations of what cooperation at the European level can achieve and is testimony to the importance of European A&D integration. The A&D cluster built through trans-national company mergers and launch of large projects at European level was instrumental in energizing and ensuring consistency across the industry. Indeed, the full value chain is mastered in Europe with in-house technologies and systems today. One only needs to consider the half-success of the mid-size firms to realize how Europe-wide support enabled the European A&D industry to match the North America leadership. Airbus is, of course, the flagship of this European A&D cluster. This success in A&D has pushed governments and other industries to also consider integration, as showed by the recent Nexter / KMW announcement project in the land of defense systems. Not least because of the repeated difficulties and risks of stand-alone national A&D projects. By ensuring the strength of the A&D industry, the European cluster has driven value added and job creation while mitigating not to say ignoring - de-industrialization. In 10 years, the key countries in the European A&D industry, Germany, France and the UK, gained market shares and added value in Europe, as the growth of their combined sales reached 5.2% per year. Germany, France and the UK have all seen a sharp outperformance of their A&D sectors compared to their national manufacturing sectors in value added. The European A&D industry has thus been a driving force in value added generation and a mitigating factor of deindustrialization, notably for France and the UK which are experiencing a significant drop in manufacturing value added. OEMs were able to resist the market pressure and to keep the bulk of their manufacturing facilities in Western Europe despite its high labor cost. For example, Airbus has no more than 10% of the A320 assembly volume in China, and most of its tier-1s are Western Europe too. Helicopters assembly is by and large in France, Germany and Italy. B 4

5 However, the European A&D industry now faces challenges similar to those other manufacturing businesses have been experiencing for a decade The European industry suffers from a long-lasting drop in profitability. Average European A&D EBITDA margin stands at 5.5% compared to 8.5% over This erosion is specific to the European A&D industry: average global A&D EBITDA margin is 12.2% over , almost the same as Of course it can be partly explained by mechanical euro-dollar parity, or the business program cyclicality but there are deeper root causes such as the low level of government funded defense R&D or the difficulties met on key programs (A380, A400M etc.). Analyzing the evolution of added value yields the same conclusion: Europe underperformed by a wide margin (3.0% p.a. vs. 3.5% p.a.) the global A&D industry. These insufficient financial results trigger a spiral of decline: companies are forced into cutting their investments. The European A&D has scaled back its investment efforts while competitors did not. Over , Europe invested an average of 5.6% of its sales vs. 6.2% over In the US, still over , figures reach an average of 6.0% - not to mention 23.8% in China. C These signals are all the more worrying that the A&D industry will face in the medium term a new competition, especially from non-western players with a potential cost advantage, such as Brazil, India, China. C CHANGE IN AVERAGE AERO EBITDA MARGINS & INVESTMENTS AS % OF SALES [ ; ; %] -3.0 pts -0.6 pts +0.2 pts pts +1.3 pts -2.1 pts -2.1 pts -1.0 pts -8.7 pts pts European Aero Global Aero Germany France UK Average EBITDA margin Average Investements as % of sales Source: IHS Global Insight, Roland Berger analysis 5

6 To overcome current challenges, the European A&D industry must address the evolution of its industrial model and investment effort, while European Governments have a bigger role to play in bolstering A&D integration The European A&D industry faces tough challenges, both external - coping with external economic context, beating emerging competition, or coping with budget cuts (especially in the defense sector) and internal challenges, such as achieving ramp-up (production and supply chain), protecting or increasing profitability and cash, or becoming greener. These challenges give the European A&D industry an opportunity to step up its industrial model. More specifically, the industry could be a frontrunner in moving to an "Industry 4.0 ecosystem": advanced manufacturing systems, additive manufacturing, robotization and fully integrated supply chain solutions could enable to achieve a disruptive industrial transformation towards a highly flexible and efficient production model. This fast adoption would be a competitive lever against traditional competitors. Early signs of this shift can already be observed: Rolls Royce gears up the use of 3D printing to manufacture jet engine parts with long lead times. The European A&D industry also needs to step up its investment efforts: closing the competitiveness gap with emerging countries and starting the shift towards the Industry 4.0 ecosystem will require a high investment effort. The current trend of lower investments compared to main competitors cannot sustain Europe's market share in the global A&D market, as it puts the A&D industry competitiveness and capacity to innovate at risk. European Governments (via the European Union or not) have a bigger role to play in bolstering the European A&D industry cluster: a deeper integration of European public investments could be implemented by pooling existing resources dedicated to A&D investments. Furthermore, new EU collaborative A&D projects such as Galileo and Copernicus would provide the industry with incentives for reinforcing the A&D cluster. Finally, a European common defense procurement program would help European A&D companies to secure larger defense contracts and drive their European integration. The A&D industry is undoubtedly a European success story, leaning against the deindustrialization trend Europe has been experiencing for years. It is the sector where Europe has taken its fair share in the world's global industrial growth. This is why, in order to rise up to challenges coming ahead, the European A&D industry needs more than ever to set up a common vision and joint efforts, to capture upcoming opportunities in a globalized world. 6

7 TEAM ROLAND BERGER DEDICATED AEROSPACE & DEFENSE TEAM Massi Begous Laurent Benarousse Max Blanchet Roberto Crapelli Daniel Feldmann Principal Rahul Gangal Principal François Guénard Principal Manfred Hader Stephan Keese Serge Lhoste Maria Mikhaylenko Robert Thomson Joerg Wahler Principal Qi Wu 7

8 Publisher ROLAND BERGER STRATEGY CONSULTANTS GMBH Mies-van-der-Rohe-Str Munich Germany This publication has been prepared for general guidance only. The reader should not act according to any information provided in this publication without receiving specific professional advice. Roland Berger Strategy Consultants GmbH shall not be liable for any damages resulting from any use of the information contained in the publication GMBH. ALL RIGHTS RESERVED.