Despite showing surprising resilience in a recession that affected commercial and military aviation suppliers alike, the aerospace and defence industry is now confronting a post-recession environment likely to be characterised by prolonged anaemic demand, lingering overcapacity, a shrinking defence budget and further consolidation. A quick turnaround is unlikely as industry still faces huge challenges.
The AlixPartners 2010 Global Aerospace & Defence Review finds that it may take years for the industry to work through the effects, both direct and indirect, of the past recession. Although original equipment manufacturers and suppliers performed surprisingly well in 2009, these companies should not expect the same conditions to continue.
The study, in fact, highlights major headwinds:
• Aircraft deliveries down 9% globally in the first quarter of 2010, while aircraft orders, which dropped 70% in 2009, have only partially recovered.
• Passenger traffic down 7.5% globally year-over-year through April, with cargo traffic down 22%, over the same period. Although passenger traffic recovered pre-recession levels in May 2010 (+11.7%), airlines only posted a 0.5% margin, a long way from sustainable profitability.
• All signs pointing to big defence spending cuts ahead, as both the Pentagon and defence ministries around the world face the fallout from the recent financial crisis and sputtering local economies. Continued weak business jet demand, due to still-fragile corporate profits and their politically incorrect image forged during the auto-bailout hearings of 2009.
• Consumer disposable income further cut by government deficit reduction efforts, recently reinforced during the G-20 meetings, hampering the economic recovery.
“The strong five year cycle of growth that we have seen in the aerospace and defence industry came to an end in 2009 and faces a turbulent ride going forward,” said Eric Bernardini, managing director of AlixPartners and co-leader of the firm's global Aerospace & Defence Practice. “The industry made it through 2009 remarkably well compared to most other industries, because the major players reacted quickly to cut production capacity. Also, of course, US defence spending continued to be strong in 2009 and so far in 2010, largely due to supplemental spending authorisations for the wars in Iraq and Afghanistan. However, because of the financial crisis and our lingering fragile economy, pressures on defence budgets will be intense going forward, which should prompt primes and non-primes alike to move now to optimize their cost structures. The commercial sector faces an economy that's uncertain, and any recovery for the industry will be slow over the next two years.”
Thierry Duvette, director at AlixPartners took up the same theme: “Business jets face the same environment with high inventory levels and large product offering while still trying to remove the ‘politically incorrect' image of private jets. On the military side, the Pentagon, as well as European governments, are actively looking to trim costs at every turn with significant budget cuts being made. The ongoing debt crisis in Europe is yet another overhang that is likely to keep a lid on aviation demand, while also making credit more costly for airlines and business jet buyers.”
Industry wide EBIT margins have dropped by 13% since 2007 especially affecting OEMs. The study shows that their profitability is lagging more than 30% behind that of suppliers, mainly due to major programme development delays. In 2009, the most value growing OEMs were American-based companies, mostly due to their access to US Defence programmes. Their European counterparts fared less well, severely penalised by major delays and overruns on highly complex European programmes.
For suppliers, it was the large companies who delivered a better performance, with an increase of 30% in profitability over the past 12 months, especially in the USA.
“For the first time in years, suppliers have been gaining the upper hand in their dealings with the OEMs,” said Bernardini. “Given the pervasiveness of risk-reward cost sharing contracts today, the aircraft programme delays have led to additional financial pressure on aircraft manufacturers. As a result, the industry must immediately begin to refocus on collaborative cost reduction, more aggressive design to cost and program management to eliminate waste and inefficiencies in their supply chains.”
In terms of improving competitiveness, the study singles out a number of areas in which the industry still lags many other manufacturing industries, including disciplined programme management, value chain optimisation, ‘lean' engineering and risk-sharing supplier management. Duvette commented: “The industry is entering a period where budget limitations and cost management are key. Companies in the defence and commercial sectors that adopt new strategies to meet these new challenges will be the winners.”
On the programme management front, AlixPartners finds that true design-to-cost practices are still not mature enough in the aerospace industry, that the number of recurring cost overruns is as high as non-recurring cost overruns today. It also finds that while many companies have partially adopted the principles of lean engineering, there is much slippage when those principles are actually put into action in programmes.
Given today's competitive environment, the cycle time for new product development needs to be cut by 40% or more. That means OEMs need to accelerate their collaborative approach. For their part, suppliers need to be open to more cost and innovation sharing in exchange for bigger pieces of new programs and earlier involvement in those programmes. In the process, everybody should be working toward the overarching goal of being competitive in what looks like a different environment going forward.
Although company valuations have recovered of late, according to the study, there are a growing number of M&A opportunities, particularly in sector consolidations. Specifically, the study points to the aerostructures, electrical-systems and non-engine MRO areas as being the most ripe for consolidation, as the top five players control just 40%, 40% and 27% of those sectors, respectively, compared with the typical 60% to 95% seen in other segments.
The push for lower fuel consumption and a smaller carbon footprint will also spur M&A activity. Technology development of new propulsion systems, electronic systems, and exotic metal matrix composites will be strategic, so the OEMs and tier one suppliers will be looking for acquisitions in these areas.
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