'Tale of Two Cycles' in Aerospace & Defense, According to AlixPartners Study

NEW YORK, June 10, 2013 (GLOBE NEWSWIRE) -- The global aerospace and defense (A &D) industry appears set to continue the drama for the foreseeable future. Some sectors, such as commercial aerospace, are booming, while others, such as defense in most Western countries, are declining. That's according to a new study, released on the eve of the industry's all-important Paris Air Show, from AlixPartners, the global business-advisory firm. Furthermore, says the study, continuous traffic growth is driving an overall industry profit pool increase, and the battle for the profit pool is expected to intensify across the board. AlixPartners concludes that in order to survive and thrive in the current industry cycle companies in the A &D industry must become more efficient, especially in the face of challenging commercial-aircraft ramp-ups, and diversify into new, more promising geographic defense markets.

The AlixPartners Global Aerospace & Defense Industry Outlook, a comprehensive analysis of sector and company financials as well as key industry trends, reveals much about the current state of the A &D industry and its future outlook. The overall industry grew by 6.8% in 2012, and showed improvement over the previous year's sales growth of 5.5%, but fell short of pre-financial-crisis growth levels (e.g., 10% in 2008). Digging deeper, however, the AlixPartners study reveals a mixed bag among sectors, with some clear winners and losers. Driving overall industry growth is commercial aerospace, which has been boosted by new orders and a 5% increase in airline and cargo traffic globally. However, the defense sector slowed significantly in the West, due to budget cuts.

While lower-tier suppliers have traditionally outperformed OEMs, the winds have changed. OEM revenue growth accelerated (from 1.6% in 2011 to 6.7% in 2012), while lower-tier supplier growth slowed (from 10.2% in 2011 to 6.6% in 2012). And, as frequent front-page headlines over the past year have noted, the airline industry has seen further consolidation, and near-consolidations, as it continued its struggle for profits.

"Right now, almost every part of the aerospace and defense business is having another look at costs, searching for efficiencies and struggling to stay ahead of the changing environments in which they do business," said Eric Bernardini, managing director at AlixPartners and head of the firm's global Aerospace & Defense Practice. "With the huge number of changes happening all at once – whether in defense or commercial aviation – identifying and keeping ahead of trends is what will generate long-term success."

Defense – Cutting Costs and Capturing Emerging-Market Growth

The war on cost is heating up in the defense sector as companies are simultaneously chasing fewer revenue opportunities in Western nations and facing stiffer competition for a slice of the addressable emerging-market pie, says the study. Driven by retrenchment in the U.S. and Europe, global defense spending fell in 2012 for the first time since the 1998 spending drop, to $1.7 trillion in 2012. At the same time, the proportion of global spending by China and Russia is increasing, and, according to the study, by 2016 those two countries will make up almost a third (32%) of global spending by the "top 5" spenders (vs. just 17% in 2011).

With China and Russia being largely inaccessible to Western defense companies, this phenomenon is further squeezing the addressable market for Western companies. This will drive intense competition to capture export business in accessible emerging markets, such as Brazil and India, says AlixPartners.

"The rules are rapidly changing in defense," said Dave Fitzpatrick, managing director at AlixPartners and leader of the firm's Aerospace & Defense Practice in North America. "Traditional selling strategies are coming under great pressure and competitions in export markets – particularly for combat aircraft – are increasingly becoming 'winner-takes-all' deals."

Those with more balanced portfolios, such as lower-tier suppliers, will more easily be able to tackle the challenges of this new environment than will most OEMs, many of whom today are 80% reliant on defense and 75% dependent on U.S. and European markets. Moreover, finds the study, the cyber security market – viewed by many as the "saving grace" of Western defense companies – will likely not grow enough to compensate for declining defense spending.

To compete and thrive in this environment, according to AlixPartners, the key for defense firms will be to focus on cost reduction, improving both domestic programs' affordability and competitiveness in emerging markets. Aside from defense growth in emerging markets, the homeland security market globally, projected by the study to grow to $281 billion by 2022, represents another potential new path to profitability, according to AlixPartners. Defense companies that can leverage their program management, integration experience and government-contracting skills will be most able to take advantage of this opportunity, says the study.

"The unprecedented events in the past year, from sequestration in the U.S. to continuous budget cuts in Europe, have created an enormously challenging climate for Western defense companies," said Bernardini. "For these companies, the keys to winning in this new environment include a sharp focus on cost-cutting and re-positioning themselves to capture growth domestically and in accessible emerging markets. Selling defense solutions in growing emerging markets requires more complex technology and manufacturing partnerships as those countries seek to develop their own A &D industries."

Airlines – Struggling to Find the Glide-Path to Profitability

Steady revenue growth and low overall profitability characterize the airlines business currently, according to the study. Despite 5.3% traffic growth globally in 2012, carriers continue to struggle for improved profitability, with an overall operating profit margin of just 3.3% projected for 2013, says the study.

"With high fuel prices keeping pressure on costs, and the growth of low-cost carriers and new global competitors keeping pressure on ticket prices, a laser-like focus on efficiency and costs is essential for airlines as they seek to improve profitability going forward," said Bernardini.

While airline-profitability figures and mergers have dominated headlines in the past year, the study reveals trends below the surface that will shape the airline business in the coming years – chiefly, the shift of the industry's center of gravity to Asia (expected to be the largest market by 2031), the fragmentation of business models and the "de-commoditization" of airlines' "product."

The airline landscape is no longer cleanly divided between low-cost and full-service carriers, says the study. While traditional, "full-service" carriers have unbundled their pricing in order to offer competitive bare-bones pricing with a range of add-on fees, "low-cost" carriers have added services previously only provided by full-service carriers, and have led industry innovation in areas such as live TV and at-seat ordering.

"The low-cost vs. full-service paradigm in the airlines sector is dead," said Fitzpatrick. "Successful carriers are now operating with a range of value propositions, including different combinations of network structures, fare offerings and classes of service. Success is no longer a question of price and schedule. The 'product' in airlines today is much more than just getting the passenger from Point A to Point B, and the winners will be those who employ state-of-the-art marketing and operations, techniques."

In a sector that has seen major consolidation in the past several years – including the American-US Airways, IAG-Vueling and Continental-United tie-ups – it's hard to imagine another year of upheaval; however, according to AlixPartners, the airlines sector could be in for another wild ride as increased competition could force more consolidation, including possible cross-border mergers and acquisitions.

Commercial Aerospace – Booming Sector Faces Supply-Chain Challenges

A bright spot on the A &D horizon, the commercial aerospace sector accounted for 52% of the overall industry profit pool last year, and all signs point to continued robust growth in the coming years. By 2017, AlixPartners expects the volume of OEMs' main commercial programs will have ramped up by 45%, to include a significant surge in big, new programs. However, new programs, says the firm, will introduce new technologies, both for airframe and engine companies, aimed at improving aircraft operating efficiency by up to 20%, which will further increase the complexity of the supply chain and the risk of delays.

"The commercial-aerospace supply chain is just not ready to handle a simultaneous increase in volume and complexity – it's going to overheat, especially among lower-tier suppliers," said Bernardini. "To keep the kettle from boiling over, further consolidation is needed, and operational maturity in the supply chain will have to improve dramatically. Additionally, monitoring by both OEMs and Tier 1 suppliers, and fixing supplier issues before they occur, not just after, will be critical to protecting cash flows."

Commercial Aerospace – Battle for Profit and the MRO Market

With the commercial aerospace profit pool expected to grow by 50% by 2020, the battle for bigger slices of the growing pie will escalate, says the study. Having already more than doubled their profit pool since 2007 (from $3.3 billion to $7.2 billion in 2012), commercial-aircraft OEMs will continue to pull out all stops to claim a larger share of profits. In addition to launching new aircraft and ramping up production for narrow- and wide-body aircraft, aircraft OEMs are likely to make a move on the maintenance, repair and operations (MRO) market, according to AlixPartners.

"Claiming a larger piece of the aftermarket profit pool will be a battle for aircraft OEMs," said Bernardini. "To succeed, aircraft-makers will have to leverage their unique access to the point-of-sale, challenge equipment and cabin OEMs by leveraging major platforms, and adopt new approaches to their business models, such as innovative 'buy-vs.-build' strategies, to secure more of the MRO business."

Aircraft OEMs, notes the study, are bidding for a piece of the rapidly growing MRO market, which saw an 11% spending increase last year. Other key trends expected to continue in the MRO sector, it says, include maintenance outsourcing for airlines and increasing penetration of integrated-component MRO services (such as "flight-by-hour"), which are expected to reach 40% by 2021 (from 23% in 2011). The study also finds that the MRO sector is facing several challenges, including the harsh reality that latest generation aircraft and engines require less maintenance.

"The question on everyone's mind is, 'Who will win the MRO battle in the next 10 years?'" said Fitzpatrick. "It's tough to predict at this stage, but it will certainly be interesting to watch it play out, especially with growing interest from players such as sovereign-wealth and private-equity funds."

M &A Outlook

M &A activity in aerospace and defense remained flat in the past year – 277 deals globally in 2012 (on par with the 283 deals in 2011) – driven primarily by the aerospace and MRO sectors, which together accounted for 61% of deal volume and 75% of deal value in 2012. Despite a relatively high level of activity, however, the total deal value of $19.5 billion in 2012 was 15% below the average level, $22.9 billion, for each of the prior 10 years. And, further illustrating the shifting landscape in the A &D industry, defense saw a drastic decrease in M &A, with that sector accounting for only 8% of deal volume last year, compared with 37% in 2011 and 57% in 2010.

However, looking ahead, according to the AlixPartners study there could well be heightened M &A activity, especially among smaller-sized deals, in the following four sectors:

  • MRO Operations – driven, in part, by the evolution of OEMs' business models to include services, strong sector fundamentals (attracting private-equity investors) and the benefits from rapid growth in emerging economies with lower labor costs.
  • Structural Components – driven by OEMs' desire for suppliers with broader and deeper capabilities, and the presence of many small companies that fit the bill in this sector.
  • Jet Engine Components – driven, in part, by aftermarket business providing another revenue stream that can be scaled up, and the presence of many small companies with specific expertise.
  • Space – driven, in part, by companies seeking to gain exposure to commercial satellite communications, fragmentation of the sector and increasing competition.

About AlixPartners

AlixPartners 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. Founded in 1981, the firm has offices around the world, and can be found on the Web at www.alixpartners.com.

CONTACT: Tim Yost + tyost@alixpartners.com

Source: AlixPartners