Uncertainty paralyzes defense contractors, but commercial aircraft manufacturers are taking up the slack
With all the gloom and doom about the future of the aerospace and defense (A&D) industry, a dose of perspective is in order. Unprecedented demand for new fuel-efficient aircraft boosted 's revenues by nearly $13 billion last year, while sales of commercial jets were up by $7.5 billion. That means that in a single year the world's two largest airframers generated enough new sales to create a company that would be bigger than or .
And many of those added billions flowed into the vast aerospace supply chain, from advanced component manufacturers down to mom-and-pop machine shops.
“Commercial is taking off,” says Deloitte's Tom Captain, one of nine industry experts who helped analyze the results of Aviation Week's 2013 Top-Performing Companies (TPC) study. “As Boeing and Airbus go, so goes the industry.”
That is good news for contractors and suppliers, which are starting to feel the first squeeze from what will likely be a prolonged downturn in the defense market. Sales at, , , and declined by a collective $6.4 billion last year, and the onset of deep automatic budget cuts in the U.S.—known as “sequestration”—signals tough times ahead. “Uncertainty is the new normal, and it has created a wait-and-see mode,” says TPC adviser Scott Thompson of PwC. “Last year was devoid of any big strategic acquisitions.” That uncertainty has only grown in 2013, inducing a state of paralysis in an industry coming off a run of prosperity that lasted more than a decade.
Paradoxically, that has led to higher profits in the near term: The TPC scores of most large defense contractors went up in this year's study, and the performance of the industry's largest companies matches the Dow Jones Industrial 30 (see chart, above). That is the payoff from moves by companies such asto get ahead of the downturn by cutting costs, shedding excess capacity and trimming workforces.
Deloitte calculates that U.S. defense contractors have handed out more than 40,000 pink slips. Yet TPC advisers caution that hunkering down is not a viable long-term strategy. “There's a limit to how long companies can squeeze efficiencies out of existing programs,” says James Schwendinger. “You turn that wrench a couple of times and it gets pretty tight.”
The consensus among the TPC advisory team is that incremental efficiency gains will not be sufficient to guide defense companies through what is likely to be a protracted downturn as governments in the U.S., Europe and Japan rein in unsustainable spending. Skeptics note the sky did not fall when sequestration took effect on March 1, but that is only because of the drawn-out nature of weapons programs. It could be another year before the full force of budget cuts hits the Pentagon's procurement and research, development, test and evaluation accounts. “I think this continues to be the calm before the storm,” says TPC adviser Jacob Markish of Renaissance Strategic Advisors. “Focusing on operational excellence and hunkering down may be dangerous, because the storm is not passing.”
Indeed, companies will have to make tough strategic decisions on how to manage the turmoil: Should they shed some operations, make selective acquisitions or diversify into new lines of business? But as they move outside their comfort zones in search of new growth, contractors run the risk of venturing into areas they don't fully understand and for which they are ill-prepared to compete—a mistake that was oft repeated during the massive aerospace consolidation of the 1990s. “They have a lot of money, they're panicked about their revenues declining and they're starting to look way outside their core,” says TPC adviser Harlan Irvine of Deloitte Consulting. “You can destroy value in a hurry if you don't think through how it is going to work.”
The companies that consistently rank high in the TPC rankings, such as Lockheed Martin,, Precision Castparts and FLIR Systems, are benefitting from years of carefully planned investments and strategic moves (see five-year graphs, page 52).
For the second consecutive year, Boeing topped the TPC rankings of publicly traded companies with revenues of more than $20 billion, beating out second-place Lockheed Martin. Boeing's score of 90 was the highest of any company in this year's study and the third-highest TPC score posted since 1998, bested only by Lockheed Martin in 2007 and General Dynamics in 1999. The Chicago-based airframer has endured a flood of negative publicity from the grounding of its 787 jet following meltdowns of the aircraft's advanced lithium-ion batteries. But TPC analysts predict the price tag of cleaning up the mess and getting the 787 back into service will not materially affect the balance sheet of a company with more than $82 billion in annual revenue.
Boeing's rival, Airbus parent, came in with a significantly lower TPC score of 64, but its rising profit margins point to a brighter future. “I would not be surprised if they moved up in the rankings next year,” says adviser Antoine Gelain of Candesic. “It's still a relatively young company, and they are going in the right direction.” Ironically, EADS's failed bid to merge with BAE Systems may prove fortuitous in the near term as most of the company's sales remain on the booming commercial side of the aerospace industry. “Airbus is doing extremely well, and European defense is doing extremely poorly,” notes Thompson.
So why didn't EADS finish higher in this year's rankings? While the company's operational performance is heading in the right direction, it is short of the mark for best-in-class status. EADS's operating margin of 3.2% last year was less than half of Boeing's 7.4%. “Their new governance model will help, but they are still saddled with European social welfare policies,” notes Captain.
Northrop Grumman, once a laggard among large defense contractors, continued its climb in the TPC rankings, rising to third place with a score of 80. The company posted operating margins of 12.4% while Huntington Ingalls, the ship division that it spun off in 2011, had margins of just 5.1%. And while Raytheon's score was flat from last year, TPC advisers believe the company is uniquely positioned for the downturn, with a strong missile-defense business and roughly a quarter of its sales generated outside the U.S. “In this new affordability environment, existing equipment will be upgraded rather than replaced,” notes Thompson. “That's their sweet spot.”
placed second-to-last in the large-company rankings, but TPC advisers say a key reason for that was the goodwill added to its balance sheet from last year's $18.4 billion acquisition of . UTC's score is expected to rise in future years as the old Goodrich operations are integrated into the company and synergies kick in.
One of the most improved scores in this year's study went to Finmeccanica, but it was a dubious distinction. The Italian aerospace company's score of 36 was up from 15 last year, but that was only good enough to tie with Curtiss-Wright for the lowest score among the 58 companies ranked this year. Finmeccanica's high-profile acquisition of DRS Technologies in 2008 has proven difficult to integrate, and operations in its home market remain riddled with inefficiencies. TPC advisers speculate the company could seek a merger or—copying a strategy famously executed by General Dynamics in the early 1990s—sell off pieces to generate value for shareholders.
The top ranking among companies with revenue of $5-20 billion went to, which produces large business jets such as the Falcon 7X and fighters. Gelain believes the French company's score of 79 and its leap to the top from 12th place last year is no anomaly. “There is a misconception that Dassault relies on a monopoly in combat aircraft in France to generate most of its profits,” he says. “While it does have a monopoly position in military, that now accounts for only 25% of their business.”
A large majority of the company's revenues came from its Falcon business jet unit which was hit hard when the bottom dropped out of that market in 2008-09. In 2009, the unit's Falcon business saw 163 net cancellations worth almost $5 billion. And yet the TPC numbers indicate a strong rebound is underway, fueled by demand for the high-end 7X in markets like the U.S., where it employs 2,500, and increasingly China. “Just looking at the numbers, they come across as a well-managed company, with solid and consistent financial performance throughout,” Gelain says.
Exelis, the defense business spun off in 2011 by parent ITT, turned in an impressive second-place performance among companies with revenues of $5-20 billion, with a score of 77. Rolls-Royce rounds out the top three with a score of 71. The ailing member of the group is aerostructures producer Spirit AeroSystems, which placed last with a score of 41. The company's results were weighed down by a $590 million pre-tax charge it took after failing to meet cost targets on work for Gulfstream and Boeing. “Aerostructures is a tough business,” says Schwendinger.
The category of companies with revenues of $1-5 billion was topped by Cubic. The company's score of 86 was underpinned by strong gains in operating profit, cash flow and productivity. “Cubic benefitted from a disciplined focus on a strong balance sheet, a legacy of excellence in financial management that goes back the entire 14 years we have tracked this company,” says TPC study manager Michael K. Lowry. Cubic was followed in the rankings by perennial top-performer Rockwell Collins and, which benefitted from a 41% gain in operating income from the prior year.
The TPC study also ranks the performance of more than 100 individual business segments in 14 categories.
With the full force of the defense downturn yet to hit, TPC advisers believe steps can be taken to prepare for impact. These include best-in-class management practices, such as fostering a culture of continuous improvement, disciplined deployment of capital, rapid and continuous adoption of lower-cost manufacturing processes and rigorous supply chain management. They caution that companies can't simply cut their way to profitability. “Sustaining operational excellence requires organizations to foster a continuous improvement culture during growth phases and downturns,” says TPC adviser John Stack of The McLean Group.
Investments in research and innovation—which can be risky and take years to pay off—also will differentiate the winners from the losers when growth resumes, as it surely will. “Don't mortgage your future,” warns Markish. “Make investments that are necessary to remain competitive in the long run. You owe your current performance—for better or worse—to investments made in the past.”
A TPC analysis of the 15 U.S. A&D companies with annual sales of at least $5 billion shows they invested an average of 4% of their revenues on independent R&D in 2012, up from 3% in 2003. But raising that further to compensate for declines in government-funded research will be a tough sell for management teams, which face Wall Street's relentless demands for near-term profits.
It should also be noted that while U.S. defense spending will decline, it will remain—by far—the world's largest military market for a long time. That is why EADS,and other companies globally will continue to try to make inroads. “No matter what happens in defense, space and security, the biggest slice of the pie is still in the U.S.,” says Peter Nicholas Lengyel, president/CEO of USA, an arm of France's Safran. “You have to be here.”
It also is fairly obvious that the slimmed-down defense industry is going to have too many contractors and not enough work. But the potential of new markets in places like India and Brazil is still too small to offset budget declines in the U.S. and Europe. Therefore, consolidation among mid- and lower-tier contractors is likely. Adviser Michael Finley predicts there will be a scramble among Tier 2 contractors.
Back on the growth side of the industry—commercial aviation—the key concern is whether the supply chain can keep pace as Airbus and Boeing raise monthly production rates and entrants from Canada, China and Russia push into the lucrative narrowbody jet market. “The commercial suppliers are stressed, but there is no real evidence they can't keep up,” says consultant and TPC adviser Tony Velocci, a former editor-in-chief of Aviation Week & Space Technology.
Thompson has a similar view. “I have not seen any major disruptions,” he says. But the sector “requires vigilance, given that the supply chain is producing at unprecedented volume.”
EDITOR'S NOTE: This article was updated to correct data in the table labeled “Average Five-Year Ranking: Revenues Between $1-5 Billion.”
2013 Top Performers
Source: TPC database
Subscribers to the Aviation Week Intelligence Network can access:
AWIN-only rankings of A&D companies with revenues between $250 million and $1 billion
Detailed Interactive charts of TPC-ranked companies with links to spreadsheets
Rankings of more than 100 A&D business segments in 14 categories
|AVIONICS/FLIGHT MANAGEMENT/CONTROL SYSTEMS|
|Crane Aerospace & Electronics|
|General Dynamics Aerospace|
|CIVIL & MILITARY TRAINING & SUPPORT SERVICES|
|Meggitt Equipment Group|
|Precision Castparts Investment Cast Products|
|Boeing Military Aircraft|
|MISSILE & WEAPONS SYSTEMS|
|Lockheed Missiles & Fire Control|
|General Dynamics Marine Systems|
|FLIR Thermal Vision and Measurement|
|Lockheed Martin Space Systems|
|Parker Hannifin Aerospace|
|Tom Captain, Vice Chairman, Global & U.S. A&D Practice Leader, Deloitte LLP|
|Michael Finley, A&D Advisory Principal, PwC|
|Antoine Gelain, A&D Practice Leader, Candesic|
|Harlan Irvine, Principal, Deloitte Consulting|
|Jacob Markish, Principal, Renaissance Strategic Advisors|
|Jim Schwendinger, A&D consultant (ret.), Deloitte LLP|
|John Stack, Managing Director and Aerospace Leader, The McLean Group|
|Scott Thompson, Partner and U.S. A&D Leader, PwC|
|Tony Velocci, A&D consultant|
|RANK||COMPANY||RESULTS ENDING||2012 REVENUE ($ millions)||TOTAL SCORE|
|2||Lockheed Martin||Dec. 12||47,182||84|
|3||Northrop Grumman||Dec. 12||25,218||80|
|4||General Dynamics||Dec. 12||31,513||75|
|7||BAE Systems||Dec. 12||26,619||72|
|9||United Technologies||Dec. 12||57,708||60|
|RANK||COMPANY||RESULTS ENDING||2012 REVENUE($ millions)||TOTAL SCORE|
|1||Dassault Aviation||Dec. 12||5,134||79|
|5||Precision Castparts||Dec. 12||7,876||65|
|9||Huntington Ingalls||Dec. 12||6,708||59|
|14||Serco Group||Dec. 12||7,869||53|
|15||Allegheny Technologies||Dec. 12||5,032||48|
|17||Spirit AeroSystems||Dec. 12||5,398||41|
|RANK||COMPANY||RESULTS ENDING||2011 REVENUE($ millions)||TOTAL SCORE|
|2||Rockwell Collins||Dec. 12||4,694||83|
|3||Orbital Sciences||Dec. 12||1,437||70|
|4||FLIR Systems||Dec. 12||1,405||67|
|6||MTU Aero Engines||Dec. 12||4,396||65|
|8||Ultra Electronics||Dec. 12||1,219||62|
|10||Alliant Techsystems||Dec. 12||4,520||60|
|11||B/E Aerospace||Dec. 12||3,085||59|
|12||Triumph Group||Dec. 12||3,663||59|
|14||Teledyne Technologies||Dec. 12||2,127||57|
|17||TransDigm Group||Dec. 12||1,778||52|
|21||Babcock International Group||Sep. 12||4,468||48|
|23||Indra Sistemas||Dec. 12||3,919||45|
|25||Barnes Group||Dec. 12||1,230||44|
|26||Engility Holdings||Dec. 12||1,655||42|
|29||BBA Aviation||Dec. 12||2,147||38|
|30||Chemring Group||Oct. 12||1,179||37|
|RANK||COMPANY||AVERAGE 5-YEAR SCORE|
|RANK||COMPANY||AVERAGE 5-YEAR SCORE|
|RANK||COMPANY||AVERAGE 5-YEAR SCORE|
|5||MTU Aero Engines||68|
|23||Babcock International Group||48|