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 Boeing's revenues by nearly $13 billion last year, while sales of commercial Airbus 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 GE Aviation or Rolls-Royce.

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 BAE Systems, Finmeccanica, General Dynamics, Northrop Grumman and Raytheon 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 as Lockheed Martin to 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, Rockwell Collins, 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 EADS, 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.”

United Technologies 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 Goodrich. 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 Dassault Aviation, which produces large business jets such as the Falcon 7X and Rafale 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 Orbital Sciences, 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, Embraer 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 Safran 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

TPC EXTRAS

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

AviationWeek.com/awin/tpc

*Revenues greater than $500 million. Complete rankings for each segment are available to Aviation Week Intelligence Network subscribers.
2013 TPC Business Segment Winners*
AVIONICS/FLIGHT MANAGEMENT/CONTROL SYSTEMS
Crane Aerospace & Electronics
BUSINESS AIRCRAFT
General Dynamics Aerospace
CIVIL & MILITARY TRAINING & SUPPORT SERVICES
Meggitt Equipment Group
COMMERCIAL AIRCRAFT
Embraer Commercial
FORGINGS/CASTINGS/PRECISION COMPONENTS
Precision Castparts Investment Cast Products
LAND SYSTEMS
Oshkosh Defense
MILITARY AIRCRAFT
Boeing Military Aircraft
MISSILE & WEAPONS SYSTEMS
Lockheed Missiles & Fire Control
NAVAL SYSTEMS
General Dynamics Marine Systems
PROPULSION
GE Aviation
RADARS/SENORS/ELECTRONIC WARFARE/C4ISR
FLIR Thermal Vision and Measurement
ROTORCRAFT
Textron Bell Helicopter
SPACE SYSTEMS
Lockheed Martin Space Systems
SUBSYSTEMS/SUBASSEMBLIES
Parker Hannifin Aerospace
2013 TPC Council of Advisers
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
2013 Aerospace & Defense Rankings, REVENUES GREATER THAN $20 BILLION
RANK COMPANY RESULTS ENDING 2012 REVENUE ($ millions) TOTAL SCORE
1 Boeing Dec. 12 81,698 90
2 Lockheed Martin Dec. 12 47,182 84
3 Northrop Grumman Dec. 12 25,218 80
4 General Dynamics Dec. 12 31,513 75
5 Raytheon Dec. 12 24,414 75
6 Honeywell International Dec. 12 37,665 74
7 BAE Systems Dec. 12 26,619 72
8 EADS Dec. 12 73,493 66
9 United Technologies Dec. 12 57,708 60
10 Finmeccanica Dec. 12 22,405 36
2013 Aerospace & Defense Rankings, REVENUES BETWEEN $5 - 20 BILLION
RANK COMPANY RESULTS ENDING 2012 REVENUE($ millions) TOTAL SCORE
1 Dassault Aviation Dec. 12 5,134 79
2 Exelis Dec. 12 5,522 77
3 Rolls-Royce Dec. 12 19,477 71
4 Embraer Dec. 12 5,956 67
5 Precision Castparts Dec. 12 7,876 65
6 Bombardier Dec. 12 16,709 65
7 Oshkosh Dec. 12 8,074 65
8 Textron Dec. 12 12,237 60
9 Huntington Ingalls Dec. 12 6,708 59
10 Thales Dec. 12 18,423 58
11 Safran Dec. 12 17,965 58
12 L-3 Communications Dec. 12 13,146 57
13 Rheinmetall Dec. 12 6,121 54
14 Serco Group Dec. 12 7,869 53
15 Allegheny Technologies Dec. 12 5,032 48
16 Harris Dec. 12 5,103 48
17 Spirit AeroSystems Dec. 12 5,398 41
2013 Aerospace & Defense Rankings, REVENUES BETWEEN $1 - 5 BILLION
RANK COMPANY RESULTS ENDING 2011 REVENUE($ millions) TOTAL SCORE
1 Cubic Dec. 12 1,380 86
2 Rockwell Collins Dec. 12 4,694 83
3 Orbital Sciences Dec. 12 1,437 70
4 FLIR Systems Dec. 12 1,405 67
5 Senior Dec. 12 1,140 66
6 MTU Aero Engines Dec. 12 4,396 65
7 Zodiac Aug. 12 4,442 62
8 Ultra Electronics Dec. 12 1,219 62
9 Hexcel Dec. 12 1,578 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
13 Saab Dec. 12 3,604 57
14 Teledyne Technologies Dec. 12 2,127 57
15 Kaman Dec. 12 1,593 55
16 Woodward Dec. 12 1,866 52
17 TransDigm Group Dec. 12 1,778 52
18 Meggitt Dec. 12 2,572 52
19 Cobham Dec. 12 2,802 51
20 Elbit Systems Dec. 12 2,889 50
21 Babcock International Group Sep. 12 4,468 48
22 Moog Dec. 12 2,490 46
23 Indra Sistemas Dec. 12 3,919 45
24 Esterline Jan. 13 1,805 44
25 Barnes Group Dec. 12 1,230 44
26 Engility Holdings Dec. 12 1,655 42
27 AAR Nov. 12 2,161 41
28 CAE Dec. 12 2,024 38
29 BBA Aviation Dec. 12 2,147 38
30 Chemring Group Oct. 12 1,179 37
31 Curtiss-Wright Dec. 12 2,098 36
AVERAGE 5-YEAR RANKING, REVENUES GREATER THAN $20 BILLION
RANK COMPANY AVERAGE 5-YEAR SCORE
1 Lockheed Martin 85
2 General Dynamics 83
3 Raytheon 79
4 Boeing 79
5 Northrop Grumman 75
6 United Technologies 71
7 BAE Systems 71
8 Honeywell International 68
9 EADS 64
10 Finmeccanica 40
AVERAGE 5-YEAR RANKING, REVENUES BETWEEN $5 - 20 BILLION
RANK COMPANY AVERAGE 5-YEAR SCORE
1 Precision Castparts 74
2 Bombardier 72
3 Rolls-Royce 70
4 Dassault Aviation 68
5 Harris 63
6 Spirit Aerosystems 62
7 L-3 Communications 61
8 Oshkosh 61
9 Embraer 60
10 Allegheny Technologies 59
11 Rheinmetall 58
12 Safran 54
13 Thales 53
14 Serco 52
15 Textron 48
AVERAGE 5-YEAR RANKING, REVENUES BETWEEN $1 - 5 BILLION
RANK COMPANY AVERAGE 5-YEAR SCORE
1 Rockwell Collins 85
2 Cubic 84
3 FLIR Systems 81
4 Ultra Electronics 72
5 MTU Aero Engines 68
6 Orbital Sciences 63
7 Indra Sistemas 66
8 Teledyne Technologies 62
9 Senior 61
10 Alliant Techsystems 59
11 Kaman 60
12 Woodward 61
13 B/E Aerospace 57
14 Triumph Group 55
15 Elbit Systems 57
16 Cobham 55
17 Saab 53
18 Chemring Group 54
19 Zodiac 55
20 Hexcel 53
21 TransDigm Group 53
22 Esterline 48
23 Babcock International Group 48
24 CAE 46
25 AAR 45
26 Curtiss-Wright 45
27 Moog 45
28 Meggitt 45
29 Barnes Group 44
30 BBA Aviation 42