Trouble Lurking As Profits Soar
A version of this article appears in the May 5 edition of Aviation Week & Space Technology.
The results of the 2014 Top-Performing Companies (TPC) study are heartening but troubling: Industry profits soared nearly 10% but the improvements are concentrated among the largest organizations. Businesses outside of the Top 25 reported a significant aggregate decline in operating profit. There is an equally unsettling dichotomy in the scores of companies by size—the largest companies did well, while those in the small category ($1-5 billion) lost significant ground.
Based on this year’s TPC results, we are witnessing a significant shift in operating profit up the supply chain, although operating margin among the commercial OEMs remains well below the industry average. The 2014 TPC study clearly shows a trend that a combination of factors is squeezing the supply chain. These include defense budget cuts and an emphasis on affordability, cost pressures from commercial OEMs and efficiency challenges in meeting an aggressive commercial aircraft production ramp-up. A recent study by PwC found that approximately one-quarter of A&D suppliers may be at risk.
Defense companies have done a good job thus far of responding to the affordability challenge. Operating margins have expanded for several years, even as revenues declined. But improvements have been incremental and expectations continue to rise. More can be done.
Much of the cost improvement has focused on overhead, but those figures may be only about 20% of the total. The majority of expenses represent direct material and labor, and often more than 60% of cost is in the supply chain. When it comes to affordability, much of the “heavy lifting” has not even begun.
To truly remove excessive costs from the supply chain will take more than a heavy hand in negotiating. It will require collaboration between OEMs and suppliers, including openness and trust. It also will require challenging the status quo surrounding manufacturing processes and productivity, program management and engineering productivity. One of the most effective ways to improve affordability is to shorten the development cycle. While the biggest impact there is customer behavior, companies can shorten development time by focusing on what they can control in their own processes.
Many defense companies have used a strategy of returning capital to shareholders. In fact, the recently announced merger ofand Alliant Techsystems would bring the first large defense-oriented acquisition since before the Budget Control Act of 2011. This is a great short-term strategy for boosting a company’s stock valuation, but it is not sustainable. And it reflects a focus on short-term results rather than long-term global competitiveness.
What defense companies ought to be focusing on is a more aggressive growth strategy that includes mergers and acquisitions as well as organic expansion. In other words, they need to restore the balance between a short-term mindset with longer-term, more-strategic thinking—with an emphasis on the latter.
We were struck by Google’s recent announcement that it is buying Titan Aerospace on the heels of Amazon revealing its strategy to deliver products by an unmanned aircraft. Many of the economy’s largest commercial markets were born in A&D (computers, computer networking and satellite communications). While executives may be wary of commercial markets due to prior experience, perhaps a new approach is warranted rather than “throwing out the baby with the bath water.”
Prior initiatives may have failed due to “an all-or-nothing” approach. In addition to focusing on their core competencies—the technologies that define who they are and what makes them an essential part of the industry—defense contractors should be seeking opportunities to partner with companies that are experts in commercial markets.
For their part, commercial aerospace companies need to do a better job of managing their prosperity than seen in past ramp-up cycles.
A counterintuitive phenomenon of declining operating margins often has accompanied periods of strong growth. A lack of focus on cost control plus out-of-sequence work, late deliveries, overtime and rush shipments—all of which erode the economic benefits of higher-volume aircraft production—are just some of the factors to blame.
But what is past does not necessarily have to be prologue. In theory, both defense and commercial aviation contractors know what they have to do to succeed. The question is whether management will apply the kind of focus and strategic thinking needed for their organizations to achieve what it means to be competitive: profitable growth.
Scott Thompson (left) is a PwC partner and leader of the firm’s U.S. Aerospace & Defense practice.
Michael Finley is a principal in PwC’s A&D advisory practice. Both are based in McLean, Va.