JUNE 2013

Pockets of Turbulence
The 2013 Aerospace & Defense Industry Outlook
inside Airlines Defense Commercial Aerospace Supply Chain MRO

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he global aerospace and defense (A&D) industry is continuing its growth in the wake of the worldwide financial crisis, yet it remains an extremely dynamic marketplace, in which some sectors are booming and others are experiencing pockets of severe turbulence. According to the AlixPartners 2013 Aerospace & Defense Industry Outlook, an indepth analysis of sector and company financials and key macroeconomic trends, the A&D industry grew by 6.8% in 2012. This was up from 2011s sales growth of 5.5% but still not at precrisis growth levels, which hit 10% in 2008. Commercial aerospace companies represent perhaps the strongest segment of the industry: they delivered more than 1,300 jets worldwide in 2013a record for the industry and new orders continue to roll in. Meanwhile, in contrast to this growth among airlines and commercial aircraft originalequipment manufacturers (OEMs), the defense sector is shrinking. Even though some of the developing-market countries are ramping up spending, the increases are not enough to make up for a sharp decline in spending by developed nations, primarily the United States, which continues to face fiscal uncertainties. According to the Outlook, the defense sector will struggle to make up for reduced top-line growth; the commercial aerospace sector will benefit from an increase in strong deliveries and will focus on translating that growth into a bigger share of the profit pool. Given this challenge, A&D companies need to become more efficient and wring costs out of their operations at all levels. In the defense sector

particularly, companies must diversify into new, more-promising international markets, where the rules of engagement are also changing. The industry will likely remain highly competitive for the foreseeable future, yet there is strong growth potential in some markets, as well as greater profits for companies nimble enough to identify and exploit those markets.

Airlines: Growth returns, but profits still languish

The airline sector reflects the current good-news/ bad-news state of the A&D industry. Steady traffic growth5.3% in 2012is leading to improved revenue, and the airlines have become much more disciplined on capacity than they were in the past. (Capacity grew 3.9% last year.) Still, airlines have struggled to translate these improvements to the bottom line, and strong profits remain elusive. Current projections call for operating margins of just 3.3% in 2013. Operators are being squeezed on both sides: high fuel prices have raised operating costs, and low-cost carriers and new global competitors have kept pressure on pricing. Even if fuel costs revert to historical averages at some point, the competitive factors are likely here to stay. As a result, the airline sector is in flux. The formerly strong European and US markets are in decline, and operators are either restructuring (American Airlines, SAS Scandinavian, Spanair) or merging (AmericanUS Airways, ContinentalUnited, International Airlines GroupVueling). As growth in mature markets has flattened, the industrys center of gravity has shifted to morerapidly-growing markets in Asia and the Middle

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East, which show favorable demographics and growing middle classes that are more and more inclined to travel by air. Accordingly, airlines in these markets are building up their fleets and placing large orders (figure 1). Indonesias Lion Air, for example, ordered 234 A320s in March 2013the biggest commercial airline order in industry history. (Even Africa showed 7.2% traffic growth in 2012, though admittedly from a small base.) By 2031, the Asia-Pacific region will be the biggest airline market in the world, receiving 31% of all new jet deliveries. The second area of flux among airlines is in operating models, as the line between low-cost and full-service carriers has blurred. Traditional network carriers have unbundled their pricing to give passengers lower fares overall, with a menu of available add-ons. Meanwhile, low-cost providers have added new servicesfor example, businessclass tickets and long-haul routesalong with service innovations like live in-flight television.
FIGURE 1: YEAR-OVER-YEAR GROWTH IN GLOBAL PASSENGER TRAFFIC AND CAPACITY (%, 2012)
RPK ASK 15.2%

The fundamental message for airlines is that the product they ostensibly sell is no longer mere transportation. When that product was a commoditya seat that takes passengers from point A to point Bairlines could differentiate based only on price and schedule. Today, they can differentiate using merchandising and marketing. They can develop innovative product and service offerings that stand apart from the competition. And they can use state-of-the-art marketing to ensure that their brand is clear in the market.

Defense: A painful contraction and a shift to the East

The defense sector is experiencing a similar shift from mature Western marketswhere cuts in defense budgets have made business far more challengingto faster-growing regions, in Asia. Global defense spending decreased in 2012 for the first time since 1998, to $1.7 trillion. That includes 3 to 4% cuts in most of the major Western markets (5.8% in the United States, the largest market worldwide). Asian countries outspent European NATO countries for the first timeand will continue to do so (figure 2). Compounding this transition, two of the largest developing-market spendersChina and Russia are effectively off-limits for outside contractors. Chinese defense spending is projected to increase at a compound annual growth rate of 18.5% for the next decade. This is tremendous growth that Western contractors cannot tap. (By 2016, China and Russia will account for 32% of all defense spending among the top five markets worldwide, up from only 17% in 2011.) Defense manufacturers are now fighting to capture the addressable

12.4%

9.5% 7.2% 6.5% 7.5% 6.0% 5.2% 5.1% 2.9% 1.1% 0.1% Africa Asia Pacic Europe Latin Middle North Total America East America Market 5.3% 3.9%

Source: International Air Transport Association Forecasts Feb 2013; ASK = available seat kilometers; RPK = revenue passenger kilometers

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FIGURE 2: GROWTH IN DEFENSE SPENDING (HISTORICAL AND FORECAST)
CAGR 20112016 25% 20% 15% 10% 5% Germany Italy 5% 5% Japan France UK 5% US 10% 10% 15% Saudi Arabia CAGR 20072011 20% 25%

directly exposed to the impact of sequestration, which requires short-term cuts. Among European firms, the threats are even more dire. As major programs like combat aircraft and shipbuilding ramp down, European contractors are now struggling to sustain innovation and industrial capacity. In the absence of a major new initiative to radically restructure European defense capacity, the industry is dangerously close to a point of no return. The situation is not yet do or die, but it is clearly do or decline. To succeed in this environment, defense companies must: Continue to reduce costs. Companies need to improve their value proposition to customersin other words, affordability has to become a reality, not just remain a buzzword and increase their returns to shareholders. Focus on international markets. Competitions for major programs are increasing winner-take-all arrangements, such as combat aircraft in developing markets; and OEMs must adapt their offerings accordingly. Pure offset deals are dying; most of the developing-market buyers demand transfer of technology, final assembly line, or local suppliers. Rebalance portfolios. A shift from big bets on major programs to a more balanced portfolioincluding, say, electronics and cybermay also help mitigate exposure to further cuts. Consolidate in Europe. Excess capacity in combat air, defense electronics, and shipbuilding is currently unsustainable, requiring a major effort with strong government leadership.

China Brazil India Russia

subsegment of developing marketsprimarily India, Brazil, and Saudi Arabiaeven as Russian and Chinese contractors increase their exports to those markets as well. These issues are not likely to change soon. Contractors that sell to the United States will be exposed to a confluence of factors, including sequestration and a drawdown in military activity once US forces leave Afghanistan in 2014. The situation will have varying effects depending on a manufacturers offering and geographic focus. Suppliers that have fairly diversified portfolios minimize their exposure to cuts in specific programs. Many OEMs, however, are vulnerable: our research indicates that 80% are reliant on defense and 75% are dependent on US and European markets. Similarly, companies that depend on annual appropriationssuch as ship repair and the supply of operational consumables like ammunition and protected vehiclesare
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Commercial aerospace: Booming with new products
The strongest sector within the A&D industry last year was commercial aerospace, which not only expanded but also accelerated its growth, particularly among OEMs. Boeing revenues grew 18.9% in 2012, and EADS by 12.7%. Current projections call for that growth to continue, due largely to a huge backlog of orders ($390 billion for Boeing and 638 billion for EADS at list price, a total of more than 9,000 aircraft). We expect that by 2017, the workload volume of OEMs main commercial programs will have ramped up by 45% and will include a significant surge in major new programs, with further increases on the horizon. At the same time, both OEMs and suppliers are translating those gains into improved earnings before interest and taxes (EBIT). Supplier segmentsincluding propulsion, cabin interiors, and components and materialsbuilt on their EBIT momentum from earlier years, with strong performers such as Precision Castparts, Safran, Rolls-Royce, UTC, Parker Hannifin, and Zodiac. Among OEMs, EADS has shown significant growth in EBIT; other competitors are still slowly returning to 2007 levels. Overall, suppliers remain more profitable than OEMs by a gap of nearly five percentage points (figure 3). That said, other indicators show that the gap in financial performance between OEMs and suppliers is starting to close. For example, OEM revenue growth is now acceleratingfrom 1.6% in 2011 to 6.7% in 2012and supplier growth seems to be slowing down: from 10.2% in 2011 to 6.6% in 2012. Similarly, an analysis of cash return on
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FIGURE 3: EBIT MARGIN GROWTH (%, 2005-2012)

+0.8 ppt 8.8% 7.6% 7.7% 8.8% 7.4% 1.4 ppt + 1.8 ppt 8.6% 8.7% 9.2%

2005

2006

2007

2008

2009

2010

2011

2012

OEMs

Suppliers 9.8% 10.7% 7.5% 9.6% 8.2% 9.6% 5.9% 10.3% 11.0% 11.3%

9.0% 6.7%

6.3%

7.4%

7.0%

7.6%

2005

2006

2007

2008

2009

2010

2011

2012

ppt = percentage point Sources: Capital IQ, AlixPartners analysis

capital invested (CROCI) shows that suppliers have trended downward since 2007, whereas OEMs have improved their CROCI performance. In part, this is because the backlog in orders has allowed OEMs to build up stronger cash positions. Moving forward, the commercial aerospace profit pool will continue to grow at a rate of 5% per year, driven in part by both airframe and engine manufacturers new technologies intended to improve aircraft operating efficiency. Aircraft deliveries will increase 2.3% a year for the next decade. As the profit pool gets larger, commercial aircraft OEMs will fight to increase their share, by developing new aircraft designs and ramping up production for both narrowbody and wide-body aircraft.

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Supply chain: Challenges on the horizon
The coming increase in sales volume is a positive sign, but it will create significant challenges for A&D supply chains. As noted earlier, we project a 45% ramp-up in workload by 2017, with new programs like the A320neo, Boeing 737 MAX, and Bombardier C Series that will tax engineering and industrial service functions. These new programs also involve more-technologicallycomplex designs aimed at increasing aircraft operating efficiency by 15 to 20%. Such advances include composite materials, fuel-efficient engines, and new systems, including avionics, fuel, braking, and electric systems.
FIGURE 4: SUPPLY CHAIN EVOLUTION
Past Aircra assembly OEMs Large-scale integration Small-scale integration Value-added parts and assemblies Make-to-print parts Raw materials Many supply paths Many direct suppliers Limited role for integrators Some role for value-adding suppliers Fewer supply paths Far fewer direct suppliers Extensive role for integrators Still-larger role for valueadding parts suppliers Few risk-sharing partners Unbundling of modules and systems by OEMs Tier 2/tier 3 supplier nomination by OEMs Small supplier base in each segment Current OEMs Future OEMs

The current industry supply chain is not always ready for this dual challenge of delivering a greater volume of more-sophisticated aircraft. In fact, there is a real and growing risk of supply chain disruptions. Certain suppliers have only limited expertise and modest engineering capabilities for implementing and sustaining several programs, especially in the detailed-parts and aerostructures segments. Some suppliers and OEMs have taken early steps to handle those limitationsfor example, by more directly involving and closely monitoring tier 1 aerostructure suppliers in new programsbut those measures represent a new risk-sharing model for which neither side is yet mature enough to implement and monitor.

Reduced supplier base managed by OEM and tier 1

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More and more, OEMs will have to lead operational improvement programs at their key suppliers, and tier 1 suppliers will have to develop similar measures further down the supply chain. As tier 1 responsibility shifts to include not only full-system but subsystem specs and integration, OEMs will have to work with those specs and that integration to ensure the OEMs have the sufficient competencies in place. In addition, OEMs will have to continue streamlining their supply chains through restructuring and integration efforts (figure 4). Consolidation is especially needed in the detailed-parts-supplier segments, and OEMs must actuate that process. We expect that airlines will continue to outsource their maintenance segments in greater volume, such as Finnairs deal with SR Technics, and Americans outsourcing of its 757 and wide-body maintenance. More broadly, aircraft OEMs are extending their reach into the MRO business. Airbus FHS and Boeing Edge could become major players in the segment in the next three to five years. The two companies can build on their unique access to airlines and can challenge component OEMs such as cabin equipment manufacturers by implementing major new programs and platforms. Another trend affecting the MRO business is that next-generation aircraft and engines simply require less maintenance. For example, the Boeing 787 requires C and D checks at half the frequency of the 767. And profits remain elusive: only a few premium players can reach an EBIT margin of 10%. In sum, there is a clear growth opportunity in the MRO segment, but to win, operators will have to navigate a dynamic market. Key requirements will be access to capital, willingness to invest long term, and a footprint with operations close to the fleet of tomorrow, including strong coverage in Asia.

MRO: Solid growth and a shuffling of competitors

Worldwide, the maintenance, repair, and operations (MRO) market grew 11% in 2012, from $50.9 billion to $56.8 billion. The civil air transport fleet, including regional jets and turboprops, is currently at about 26,000 aircraft, and that number will grow sharply in the coming decades: in 15 years, the in-service fleet will be about twice as large as todays. That growth will lure new entrants to the MRO field and realign the competitive landscape, and we are already seeing evidence of the shuffling. For example, Goodrich merged with Hamilton in 2012 to form UTAS, a megaplayer in the component flight-hour-services (FHS) field, with a strong intellectual property position on several new platforms like the Boeing 787. In other shifts, the US market saw several bankruptcies, and the component MRO business of Aveos was taken over by A J Walter Aviation.

Thriving in an unstable market

The compounding effects of the growing markets in Asia and the Middle East, rapidly evolving technologies, and fiscal strains on mature markets in Europe and the United States will likely lead to instability for the A&D industry over the coming years. Successful companies in the industry will

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focus on several priorities. First, profitability is an ongoing challenge, and companies must redouble their efforts to reduce costs. Those that can achieve more-efficient operations and greater EBIT margins can give themselves the head room to pursue future opportunitiesand endure future downturns. Second, companies should accelerate their diversification into new and faster-growth markets. This entails more than a mere geographic changewith the inherent supply chain challengesand involves the tailoring of products and services for customer segments with varying priorities and requirements. Last, innovation is a major theme across all segments. The ability to identify and anticipate demand for new products and servicesoften driven by new technologieswill be a clear differentiator in A&D companies. These are sizable challenges, yet they also point to clear opportunities. A&D operators that can get these three areas right can give themselves a clear, competitive edge in a volatile industry.

FOR MORE INFORMATION, PLEASE CONTACT: Eric Bernadini Managing Director ebernadini@alixpartners.com +33 1 76 74 72 06 David Fitzpatrick Managing Director dfitzpatrick@alixpartners.com +1 (415) 848-0307

ABOUT ALIXPARTNERS AlixPartners conducts a broad range of surveys and research in industries around the globe. To learn more about our publications, please visit www.alixpartners.com/en/whatwethink.aspx. AlixPartners, LLP 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. The firm was founded in 1981 and can be found on the Web at www.alixpartners.com.
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