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After a Record Year in 2013, a New Wave of Structural Challenges, and Possible M&A, Facing the A&D Industry, According to AlixPartners Study

Commercial aerospace may be reaching its peak as the ‘war on costs’ continues in defense and new players and technologies enter the industry

July 07, 2014

After a record year, the Aerospace and Defense (“A&D”) industry is likely on the verge of a new wave of major structural transformation and possible M&A moves, at the same time that commercial aerospace may be reaching its peak and as the “war on costs” intensifies in the defense sector. New players and technologies, that many thought unheard-of just a few years ago, are also entering the industry. That’s according to a new study by AlixPartners, the global business-advisory firm.

2013 proved to be a record profit year for the industry, mainly driven by the boom in commercial aerospace. Average profitability of the top 100 companies in the industry reached a record level, close to a 10% EBIT margin, with continuous growth since 2009. Airline industry EBIT remains much lower, at 3% in 2013, with an increase to 4.3% expected for 2014. However, what’s on the horizon for the A&D industry is likely not without turbulence, especially given declining defense budgets in Europe and North America, and the potential prospect of a cycle peak for commercial aerospace, considering the record backlog for Airbus and Boeing jets, up 17% from 2012.

The AlixPartners study focuses on three main levers of structural and strategic change facing the industry today:

  • The battle for the profit pool in commercial aerospace,
  • Signs of a new M&A rebound that could be on its way,
  • Disruptive innovations, led by SpaceX (Space Exploration Technologies Corp.), 3D printing and Internet giants such as Google and Facebook.

1. The overall A&D industry increased its profitability, driven by the commercial aerospace segment, whereas defense budgets declined for the second consecutive year in Western countries.

Profitability among the industry’s top 100 players reached a record level in 2013, nearly 10% average EBIT margins; but a “cash culture” gap remains between Europe and North America.

In 2013, the A&D Top 100 revenue grew at a still-healthy 4.8%, slightly down from 2012, driven by robust aircraft deliveries in the civil sector. Profitability improved significantly to a record 9.4% of EBIT margin, rising above pre-crisis levels thanks to sales growth and better cost control. Suppliers structurally enjoy higher profits than OEMs, a gap of 3.9 percentage points due partly to higher exposure to profitable aftermarket business. This is a clear cash profitability advantage for suppliers. The dominance of North American players (9.5%) over European ones (5.2%) has never been so marked, driven by a combination of better profitability, working-capital management and asset utilization. Commercial-aerospace revenues and fleet growth have been sustained by global air-passenger traffic, says the study, steadily rising at 4.8% annually in the last 20 years and expected to grow at about the same rate for the next 20.

The passenger-jet fleet reached 19,200 aircraft at year-end 2013, up 78% in 20 years, and the study forecasts that this will increase by 91% over the next 20 years, with more than 32,000 new deliveries expected. Asia Pacific could be the biggest beneficiary, with that region accounting for 37% of the global passenger jet fleet by 2033, compared to 27% today.

Yet, with a record backlog for Airbus and Boeing jets at 10,600 (up 17% from 2012), 2013 may turn out to be the peak of the current commercial aircraft industry cycle, suggests the study. The last few months have proven less than prolific in new orders. The sector might be entering a slower order-intake phase, as backlog at the end of 2013 is more than eight years’ worth of production for the most sold programs and airlines are constantly adapting to changing market conditions, reassessing fleet growth plans and scaling down the type of mega-orders seen in recent years.

Commercial airline revenues are up but profitability remains low, diverging between much-improved US carriers and still-struggling legacy carriers.

Commercial airline revenues grew by 49% from 2009 to 2013, with EBIT improving from 0.4% in 2009 to 3.0% in 2013, a level which is forecasted to grow to 4.3% in 2014 – an improvement, to be sure, but still below many investors’ expectations. The sector is also being driven by the continued expansion of Middle East-based carriers, led by Etihad Airways, Emirates and Qatar Airways, which are increasing their scale and scope through massive fleet orders, acquisitions and commercial agreements. Due to their importance as launch customers and the sheer size of their order books, Gulf carriers are exerting significant influence on aircraft OEMs, in terms of new aircraft design, product strategy and production, and MRO footprint. European legacy carriers and cargo operators continue to face major challenges.

At the opposite end of the spectrum, the defense sector faces a major transformation as it sees declining sales, more-demanding challenges internationally and high cost structures.

Western defense spending continues its steep decline (down 13% from 2010 to 2013); this may translate for some key players into a 20 to 30% top-line reduction in the next three to five years. Despite this trend, the US market remains the largest in the world with growth opportunities (in UAVs, cyber, mini-satellites, MRO, etc.), especially if companies succeed in creating agile business models, more partnerships and lower-cost solutions. The European market keeps declining with no clear sign of an upturn.

Growth markets such as China, Russia are mainly captive markets with most of the business directed toward domestic players. The few accessible international markets for Western players, such as Saudi Arabia, India and Brazil are therefore increasingly competitive. Consequently, European leaders are embarking upon a tough journey to execute much-needed structural changes to downsize and reshape their industrial base, at the right pace.

The new marketplace is highly competitive and fragmented. Most players are reshaping their footprint and offering to adapt to the lower structural Pentagon budget of around US$550 billion, down 40% from 2010.

Space is a solidly growing market, still heavily funded by governments, but where industrial players are facing new challenges.

Space is a solidly growing market (US$270 billion in 2013), growing at an average 8.6% per year since 2007, but still sustained by public funding by up to 30%. The study shows how the value is mostly in “downstream”, in satellite operators, with launch services and satellite manufacturers accounting for only 10% of revenues in 2013 (US$20 billion) versus 90% for satellite operations and services (US$170 billion).

Legacy launcher OEMs must reinvent themselves quickly to respond to SpaceX challenges. The recently announced Airbus/Safran joint venture could be a clear step in the right direction to restore Ariane competitiveness, as is the announced merger between Orbital and ATK, integrating propulsion and launcher players.

Meanwhile, miniaturized satellites, or nanosats, are opening up space to a whole new range of users: these new, smaller satellites provide a degraded functionality compared to traditional satellites, but for a fraction of the cost – from about US$150,000 to $1 million for such a satellite, including launch, vs. about US$200 million to $1 billion for full-sized satellites.

2. The A&D industry is showing signs of a deep structural transformation and might be on the verge of a new wave of strategic moves.

The civil aviation profit pool pie reached a record level of $48bn in 2013, but the battle intensity is rising between Aircraft OEMs eager to increase their share and all other players in the sector.

Airlines share of the civil aviation profit pool climbed back to its 2007 level at $21bn in 2013, a 75% increase compared to 2012, but still below its 2010 record, highlighting the high cyclicality of airlines, driven by economic cycles and fuel prices. Aerospace industry profit pool reached a record $26bn in 2013, up 65% from 2007.

Aircraft OEMs almost tripled their profit since 2007, reaching more than one third of the Aerospace industry profit pool (excluding airlines), thanks to a strong increase in revenues (+7% per year) and EBIT (+3.4 ppt as average), with the strongest improvement reported by Airbus. The new paradigm is re-engineering of existing models (A320NEO / B737 MAX, 777X, maybe A330 NEO), emerging after a decade of complete new aircraft developments (B787, A380, A400M, A350). Many new entrants are targeting the narrow body segment (e.g., COMAC C919; Irkut MS-21; Bombardier C-Series), but most are struggling with serious development delays or limited commercial success.

Engine OEMs, suppliers and equipment OEMs have enjoyed average increases in revenues and EBIT since 2007, but not enough to maintain their overall share of the industry profit pool, challenged mainly by aircraft OEMs. A symptom of this battle’s intensification is the emergence of a new business model on some aircraft programs, with the engine OEMs no longer negotiating engine and nacelle (engine housing) prices with each airline, but directly with aircraft OEMs, which then negotiate the overall aircraft-and-propulsion system price with airlines. Dominance of equipment OEMs is being challenged by aircraft OEMs, through cost-reduction campaigns, an increasingly significant role played by OEMs in the aftermarket, and a fight to keep or regain control of core systems and the integrator role on new or upgraded programs. The growing “cabin” market as well as high profitability of key players also attracts aircraft OEMs to this segment. It notes that aerostructure suppliers have reported a strong reduction in their share of industry profits since 2007 (from 8% to 2% in 2013), due to extra costs for new aircraft development and relatively low standard profit margins.

MRO market profitability remained stable compared to 2007, but its share of the industry profit pool decreased and only players with premium and unique positioning were able to achieve 10% EBIT margin or more. Major aircraft and equipment OEMs, global MRO leaders and private-equity firms attracted by strong fundamentals are likely to invest in MRO to support a fleet which will almost double in the next 20 years – and drive the upcoming consolidation.

Key drivers seem to be in place for strong M&A rebound in 2014, driven by commercial aerospace.

The current industry context of steep industrial ramp-ups and record backlogs requires significant cash availability to ensure deliveries, and only players that generate strong operational cash-flows can conduct M&A operations without suffering from incapacitating levels of debt. Many major companies today are cash-rich, with, at the end of 2013, US$86 billion of cash sitting on the balance sheets of publicly listed companies, an 8% increase compared to 2012.

The study finds that the share, measured in deal count, of civil-aerospace deals as a percentage of all A&D M&A has been constantly increasing from a post-financial-crisis low of 32% in 2010 to 68% in 2013, with the defense and space sectors accounting for the remaining 32%.

Until now, M&A activity in A&D has largely been driven by short-term considerations of coping with complex supply chains and increasing productivity, and by medium–term desires to penetrate highly competitive emerging markets; but going forward, longer-term strategic developments will be more important, with key M&A drivers including the desire to shift positions along the value chain and the search for new profit-margin sources and step-change-enabling technologies.

So far in 2014, there has been an increase in transaction activity in A&D, with several large potential deals announced, such as the announced merger of ATK and Orbital, and BE Aerospace’s current strategic review.

3. Disruptive innovation can create business breakthroughs in A&D mainly in the product design and industrialization phases.

Key examples of such potential disruption are: SpaceX, Expliseat, 3D printing, Big Data and innovative approaches to providing Internet services by tech titans.

SpaceX could be a major disruptive innovator and its success can be measured by the swift reaction of its competitors: Airbus, Safran, Orbital, ULA. Its key success factors include:

  • A lean and flat start-up organization,
  • Designs that focus on reliability, modularity (especially in engines) and re-use (especially in boosters) across the product family,
  • Vertically integrated operations at one single site, and in-house engines,
  • A disruptive business model with an aggressive marketing and lobbying strategy and a simultaneous attack on three key markets: commercial-launch, government-launch and space missions (ISS resupply / Orion capsule).

Expliseat, an aircraft-seat startup, also relied on radical design simplification and use of advanced materials (composite and titanium) to achieve a drastic 50% weight reduction, which, according to the study, could be a game-changer for seat economics, with potential payback on a full eco cabin retrofit in less than three years.

A&D companies are at the forefront of 3D metal printing due to the technology’s key features: freedom in design, weight savings, optimized airflow and tool-less production. Aerospace 3D printing applications are expected to increase 5-fold, to more than US$10 billion, in the next eight years. It sees the main growth drivers being a shift from prototyping to production, with a focus on high value-added metal parts and spare-parts applications (both metallic and non-metallic), where parts could be produced on-demand without high requirements for inventory.

Internet titans such as Google and Facebook are investigating aerospace-based solutions to make a step-change in web access for remote areas not covered by traditional solutions (GSO - Geostationary Satellite Orbit), notes the study. Smaller satellites (e.g., O3b, or “other 3 billion” satellites), solar-powered drones (e.g., Titan Aerospace acquisition by Google, Ascenta’s by Facebook) and helium balloons (e.g., Google’s Loon project) are among the alternative technologies being investigated today by industry players, new and old.