Despite showing surprising resilience in a recession that affected commercial and military aviation suppliers alike, the aerospace and defense industry is now confronting a post-recession environment likely to be characterized by prolonged anemic demand, lingering overcapacity, a shrinking defense budget , further consolidation and an emergence of new airline behemoths.
In the face of the developed market slow down, the Middle East aviation sector is bucking the trend with continued heavy investment and promising growth, led through the increasing number of hubs, rising regional demographics and a concurrent increase in wealth and ability to travel. With huge orders of large-capacity aircraft being placed by the likes of Emirates, the reemergence of carriers such as RAK Airways, and the launching of logistical mega-hubs such as Dubai World Central, the Middle East has become an aviation powerhouse.
The AlixPartners 2010 Global Aerospace & Defense Review finds that it may take years for the industry to work through these effects, both direct and indirect, of the past recession. Although original equipment manufacturers and suppliers performed surprisingly well in 2009, these companies should not expect the same conditions to continue. Companies like Qatar Airways and Emirates will continue to challenge the more established carriers for market share of long-haul travel and cargo routes, the Middle East is now offering an attractive market to all manufacturers, especially tier 1 suppliers.
The study, in fact, highlights major global headwinds, highlighting the bigger part the Middle East and Asia will begin to play in the future:
Ø Aircraft deliveries down 9% globally in the first quarter of 2010, while aircraft orders, which dropped 70% in 2009, have only partially recovered.Ø Passenger traffic down 7.5% globally year-over-year through April, with cargo traffic down 22%, over the same period. Although passenger traffic recovered pre-recession levels in May 2010 (+11.7%), airlines only posted a 0.5% margin, a long way from sustainable profitability.Ø All signs pointing to major defense-spending cuts ahead, as both the Pentagon and defense ministries around the world face the fallout from the recent financial crisis and sputtering local economies. Globally-driven weak business jet demand, due to still-fragile corporate profits and their "politically incorrect" image forged during the auto-bailout hearings of 2009.Consumer disposable income further cut by government deficit-reduction efforts, recently reinforced during the G-20 meetings, hampering the economic recovery.
"The strong five year cycle of growth that we have seen in the aerospace and defense industry came to an end in 2009 and faces a turbulent ride going forward," said Eric Bernardini, a managing director of AlixPartners and co-leader of the firm's global Aerospace & Defense Practice. "The industry made it through 2009 remarkably well compared to most other industries," he continued, "because the major players reacted quickly to cut production capacity. Also, of course, U.S. defense spending continued to be strong in 2009 and so far in 2010, largely due to supplemental spending authorizations for the wars in Iraq and Afghanistan. However, because of the financial crisis and our lingering fragile economy, pressures on defense budgets will be intense going forward, which should prompt primes and non-primes alike to move now to optimize their cost structures.
Eric Benedict, a managing director responsible for the firms work in the Middle East continued, "In the face of the weak global demand, we now have a phenomenal opportunity in time for the Middle East carriers to take advantage of their location, network, capacity, and infrastructure to grow long-haul traffic and freight through the region and emerge as major competition.
Industry wide EBIT margins have dropped by 13% since 2007 especially affecting OEMs. The study shows that their profitability is lagging more than 30% behind that of suppliers, mainly due to major program development delays. In 2009, the most value growing OEMs were American based companies, mostly due to their access to US Defense programs. Their European counterparts fared less well, severely penalized by major delays and overruns on highly complex European programs.
For suppliers, it was the large companies who delivered a better performance, with an increase of 30% in profitability over the past 12 months, especially in the USA.
"For the first time in years, suppliers have be gaining the upper hand in their dealings with the OEMs," said Bernardini. "Given the pervasiveness of risk-reward cost sharing contracts today, the aircraft program delays have led to additional financial pressure on aircraft manufacturers. As a result, the industry must immediately begin to refocus on collaborative cost reduction, more aggressive design to cost and program management to eliminate waste and inefficiencies in their supply chains."
Keys to competiveness rely on new way of working between OEMs and suppliers
In terms of improving competitiveness, the study singles out a number of areas in which the industry still lags many other manufacturing industries, including disciplined program management, value chain optimization, "lean" engineering and risk-sharing supplier management. Dave Fitzpatrick, a managing director in AlixPartners Aerospace & Defense Practice commented, "The industry is entering a period where budget limitations and cost management are key. Companies in the defense and commercial sectors that adopt new strategies to meet these new challenges will be the winners."
On the program-management front, AlixPartners finds that true design-to-cost practices are still not mature enough in the aerospace industry, that the number of recurring cost overruns is as high as non-recurring cost overruns today.
It also finds that while many companies have partially adopted the principles of lean engineering, there is much "slippage" when those principles are actually put into action in programs.
Given today's competitive environment, the cycle time for new product development needs to be cut by 40% or more. That means OEMs need to accelerate their collaborative approach. For their part, suppliers need to be open to more cost and innovation-sharing in exchange for bigger pieces of new programs and earlier involvement in those programs. In the process, everybody should be working toward the overarching goal of being competitive in what looks like a different environment going forward."
Pace of M&A likely to accelerate given the lack of organic growth
Although company valuations have recovered of late, according to the study, there are a growing number of M&A opportunities, particularly in sector consolidations. Specifically, the study points to the aerostructures, electrical-systems and non-engine MRO (maintenance, repair and overhaul) areas as being the most ripe for consolidation, as the top five players control just 40%, 40% and 27% of those sectors, respectively, compared with the typical 60% to 95% seen in other segments. The push for lower fuel consumption and a smaller carbon footprint will also spur M&A activity. Technology development of new propulsion systems, electronic systems, and exotic metal-matrix composites will be strategic, so the OEMs and Tier 1 suppliers will be looking for acquisitions in these areas.
