2011 Midyear outlook for the global aerospace and …...Aerospace & Defense Industry Performance...

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India a bright spot; Commercial is coming back

2011 Midyear outlook for the global aerospace and defense sector

announcement of the A320 New Engine Option (A320neo) was met with anticipation by suppliers and potential new customers alike. New program starts and development programs are under way in the United States, Canada, Europe, Japan, China, and Russia. Vendors up and down the supply chain are delighted that the future is looking bright on the sales front.

For defense, the largest global market is the United States, but Department of Defense (DOD) budgets for research and development (R&D) and procurement are declining, with a US$78 billion budget reduction targeted over the next five years.3 Plans by deficit hawks to take back the US$101 billion in overhead reductions meant for additional procurement and other defense priorities are of great concern to the industry.4 In the United Kingdom, the Ministry of Defense (MOD) announced an 8 percent

3 Federal Times, “DOD Secretary Gates announces $78 billion in Pentagon cuts,” 6 January 2011.

4 Defense News, “U.S. Industry Braces for ‘New Era’ of Acquisition,” 20 September 2010.

The past year was a comparatively good year when contrasted with many other industries, as aerospace and defense (A&D) sector sales and profits were relatively flat, which was good in a recessionary environment.1 Flat was the new up in 2010.

On the commercial side, a sustained upswing in sales and production is now anticipated. Airbus and Boeing have both announced production-rate increases for their best selling single-aisle aircraft. Indeed, 2010 was the second best year in history for commercial aircraft production, reaching 972 aircraft deliveries.2 Going forward, the key for a United States upswing is production deliveries of the Boeing 787 Dreamliner, and the recovery of the business jet and general aviation segments. For Europe, the Airbus

1 Deloitte United States (Deloitte Development LLC), “2009 Global Aerospace & Defense Industry Performance Wrap-up: A Study of the 2009 Financial Performance of 91 Global A&D Companies,” 11 May 2010.

2 Flightglobal, “Analysis: Airbus’s late push sees off Boeing — again,” 17 January 2011.

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budget cut in October 2010.5 This budget decrease is closer to 25 percent when accounting for the projected overspend of 18 percent, which is a concern that also needs to be addressed.

Across the globe, governments face pressure to cut costs and to improve efficiency. In traditional defense markets, additional program cuts are expected due to cost overruns or a determination they are no longer needed. New program starts going forward look sparse — all adding up to a sense of unease.

On the bright side, however, new defense markets, notably in India, Saudi Arabia, Brazil, and the United Arab Emirates (UAE), are showing promise with announced acquisition deals or ongoing procurement selection processes. As nations face emerging security threats and their economies allow for improved defense capabilities, new market opportunities arise for global defense contractors. Nontraditional markets thus represent a counterbalance to the declining budgets in traditional defense markets.

Deloitte Touche Tohmatsu Limited’s (DTTL) Global Manufacturing Industry Group interviewed A&D leaders from Deloitte member firms, and asked questions about where the industry stands, and what is the outlook for 2011 and beyond.

5 Aviation Week & Space Technology, “UK In Wholesale Revamp Of Defense Spending Plans,” 25 October 2010.

What does delivery of the first Boeing 787 Dreamliner mean for the global commercial aircraft market?The Dreamliner is good news for the entire global commercial aircraft market. Estimates are that between 26,000 and 30,000 new aircraft will be produced over the next 20 years in order to meet the growing demand for commercial business, leisure, and freight traffic, as well as to replace obsolete aircraft.6 Despite the economic challenges faced by the commercial airline industry, revenue passenger kilometer (RPK) growth is expected to be in the 5 percent range for several decades to come.7

With fuel prices increasing, repair and overhaul costs continuing to rise, and emissions costs starting to take hold, new aircraft are needed that are fuel efficient, eco-friendly, and cost less to maintain. The Boeing 787 Dreamliner is coming to market just when many airlines have expressed desire to replace obsolete equipment. Airlines have ordered 835 of these aircraft, which is likely to keep suppliers busy for many years and represents a bright spot for the entire supply chain.8

Figure 1 illustrates that commercial aircraft manufacturing activity is expected to reach a seven year moving average production rate of 1,000 aircraft per year in the next two

6 Airbus, “Global Market Forecast 2010-2029;” The Boeing Company, “Current Market Outlook 2010.”

7 The Boeing Company, “Current Market Outlook 2010.”8 The Boeing Company website, “Boeing 787 Dreamliner will provide

new solutions for airline passenger.”

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Figure 1: Commercial aircraft orders and production (1981–2012E)

Figure 2: Total U.S. DOD appropriations in $US billions (FY2001-FY2011)

Figure 4: U.S. DOD major defense acquisition program cost overruns

Figure 5: A&D U.S. M&A volume and value comparison (2009 versus 2010)

Source: Deloitte Touche Tohmatsu Limited’s Global Manufacturing Industry Group analysis.

Note: FY2009 non-war supplemental was appropriated through the American Recovery and Reinvestment Act of 2009.Source: DOD Appropriations Acts, FY2001-FY2011; FY2011 President’s budget documents; OMB historical tables FY2011.

Source: Deloitte United States (Deloitte Development LLC), “Can we afford our own future? Why A&D programs are late and over-budget –and what can be done to fix the problem,” Copyright 2009.

Source: Capital IQ data.

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to three years, which is twice what it was as recently as 1991. This level of production represents a promising market environment for manufacturers of commercial aero structures, electronics, engines, and components, and other suppliers to this segment of the industry.9

What impact will the recently announced Airbus A320neo program have in the market?As part of the larger picture described above, increased demand is expected for next generation commercial aircraft that will be less expensive due to fuel efficiency. The A320neo program is designed to accomplish that with targeting savings in the 15 percent range. The engines of the A320neo program will be replaced with the new Pratt & Whitney Geared Turbofan (GTF) or the CFM LEAP-X technologies.10 Indeed, in January 2011, IndiGo, a budget airline in India, provided a memorandum of understanding for 150 new aircraft.11 Virgin Airlines also placed an order for 60 new A320s, of which 30 are to be A320neo.12 The A320neo is likely to extend the program life of the successful A320 aircraft family seating between 107 and 220, which has a backlog as of December 2010 of 2,250 aircraft.13

However, there have been concerns reported in the industry that airline operators who have back orders for classic A320s may consider substituting for the new A320neo, thus not adding to cumulative backlog.14 However, it is believed this would be relatively insignificant due to continued growth in demand for fuel-efficient aircraft to serve the increased overall demand for airline travel, especially in rapidly-growing economies, such as China, India, and the Middle East.

Given growing demand for fuel efficient, single-aisle commercial aircraft, other competitors are entering the market. In particular, Bombardier has under development the CS100 and CS300 single-aisle aircraft powered by the new Pratt & Whitney GTF engine. The Commercial Aircraft Company of China (COMAC) is developing the C919 using the CFM LEAP-X engine technology. These new aircraft are expected to compete with legacy aircraft, the new A320 aircraft, as well as the traditional competitor, the Boeing 737. Furthermore, there are reports that Boeing

9 The Boeing Company, “Current Market Outlook 2010.”10 Airbus, “Global Market Forecast 2010-2029.”11 Centre for Asia Pacific Aviation, “IndiGo orders 180 A320s. The

largest jet order in aviation history gives a boost to Airbus’ A320neo,” 12 January 2011.

12 Bloomberg, “Virgin America Places $5.1 Billion Airbus A320 Order to Double Fleet Size,” 17 January 2011.

13 Airbus SAS website, “A320 Family of Aircraft.”14 New York Times, “Airbus to Update A320 With New Engines and

Wings,” 2 December 2010.

will announce its own response to the A320neo by mid-2011.15 All of this bodes well for the entire supply chain, as additional work packages are expected to keep the industry very busy for the foreseeable future.

What are the implications of the entrance of COMAC onto the world stage?China has previously attempted to enter the commercial aircraft market, most notably with the CATIC and McDonnell Douglas MD-80/90 Trunk-liner JV program in 1992.16 That program did not achieve commercial success due to lack of customer interest, wrangling over financing, disagreements about work-share arrangements, lack of a global customer support infrastructure, and tepid government support.17 However, almost two decades later, the story could not be more different, with the extraordinary growth of the Chinese economy, funding availability, government support, as well as attractive and burgeoning commercial aircraft market opportunities globally.

As cited earlier, the 20-year global forecast for commercial — aircraft production is upwards of 30,000 units.18 Of those, over 14 percent, or over 4,000 new commercial aircraft, are expected to be placed into service in the Chinese airline industry.19 Over 3,000 of those aircraft are expected to be single-aisle aircraft,20 and COMAC’s new C919 is expected to take a portion of that market share. If COMAC is treated as a preferred vendor in the internal Chinese marketplace, orders could be substantial, and a primary competitive differentiator for COMAC. If COMAC achieves even a small-market share with those airlines, for example, 20 percent or 600 aircraft, the program would be considered a success, aside from any sales garnered from foreign customers.

What are the prospects for the Indian commercial aircraft market?It is estimated that over the next 20 years India will require approximately 1,100 commercial jets at a price of up to US$130 billion, representing about 4 percent of the worldwide forecast for commercial airplanes.21 The blockbuster IndiGo order for Airbus single-aisle aircraft at the start of 2011 may be a sign of a significant uptick

15 Bloomberg, “Boeing Doesn’t See Case for New 737 Engine After Airbus Order,” 13 January 2011.

16 U.S. International Trade Commission, “China’s Growing Market for Large Civil Aircraft,” February 2008.

17 LA Times, “McDonnell Sells China 40 Jets in $1-Billion Deal,” 29 June 1992.

18 Airbus, “Global Market Forecast 2010-2029;” The Boeing Company,” Current Market Outlook 2010.”

19 Ibid.20 Ibid.21 Ibid.

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in order activity. SpiceJet, another low-fare domestic airline, recently placed an order for 30 Boeing jets and 30 turboprop aircraft from Bombardier.22 Indian orders are being driven by forecasted annual RPK growth of 15 percent over the next five years and about 8.5 percent on average over the next 20 years, significantly higher than the forecast global growth rate of 5 percent.23

As order activity picks up in India, commercial-aircraft manufacturers may be asked to place engineering and component manufacturing work in country, to promote economic development, job creation, and an improved industrial capability. It is believed commercial aerospace firms may need to provide “offset” arrangements, similar to defense contractors selling in foreign military markets.

India’s defense spending is on the rise and looks to provide opportunities for indigenous, as well as traditional global arms suppliers. What is expected for India in 2011?India is expected to spend US$80 billion over the next four to five years for the Indian Armed Forces.24 Today, India imports from global A&D companies approximately 65 percent to 70 percent of its total defense acquisition requirements.25 Going forward, an Indian government initiative to promote participation by the Indian private sector industries is inviting bids from Indian industry to participate in future military requirements under the “make” category.

High-profile defense procurements expected in 2011 by the Indian MOD or the Armed Forces are for medium multi-role combat airplanes (MMRCA), future infantry combat vehicles, fifth-generation aircraft, C-70 and C-130 Hercules transport aircraft, air-to-air refueling planes, and tactical communication systems. Approval is also likely to be provided for modernization of airfield infrastructure, for which requests for proposals were floated to global A&D firms. Further technology requirements have been described in the areas of unmanned air vehicles (UAVs), tactical missiles, destroyers, radar-based electronics, warfare systems, and munitions.

The increased emphasis on procuring from the Indian private sector may result in a higher number of merger and acquisition (M&A) deals. Recently, Mahindra &

22 Dowjones, “Newswires First with Indigo’s Record Airbus Order,” 11 January 2010.

23 Wall Street Journal, “Boeing sees growth in India’s airline industry,” 14 January 2011.

24 Government of India, “13th Finance Commission Report 2010-15.”25 MOD of India, “Standing Committee on Defence (2005-06) Sixth

Report and Standing Committee on Defence (2009-10) Sixth Report.”

Mahindra and Tata Group have made acquisitions outside and in India respectively.

India’s Defense Acquisition Council recently issued a new Defense Procurement Procedure 2011 (DPP) and defense production policy. The new DPP includes procuring Indian goods for homeland security and civil aviation, including simulators and training, as part of offset programs. This has widened the list of goods that can be procured from Indian industry as offset by overseas companies; offset was otherwise becoming an unachievable task for these companies.

Through its new production policy, the Indian Government aims to make the Indian defense sector self-reliant. This policy envisages external procurement, only where the local industry has no capability to design or manufacture in a given timeframe.

What is the expected impact on United Kingdom industry of the passage of the Strategic Defense and Security Review (SDSR) in late 2010?As in the United States, domestic priorities and an economy affected by the global recession have required the United Kingdom MOD to take a hard look at spending priorities and to propose painful cuts in defense spending. The SDSR identified several programs to be canceled and cutbacks in force structure, altogether representing an 8 percent cut.26 While some high-profile SDSR actions have already been taken, such as retiring the Harrier fleet, the full impact on United Kingdom forces is still being evaluated.

In addition, the United Kingdom government released “Equipment, Support, and Technology for UK Defense and Security: A Consultation Paper” in December 2010, a study that is expected to establish the UK industrial capabilities deemed essential to meet national security needs.

The consultation paper focuses on four key areas: 1. Promoting exports as a replacement for

reduced United Kingdom spending, which will require UK products to have an increased “off the shelf” capability.

2. Bilateral activity, specifically within R&D, and defense/equipment cooperation, with the United States and France being the championed relationships.

3. An intention to award a quarter of government contracts to small and medium-sized enterprises (SMEs).

4. Ensuring that the United Kingdom develops national cyber security capabilities.

26 Aviation Week & Space Technology, “UK in Wholesale Revamp of Defense Spending Plans,” 25 October 2010.

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How industry responds to these government pronouncements will determine the long-term size and capabilities of the UK industry, which currently employs 300,000 and contributes £35 billion to the United Kingdom economy.27 The SME players in the United Kingdom, which number about 8,000 core companies (a larger A&D industrial base than the rest of western Europe combined), will hope for government export support and a fair share of MOD contracts.28 However, in response to the cutbacks, the major players are expected to trim headcount, make additional overhead cost reductions, and conduct portfolio restructuring to align their businesses to future government requirements. Acquisitions can also be expected, in order to reduce reliance on the United Kingdom market, access new geographies. M&A activity is expected to fill gaps in existing capabilities, as well as build capabilities in such “new reality” areas as UAVs and cyber security.

Since the major players in the United Kingdom market actually derive the majority of their sales from outside the UK, they can also be expected to keep a keen eye on what is happening in the U.S. market.

What changes are expected in the A&D industry in France in 2011?France is by no means immune to the conflicting challenges of needing to modernize its capabilities to respond to ever more diffuse threats while public finances are under pressure. Exceptional budgetary receipts will allow France to maintain planned spending on the priorities outlined in the 2008 white paper on defense and national security and the associated 2009–2014 military spending bill, including investments in areas, such as space observation, UAVs, and cyber intelligence.29

Together with a strategic emphasis on knowledge and anticipation, budgetary and institutional flexibility will be the watchwords for 2011. The landmark Defense and Security Cooperation Treaty between France and the United Kingdom sets a particularly important precedent.30 Continued budget pressure can be expected to drive further sharing and pooling of capabilities, as well as deeper industrial and technological cooperation as part of the progressive framing of a common European security and defense policy.

27 Defence Industries Council (DIC), “Securing Britain’s Future and Prosperity,” 9 February 2010.

28 Aerospace Defense Security (A|D|S), “New Defense & Security Industrial Policy Consultation: UK Industry Comment,” 20 December 2010.

29 CSS Analyses in Security Policy, “The French White Paper on Defense and National Security,” December 2008.

30 GlobalSecurity.org, “UK-France Defence Co-operation Treaty announced,” 2 November 2010.

In the commercial sector, the success of Airbus has spurred the creation and development of a sophisticated supplier network. Indeed, Aerolia was created as a separate organization, wholly owned by Airbus, to gain scale economies and to improve efficiencies. Airbus will likely continue consolidation of its supply network in order to gain scale and improve productivity.

Will Germany face the same economic challenges in A&D as the U.S. and United Kingdom?Based on the rapid recovery of the global commercial market, the German aerospace industry should experience a positive trend for 2011. The large companies will benefit from increased production levels and the new technological trends discussed earlier. Some consolidation may occur in the commercial-supplier base to improve component, system, and specific non-traditional commercial aerospace capabilities, as well as economies of scale.

With the appointment of the new Defense Minister, Karl-Theodor zu Guttenberg, the defense industry is facing new and stricter policies by the government.31 Existing long-term contracts were scrutinized by the ministry and in some cases classified as being not stringent enough, leading to late delivery and products not fully complying with specifications. The ministry announced that this will change, with more specificity coming at a later date. Uncertainty within the defense industry has resulted from the announcement of a €400 million cutback of the defense budget of €31 billion in 2011, coupled with the commitment of a significant contribution of the Defense Ministry (€8.3 billion within the coming four years has been proposed and in discussion) to the overall long-term budget consolidation efforts of the government.32 A large restructuring of the armed forces, including the decrease of service men and women from 240,000 to 185,000, a significant cut in operational but also acquisition spending and a shift in procurement policy towards more flexibility has been announced.33 In line with this negative outlook, the industry currently has initiated large transformation and cost savings programs, similar to several large Western countries.

It is believed 2011 will be a challenging year of structural industrial change and clarification of the government’s direction. Closer collaboration between customer

31 Karl-Theodor zu Guttenberg (Defense Minister), April 2010 in Mazar-i-Sharif and October 2010 in Bonn.

32 German Federal Government, “Finanzplan des Bundes 2010 bis 2014.”

33 Stream-tv, “Abschlußbericht der Expertenkommission zur Reform der Bundeswehr,” 26 October 2010.

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platform integrators. Major programs under development are the Mitsubishi Regional Jet (MRJ) by Mitsubishi Heavy Industry/Mitsubishi Aircraft Cooperation, Honda Jet by Honda, commercial derivatives of the XC-2 by Kawasaki Heavy, and US2 by ShinMaywa.

Among those programs, the MRJ program is getting the most attention. Program prototype manufacturing began in September 2010, with the first flight to be scheduled by mid-2012.37 The MRJ is expected to capture significant market share along with incumbents Bombardier and Embraer.38 The Japanese industry has high hopes for the commercial success of this program because it represents an opportunity to showcase indigenous engineering and systems integration capability. It also represents a key pathway for economic development, job creation, and national pride.

The Ministry of Economy, Trade, and Industry intends to double the size of the Japanese A&D industry by 2020. Although that is an aggressive goal, the MRJ program and other step change initiatives increase the probability of success. Success over the next five years is critical for the industry to reach this next level of performance and achieve global status as a legitimate prime contractor of airframe platforms.

On a global basis, what are the lessons learned from the challenges in the U.S. Air Force refueling tanker program competition?Three selection processes have occurred, resulting in protests or bid request withdrawal, with a third process recently concluded in favor of Boeing.39 This competition has demonstrated the importance of accurate and unbiased requirements specification, transparency, high fidelity, and a solid down selection process. Across the globe, protests are becoming the norm in large selection processes, which has raised the bar. In this case, the war fighter is affected by the inevitable delays in delivering the needed capabilities. The taxpayer has the burden of paying for increasingly expensive maintenance on old aircraft.

Buying on “best value” is a noble selection criterion, but it can be affected by the economic, policy, and political repercussions associated with large-scale defense procurements. In an environment where there are fewer programs of record and losing a major competition has

37 AIN online, “Mitsubishi To Delay MRJ First Flight,” 9 September 2009.

38 Flight Global, “Analysis — MRJ technical appraisal,” 7 April 2008.39 Reuters, “Boeing bests EADS in surprise U.S. aerial tanker win,” 24

February 2011.

requirements and suppliers should improve development efficiency and better meeting the armed forces’ needs in a volatile threat environment. It is expected industry and policy makers to work hand-in-hand to improve the export capabilities of the German defense industry. While keeping its support for German high-tech capabilities, government procurement policies may need to address German specific requirements, to further improve the potential for stronger European collaboration on defense and security, as well as the internationalization/exportability of programs and products. In parallel, an alignment of the very restrictive German export control regulations to European standards is targeted by the government to support the industry’s refocus on new markets.

Japan is getting a lot more attention in the industry with large supplier contracts as well as several original equipment manufacturers (OEMs) platforms under development. What lies ahead for the industry in Japan in 2011?The Japanese A&D industry is small by global standards at US$18 billion, which is one-third the size of the United Kingdom or French A&D industries.34 However, the Japanese A&D industry fills a critical supply role in the global industry. Although much devastation has occurred to Japan with the recent earthquake, there was little impact to the A&D industry. The country’s A&D sector is located in the city of Nagoya which is several hundred kilometers from the earthquake’s epicenter.35

A defining moment in 2011 will be the first delivery of Boeing 787 Dreamliner to All Nippon Airways. This milestone is important because a Japanese airline operator will be the first customer of this next generation commercial aircraft. Second, the Japanese supplier network is actively engaged on this program, and is anticipating a gradual production rate increase. Indeed, more than 35 percent of Boeing 787 components are made by Japanese companies, and fully 20 Japanese companies participate in the Airbus A380 manufacturing program.36 It is expected that rate increases in these and other programs will help grow revenues, employment, and related economic activity for the industry in Japan for several years.

The current-global role of the Japanese A&D industry is primarily as a tier one supplier. However, a few OEMs are taking significant steps toward becoming full-scale

34 The Society of Japanese Aerospace Companies, “Aerospace Industry in Japan 2010.”

35 Frost & Sullivan, “Impact of the Japan Crisis on the Airlines and Aerospace Industry,” 11 April 2011.

36 The Society of Japanese Aerospace Companies, “Aerospace Industry in Japan 2010.”

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significant consequences, the outcome of a selection process becomes even more important.

However, employment considerations in sovereign nations and promotion of domestic industrial base issues may drive bid strategies. Defense contractors understand that and should continue to be cautious entering into foreign sales campaigns by planning accordingly. A key strategy is to align with local companies through generous offset arrangements that promote local job creation or retention.

What does the U.S. DOD cost reduction initiative mean for global defense contractors in 2011?The U.S. Congress in late December passed a US$726 billion FY10 defense budget, US$18 billion more than President Obama requested, and a slight increase over the President’s proposed 2010 budget submission.40 The budget includes Overseas Contingency Operation (OCO) funding for winding down the Iraq war and sustaining the Afghanistan war. Going forward, Secretary of Defense, Robert Gates, has proposed a US$78 billion budget reduction over five years by decreasing Army and Marine troop levels and canceling additional weapons programs, among other cost reduction actions.41 Defense contractors may therefore see a reduction in addressable spend. Secretary Gates outlined a broad-based plan to reduce overhead by US$101 billion over the next five years and

40 Center for new American Security, “U.S. House Panel OKs $726B Defense Budget,” 24 May 2010.

41 Federal Times, “Gates announces $78 billion in Pentagon cuts,” 6 January 2011; Pentagon, “Statement on Department Budget and Efficiencies As Delivered by Secretary of Defense Robert M. Gates,” 6 January 2011.

plow those savings back into the department.42 However, deficit reform advocates would like to take some or all of these efficiency savings away from the DOD as part of an overall government cost reduction effort.

For European A&D companies that have successfully entered the U.S. defense market, the planned budget cutbacks for weapons programs serve as a reminder of unforeseen market dynamics. Companies now need to react swiftly to pending market shrinkage and increased competition for a diminishing DOD budget. However, there are still continued needs, and budget is available for innovative weapons systems that are smaller, more energy efficient, and useful in the current conflicts and expeditionary-defense campaigns.

Figure 2 illustrates the steady growth in U.S. defense appropriations over the last decade.43 However, budget pressures may reduce this upwards trend given Secretary Gates DOD efficiencies initiative and other efforts aimed at eliminating waste and redundancy throughout the DOD. An ever-increasing slice of the budget is being allocated for military health care and equipment, operations, and maintenance, leaving less funding available for the R&D, testing, and evaluation, as well as the procurement accounts.

42 Comment from DOD Secretary Robert Gates and Under Secretary of Defense for Acquisition Technology and Logistics Dr. Ashton Carter, 14 September 2010.

43 U.S. DOD, “Appropriations Acts FY2001–FY2010,” 2011 President’s budget documents.

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This trend means that defense contractors should consider several key initiatives in 2011, including competing more effectively to win the few new program starts with competitive pricing and innovative technologies that can be rapidly developed and deployed. Priorities that A&D companies may want to consider in the “new reality” areas being emphasized, including remotely piloted vehicles, cyber security, intelligence surveillance reconnaissance (ISR), mission operations systems integration, data fusion, directed energy, precision strike, and energy security. Also, there may be a wave of acquisitions to address these markets, as well as to provide increased scale. Finally, contractors should consider focusing additional attention on non-DOD markets, in particular foreign military and commercial sales.

Explain the changes in defense and security threats, and how global companies are reacting.The nature of the threat and adversary are changing, and now entering a period, as many describe it, of “persistent conflict” Even though the conflicts in Iraq and Afghanistan will drawdown over the next few years, U.S. military presence in the Middle East region will likely be necessary for the foreseeable future. Iran’s continued pursuit of a nuclear weapon, renewed unrest in Lebanon, ongoing Palestinian crisis, and recent instability in North Africa will drive military spending in the region. In the Persian Gulf region, Iran’s nuclear program is driving a weapons buying program by Saudi Arabia (US$100 billion primarily on new aircraft and air defense systems)44, the UAE (US$40 billion on air and air defense and C2 Systems)45, and other Gulf Cooperation Council States. In Africa, primarily on the oil rich west coast and the Horn on of Africa, unstable or nonexistent governments will drive regional neighbors to continue to build defense and security capacity.

The rise of China’s military ambitions, plus the tragic terrorist event on November 26, 2008 in Mumbai has partly resulted in India’s commitment to spend over US$80 billion on defense and security related procurement over the next five years.46 India is poised to announce in 2011 the winner of a multinational competition for India’s new 126 medium multi-role combat aircraft fleet, a contract worth over US$11billion.47 Due to perceived regional threats, India is expected to continue to modernize its

44 People’s Daily Online, “Gulf region buying more arms but cooperation lags,” 15 October 2010.

45 National Post, “Goodspeed Analysis: Arming the Mideast,” 25 September 2010.

46 Government of India, “13th Finance Commission Report 2010–15.”47 Opinion Asia, “Defence Diplomacy or Foreign Policy? Hectic lobbying

for Indian fighter deal,” 4 April 2008.

naval, ground and space forces, with heavy emphasis on intelligence and precision capabilities. Brazil, with its rapidly growing economy, is committed to becoming a global player and has moved to upgrade and modernize its military, as reflected by the decision to purchase a new fourth generation Western fighter aircraft.

Due to the rapidly-growing threat in the cyber security and critical infrastructure arenas, nations will continue to address their growing homeland-security requirements through improved information technology and intelligence capabilities. Upgrades to command and control and response capabilities will keep demand high for innovative technologies. The consequent growth in the defense market will be global, due to the growing number of capable international defense manufacturers. Along with that global growth will come increased competition, and those companies best able to efficiently compete internationally will be winners.

What should global defense contractors be focused on as they try to sell in nonhome markets?Many of the new international defense markets present unique challenges. As the saying goes, “virtual presence is actual absence,” and this could not be truer than in international defense markets.

Contractors should consider committing to on-the-ground relationship building and developing a comprehensive understanding of the unique characteristics of each local market. Trade compliance should be a key priority when operating globally. Many countries have complex and challenging offset requirements that should be incorporated into up-front capture strategies. In turn, a savvy offset strategy can be a key element in a profitable international business plan.

Added to those requirements will be local market expectations for access to upgrades and improvements, which have the potential to create significant aftermarket opportunities as well.

Figure 3 illustrates the different offset requirements and policies of various nations where European and U.S. defense contractors may seek to do business.

The A&D industry continues to experience program delays and significant cost overruns. Will there be improvement in 2011?Technical problems with several A&D programs in development have become front-page news as media attention focused on recent rocket launch delays or failures, airplane program schedule delays, or military

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Nations Offset sector

Minimum value (US$ million)

Minimum offset percentage

Direct versus indirect

Offset activities focus areas

Saudi Arabia Civilian and military

Not explicitly stated 35% Both Economic diversification, manpower development, strategic self-sufficiency, and technology transfer

India Military $65 million 30% Direct Purchase, invest in Indian firms, and joint ventures (JVs)

Korea Military $10 million, but possibly lower when offset is needed

More than 30%–50%

Both Acquiring high technology, manu-facturing and exporting parts, and components

Brazil Military $5 million 100% Mix Technology transfer

Canada Civilian and military

$100 million, but possibly lower based on type

100% Both Technology transfer

Australia Civilian and military

$9 million (civilian) $4 million (military)

“Maximized local content where cost effective”

Both Local production, R&D, technology transfer, export sales, infrastructure, and JVs

Turkey Civilian and military

$10 million 50% Both Export, technology transfer, R&D, and training

Israel Civilian and military

$5 million 35% No distinction Subcontracts, R&D, technology transfer, and market access/exposure

UAE Military $10 million 60% Indirect Add economic value to UAE’s economy

Kuwait Civilian and military

$34 million (civilian) $10 million (military)

35% Mix Technology transfer and technology partnerships

Figure 3: National offset policy comparison

Source: Deloitte United States (Deloitte Development LLC), “Defense — New Realities, Innovative Responses,” 8 October 2010.

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fighter jet cost overruns. However, the industry has also produced iconic innovations that have changed our daily lives in unimaginable ways due to the creativity, commitment, and skill of its people. These complex products are typically the result of experimentation, testing, and failure, which used to happen with less fanfare before the digital age of 24 by 7 news reporting.

On the other hand, program delays and cost overruns are a business imperative because of the amount of money at risk. The United States Government Accountability Office (GAO) has reported on cost overruns over the last several decades. The GAO office reported that of the 95 major defense acquisition programs, the average schedule delay is 21 months and the cumulative cost overrun is close to US$300 billion or 26 percent over budget.48

Figure 4 illustrates a forecast that by 2020, cost overruns could be 44 percent, based on a regression analysis of DOD major defense acquisition program reports going back to 1993.49 However, with the new DOD efficiency initiative, as well as further efforts underway to improve the technical requirements definition phase of product development, the engineering testing and change order process, and other program management improvement initiatives, over time cost and schedule overruns are likely to trend in a positive direction.50

48 GAO Report to Congressional Committees (GAO-08-467SP), “Defense Acquisitions: Assessments of Selected Weapon Programs,” March 2008.

49 Deloitte United States (Deloitte Development LLC), “Can we afford our own future? Why A&D programs are late and over-budget — and what can be done to fix the problem,” Copyright 2009.

50 U.S. DOD, “Weapons Systems Acquisition Reform Act of 2009.”

With many current large-scale industry programs nearing low-rate production, most of the bad news is likely over. But, for commercial and military programs entering their requirements definition and systems development phases, there continues to be risk of cost overruns. Many of these programs may have been planned assuming a “sunny day” scenario in which contingency costs were kept to a minimum, bids had to be lowered in order to win the program, or technology maturities were not demonstrated out to sufficient levels.

Where do you see industry consolidation going in 2011? The global A&D industry has been consolidating in order to gain concentration, scale economies, and cost efficiencies, resulting in better value to the end customer. Globally, 57 percent of A&D industry revenues are estimated to be generated by the top 10 A&D firms.51 Due to antitrust laws and potential United States and European Union restrictions on further top 10 consolidations, further mega-merger consolidation among this group appears unlikely. However, hundreds of companies involved as suppliers to the top companies could gain scale and cost efficiencies by merging.

This group of smaller companies has seen a significant uptick in M&A activity in the last year, and we expect continued consolidation among tier one, two, and three suppliers in 2011 and beyond, because the industry


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enjoys high-cash levels and investors seek greater returns on these balances. Supplier consolidation should lead to cost efficiencies, resulting in lower pricing to customers. Also, consolidation will likely continue the trend toward innovative process technologies that reduce the labor content in products — resulting in more competitively priced products.

In the expected wave of M&A activity going forward, what subsegments of the A&D industry should see the most activity?M&A activity in 2011 is likely to be driven by several factors including the cash deployment challenge, which has been exacerbated by the fact that many firms have already paid down debt, bought back shares and made elective payments on pension obligations. Public A&D companies reported a total accumulated cash of $72.1 billion.52

This availability of capital could allow for, among other things, acquisitions of companies that possess “new reality” technologies such as cyber security, ISR, precision engagement, data fusion, and a need to grow revenue and increase operational scale to capture cost efficiencies.

Figure 5 shows almost a 192 percent increase in the value of completed and announced M&A deals in 2010, compared to 2009.53 In this next cycle, private equity may compete for many of the same assets as strategic buyers after largely staying on the sidelines for the past few years.

52 Deloitte United States (Deloitte Corporate Finance LLC), “A&D Update: Third Quarter 2010,” 31 December 2010.

53 Capital IQ data.

Several key supplier segments may see additional consolidation as selected private equity firms unwind their long-held positions. Such segments include aero structures, electronic components, engine components, electrical power supply, and systems monitoring, where more than 10 suppliers may be fighting for an increasingly commoditized market with lower pricing being the differentiator. In addition, increased activity could occur among those companies with significant rotorcraft exposure, given the aging of the fleet and their increasing importance in the tactical theater. Finally, service providers focused on the “new reality” areas mentioned above, as well as logistical and energy related services, are likely to be particularly active.

A&D firms had flat revenue and profits in 2009, yet they seem to generate lots of cash. Why have they deployed that cash to paying down debt, buying back shares, and making elective payments to reduce pension liabilities? In 2009, industry sales rose a nominal 1.3 percent and profits were essentially flat after adding back the nonrecurring write-offs associated with over budget programs.54 However, the industry in the United States earned 9.3 percent margins after these write offs and generated significant cash flow, continuing a seven-to-eight-year trend. United States firms with sales above US$500 million in revenue had year-end balances of


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US$32 billion in free cash.55 Sales revenue growth in 2010 is expected to follow the same pattern, as cited earlier.

After several years of buying back shares, paying down debt, and making niche acquisitions, selected companies are also making elective contributions to pension accounts. Cash deployment has become one of the major challenges for A&D executives, because leaving short-term securities on the balance sheet reduces margins due to the historically low interest rates being earned. Thus, in the short term, A&D companies are likely to increase spending on internal R&D efforts, efficiency initiatives, and acquisition activity in order to earn a higher return on excess cash. These companies may also begin investing in creating a presence in such promising foreign markets as the Middle East and India.

The following factors appear to have figured into the resistance to using cash for other purposes: •Higher relative valuations for potential acquisitions•In the cyclicality in share prices of companies•Conservatism in uncertain macroeconomic times,

both in operating the core business and in pursuing potential acquisitions

•High-interest rates on existing debt on the balance sheets

55 Ibid.

What are your predictions for the future of the A&D industry?The industry has significant long-term potential, despite its well publicized current challenges. This is an industry, which is only 107 years old. Since the Wright brothers’ first flight on 17 December 1903, U.S. has landed a man on the moon, and created the global positioning system, radar, internet, supersonic flight, and other innovations of historic importance. It has been key in bringing and maintaining peace and security around the world. It has also benefited mankind by bringing people closer together through affordable, ubiquitous air travel. It kept Berlin alive after World War II in the airlift. It brings humanitarian aid to victims of natural disasters anywhere in the world.

This trend of innovation and contribution to society at large will likely continue at a rapid pace. The possibilities could include air travel becoming more affordable and safer for consumers, global security continuing to be served by the technologies produced in this industry, and new discoveries in the universe, enabled by the innovations in space exploration, expanding our knowledge base.

In retrospect, 2010 was an inflection point in the current economic cycle for A&D. As the industry faces reduced defense spending, recovery in air-travel demand, and the end of the Great Recession. It is likely 2011 will include flattening revenue and profit picture, but selected firms have the potential to prosper as new opportunities are pursued.

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ContactsTom Captain

Global Aerospace & Defense Leader

DTTL

Tel: +1 206 716 6452

E-mail: [email protected]

General (USAF retired)

Charles Wald

Aerospace & Defense Industry Sector,

Director and Senior Advisor

Deloitte United States

(Deloitte Services LP)

Tel: +1 571 882 7800


Nidhi Goyal

Director, A&D industry and Tax and

Regulatory services

Deloitte India

Tel: +91 124 679 2299


Pauline Biddle

Partner, Transaction Services

Deloitte United Kingdom

Tel: +44 118 322 2452


Michael Hessenbruch

Partner, A&D

Deloitte Germany

Tel: +49 711 16554 7311


Yuichiro Kirihara

Senior Manager, A&D

Deloitte Japan

Tel: +81 3 4218 7592


Pascal Pincemin

Partner

Deloitte France

Tel: +33 1 40 88 28 57


Rosa Yang

Partner

Deloitte China

Tel: + 86 21 6141 1578


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2011 Midyear outlook for the global aerospace and …...Aerospace & Defense Industry Performance...

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