Steady growth in defense spending and the longest upward trend in commercial aviation history have made the past decade one for the record books. In the United States, a erospace and defense (A&D) companies posted a historic performance in 2012. The top 100 A&D companies reported a record-setting $695 billion in revenue and $59.8 billion in operating profit. Compared with 2011, this put revenue up 4% and operating profit up 2%.1
Gains came as a result of a particularly strong showing from the commercial aviation segment, with more than 2,000 large aircraft orders for the second year in a row. Consumer demand for air travel remained healthy in 2012, and the corollary demand for commercial aircraft far outstripped the supply. The manufacturing backlog now totals more than 9,000 aircraft. At current production rates, it will take seven years to deliver these orders.
The A&D industry also continued to globalize in 2012. Companies reported increased foreign direct investment at a rate approximately double what it was a decade ago, with China and India holding the top two spots for manufacturing investments, followed by the United States and Mexico, respectively.
But 2013 brings new challenges and intensifying risks. Defense budgets in the United States and Europe are declining, even as security threats in the Middle East and the Korean peninsula persist. Defense companies will face increasing pressure to improve productivity and comply with increasingly complex regulations. Although the path ahead looks bumpy, the industry’s growth and achievements over the past few years leave it well poised to come out ahead. To remain competitive in 2013 and years to come, the strongest companies will proactively respond to the following eight key trends affecting the industry.
In itself, strategy represents nothing new to the A&D industry. But the pace of strategic decision-making— aimed at reorienting businesses in response to a changing budgetary environment—will accelerate in the coming years. The defense segment in particular must account for reductions in US spending. Companies will make strategic decisions with three principal shifts in view.
First, companies in the defense segment will respond to new spending priorities. Governments will focus on technology acquisitions and updates that make the most of what they already own, rather than making outlays for wholly new platforms and equipment. Defense budgets will reflect sensitivity to the lifetime affordability of potential procurements, and they will limit unnecessary proliferation of new systems. With an emphasis on energy efficiency, defense spending will focus on command, control, computers, communication, intelligence, surveillance and reconnaissance.
Second, the recent trend in spin-offs and divestitures will be replaced by a move toward industry consolidation as spending cuts take hold. We expect significant consolidation of the A&D supply chain, despite the failed merger of EADS and BA E Systems, which some view as a sign that governments will resist mergers between major prime contractors.
Finally, companies will need to open new markets to thrive. Developing international markets can help compensate for declining revenues in the US, though doing so may also require expanded international footprints. The White House sent export control reform proposals to Congress on March 7, 2013, redefining restricted categories on the US Munitions List. These reforms will ease the flow of A&D products to international markets. In parallel, companies will focus more on commercial applications in adjacent technologies and markets.
For many companies, innovation is the most important determinant of success. A competitive market position depends on the development of new products, updates to existing products and clear sight far into the future of A&D technology.
Executives from 20 of the top A&D companies told us that innovation is their highest business priority. However, an emphasis on innovation also comes with risk: Failure to innovate has a tall opportunity cost. Companies must recognize the innovation risk, without letting the more measurable operational and compliance risks crowd the view.
As government research and development budgets contract, defense companies will need to make greater investments in independent R&D. The challenge for the defense and space segments is to become more commercial in their approaches to innovation. By contrast, the challenge for the commercial a erospace segment is to maintain upward momentum and gain the resources, both human and economic, to keep up with the accelerating pace of innovation and product development. Going forward, innovation must be viewed as a core business process—not a mere result— across the A&D industry.
This year, the A&D industry must overcome the obstacles that make it harder to attract and retain an adequate supply of skilled talent. Retirement eligibility is in the double digits in most job categories and is expected to reach 18.5% by 2015. To counteract this attrition, companies will need to backfill positions formerly held by experienced, senior personnel with younger, qualified workers.
Building the next generation of talent naturally depends on education. Yet the number of US graduates in science, technology, engineering and mathematics (STEM) remains problematically low, with shortages of scientists and design engineers particularly pronounced. This shortfall is exacerbated by an industry job pool concentrated on the defense and security categories, where the requirement for US citizenship imposes further restrictions on employment.
Making the right course correction will require the A&D industry to forge stronger alliances with universities, recognizing the increasingly strategic role human resources departments play in the talent supply chain. New recruiting efforts must also keep stride with new priorities the younger generation brings to the table, including organizational designs that facilitate crossfunctional collaboration.
Built-in profitability constraints—such as cost-based, fixed-price contracts—have a significant impact on defense contract productivity. Since suppliers must create leading technologies, their development processes are often manually intensive with several rounds of trial and error. Once complete, technologies are sold in much smaller quantities than those in average commercial markets. And throughout the cycle, tough regulations elevate compliance costs.
Despite these limitations, the industry sees opportunity for productivity improvement. Workforce reductions, early retirements and facilities consolidation can quickly reduce overhead costs. Cutting direct product costs, on the other hand, would prove much more difficult. We see four key opportunities for A&D companies to improve productivity and affordability in 2013.
First, avoid costly development delays, and use independent benchmarking to hold all involved accountable. Second, demand more from the supply chain, which accounts for as much as 80% of production value. Reject long lead times and suppliers with poor performance. Third, glean the full value of existing IT investments. Discover unused capabilities and focus on competitive advantage over maintaining legacy systems. And fourth, create a culture of strategic knowledge management, capturing key people’s insight with searchable technology tools to prevent talent drain.
The commercial aviation industry set records for aircraft deliveries in both 2011 and 2012.
The commercial aviation industry set records for aircraft deliveries in both 2011 and 2012. In 2012, the tally reached 1,189—an 18% increase over 2011.1 In the long term, we expect this trend to continue, with demand reaching 1,700 aircraft per year, which would require production rates to increase by as much as another 40%.
Current and projected production levels will strain a complex supply chain that may already have the longest lead time of any, in any industry. Maximizing the efficiency of supply channels will be critical.
While the commercial aviation segment continues to grow, recent cuts to defense budgets may put small suppliers at risk. The trend toward consolidation will simplify the defense procurement process, but it will also make life harder on suppliers who don’t find partners. Some of these companies are the sole supplier in the industry. Others produce unique, hardto- find components. Budget pressures putting these businesses at risk may therefore also jeopardize certain defense procurements. Commercial aerospace and defense contractors will need to reevaluate their supply chain strategies with an eye to mitigating supplier performance risk.
The Asia-Pacific region is expected to take more aircraft deliveries in both units and value over the next 20 years than North America and Europe combined. Fast-growing populations and the rise of a new middle class in the BRIC countries (Brazil, Russia, India and China) increase demand for consumer and business travel. At the same time, global economies show increasing dependence on knowledge, which means that human capital must be easily deployed around the world to meet 21st-century business demands.
On the consumer side, air travel was once viewed as a privilege of the wealthy alone. Today, the relatively lower cost of airfare gives access to a broader crosssection of people. Emerging market economies therefore see aviation as a strategic industry. Many governments now own direct or indirect stakes in national airline carriers and are making moves to enhance infrastructure—from airports to aircraft fleets—to support their strategic positions.
Aviation is expected to grow about 2 percentage points faster than global GDP for the foreseeable future. This creates new opportunities and challenges. Among them are competition with international manufacturers and the need to operate more globally to stay close with customers and suppliers, improve responsiveness and service, and bring in new talent.
Globalization is also having an impact on defense, with US defense export authorizations spiking from $61 billion in 2005 to $264 billion in 2011.1 In a recent PwC study, a erospace and defense companies cited five obstacles to expanding internationally. They include safeguarding intellectual property, export control compliance, creating ethical cultures, managing financial risks, and managing offset and industrial participation requirements.
Information technology in every part of the A&D industry creates efficiency and opportunity—and also complex security challenges. As hackers become increasingly savvy in their efforts to disrupt IT networks, threats of intellectual property theft, exposure of sensitive business data, sabotage and reputation damage grow.
A&D is the industry most at risk of economic espionage from other nations’ intelligence services and also from terrorists, rogue states and hacker activists.
A&D is the industry most at risk of economic espionage from other nations’ intelligence services and also from terrorists, rogue states and hacker activists. It’s likely that every company in the sector has been targeted by what’s known as an advanced persistent threat (APT), designed to steal information from targeted IT networks. APTs can go undetected for months and typically spread through infected files attached to emails.
The insider threat posed by a disgruntled or corrupted employee is just as concerning. As more A&D companies engage in joint ventures, establish partnerships with other companies, and establish manufacturing and research facilities in new markets, more intruders could find new ways to gain access. Staying ahead of them and securing corporate IT systems will continue to be a complex and critical business challenge.
To help, the Departments of Defense and Homeland Security have created a forum where A&D companies can report cyberintrusions and learn about threat information from federal authorities. New federal regulations to heighten cybersecurity are also on the way, with the potential to improve security in critical infrastructure and allow federal agencies to share more threat information with the private sector. Other proposed regulations could protect companies from legal liability when they voluntarily share information with the federal government and establish requirements for security-cleared defense contractors to develop programs to detect and prevent insider threats.
A&D companies’ IT security programs must also keep pace with new developments such as the broad adoption of mobile technology, cloud computing and social networking. These technologies provide more opportunities for access by employees and intruders alike. And we could see new incentives for cyberattackers on the horizon, including government-sponsored A&D programs in unfriendly nations and a potential black market for stolen computer files.
A&D companies must comply with stringent federal regulations, and reforms tend to increase the regulatory burden they face. We see opportunities for strategic reforms that could improve the environment for defense companies in particular.
First, acquisition reform could address how Congress funds long-term programs on a short-term basis. We recommend reform that addresses the definition and stability of customer requirements, establishes realistic budgets based on the risks of developing advanced technologies, promotes a more flexible and innovative bid and proposal process, creates contract structures appropriate to the risk involved and fosters international cooperation and cost sharing.
We also see potential in export control reform. Many have observed that current export control regulations haven’t kept pace with changes in the industry and actually put US defense contractors at a competitive disadvantage. For example, it’s not uncommon for technologies that are broadly used in commercial applications to be subject to export control restrictions. The White House export reforms proposed in March 2013 could boost US exports and preserve key skills in the industry.
A look at the performance of the top 100 A&D companies reveals smart, disciplined management over the past decade and strong demand for the industry’s products and services moving forward. Today’s businesses in every sector rely on the aviation industry to make global operations possible, sending employees and freight to locations around the world. And even though defense budgets are tightening, security threats are still very real. Defense priorities could change in response to these threats, and the industry must be able to respond with an eye toward affordability and increased productivity. 2013 shows promise of being another strong year for the industry and could even set new records in growth and revenue.
1. Aerospace and Defense 2012 year in review and 2013 forecast, PwC