aerospace & defense - pwc · 19 places to #51. bae systems reported the largest revenue decline...

www.pwc.com/us/aerospaceanddefense

Aerospace & defense2012 year in review and 2013 forecast

How are aerospace

and defense companies

performing today?

What challenges

and opportunities do

they face?

PwC takes a look.

http://www.pwc.com/us/en/industrial-products/aerospace-defense.jhtml

Aerospace and defense year in review 1

Commercial aerospace 7

Defense 15

Trends 20

Mergers and acquisitions 31

In summary 33

Top 100 list 34

Contents

Our analysis is based on the fiscal 2012 data for the largest 100 aero-space and defense (A&D) companies, by revenue, with publicly available financial reports. Our cut-off date for publication was April 25, 2013. Consequently, several companies were not included because they had not reported results by the announced deadline.

A&D companies include those that generate the majority of their revenue from aerospace and defense activities or, for diversified companies, those

Methodologyreportable segments that derive a majority of revenue from aerospace and defense activities. The results are reported in US dollars. Foreign currencies are translated at average exchange rates for the years ending December 31, 2012 and December 31, 2011, respectively.

Our report also offers PwC’s point of view on topics affecting the industry. Our viewpoints have been developed based on our interactions with our clients and other industry leaders and analysts.

A&D 2012 year in review and 2013 forecast 1

The aerospace and defense industry reported its best year ever in 2012, in terms of revenue and profit. The uptick came on the strength of a surging commercial aviation market that more than offset a soft defense performance. For 2012, the top 100 A&D companies reported a record-setting $695 billion in revenue and $59.8 billion in operating profit. Revenue was up 4 percent compared with 2011, while operating profit was up 2% over 2011. Operating margin decreased 17 basis points to 8.60 percent.

We report only full fiscal year results, so these statistics slightly understate the strength of commer-cial aviation earnings as a result of the acquisitions of Goodrich and Avio. The Goodrich deal closed at midyear, so United Technologies Corporation (UTC) picked up about half of Goodrich’s annual revenue, meaning that the year over year statistics do not take into account more than $4 billion of revenue from Goodrich. Similarly, Avio was acquired by GE Aviation at the end of the year, so the year over year statis-tics do not include about $3 billion of revenue related to Avio. While these types of anomalies occur every year, they were particularly pronounced in 2012.

Commercial aerospace companies continue to be optimistic about the future. Air traffic is robust and steady, driving the lucrative aftermarket business. The industry increased large commercial aircraft output by 18 percent in 2012 to a new record, and captured more

Aerospace and defense industry delivers a third consecutive year of record revenues and profits

Summary table (US $ billions) 2012 2011 Change

Revenue $695 $666 4%

Operating profit $59.8 $58.4 2%

Operating margin 8.60% 8.77% -17bps

Source: PwC analysis

PwC2


than 2,000 large aircraft orders for the second consecutive year and the third time in history. As a result, there’s a record backlog—more than seven years at current production rates. And the industry is anticipating another record output in 2013.

In the wake of modest revenue declines reported for 2012, defense companies face an uncertain 2013. Despite efforts by the industry and others, sequestration went into effect on March 1, 2013. Compa-

nies now are bracing for the conse-quences and waiting for details regarding the impact on specific programs. Defense companies face more pressure than ever to improve productivity, increase transparency, and respond to increasingly complex government regulations and over-sight. There are also significant challenges associated with tighter schedules, and generally higher expectations. Persistent security threats, the Iranian and North Korean nuclear threats, and

geopolitical instability underscore the need for increased global security and could rapidly affect defense priorities.

For more than a decade, the industry has enjoyed steady growth in defense spending and, simultaneously, the longest up cycle in commercial aviation history. The industry, having well managed the growth and achieving record results, now must effectively weather the down cycle.

Despite efforts by the industry and

others, sequestration went into effect on

March 1, 2013. Companies now are

bracing for the consequences and waiting

for details regarding the impact on

specific programs.

Defense companies face more pressure than ever

to improve productivity, increase transparency,

and respond to increasingly complex government

regulations and oversight.



Some highlights from our analysis of 2012 results

Largest increase in revenue (dollars) Boeing $12,963 M

Largest increase in revenue (percentage) AVIC Aircraft Company 82%

Largest increase in operating profit (dollars) Finmeccanica $2,731 M

Largest increase in profit (percentage) Dyncorp 700%

Highest operating margin Transdigm 41.2%

Largest increase in top 100 list AVIC Aircraft Company +19 to 51

Largest decrease in revenue (dollars) BAE Systems -$2,482 M

Largest decrease in revenue (percentage) ThyssenKrupp Marine -27%

Largest decrease in profit (dollars) General Dynamics -$2,993 M

Largest decrease in profit (percentage) Engility -458%

Largest decrease in top 100 list ThyssenKrupp -12 to 68

Deleted from the 2011 list

Goodrich Acquired by United Technologies

Avio Acquired by GE Aviation

Barnes Group Segment reporting change

Loral Space & Communications Acquired by MacDonald Detwiler

Titanium Metals Acquired by Precision Castparts

Volvo Aero Acquired by GKN

Indra Security & Defense 16% decline in revenue

Added to the 2012 list

#66 Engility Spun off from L-3 Communications

#72 Korea Aerospace Did not make reported date cutoff in 2011

#77 Cytec Engineered Materials and Umeco Business combination

#80 Kratos Defense Acquisitions

#92 Nabtesco Aircraft and Hydraulic Equipment

#93 Wesco Aircraft Holdings

#99 Sumitomo Precision Products


PwC4


Companies with operating margin > 20%

#19 Precision Castparts 25.1%

#46 Hindustan Aeronautics Limited 23.7%

#49 Meggitt 24.5%

#64 Transdigm 41.2%

#69 FLIR Systems 21.65%

#93 Wesco Aircraft Holdings 20.5%

#97 Crane Aerospace & Electronics 22.3%


Another year of record deliveries and backlog for commercial aerospace

Boeing again was the industry’s largest company, with $81.2 billion in revenue, a 19 percent increase, on the strength of commercial aircraft deliveries. Boeing reported the largest revenue growth, $12.963 billion. In fact, the amount of revenue that Boeing added in 2012 would be equivalent to the 15th largest A&D company. EADS increased revenue by 15 percent, from €49.1 billion to €56.5 billion (6% when translated into US

dollars). Predominantly commer-cial aerospace companies generally reported strong revenue growth. United Technologies, GE Aviation, and Honeywell Aerospace all reported growth between 5 percent and 8 percent, thanks in part to acquisitions. Precision Castparts, Spirit, Babcock, Triumph, and BE Aerospace, among others, reported double-digit growth. AVIC Aircraft Company reported the largest revenue percentage increase—82 percent. AVIC also made the largest jump on the list, advancing 19 places to #51. BAE Systems reported the largest revenue decline but improved operating income through a 100 basis point increase in operating margin, the largest of any defense contractor.

Boeing was also the industry’s most profitable company, with $6.311 billion in operating profit, an increase of 8 percent. Finmeccanica reported the largest profit increase—$2.7 billion—due to the absence of large program charges recognized in

The amount of revenue that Boeing

added in 2012 would be equivalent to

the 15th largest A&D company.



2011. Industry operating margin decreased 17 basis points to 8.60 percent. Despite the record results, the industry as a whole continues to be eluded by double-digit operating margins. The industry’s best oper-ating margin belongs to Transdigm, at 41.2 percent, up slightly from 40.4 percent the previous year.

Globalization

The A&D industry is becoming increasingly globalized. Companies are reporting more foreign direct investment, with the rate more

than tripling from a decade ago. For investments in manufacturing, China and India have been the top targets. The United States is third, on the strength of its market size and capa-bilities. Fourth on the list is Mexico, which has developed an aerospace manufacturing niche. India was the top target for R&D investments, while China came in seventh, presumably because of concerns over intellectual property protection. The United States was the second most popular target for aerospace and defense R&D investments.

0

5

10

15

20

25

30

35

40

2012201120102009200820072006200520042003200220012000

24

21

12

1813

77

6

3

695

7

2 2 13 2 3

79

64

9 106

R&D Manufacturing

Investments by top 50 global A&D companies in international markets

Source: Company reports

PwC6


2013 forecast and risks

The A&D industry has reported its third consecutive year of record revenue and profit, as the growth in commercial aviation more than offset a soft defense market and multi-billion dollar impairment charges at large defense contrac-tors. The principal risks related to 2013 performance are familiar, and sequestration is certain to have a negative impact on defense industry revenue and profit.

Given the significant uncertainty in the US defense market, it is difficult to predict what’s ahead for 2013. Commercial aerospace growth is expected to slow to a rate of between 4 percent and

5 percent, which is approximately the percentage defense revenue is expected to decline. As a result, industry revenue is expected to be flat in 2013. However, operating profit could set new records, if the industry avoids the large impair-ment charges of recent years. While there is a risk of some impairments resulting from the decline in US defense spending, the magnitude of those charges is likely to be less than in recent years. The growth in commercial aerospace should approximately offset declines in defense spending. Accordingly, operating profit performance is expected to be flat, with the poten-tial for improvement in the absence of large impairment charges.

While there is a risk of some impairments

resulting from the decline in US defense

spending, the magnitude of those charges is

likely to be less than in recent years.


In 2011, the industry set a record, for the first time delivering more than 1,000 large aircraft; in 2012, the industry beat the previous year’s record output by 18 percent, deliv-ering 1,189 aircraft. Boeing delivered 601 aircraft in 2012, the second best in its history and close to its record of 620 deliveries in 1999. In 1999, Airbus recorded 294 deliveries, less than half of Boeing’s tally the same year. In 2012, Airbus delivered 588 aircraft, exactly double its output of 1999, its eleventh consecutive year of record production. It was the first time Boeing delivered more aircraft than Airbus since 2002.

2012 was also the third best year for orders. Orders exceeded expecta-tions, surpassing the 2,000 mark for the second consecutive year and for only the third time in history. The industry book-to-bill was 1.7:1, pushing backlog to another record of more than 9,000 aircraft, or approxi-mately seven-and-a-half years at current production levels.

In 2012, Boeing aircraft programs achieved several milestones. The company booked 1,124 orders for the 737, the most for any Boeing model in a single year, bringing cumulative program orders above the 10,000 mark. In addition, Boeing exceeded 1,000 cumulative orders for the 737 MAX, approximately 18 months after launch. Those orders included Boeing’s largest order ever: 230 737s for Lion Air. The 777 also achieved a program milestone, exceeding 1,000 deliveries since inception.

Commercial aerospace

PwC8


Boeing’s backlog is at a record $319 billion, and Airbus’ backlog is at $638 billion (at list price).

IATA statistics 2012 2011 2010

Revenue passenger miles 5.30% 5.90% 8.20%

Load 79.10% 78.10% 78.40%

Cargo freight ton miles -1.50% -0.70% 20.60%

Load 45.20% 45.90% 53.80%

Source: IATA

Backlog (US $ billions) 12/31/12 12/31/11 12/31/10 12/31/09

Boeing $319 $293 $256 $250

Airbus* $638 $679 $480 $459

*At list price

Aircraft backlog (units) Boeing Airbus Total

Backlog at December 31, 2011 3,771 4,437 8,208

Net orders 1,203 833 2,036

Deliveries 601 588 1,189

Backlog at December 31, 2012 4,373 4,682 9,055

Source: Boeing annual report; Airbus annual report

For 2012, the International Air Transportation Association (IATA) reported revenue passenger growth of 5.3%, a level of demand boding

well for the 20-year forecast of approximately 34,000 new planes at a value of $4.5 trillion.



Order activity continued to be driven in large part by the new single-aisle aircraft, 737MAX and A320neo. Both offerings are re-engined versions of the existing models, offering at least a 15 percent improvement in fuel efficiency. To put this in perspective, aircraft

engines have achieved a 49 percent fuel efficiency improvement in more than five decades of the jet era, or about 1 percentage point annually. Consequently, a 15 percent improve-ment in one generation constitutes a significant advance in fuel efficiency.

Some larger orders from 2012, with approximate value

Lion Air, 230 737 MAXs and 737-900ERs $22 billion

Norwegian, 222 narrow-body split between Boeing and Airbus $22 billion

United, 150 737 MAXs and -900s $15 billion

Pegasus, 100 A320neos not disclosed

GECAS, 100 737 MAXs and -800s $7 billion

Air Lease, 75 737 MAXs $7 billion

To put this in perspective, aircraft engines

have achieved a 49 percent fuel efficiency

improvement in more than five decades

of the jet era, or about 1 percentage point

annually.

Consequently, a 15 percent improvement

in one generation constitutes a significant

advance in fuel efficiency.

PwC10


Regional aircraft

Mitsubishi reported its largest order yet for the MRJ in 2012 from SkyWest, which ordered 100 firm and 100 options of the jet. That more than doubled Mitsubishi’s backlog to 165 aircraft, pulling ahead of Bombardier, which has received 148 orders for C-Series. Embraer will formally launch its second-generation E-Jets during 2013. Among the improvements will be Pratt & Whitney PW1700G and PW 1900G geared turbo fan engines, fly-by-wire, and new wings. In a complete turnabout in the regional engine market, Pratt & Whitney, once absent from the regional jet space, now dominates new produc-tion platforms, with engines on the Bombardier C-Series and Mitsubishi

Aviation deliveries 2011 2012

Global business jet deliveries 696 672

Global turboprop deliveries 526 580

Global piston aircraft deliveries 898 881

Source: General Aviation Manufacturers Association

MRJ, and its recent selection for Embraer’s second-generation E-Jets.

Business jets

Business jet deliveries and cycles experienced a flat year and remain more than 10% below the pre- recession peak. Business jet cycles are roughly the same as a decade ago. Business jet growth looks favorable for the long term, with strong growth in the international markets, as well as improvement in the United States, driven by an improving economy and growing demand for replacement aircraft. During 2012 the number of business jets in China increased 40% to 336. Long-term estimates exceed 2,000, according to the Aviation Week Intelligence Network.



Source: FAA and UBS estimates

0

50,000

100,000

150,000

200,000

250,000

Seasonally adjusted business jet monthly cycles

00 01 02 03 04 05 06 07 08 09 10 11 12

Total orders Total deliveries

Sources: Actual deliveries from GAMA. Orders estimated from competitive intelligence, OEM guidance.Excludes Very Light Jet and Large corporate airliners segments.

2011201020092008200720062005200420032002-1,000-800-600-400-200

-0200400600800

1,0001,2001,4001,6001,800

Industry orders and deliveries—Units, 2002–2011

All graphs represent business jet data

PwC12


Commercial aerospace 2013 forecast

For 2013, Boeing is forecasting between 635 and 645 deliveries, a 6 percent to 7 percent increase, and Airbus is expected to achieve another year of record deliveries of 600 to 610 units, a 2 percent to 4 percent increase.

While these growth rates are more modest than the 18 percent growth in original equipment manufac-turer (OEM) deliveries in 2012, the industry continues to establish new records for output. These record

output levels create considerable strain on an industry that arguably has the most complex supply chain and the one with the longest lead time. The challenge will be to avoid previous supply chain issues while increasing production rates. The industry previously has faced raw materials shortages, late deliveries, out-of-sequence work, overtime, and rush shipments throughout the supply chain, all of which erode the economic benefits of higher volume from dropping to the bottom line. The industry will face these chal-lenges in 2013, and in the longer term, as capacity constraints bump up against record backlogs. OEMs and suppliers are encouraged to perform thorough supplier capacity and readiness assessments.

While it is difficult to predict orders, it is unlikely that orders will main-tain the manic pace of 2011 and 2012. However, 2013 is already off to a strong start. In the first quarter of 2013, Airbus booked 431 orders and Boeing recorded 220 orders, a combined rate of 2,600 orders annu-ally. Lion has ordered 234 A320s, Ryan Air ordered 175 737s, Lufthansa ordered 100 A320s, and Turkish Airlines has ordered 82 A320s. We do not expect this pace to continue or for orders to exceed 2,000 for the third straight year. But we certainly expect orders to exceed the approximately 1,250 deliveries predicted for 2013, pushing backlog to another new high by the end of 2013.


For the past three decades, leased and financed aircraft have steadily grown to represent about half of the commercial airline fleet, and leasing companies have about 16 percent of the current backlog, a historic high. Aircraft lessors will become even more important as their more stable business models, diversified portfolios, and compara-tively higher grade ratings ease their access to capital markets.

Economic risks include the potential for slowing global growth, resulting in part from government spending declines. In addition, the European sovereign debt crisis has the poten-tial to disrupt aviation financing markets. However, any disruption may be mitigated through increases in private financing. As we discussed in our recent report, “Aviation Finance: Fasten your Seatbelts,” as global risks are re-priced, the competition to obtain financing for aircraft may intensify, and the cost of financing may rise. We expect the industry as a whole to be able to attract funding, but new sources of finance will need to be tapped.

Export Credit Agency (ECA) financing, traditionally a backstop, has become the funding source of choice for many airlines. However, the new Aircraft Sector Under-standing (ASU), which governs pricing of ECA financing, will go into effect in 2013, resulting in consid-erable premium increases for this financing stream.

Overall, modest growth in commer-cial aerospace is expected for 2013.

Space

Space-related initiatives are expected to increase significantly in 2013. SpaceX will continue its cargo missions to the International Space Station (ISS) and Orbital Sciences is scheduled for its first berthing with the ISS under the Commercial Orbital Transportation Services (COTS) program. In addition, research and development continues under the Commercial Crew Devel-opment (CCDev) program. Boeing, SpaceX, United Launch Alliance, and Sierra Nevada are among the compa-nies receiving NASA funding for CCDev. The impact of sequestration on these and other space programs remains to be seen.

Long-term forecast

The long-term forecast for commer-cial OEM aircraft is about 34,000 deliveries valued at about $4.5 tril-lion over the next 20 years. While some observers have questioned whether these forecasts are overly optimistic, they are nevertheless based on well-founded assumptions about global economic growth and the rate of aircraft replacement. In fact, the significant improvements in efficiency for new aircraft may accel-erate the demand for replacement aircraft. With long-term demand at more than 1,500 aircraft per year and current production rates at


about 1,200 per year, the industry can look to future growth and a lot of cushion between forecasted demand and current production to absorb any softening in demand. Perhaps a key competitive advan-tage will go to the company that can effectively raise production rates fastest to shorten delivery times.

At the same time, new competi-tors are trying to take advantage of the growing market. Commer-cial Aircraft Corporation of China (COMAC) has launched its C919 aircraft. COMAC is projecting to sell more than 2,000 planes, capturing about 7 percent of market share. In addition, Irkut of Russia has launched a narrow-body aircraft, and Bombardier is marketing its CSeries. Embraer is expected to launch its next-generation E-Jet in 2013, but it has not announced any plans to compete in the narrow-body market.

PwC14


Growth in business jets

The business jet rebound remains elusive and slower than was expected at the beginning of the year. Overall cycles for 2012 were still more than 10 percent below the 2007 peak.

Companies are reporting that business jet backlogs have been cut approximately in half since the start of the recession. The recovery in business jets is expected to align with the overall Western economic

recovery, which continues to be slow. In addition, residual values for aircraft remain challenged, given the lack of demand, leaving many owners, operators, and their financiers exposed. Therefore, business jets should expect another year of modest improvement. In the medium to long term, business jets should see significant increases, driven by economic growth and adapting regulations in Asia and the Middle East, particularly in China. These longer routes favor the larger segment of the business jet market.

The business jet rebound remains

elusive and slower than was expected

at the beginning of the year.

Companies are reporting that business jet

backlogs have been cut approximately in half

since the start of the recession.


The top dozen global defense compa-nies reported revenue decreases of about 4 percent, and an increase in profits of 2 percent (the profit statis-tics exclude the results of General Dynamics and Finmeccanica, which reported large impairment charges in 2012 and 2011, respectively). Only 3 of the top 12 companies reported revenue increases, with Boeing up 3 percent, Lockheed Martin up 1 percent and Safran up 7 percent. Revenue at Thales and L-3 was essen-tially flat. Five of those companies reported increased profits (Lockheed Martin, 10 percent; BAE Systems, 2 percent; Raytheon, 6 percent; Thales, 18 percent; and Safran, 13 percent). Northrop Grumman reported the best operating margin, at 12.4 percent. Four other companies reported double-digit operating margins (Raytheon, 12.2 percent; Safran, 10.5 percent; L-3, 10.3 percent; and UTC-Sikorsky, 10.5 percent). Operating margin for the group was 9.4 percent, an improvement on 30 bps. The best improvements in operating margin were reported by BAE Systems, at 100 bps; Thales, at 90 bps; and Lockheed Martin and Raytheon, at 80 bps. However, some investors are asking whether the margin improvements are sustainable or are a temporary result of cost reduction preceding a revenue decline.

Sequestration went into effect on March 1, 2013 and provides for $85 billion in spending cuts in FY13, half from defense. The defense cut repre-sents about 8 percent of the Depart-ment of Defense’s FY13 base budget request. The DoD is taking actions that include reduction and furlough

DefenseDefense contractors brace for sequestration

PwC16

Defense

of civilian staff and cutbacks in base support services. Much uncertainty remains about the impact of seques-tration on specific defense programs, but the defense industry should expect a proportionate reduction.

During 2012, European defense ministries began responding to the consequences of budgetary reduc-tions by cutting and reprofiling programs and reducing platform numbers. This process is still unfolding, and it is driving signifi-cant uncertainty in the supply base as companies struggle to manage both the impact of known reductions and the risk of uncer-

tain future reductions. Initiatives to preserve capability at the same or lower cost have burgeoned in Germany, Sweden, Norway, the UK, and elsewhere. Globally, there is a growing appetite for capability and cost-sharing between nations—initiatives that remain at the discus-sion stage. The NATO Secretary General’s “Smart Defense” initiative seeks to achieve this for the Alliance, and bilateral arrangements such as the Anglo-French Defense and Security Cooperation Treaty encourage collaboration in a range of activity, from military opera-tions to acquisition to asset sharing.

Backlog (US $ billions) 12/31/2012 12/31/2011

EADS Defense $64 $73

Lockheed Martin $82 $81

Finmeccanica $57 $64

BAE Systems $67 $58

Boeing Defense, Space & Security $71 $60

Thales $32 $33

Northrop Grumman $41 $40

General Dynamics (exc. Gulfstream) $36 $40

Raytheon $36 $35

L-3 $11 $10

Total $497 $494

Source: Company reports

NATO’s operations in Libya high-lighted the importance of having the capability to respond to unexpected events—the “return to contin-gency”—and of a strong blend of European capabilities able to be deployed at short notice. Though the Libyan operation was relatively short-lived, it highlighted significant capability gaps (e.g., in intelligence and surveillance systems) that European nations will find difficult to fill while under the current financial pressures.

European defense companies are responding to declines in their traditional markets and are simul-taneously pursuing opportunities in growth markets, including the Middle East, Brazil, Turkey, South-east Asia, and India. The challenges in those regions are strong competi-tion and in-country barriers to entry.

Exports

The growth of defense export deals has led to a record backlog of $327 billion at mid-year 2011. “We have in excess of 13,000 active cases with more than 165 countries and institutions,” adding up to about $327 billion, said Vice Admiral Bill Landay at a Pentagon news briefing ahead of the Paris Air Show.1

1 Bloomberg, Gopal Ratnam, “Pentagon Has $327 Billion Export Backlog, Sees Drone Demand,” June 10, 2011.


Defense

US defense export authorizations spiked at $264 billion in 2011, the most recent year for which data is available. It represents an $84 billion increase, 48%, from 2010, and a 394% increase compared with 2006. The export backlog, which was disclosed at $327 billion at mid-year 2011, is now estimated at around $500 billion. The significant growth in defense exports should help soften the impact of US defense

cuts. Much of the growth during this period has been in Asia, due to concerns about China’s growing military power and tensions between North Korea and South Korea, and in the Middle East, due to concerns about Iran’s military ambitions. And the United States is not the only country benefiting. Western European countries, Israel, South Korea, and Russia are all gaining from increased defense exports.

US foreign military sales (FMS) agreements and direct commercial sales authorizations2,3

USD Billions

0

50

100

150

200

250

300

2011201020092008200720062005200420032002200120001999

238

154123

107

8967

52676253525547

11 11 12 12 13 13 18 18 29 30 24 269

Foreign military sales (FMS) agreements Direct commercial sales authorizations

On March 7, 2013, the White House sent its export control reform proposals to Congress for approval. The reforms redefine restricted categories on the US Munitions List (USML), with oversight responsi-bility for some categories moving from the State Department to the Commerce Department. These reforms, which have been supported by industry, are designed to simplify and streamline the export process and may lead to further increases in export authorizations.

2 US Department of Defense, “Fiscal Year Series,” http://www.dsca.mil/programs/biz-ops/factsbook/ Fiscal%20Year%20Series%20-%2030%20September%202011.pdf, Sept. 30, 2011.

3 US Department of State, “Section 655 Annual Military Assistance Reports,” http://www.pmddtc.state.gov/reports/655_intro.html

PwC18

Defense

Defense forecast

Due to sequestration, the initial effects of which will be felt during 2013, our expectation is that defense revenue will decline by about 5 percent, based on our calculation of the defense portion of seques-tration for about seven to eight months. But the impact on profits may be mitigated, because as the industry contracts, many of the costs to reduce capacity and restruc-ture or terminate programs will be absorbed by the federal government. The industry drove a slight increase in margins in 2012, despite modest declines in revenue. According to our estimates, the industry will likely hold operating margins flat, before considering potential impair-ments. As the industry contracts, expectations are that some compa-nies will be susceptible to impair-

ment charges, similar in nature, although not necessarily magni-tude, to those reported by General Dynamics and Finmeccanica over the last two years.

Market contraction, coupled with increasing certainty about the nature and amount of defense budget cuts and the impact on specific programs, is also expected to drive significant industry consoli-dation. In recent years, the trend has been toward spin-offs and divesti-tures. High-profile spin-off transac-tions have included the Huntington-Ingals split from Northrop Grumman, Exelis from ITT, and Engility from L-3. In 2013, SAIC is scheduled to complete a spin-off to be known as Leidos. The period of spin-offs looks to be nearing its end, to be followed by a period of defense consolidation. The defense industry is already highly concen-trated, resulting from consolidation

Market contraction, coupled with increasing certainty

about the nature and amount of defense budget cuts and

the impact on specific programs, is also expected to drive

significant industry consolidation.


Defense

during the post-Cold War era. The Defense Department has opposed any further consolidation among major prime contractors, but that position could soften, depending on market conditions. Regardless of whether the major prime contractors consolidate further, expectations are for significant consolidation of the supply base.

Contractors may also continue to respond to market conditions in other ways. The current focus remains on affordability, and the Defense Department now lists affordability among its procurement criteria. Contractors should stay focused on improving productivity, as the industry is beginning a period of fewer new platforms. At the same time, there is a need to recapitalize equipment. So the focus will likely shift from new platforms to plat-form upgrades and sustainment. Electronics and C4ISR, including unmanned aerial vehicles and cybersecurity, will likely be among the areas of growth.

Many companies are exploring commercial applications for their technologies. Most defense contrac-tors, and their investors, have approached commercial markets cautiously because of mixed experi-ences, weighted toward the nega-tive, in the past. Much of that expe-rience, though, is dated; defense contractors have had ample opportu-nities in their core markets for more than a decade. However, many of

the industry’s largest commercial markets have their roots in defense and space technologies, such as computers, computer networking, and telecommunications. Going forward, defense contractors are expected to seek commercial appli-cations for their technologies, even if it means licensing or supplying technology to commercial entities.

The future of the defense industry is difficult to predict, as developments in North Korea’s and Iran’s nuclear weapons programs, instability in the Middle East, and other factors could bring rapid changes in defense priorities.

During 2013, the European defense markets will likely begin to stabi-lize as defense ministries address the budget cuts initiated two years ago. Budgetary increases are not expected until 2015, and it may be necessary to pare some defense budgets, specifically procurement budgets, still further if the Euro-zone’s austerity measures need to be tightened. According to the London Times, the United Kingdom has announced plans to roll out a “balanced defense program” for the first time in a generation; the program will provide clarity for OEMs after some years of uncer-tainty. At the same time, acceler-ated “transition” in Afghanistan will likely start to manifest itself in rationalizing in-theater equipment and logistic support and an increase in logistic movement as military materiel is redeployed. As a result,

the next few years will likely bring an acceleration of equipment refur-bishment, although the extent and its effect on the industry has yet to be quantified.

European nations will likely continue various transformation programs aimed at preserving capability at lower cost and will import many of the ideas and concepts pioneered in the United Kingdom a few years ago; expectations also are for an increase in availability contracting for land, sea, and air platforms, plus an increasing appetite for industry-led solutions in the provision of training, infrastructure, and back-office shared services. Programs for industry will likely take on more complex and broader roles, and the United Kingdom’s Advanced Materials strategy may prove to be a pioneering approach. The drive for exports will also likely continue and remain fiercely competitive as the global defense industry competes in growth markets.

So while the traditional, platform, and equipment-based defense markets in Europe remain under intense pressure, opportunities exist for industry to more broadly deliver service-based capabilities in many countries. In the United Kingdom, the whole of the defense support services market is projected to be worth an estimated £16 billion per year by 2020, or approximately 75 percent of total MoD spend with industry; these trends will accelerate in Europe. (PwC assessment based on public domain sources, 2012.)

PwC20

1 Strategy

While strategy is continually evolving, the pace of significant strategic deci-sion making is expected to accelerate due to a rapidly changing environ-ment, particularly in defense. With the advent of significant reductions in US defense spending, companies will likely make strategic decisions regarding prioritization of markets and technologies. Going forward, defense spending is expected to emphasize:

• Lifetime affordability

• Fewer new platforms

• Upgrades and sustainability of existing platforms

• Command, control, computers, communication, intelligence, surveillance and reconnaissance (C4ISR)

• Energy and efficiency

Many strategic decisions have been made in anticipation of these changes; many actions have been in the form of spin-offs and dives-titures. But the market is expected to shift toward industry consolida-tion as spending cuts take hold. The failed merger between EADS and BAE Systems might be viewed as a harbinger of things to come. Whether the governments involved will allow mergers among any of the major prime contractors may depend on the extent of defense spending cuts. Regardless of whether major primes merge, significant consolidation of the supply chain is expected.

TrendsEight trends to watch in A&D for 2013 and beyond


Trends

In addition, companies are expected to have a greater focus on inter-national markets, in order to help compensate for the decline in US revenues. In recent years, exports have increased significantly. However, companies will increas-ingly focus on international strate-gies, which may include a more significant international footprint. These efforts may be aided by export control reforms proposed by the White House. Additionally, compa-nies will likely focus on adjacent technologies and markets. While many organizations are expected to approach commercial markets cautiously, they are expressing greater interest in commercializa-tion of their technologies.

2 Innovation

Innovation is another area that is steadily evolving. For many companies, innovation is the single most important success factor, as confirmed by a PwC survey of more than 20 executives from leading A&D companies, who collectively ranked innovation as the highest business priority.

Innovation, therefore, is a major risk to be addressed when examining enterprise risk. Yet many companies do not view innovation as a top risk. They are focused on financial and compliance risks, when a failure to innovate may pose the greatest risk. Perhaps innovation is not under-stood as a risk because companies

are more adept at measuring finan-cial and compliance risks, including operational risks that have financial consequences. In comparison, it is much more difficult to evaluate opportunity cost and the effective-ness of research and development and the innovative culture. With reduced government funding for research and development, defense companies look to be making greater investments in independent research and development (IR&D). The challenge for the defense and space industry is to become more commer-cial in its approach to innovation.

Commercial aerospace is enjoying its longest up cycle in history. Not only is demand of the end markets strong, but successful innovations with dramatic improvements to efficiency, reliability, and safety are helping drive the boom. The chal-lenge lies in gaining the resources, both human and economic, to keep up with the accelerating pace of innovation and product develop-ment. As one company executive described it, “We have more oppor-tunities with good business cases than we can afford.”

Commercial aerospace and defense companies should gain greater productivity from research and devel-opment activities as well as prioritize investments. The solution depends partly on viewing innovation as a business process. To learn more about PwC’s perspective on achieving innovation excellence, please visit www.pwc.com/us/gainingaltitude.

PwC22

Trends

3 Talent management

Demographics

The A&D sector continues to face two significant challenges related to talent: steady losses of experienced senior personnel and the need to attract skilled talent. While retire-ment levels for 2011 remained low, retirement eligibility—double-digit in most job categories—is growing by one to two percent annually and estimated to reach 18.5 percent in 2015. And while attrition rates show small decreases, as well as possible declines among the youngest workers, more than 45 percent of workers under 35 plan to switch employers within the next five years, portending a significant talent drain. With defense spending cuts on the way, expectations are for declines in employment levels. The industry faces a challenge similar to that faced by companies during the post-Cold War era: How can businesses avoid losing the next generation of A&D talent?4

A skilled work force

The number of US graduates within the critical fields of science, tech-nology, engineering, and mathematics (STEM) remains low. Shortages in the pool of scientists and design engi-neers are particularly pronounced, with demand expected to show continued growth in 2013. Further-more, a majority of industry jobs are in defense and security, where US citizenship is required, further limiting the pool of available talent.

According to the Aerospace Indus-tries Association, only 44,000 of the 70,000 engineers that graduate each year in the United States are quali-fied to work in the aerospace sector, suggesting the need for stronger partnerships between universities and A&D in order to identify the skills required within the industry. A&D companies also face competition from organizations and other industries for the available talent. This trend is mirrored in other developed aerospace nations.

The resulting pressure has HR playing an increasingly strategic role in the talent supply chain. Mentoring programs and training initiatives, designed to help retain key knowl-edge and skills, are growing in popularity. Additionally, succession fosters early identification of top talent, and recruiting partnerships are being developed to deliberately attract talent from universities.

Two other areas important to talent management are knowledge capture and organization design. Knowledge management programs are increas-ingly critical in minimizing the effects of turnover. And firms are paying attention to the organizational design elements that compromise project execution and cross-functional collab-oration, which may be particularly important to younger workers.

4 Aviation Week, Carole Rickard Hedden, “Aviation Week Workforce Study”, Aug. 13, 2012.


Trends

Engineering talent and US citizenship

The pinch is also evident abroad. In Europe, for example, only about 10,000 graduates from technical universities choose to work within A&D, while the industry needs at least 12,500 graduates every year.5

Global/US citizenship

The search for qualified talent forces US companies to focus increasingly overseas. And while organizations have historically attracted engi-neering talent from countries such as India and Russia, several forces have slowed the promise of an interna-tional labor pool.

The growth of international markets for A&D has resulted in increased competition from countries like China for skilled labor. Another concern is the US government’s restrictions on the number of H-1B visas, a special designation letting firms hire tempo-rary high-skilled workers. Addition-ally, US talent is typically preferred in organizations like the US Defense Department, where security clear-ance requirements rule out inter-national talent, while laws such as the US International Traffic In Arms Regulations (ITAR) prevent sharing technical data and knowledge with foreign nationals.

5 Aviation Week, Carole Rickard Hedden, “Aviation Week Workforce Study”, Aug. 13, 2012.

Still, the foreign labor pool is signifi-cant, making immigration reform a major issue for the A&D industry. According to a 2007 study by the Woodrow Wilson School of Public and International Affairs at Princeton, two countries in particular, India and China, with their vast, educated, low-wage workforces, attracted more than 100,000 H-1B visa holders in a single year. Stricter immigration controls may serve to constrict this supply of talented workers.

For more information on talent management, please visit us online at www.pwc.com/us/peopleandchange.

The growth of international markets

for A&D has resulted in increased

competition from countries like China

for skilled labor.

PwC24

Trends

4 Productivity and affordability

The Pentagon has emphasized affordability, including it as a criterion for procurement decisions. Accordingly, defense contractors have strategized to reduce costs and improve productivity. We compared defense companies with companies in the Dow Jones Industrial Average (DJIA) on the basis of revenue per employee, using data from company earnings statements and company profiles. We acknowledge that revenue per employee is an imperfect measure and that a better measure would be value added per employee, but since that data is not available, we have used revenue per employee as a reasonable surro-gate. In this comparison, we see that defense contracts are about half as productive as the DJIA. We believe there are some valid reasons why defense companies have lower productivity, including:

• Limits on profitability—Much of defense revenue is under cost-reimbursable, or cost-

based, fixed-price contracts, with revenues limited based on profit limitations. Defense contractor profitability is typically a little more than half of the DJIA.

• Development of leading technolo-gies—Defense contractors are frequently developing cutting-edge technologies, which are inherently manually intensive and involve some degree of trial and error.

• Extremely low volumes—Many defense contracts are for single units or quantities measured in the dozens or hundreds, compared with commercial enterprises that typically measure volumes in the millions of units. The low volumes result in manu-ally intensive manufacturing and assembly and low absorption of fixed costs in a capital-intensive industry.

• Regulation—The industry is highly regulated, which can increase compliance costs, including compliance with federal acqui-sition regulations (FAR), cost accounting standards (CAS), and export controls (ITAR).

The industry is highly regulated,

which can increase compliance costs.


Trends

Despite these inherent limitations, the industry recognizes there is room for improvement in produc-tivity. Many companies have been taking action to reduce overhead costs, including workforce reduc-tions, early retirements, and facili-ties consolidation. Direct product costs will likely be more challenging. We believe the following areas offer opportunities:

• Program management/short-ened development cycle

• Supply chain management

• Information technology

• Knowledge management

Improving the speed and effective-ness of program development typi-cally produces the biggest gains in affordability. Schedule delays are the biggest factor in budget overruns. While contractors take pride in their program manage-ment abilities, the industry should seek continuous improvement, including unbiased, independent assessments and benchmarking.

The defense supply chain has become extremely complex. Typi-cally, 50 percent to 80 percent or more of the total value of production is rooted in a technically complex, multi-tier supply chain. Accord-ingly, any productivity improvement initiative should address suppliers, the most significant component of costs. Defense contractors can no longer accept long lead times and

marginal supplier performance as industry norms. The industry should challenge itself to get much closer to “just in time” delivery. The industry might consider adopting leading-edge risk management practices to regain visibility into the supply chain that has been lost through outsourcing.

Information technology represents one of the biggest areas for discre-tionary spending at most companies, including defense firms. Many A&D companies have invested millions in systems implementations but haven’t yet realized the full capabilities and productivity enhancements that these systems enable. Many IT organiza-tions are still spending most of their time in legacy system maintenance and enhancements. Companies should unlock the full capabilities of their IT platforms, become leaner, and migrate the IT organization away from costly maintenance toward strategic initiatives and competitive advantage.

Finally, improved knowledge management will likely become more critical. Talent drain, already a factor due to demographics, has been accelerated by early retirements and workforce reductions. Compa-nies should identify the key people and knowledge in their organiza-tions and capture that information using searchable technology tools. Organizations should also create a knowledge management culture that promotes and rewards the effective capture and use of knowledge.

PwC26

Trends

5 Supply chain

In 2013, two major trends are expected to have a significant impact on the supply chain:

Commercial aircraft production rate ramp-up

• Previously, we discussed the commercial aircraft production rate ramp-up of historic propor-tions. In 2012, the industry delivered a record 1,189 large commercial aircraft, an 18% increase over the prior year, which was also a record. In the long term, demand is projected to be about 1,700 aircraft annually, meaning that annual production rates may continue to increase by another 40 percent. The current and projected production levels will likely strain a supply chain that can be considered to have the most complex and longest lead time supply chain of any industry.

Defense spending reductions

• For the defense supply chain, the concern is that significant defense spending cuts will drive small suppliers out of business. Some of these suppliers may be sole source or produce unique components. Accordingly, the supply chain could be left with a shortage of critical parts and long lead times to qualify new suppliers.

Both commercial aerospace and defense contractors should reeval-uate supply chain strategy and evaluate supplier performance risk.

To learn more about PwC’s perspec-tive on the supply chain, please visit www.pwc.com/us/gainingaltitude.

6 Globalization

Globalization is driving the boom in commercial aviation. The Asia-Pacific region is expected to take more aircraft deliveries, in units and value, over the next 20 years than North America and Europe combined. Why?

• Developing economies, particu-larly in the BRIC countries (Brazil, Russia, India, and China) are growing faster than devel-oped economies. The economy is becoming more knowledge based, with businesses increas-ingly relying on the global deployment of human capital, a requirement for operating a twenty-first century business. That new paradigm is driving strong demand for aviation, as well as resiliency for the industry. Aviation once was a hyper-cyclical industry, overre-acting to business cycles. Now, that dynamic has fundamen-tally changed, as demonstrated during the most recent recession. While aviation demand did take an extreme downturn during the


Trends

recession, demand rebounded faster than the overall economy and more quickly than in previous economic cycles, rapidly returning to pre-reces-sion levels and demonstrating that aviation demand has become much less elastic than it used to be.

• Consumer air travel once was largely a privilege of the wealthy. As the relative cost of air travel has declined, it has become highly accessible to the middle class and not readily relinquished, even during a slow economy. Aviation growth will likely continue to be driven by the growing middle class in developing economies.

• Aviation is viewed as a strategic industry in emerging market countries. Governments, keen to promote aviation, airports, and the associated infrastructure, own direct or indirect stakes in many national carriers, enabling them to place large orders for aircraft.

As a result, aviation is expected to grow about 2 percentage points faster than global GDP for the fore-seeable future. While globalization is creating tremendous growth and opportunity for the industry, it is also driving challenges that require new strategies. Among these are:

• Competition—The growth in the industry and lure of high tech-nology in aerospace is attracting such new competitors as Comac of China, Irkut of Russia, and Mitsubishi of Japan. In addition, regional jet makers are increasing the size and range of their jets, competing at the smaller end of the narrow-body market.

• Globalization of customers and suppliers is driving numerous challenges. The aerospace industry once was principally a domestic industry relying on exports. But as the customer base and supply chain have diversified, aerospace compa-nies increasingly are operating

While globalization is creating tremendous

growth and opportunity for the industry,

it is also driving challenges that require

new strategies.

internationally in order to drive intimacy with customers and suppliers, improve responsive-ness and service, satisfy offset and industrial participation requirements, and, in some cases, take advantage of interna-tional talent or lower costs.

Globalization, not limited to commercial aerospace companies, is also having a significant impact on defense. US defense export sales authorizations (for future deliveries) have increased more than four-fold since 2005, from $61 billion to $264 billion in 2011, as seen in the chart on page 17. These arms largely are destined for the Middle East and Asia-Pacific. Defense contractors are expected to continue to focus on international markets and develop global footprints.

In a recent PwC study, aerospace and defense companies cited the following as the greatest obstacles to becoming more international:

• Safeguarding intellectual property

• Export control compliance

• Creating ethical cultures

• Managing financial risks

• Managing offset and industrial participation requirements

For more information on strategies to address globalization opportuni-ties and risks, please refer to A&D Insights: Accelerating global growth.

PwC28

Trends

7 Cybersecurity

Given their role in developing cutting-edge technologies with military applications, A&D compa-nies have long faced heightened security challenges. With ubiquitous and interconnected information technology (IT) systems driving every phase of the A&D industry, companies face complex challenges to the security and integrity of their operations and reputation, including ongoing efforts to steal intellectual property and other sensitive business data, as well as attempts to sabotage opera-tions and tarnish reputations by disrupting IT networks.

Economic espionage.

A&D remains the industrial sector most targeted by economic espio-

nage conducted by nation-states’ intelligence services. Systems supporting unmanned aerial vehi-cles (drones) may get particular attention from economic spies because of their highly publicized use for intelligence gathering and kinetic strikes in war zones.

Intrusions into A&D companies’ IT systems have lasted for months or years before being detected. In February 2013, one cybersecurity firm reported how an advanced persistent threat (APT) has “system-atically stolen hundreds of terabytes from at least 141 organizations…spanning 20 major industries.” Two other APTs—dubbed “Shady RAT” and “Beebus”—may have been created by hackers linked to a foreign government. All three APTs appear to have been designed to steal information from targeted IT

networks, where they are typically introduced by infected files attached to “spearphishing” emails.6

• It is likely that every company in the A&D sector has been targeted by these APTs.

• Many US A&D companies have responded to APTs by partnering with the federal government. The Defense Industrial Base Cyber Security/Information Assurance Program, under the aegis of the Department of Defense (DoD) and Homeland Security (DHS), is a forum letting A&D companies volun-tarily report cyberintrusions and letting federal authorities share detailed threat information.

• Cybertools are not the only means of conducting economic espionage. Exploiting the access of disgruntled or corrupted insiders—the “insider threat”—is often just as dangerous: Dongfan Chung, who worked on the B-1 bomber, space shuttle, and other A&D projects for nearly 30 years, was convicted in 2010 of economic espionage on behalf of the Chinese aviation industry.

The complex business ecosystem in the A&D sector, with compa-nies increasingly relying on joint ventures, partnerships, and manu-facturing and R&D facilities in expanding markets—potentially opening new points of access for intruders—adds to the challenge of keeping corporate IT systems secure.

6 Mandiant, “APT1: Exposing One of China’s Cyber Espionage Units”, www.mandiant.com, Feb. 19, 2013.


Trends

Disruption and sabotage.

The same elements making A&D companies attractive to spies also make them targets for cyberdisrup-tion campaigns by terrorists, rogue states, and hacktivists.

Hacktivists, who have already attacked financial and energy companies, could conduct distrib-uted denial of service campaigns to disrupt IT networks or intrusion attempts aimed at exfiltrating and publicizing sensitive data about corporations or their employees.

Similarly, kinetic strikes using a particular weapons system against a rogue state or terrorist group could lead to retaliatory cyberattacks designed to disable or disrupt the computer networks of the weapon’s manufacturer.

Unique and evolving regulatory environment.

Because most of the largest A&D companies work on classified and military-related projects, many of their processes for handling sensitive information are subject to unusually strict governmental oversight. These companies should be prepared for regulatory changes, which are in the offing in three broad areas.

First, important changes stem from a White House executive order (EO), “Improving Critical Infrastructure’s Cybersecurity,” published in February 2013. The order calls for the creation of a framework to reduce cyber-risk to critical infrastructure, as well as provisions letting federal agencies share more threat information with

the private sector. The EO also calls on the secretary of Homeland Security to identify “critical infra-structure at greatest risk”—which may include A&D firms with signifi-cant military contracts—and to let the owners of such organizations know of that designation. Many of the details of the order will be released in coming months.

In addition, the Cyber Intelligence-Sharing and Protection Act has been reintroduced in the House of Representatives, and this year’s draft is expected to receive White House support. Legislation may be necessary for the complete imple-mentation of the executive order. One particular concern of many companies is to obtain protection from legal liability that could result from voluntary information-sharing with the federal government.

Finally, cleared defense contractors, including most major A&D compa-nies, must soon develop insider threat programs and enhance their capa-bilities to detect and prevent these threats, in accordance with Executive Order 13587, issued in October 2011 and establishing a national policy and minimum standards for insider threat mitigation programs across federal departments and agencies.

Looking ahead.

Over the next decade, the A&D industry will likely remain a high-priority target of threat actors due to economic factors as well as mili-tary calculations. The challenge of protecting corporate assets, and IT systems in particular, will likely grow.

The ultimate nature of these develop-ments is to be determined, but two broad trends are likely to emerge.

Technological and cultural shifts: smartphones, tablets, and other devices that can connect to the Internet are becoming ubiquitous and, with the move to a cloud computing paradigm, will likely drive opportunities for theft and manipulation of companies’ sensi-tive data. And employees and other individual stakeholders can expect ever greater access to companies’ IT systems and data from their personal devices and from locations of their choice.

New threat factors are also likely to emerge, reflecting shifts in global economic activity:

• Governments seeking to jump-start fledgling A&D companies could be tempted to sponsor cyber-intrusions and other efforts to pilfer the intellectual property and know-how of industry leaders.

• Similarly, the nature of criminal hacking may evolve, with social networking tools potentially facilitating a new black market in stolen computer files, thus creating powerful incentives for newcomers to attack corporate networks.

For more information on cybersecu-rity, please visit PwC’s Information security, privacy, and risk page.

PwC30

Trends

8 The regulatory environment

The current regulatory environment is a key challenge facing the defense industry.

Several reforms may help improve the environment for defense companies.

Acquisition reform

Attempts to improve the current defense acquisition process have not succeeded. One reason could be that reforms have sought to place ever-increasing regulations on the contractors. Acquisition reform might benefit from addressing how Congress funds long-term programs on a short-term basis, and the manner in which the customer initially defines requirements and the impact of subsequent modifica-tions. Some observations concerning areas ripe for reform include:

• Addressing the definition and stability of requirements

• Establishing realistic budgets and funding based on the inherent risks of developing advanced technologies

• Promoting flexibility and inno-vation in the bid and proposal process

• Using contract structures appropriate to risk

• Promoting international cooperation and cost sharing

The Defense Contract Audit Agency

The purpose of the Defense Contract Audit Agency (DCAA) is to protect the government and taxpayers from fraud and abuse. The following are some considerations that could improve the effectiveness and efficiency of DCAA audits:

• Audit approach—Benchmark the audit approach against commercial practices, such as those regulations established under the American Institute of Certified Public Accountants (AICPA) and Public Company Accounting Oversight Board (PCAOB).

• Materiality—Establish mate-riality standards. Materiality is not defined for government contracting exceptions. It is widely accepted in commercial practice that it is impractical and cost-prohibitive to build a control system to catch minor errors.

• Third-party reliance—The DCAA’s resources are limited. While DCAA standards allow for reliance on third parties, it seldom occurs. The DCAA could consider establishing standards for third-party reliance that promote such use where the third party is objective and compe-tent to improve the speed and effi-ciency of the regulatory process.

Export control reform

Many observers believe current export control regulations are outdated and drive a competitive disadvantage for the US defense industrial base. Many technologies that are broadly used in commercial application are still subject to export control restrictions. On March 7, 2013, the White House sent its proposal for export reform to Congress. Export control reform could be effective in promoting US exports and preserving key skills in the indus-trial base.


The total A&D deal value for the year was $19.5 billion, about 15 percent below the preceding 10-year average of $22.9 billion. Based on our methodology, the 2012 statistics include the announcement that Hawker Beechcraft would be purchased by Superior Aviation Beijing; however, the deal subsequently was aban-doned. Excluding that deal, annual deal value was $17.7 billion, or 23 percent below the 10-year average.

Overall, commercial aerospace M&A had a strong year. However, the defense sector did not generate even one mega deal (above $1 billion) in 2012, while 2011 brought four mega deals in defense, totaling $10.6 billion.

In 2012, the defense sector faced potential US sequestration and uncertainty in defense spending, which continues into 2013. Once there is more certainty—or at least less uncertainty—regarding the future of defense budgets and the impact on specific programs, the defense industry will be able to value companies and better assess M&A opportunities. When this period begins, defense M&A is expected to become much more dynamic and could lead to some historic deals.

Defense M&A is facing a “perfect storm” of pent-up demand, strong balance sheets and cash positions, and, most importantly, the neces-sity to consolidate in response to a contracting market. We view

Mergers and acquisitions

PwC32

Mergers and acquisitions

the attempted merger between EADS and BAE Systems in 2012 as a harbinger of further defense deals. While mergers among global defense prime contractors will continue to be challenging, due to concerns by government stake-holders, some transformative M&A transactions are expected in defense once the cloud of uncertainty is lifted in the United States.

Looking ahead, four trends are likely to affect M&A activity in the coming years:

• Increasing consolidation in response to a contracting defense market and cost pressures

While mergers among global defense prime

contractors will continue to be challenging…

some transformative M&A transactions

are expected in defense once the cloud of

uncertainty is lifted in the United States.

• Further re-evaluation of supply chains by big manufacturers, in both civil and military segments, as they seek to gain better control of their large program pipelines

• Continuing growth in the secu-rity, surveillance, and homeland security sector

• Greater investment in and competition from fast-growing markets, most notably China

We believe these trends will provide the context for growth in deal volume and value in 2013.


The performance of the top 100 A&D companies is a barometer for the health of the industry and reflects strong and disciplined management over the past decade. It also reflects the strong demand for the industry’s products and services.

Aviation has become a critical part of our global infrastructure. Businesses cannot operate effectively without global deployment of human capital. Aviation is increasingly inelastic, and it demonstrated its resiliency during the recession. While air freight is still dwarfed by sea and land freight, an increasingly larger portion of the global supply chain now relies on air cargo.

The outlook for defense is clouded by the impact of sequestration in the United States and cuts to the defense budget. It is still not clear how defense budget cuts will impact major defense programs. Furthermore, the security threat is dynamic and could rapidly change defense priorities. The defense industry must respond to the affordability chal-lenge and improve productivity.

The near-term and long-term forecast for commercial aerospace is optimistic, with expectations for significant growth. Aviation will continue to grow faster than the overall economy because of its critical role in the global economic infrastructure, bolstered by economic growth in Asia, the Middle East, Eastern Europe, and Latin America. Defense faces challenges, including an extended period of budget battles and uncertainty. We believe 2013 should be another strong year for the industry, and possibly another record year, as avia-tion growth continues to offset a weaker defense market.

In summary

PwC34

In summary

Revenue (US $ millions)

Operating Profit (US $ millions)

# Company 2012 2011 Change 2012 2011 Change1 Boeing 81,698 68,735 19% 6,311 5,844 8%2 EADS 72,587 68,328 6% 2,809 2,359 19%3 Lockheed Martin 47,182 46,499 1% 4,434 4,020 10%4 General Dynamics 31,513 32,677 -4% 833 3,826 -78%5 United Technologies 29,089 24,826 17% 3,245 3,466 -6%6 BAE Systems 28,263 30,745 -8% 2,599 2,536 2%7 Northrop Grumman 25,218 26,412 -5% 3,130 3,276 -4%8 Raytheon 24,414 24,791 -2% 2,989 2,830 6%9 Finmeccanica 22,128 24,086 -8% (587) (3,318) 82%

10 GE Aviation 19,994 18,859 6% 3,747 3,512 7%11 Rolls Royce 19,273 17,856 8% 2,176 1,904 14%12 Thales 18,196 18,120 0% 1,191 1,010 18%13 Safran 17,427 16,214 7% 1,826 1,613 13%14 L-3 Communications 13,146 13,158 0% 1,351 1,442 -6%15 Honeywell Aerospace 12,040 11,475 5% 2,279 2,023 13%16 SAIC 10,587 10,921 -3% 311 947 -67%17 Textron 9,122 8,387 9% 853 722 18%18 Bombardier Aerospace 8,628 8,594 0% 382 502 -24%19 Precision Castparts Corp. 7,215 6,220 16% 1,817 1,503 21%20 Huntington Ingals 6,708 6,575 2% 358 100 258%21 Mitsubishi Aerospace 6,216 5,923 5% (137) (43) -220%22 Embraer 6,178 5,803 6% 612 318 92%23 CSC North American Public Sector 5,703 6,002 -5% 132 528 -75%24 Exelis 5,522 5,839 -5% 561 535 5%25 Harris Corp 5,451 5,418 1% 559 600 -7%26 Spirit AeroSystems 5,398 4,864 11% 92 356 -74%27 Serco UK & Europe and Americas 5,252 5,559 -6% 396 380 4%28 Singapore Technologies 5,108 4,755 7% 527 483 9%29 Dassault Aviation 5,065 4,597 10% 703 524 34%30 Babcock International Group 4,865 4,339 12% 521 442 18%31 Rockwell Collins 4,726 4,806 -2% 859 846 2%32 Alliant Techsystems 4,618 4,842 -5% 496 526 -6%33 Zodiac 4,422 3,804 16% 610 512 19%34 MTU Aero Engines 4,343 4,078 6% 481 456 5%35 Delta Tucker Holdings / DynCorp International 4,044 3,719 9% 96 12 700%36 Oshkosh Defense 3,951 4,365 -9% 237 543 -56%37 CACI 3,774 3,578 5% 300 251 20%38 IHI Aero Engines and Space Operations 3,752 3,438 9% 75 73 3%39 Saab 3,547 3,615 -2% 300 452 -34%40 Triumph Group 3,408 2,905 17% 515 314 64%41 Israeli Aerospace Industries 3,300 3,436 -4% 78 133 -41%42 Hindustan Aeronautics Limited (HAL) 3,126 3,279 -5% 622 604 3%43 BE Aerospace 3,085 2,500 23% 540 428 26%44 Rheinmetall Defence 3,001 2,978 1% 224 310 -28%45 Elbit Systems 2,889 2,817 3% 203 116 75%46 GKN Aerospace 2,813 2,377 18% 269 266 1%47 Cobham 2,772 2,977 -7% 374 420 -11%48 Kawasaki Aerospace 2,588 2,472 5% 98 38 160%49 ManTech International 2,582 2,870 -10% 171 227 -25%50 Meggitt 2,545 2,335 9% 625 578 8%


In summary

Revenue (US $ millions)

Operating Profit (US $ millions)

# Company 2012 2011 Change 2012 2011 Change51 AVIC Aircraft Company 2,474 1,361 82% 34 19 79%52 MOOG 2,470 2,331 6% 243 219 11%53 QinetiQ 2,329 2,731 -15% 256 233 10%

54Allegheny Technologies High Performance Metals

2,191 1,956 12% 372 365 2%

55 BBA Aviation 2,179 2,137 2% 163 181 -10%56 Teledyne Technologies 2,173 1,942 12% 243 227 7%57 Parker Hannifin Aerospace 2,103 1,922 9% 290 247 17%58 Curtiss-Wright 2,098 2,017 4% 161 187 -14%59 AAR 2,064 1,805 14% 131 134 -2%60 Trimble 2,040 1,644 24% 213 156 37%61 Esterline Technologies 1,992 1,718 16% 189 198 -5%62 RUAG 1,856 1,932 -4% 122 124 -2%63 CAE 1,822 1,649 10% 302 286 6%64 Eaton Aerospace 1,719 1,648 4% 213 244 -13%65 TransDigm Group 1,700 1,206 41% 700 487 44%66 Engility 1,655 2,071 -20% (329) 92 -458%67 Hexcel 1,578 1,392 13% 249 192 30%68 ThyssenKrupp Marine Systems 1,526 2,076 -27% (18) 296 -106%69 Orbital Sciences 1,437 1,346 7% 113 80 41%70 FLIR Systems 1,405 1,544 -9% 303 313 -3%71 Cubic Corporation 1,381 1,296 7% 128 114 12%72 Korea Aerospace Industries 1,367 1,163 18% 112 96 17%73 Kongsberg Gruppen Defense and Protech 1,294 1,443 -10% 172 178 -3%74 Ultra Electronics 1,206 1,174 3% 141 159 -12%75 Chemring Group 1,173 1,162 1% 59 162 -64%76 Bharat Electronics 1,066 1,164 -8% 201 247 -19%77 Cytec Engineered Materials & Umeco 1,054 789 34% 166 125 33%78 Fuji Aerospace 1,006 1,039 -3% 36 27 34%79 GenCorp 995 918 8% 35 39 -10%80 Kratos Defense & Security Solutions 969 714 36% (50) 30 -267%81 SIA Engineering 937 879 7% 104 108 -4%82 Aselsan 907 899 1% 113 140 -20%83 Heico Corporation 897 765 17% 163 138 18%84 Woodward Governor Aerospace 896 843 6% 130 130 0%85 MacDonald Dettwiler & Associates 880 761 16% 127 117 9%86 Ball Aerospace 877 785 12% 85 80 6%87 ViaSat 864 802 8% 2 39 -95%88 Latecoere 827 801 3% 34 62 -45%89 Smiths Detection 823 819 0% 109 105 4%90 Alion Science and Technology 817 787 4% 40 35 14%91 OHB Technology 813 773 5% 40 38 6%92 Nabtesco Aircraft and Hydraulic Equipment 805 742 9% 77 70 9%93 Wesco Aircraft Holdings 776 711 9% 159 162 -2%94 Ducommun 747 581 29% 55 (34) 262%95 Senior Aerospace 746 614 21% 108 88 23%96 Magellan Aerospace Corp 705 699 1% 61 60 2%97 Crane Aerospace & Electronics 701 678 3% 156 146 7%98 Aeroflex 673 729 -8% (21) 53 -140%99 Sumitomo Precision Products 655 706 -7% 53 63 -17%

100 Jamco Corp 624 539 16% 13 25 -45%

Total 694,763 665,969 4% 59,752 58,427 2%

© 2013 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. NY-13-0466

www.pwc.com

For more information contact:

Scott ThompsonUS Aerospace & Defense Leader 703.918.1976 [email protected]

Charles MarxUS Aerospace and Defense Advisory Leader 602.364.8161 [email protected]

James GrowUS Aerospace and Defense Tax Leader 703.918.3458 [email protected]

aerospace & defense - pwc · 19 places to #51. bae systems reported the largest revenue decline...

Documents