Pwc aerospace-defense-year-in-review-and-forecast-may2013

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This Pwc analysis is based on the fiscal 2012 data for the largest 100 aerospace and defense (A&D) companies, by revenue, with publicly available financial reports. Our cut-off date for publication …

This Pwc analysis is based on the fiscal 2012 data for the largest 100 aerospace 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.

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  • 1. www.pwc.com/us/aerospaceanddefenseAerospace & defense2012 year in reviewand 2013 forecastHow are aerospaceand defense companiesperforming today?What challengesand opportunities dothey face?PwC takes a look.
  • 2. Aerospace and defense year in review 1Commercial aerospace 7Defense 15Trends 20Mergers and acquisitions 31In summary 33Top 100 list 34Contents
  • 3. Our analysis is based on the fiscal2012 data for the largest 100 aero-space and defense (A&D) companies,by revenue, with publicly availablefinancial reports. Our cut-off datefor publication was April 25, 2013.Consequently, several companieswere not included because theyhad not reported results by theannounced deadline.A&D companies include those thatgenerate the majority of their revenuefrom aerospace and defense activitiesor, for diversified companies, thoseMethodologyreportable segments that derive amajority of revenue from aerospaceand defense activities. The resultsare reported in US dollars. Foreigncurrencies are translated at averageexchange rates for the years endingDecember 31, 2012 and December31, 2011, respectively.Our report also offers PwC’s point ofview on topics affecting the industry.Our viewpoints have been developedbased on our interactions with ourclients and other industry leadersand analysts.
  • 4. A&D 2012 year in review and 2013 forecast 1The aerospace and defense industryreported its best year ever in 2012,in terms of revenue and profit. Theuptick came on the strength of asurging commercial aviation marketthat more than offset a soft defenseperformance. For 2012, the top 100A&D companies reported a record-setting $695 billion in revenue and$59.8 billion in operating profit.Revenue was up 4 percent comparedwith 2011, while operating profitwas up 2% over 2011. Operatingmargin decreased 17 basis points to8.60 percent.We report only full fiscal yearresults, so these statistics slightlyunderstate the strength of commer-cial aviation earnings as a result ofthe acquisitions of Goodrich andAvio. The Goodrich deal closed atmidyear, so United TechnologiesCorporation (UTC) picked up abouthalf of Goodrich’s annual revenue,meaning that the year over yearstatistics do not take into accountmore than $4 billion of revenuefrom Goodrich. Similarly, Avio wasacquired by GE Aviation at the end ofthe year, so the year over year statis-tics do not include about $3 billion ofrevenue related to Avio. While thesetypes of anomalies occur every year,they were particularly pronouncedin 2012.Commercial aerospace companiescontinue to be optimistic aboutthe future. Air traffic is robustand steady, driving the lucrativeaftermarket business. The industryincreased large commercial aircraftoutput by 18 percent in 2012 to anew record, and captured moreAerospace and defense industrydelivers a third consecutive yearof record revenues and profitsSummary table (US $ billions) 2012 2011 ChangeRevenue $695 $666 4%Operating profit $59.8 $58.4 2%Operating margin 8.60% 8.77% -17bpsSource: PwC analysis
  • 5. PwC2Aerospace and defense industry delivers a third consecutive yearof record revenues and profitsthan 2,000 large aircraft orders forthe second consecutive year andthe third time in history. As a result,there’s a record backlog—more thanseven years at current productionrates. And the industry is anticipatinganother record output in 2013.In the wake of modest revenuedeclines reported for 2012, defensecompanies face an uncertain 2013.Despite efforts by the industry andothers, sequestration went intoeffect on March 1, 2013. Compa-nies now are bracing for the conse-quences and waiting for detailsregarding the impact on specificprograms. Defense companies facemore pressure than ever to improveproductivity, increase transparency,and respond to increasingly complexgovernment regulations and over-sight. There are also significantchallenges associated with tighterschedules, and generally higherexpectations. Persistent securitythreats, the Iranian and NorthKorean nuclear threats, andgeopolitical instability underscorethe need for increased globalsecurity and could rapidly affectdefense priorities.For more than a decade, the industryhas enjoyed steady growth in defensespending and, simultaneously, thelongest up cycle in commercialaviation history. The industry, havingwell managed the growth andachieving record results, now musteffectively weather the down cycle.Despite efforts by the industry andothers, sequestration went into effect onMarch 1, 2013. Companies now arebracing for the consequences and waitingfor details regarding the impact onspecific programs.Defense companies face more pressure than everto improve productivity, increase transparency,and respond to increasingly complex governmentregulations and oversight.
  • 6. A&D 2012 year in review and 2013 forecast 3Aerospace and defense industry delivers a third consecutive yearof record revenues and profitsSome highlights from our analysis of 2012 resultsLargest increase in revenue (dollars) Boeing $12,963 MLargest increase in revenue (percentage) AVIC Aircraft Company 82%Largest increase in operating profit (dollars) Finmeccanica $2,731 MLargest increase in profit (percentage) Dyncorp 700%Highest operating margin Transdigm 41.2%Largest increase in top 100 list AVIC Aircraft Company +19 to 51Largest decrease in revenue (dollars) BAE Systems -$2,482 MLargest decrease in revenue (percentage) ThyssenKrupp Marine -27%Largest decrease in profit (dollars) General Dynamics -$2,993 MLargest decrease in profit (percentage) Engility -458%Largest decrease in top 100 list ThyssenKrupp -12 to 68Deleted from the 2011 listGoodrich Acquired by United TechnologiesAvio Acquired by GE AviationBarnes Group Segment reporting changeLoral Space & Communications Acquired by MacDonald DetwilerTitanium Metals Acquired by Precision CastpartsVolvo Aero Acquired by GKNIndra Security & Defense 16% decline in revenueAdded 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 ProductsSource: PwC analysis
  • 7. PwC4Aerospace and defense industry delivers a third consecutive yearof record revenues and profitsCompanies 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%Source: PwC analysisAnother year of recorddeliveries and backlog forcommercial aerospaceBoeing again was the industry’slargest company, with $81.2 billionin revenue, a 19 percent increase,on the strength of commercialaircraft deliveries. Boeing reportedthe largest revenue growth,$12.963 billion. In fact, the amountof revenue that Boeing added in2012 would be equivalent to the15th largest A&D company. EADSincreased revenue by 15 percent,from €49.1 billion to €56.5 billion(6% when translated into USdollars). Predominantly commer-cial aerospace companies generallyreported strong revenue growth.United Technologies, GE Aviation, andHoneywell Aerospace all reportedgrowth between 5 percent and 8percent, thanks in part to acquisitions.Precision Castparts, Spirit, Babcock,Triumph, and BE Aerospace, amongothers, reported double-digit growth.AVIC Aircraft Company reportedthe largest revenue percentageincrease—82 percent. AVIC also madethe largest jump on the list, advancing19 places to #51. BAE Systemsreported the largest revenue declinebut improved operating incomethrough a 100 basis point increase inoperating margin, the largest of anydefense contractor.Boeing was also the industry’s mostprofitable company, with $6.311billion in operating profit, an increaseof 8 percent. Finmeccanica reportedthe largest profit increase—$2.7billion—due to the absence of largeprogram charges recognized inThe amount of revenue that Boeingadded in 2012 would be equivalent tothe 15th largest A&D company.
  • 8. A&D 2012 year in review and 2013 forecast 5Aerospace and defense industry delivers a third consecutive yearof record revenues and profits2011. Industry operating margindecreased 17 basis points to 8.60percent. Despite the record results,the industry as a whole continues tobe eluded by double-digit operatingmargins. The industry’s best oper-ating margin belongs to Transdigm,at 41.2 percent, up slightly from40.4 percent the previous year.GlobalizationThe A&D industry is becomingincreasingly globalized. Companiesare reporting more foreign directinvestment, with the rate morethan tripling from a decade ago. Forinvestments in manufacturing, Chinaand India have been the top targets.The United States is third, on thestrength of its market size and capa-bilities. Fourth on the list is Mexico,which has developed an aerospacemanufacturing niche. India was thetop target for R&D investments, whileChina came in seventh, presumablybecause of concerns over intellectualproperty protection. The UnitedStates was the second most populartarget for aerospace and defenseR&D investments.051015202530354020122011201020092008200720062005200420032002200120002421121813776369572 2 13 2 379649 106R&D ManufacturingInvestments by top 50 global A&D companies in international marketsSource: Company reports
  • 9. PwC6Aerospace and defense industry delivers a third consecutive yearof record revenues and profits2013 forecast and risksThe A&D industry has reported itsthird consecutive year of recordrevenue and profit, as the growthin commercial aviation more thanoffset a soft defense market andmulti-billion dollar impairmentcharges at large defense contrac-tors. The principal risks related to2013 performance are familiar, andsequestration is certain to have anegative impact on defense industryrevenue and profit.Given the significant uncertaintyin the US defense market, it isdifficult to predict what’s aheadfor 2013. Commercial aerospacegrowth is expected to slow to arate of between 4 percent and5 percent, which is approximatelythe percentage defense revenue isexpected to decline. As a result,industry revenue is expected to beflat in 2013. However, operatingprofit could set new records, if theindustry avoids the large impair-ment charges of recent years. Whilethere is a risk of some impairmentsresulting from the decline in USdefense spending, the magnitudeof those charges is likely to be lessthan in recent years. The growthin commercial aerospace shouldapproximately offset declines indefense spending. Accordingly,operating profit performance isexpected to be flat, with the poten-tial for improvement in the absenceof large impairment charges.While there is a risk of some impairmentsresulting from the decline in US defensespending, the magnitude of those charges islikely to be less than in recent years.
  • 10. A&D 2012 year in review and 2013 forecast 7In 2011, the industry set a record,for the first time delivering morethan 1,000 large aircraft; in 2012,the industry beat the previous year’srecord output by 18 percent, deliv-ering 1,189 aircraft. Boeing delivered601 aircraft in 2012, the second bestin its history and close to its recordof 620 deliveries in 1999. In 1999,Airbus recorded 294 deliveries, lessthan half of Boeing’s tally the sameyear. In 2012, Airbus delivered 588aircraft, exactly double its output of1999, its eleventh consecutive yearof record production. It was the firsttime Boeing delivered more aircraftthan Airbus since 2002.2012 was also the third best year fororders. Orders exceeded expecta-tions, surpassing the 2,000 markfor the second consecutive year andfor only the third time in history.The industry book-to-bill was 1.7:1,pushing backlog to another record ofmore than 9,000 aircraft, or approxi-mately seven-and-a-half years atcurrent production levels.In 2012, Boeing aircraft programsachieved several milestones. Thecompany booked 1,124 orders for the737, the most for any Boeing modelin a single year, bringing cumulativeprogram orders above the 10,000mark. In addition, Boeing exceeded1,000 cumulative orders for the 737MAX, approximately 18 monthsafter launch. Those orders includedBoeing’s largest order ever: 230 737sfor Lion Air. The 777 also achieved aprogram milestone, exceeding 1,000deliveries since inception.Commercial aerospace
  • 11. PwC8Commercial aerospaceBoeing’s backlog is at a record $319 billion, and Airbus’ backlog is at$638 billion (at list price).IATA statistics 2012 2011 2010Revenue 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: IATABacklog (US $ billions) 12/31/12 12/31/11 12/31/10 12/31/09Boeing $319 $293 $256 $250Airbus* $638 $679 $480 $459*At list priceAircraft backlog (units) Boeing Airbus TotalBacklog at December 31, 2011 3,771 4,437 8,208Net orders 1,203 833 2,036Deliveries 601 588 1,189Backlog at December 31, 2012 4,373 4,682 9,055Source: Boeing annual report; Airbus annual reportFor 2012, the International AirTransportation Association (IATA)reported revenue passenger growthof 5.3%, a level of demand bodingwell for the 20-year forecast ofapproximately 34,000 new planesat a value of $4.5 trillion.
  • 12. A&D 2012 year in review and 2013 forecast 9Commercial aerospaceOrder activity continued to bedriven in large part by the newsingle-aisle aircraft, 737MAXand A320neo. Both offerings arere-engined versions of the existingmodels, offering at least a 15 percentimprovement in fuel efficiency.To put this in perspective, aircraftengines have achieved a 49 percentfuel efficiency improvement in morethan five decades of the jet era, orabout 1 percentage point annually.Consequently, a 15 percent improve-ment in one generation constitutes asignificant advance in fuel efficiency.Some larger orders from 2012, with approximate valueLion Air, 230 737 MAXs and 737-900ERs $22 billionNorwegian, 222 narrow-body split between Boeing and Airbus $22 billionUnited, 150 737 MAXs and -900s $15 billionPegasus, 100 A320neos not disclosedGECAS, 100 737 MAXs and -800s $7 billionAir Lease, 75 737 MAXs $7 billionTo put this in perspective, aircraft engineshave achieved a 49 percent fuel efficiencyimprovement in more than five decadesof the jet era, or about 1 percentage pointannually.Consequently, a 15 percent improvementin one generation constitutes a significantadvance in fuel efficiency.
  • 13. PwC10Commercial aerospaceRegional aircraftMitsubishi reported its largestorder yet for the MRJ in 2012 fromSkyWest, which ordered 100 firmand 100 options of the jet. That morethan doubled Mitsubishi’s backlogto 165 aircraft, pulling ahead ofBombardier, which has received148 orders for C-Series. Embraerwill formally launch its second-generation E-Jets during 2013.Among the improvements will bePratt & Whitney PW1700G and PW1900G geared turbo fan engines,fly-by-wire, and new wings. In acomplete turnabout in the regionalengine market, Pratt & Whitney,once absent from the regional jetspace, now dominates new produc-tion platforms, with engines on theBombardier C-Series and MitsubishiAviation deliveries 2011 2012Global business jet deliveries 696 672Global turboprop deliveries 526 580Global piston aircraft deliveries 898 881Source: General Aviation Manufacturers AssociationMRJ, and its recent selection forEmbraer’s second-generation E-Jets.Business jetsBusiness jet deliveries and cyclesexperienced a flat year and remainmore than 10% below the pre-recession peak. Business jet cyclesare roughly the same as a decadeago. Business jet growth looksfavorable for the long term, withstrong growth in the internationalmarkets, as well as improvementin the United States, driven by animproving economy and growingdemand for replacement aircraft.During 2012 the number ofbusiness jets in China increased40% to 336. Long-term estimatesexceed 2,000, according to theAviation Week Intelligence Network.
  • 14. A&D 2012 year in review and 2013 forecast 11Commercial aerospaceSource: FAA and UBS estimates050,000100,000150,000200,000250,000Seasonally adjusted business jet monthly cycles00 01 02 03 04 05 06 07 08 09 10 11 12Total orders Total deliveriesSources: Actual deliveries from GAMA. Orders estimated from competitive intelligence, OEM guidance.Excludes Very Light Jet and Large corporate airliners segments.2011201020092008200720062005200420032002-1,000-800-600-400-200-02004006008001,0001,2001,4001,6001,800Industry orders and deliveries—Units, 2002–2011All graphs represent business jet data
  • 15. PwC12Commercial aerospaceCommercial aerospace2013 forecastFor 2013, Boeing is forecastingbetween 635 and 645 deliveries,a 6 percent to 7 percent increase,and Airbus is expected to achieveanother year of record deliveriesof 600 to 610 units, a 2 percent to4 percent increase.While these growth rates are moremodest than the 18 percent growthin original equipment manufac-turer (OEM) deliveries in 2012, theindustry continues to establish newrecords for output. These recordoutput levels create considerablestrain on an industry that arguablyhas the most complex supply chainand the one with the longest leadtime. The challenge will be to avoidprevious supply chain issues whileincreasing production rates. Theindustry previously has faced rawmaterials shortages, late deliveries,out-of-sequence work, overtime,and rush shipments throughout thesupply chain, all of which erode theeconomic benefits of higher volumefrom dropping to the bottom line.The industry will face these chal-lenges in 2013, and in the longerterm, as capacity constraints bumpup against record backlogs. OEMsand suppliers are encouraged toperform thorough supplier capacityand readiness assessments.While it is difficult to predict orders,it is unlikely that orders will main-tain the manic pace of 2011 and2012. However, 2013 is already offto a strong start. In the first quarterof 2013, Airbus booked 431 ordersand Boeing recorded 220 orders, acombined rate of 2,600 orders annu-ally. Lion has ordered 234 A320s,Ryan Air ordered 175 737s, Lufthansaordered 100 A320s, and TurkishAirlines has ordered 82 A320s. We donot expect this pace to continue or fororders to exceed 2,000 for the thirdstraight year. But we certainly expectorders to exceed the approximately1,250 deliveries predicted for 2013,pushing backlog to another new highby the end of 2013.
  • 16. A&D 2012 year in review and 2013 forecast 13For the past three decades, leasedand financed aircraft have steadilygrown to represent about half ofthe commercial airline fleet, andleasing companies have about16 percent of the current backlog,a historic high. Aircraft lessors willbecome even more important astheir more stable business models,diversified portfolios, and compara-tively higher grade ratings easetheir access to capital markets.Economic risks include the potentialfor slowing global growth, resultingin part from government spendingdeclines. In addition, the Europeansovereign debt crisis has the poten-tial to disrupt aviation financingmarkets. However, any disruptionmay be mitigated through increasesin private financing. As we discussedin our recent report, “AviationFinance: Fasten your Seatbelts,”as global risks are re-priced, thecompetition to obtain financing foraircraft may intensify, and the costof financing may rise. We expectthe industry as a whole to be able toattract funding, but new sources offinance will need to be tapped.Export Credit Agency (ECA)financing, traditionally a backstop,has become the funding source ofchoice for many airlines. However,the new Aircraft Sector Under-standing (ASU), which governspricing of ECA financing, will go intoeffect in 2013, resulting in consid-erable premium increases for thisfinancing stream.Overall, modest growth in commer-cial aerospace is expected for 2013.SpaceSpace-related initiatives areexpected to increase significantly in2013. SpaceX will continue its cargomissions to the International SpaceStation (ISS) and Orbital Sciencesis scheduled for its first berthingwith the ISS under the CommercialOrbital Transportation Services(COTS) program. In addition,research and development continuesunder the Commercial Crew Devel-opment (CCDev) program. Boeing,SpaceX, United Launch Alliance, andSierra Nevada are among the compa-nies receiving NASA funding forCCDev. The impact of sequestrationon these and other space programsremains to be seen.Long-term forecastThe long-term forecast for commer-cial OEM aircraft is about 34,000deliveries valued at about $4.5 tril-lion over the next 20 years. Whilesome observers have questionedwhether these forecasts are overlyoptimistic, they are neverthelessbased on well-founded assumptionsabout global economic growth andthe rate of aircraft replacement. Infact, the significant improvements inefficiency for new aircraft may accel-erate the demand for replacementaircraft. With long-term demand atmore than 1,500 aircraft per yearand current production rates atCommercial aerospaceabout 1,200 per year, the industrycan look to future growth and alot of cushion between forecasteddemand and current production toabsorb any softening in demand.Perhaps a key competitive advan-tage will go to the company that caneffectively raise production ratesfastest to shorten delivery times.At the same time, new competi-tors are trying to take advantageof the growing market. Commer-cial Aircraft Corporation of China(COMAC) has launched its C919aircraft. COMAC is projecting to sellmore than 2,000 planes, capturingabout 7 percent of market share.In addition, Irkut of Russia haslaunched a narrow-body aircraft,and Bombardier is marketing itsCSeries. Embraer is expected tolaunch its next-generation E-Jetin 2013, but it has not announcedany plans to compete in the narrow-body market.
  • 17. PwC14Commercial aerospaceGrowth in business jetsThe business jet rebound remainselusive and slower than wasexpected at the beginning of theyear. Overall cycles for 2012 werestill more than 10 percent belowthe 2007 peak.Companies are reporting thatbusiness jet backlogs have beencut approximately in half since thestart of the recession. The recoveryin business jets is expected to alignwith the overall Western economicrecovery, which continues to beslow. In addition, residual valuesfor aircraft remain challenged,given the lack of demand, leavingmany owners, operators, and theirfinanciers exposed. Therefore,business jets should expect anotheryear of modest improvement. In themedium to long term, business jetsshould see significant increases,driven by economic growth andadapting regulations in Asia and theMiddle East, particularly in China.These longer routes favor the largersegment of the business jet market.The business jet rebound remainselusive and slower than was expectedat the beginning of the year.Companies are reporting that business jetbacklogs have been cut approximately in halfsince the start of the recession.
  • 18. A&D 2012 year in review and 2013 forecast 15The top dozen global defense compa-nies reported revenue decreases ofabout 4 percent, and an increase inprofits of 2 percent (the profit statis-tics exclude the results of GeneralDynamics and Finmeccanica, whichreported large impairment chargesin 2012 and 2011, respectively). Only3 of the top 12 companies reportedrevenue increases, with Boeing up3 percent, Lockheed Martin up 1percent and Safran up 7 percent.Revenue at Thales and L-3 was essen-tially flat. Five of those companiesreported increased profits (LockheedMartin, 10 percent; BAE Systems, 2percent; Raytheon, 6 percent; Thales,18 percent; and Safran, 13 percent).Northrop Grumman reported the bestoperating margin, at 12.4 percent.Four other companies reporteddouble-digit operating margins(Raytheon, 12.2 percent; Safran, 10.5percent; L-3, 10.3 percent; and UTC-Sikorsky, 10.5 percent). Operatingmargin for the group was 9.4 percent,an improvement on 30 bps. The bestimprovements in operating marginwere reported by BAE Systems, at 100bps; Thales, at 90 bps; and LockheedMartin and Raytheon, at 80 bps.However, some investors are askingwhether the margin improvementsare sustainable or are a temporaryresult of cost reduction preceding arevenue decline.Sequestration went into effect onMarch 1, 2013 and provides for $85billion in spending cuts in FY13, halffrom defense. The defense cut repre-sents about 8 percent of the Depart-ment of Defense’s FY13 base budgetrequest. The DoD is taking actionsthat include reduction and furloughDefenseDefense contractors brace for sequestration
  • 19. PwC16Defenseof civilian staff and cutbacks in basesupport services. Much uncertaintyremains about the impact of seques-tration on specific defense programs,but the defense industry shouldexpect a proportionate reduction.During 2012, European defenseministries began responding to theconsequences of budgetary reduc-tions by cutting and reprofilingprograms and reducing platformnumbers. This process is stillunfolding, and it is driving signifi-cant uncertainty in the supplybase as companies struggle tomanage both the impact of knownreductions and the risk of uncer-tain future reductions. Initiativesto preserve capability at the sameor lower cost have burgeoned inGermany, Sweden, Norway, the UK,and elsewhere. Globally, there is agrowing appetite for capability andcost-sharing between nations—initiatives that remain at the discus-sion stage. The NATO SecretaryGeneral’s “Smart Defense” initiativeseeks to achieve this for the Alliance,and bilateral arrangements suchas the Anglo-French Defenseand Security Cooperation Treatyencourage collaboration in a rangeof activity, from military opera-tions to acquisition to asset sharing.Backlog (US $ billions) 12/31/2012 12/31/2011EADS Defense $64 $73Lockheed Martin $82 $81Finmeccanica $57 $64BAE Systems $67 $58Boeing Defense, Space & Security $71 $60Thales $32 $33Northrop Grumman $41 $40General Dynamics (exc. Gulfstream) $36 $40Raytheon $36 $35L-3 $11 $10Total $497 $494Source: Company reportsNATO’s operations in Libya high-lighted the importance of having thecapability to respond to unexpectedevents—the “return to contin-gency”—and of a strong blend ofEuropean capabilities able to bedeployed at short notice. Thoughthe Libyan operation was relativelyshort-lived, it highlighted significantcapability gaps (e.g., in intelligenceand surveillance systems) thatEuropean nations will find difficultto fill while under the currentfinancial pressures.European defense companies areresponding to declines in theirtraditional markets and are simul-taneously pursuing opportunitiesin growth markets, including theMiddle East, Brazil, Turkey, South-east Asia, and India. The challengesin those regions are strong competi-tion and in-country barriers to entry.ExportsThe growth of defense export dealshas led to a record backlog of $327billion at mid-year 2011. “We havein excess of 13,000 active caseswith more than 165 countries andinstitutions,” adding up to about$327 billion, said Vice Admiral BillLanday at a Pentagon news briefingahead of the Paris Air Show.11 Bloomberg, Gopal Ratnam, “PentagonHas $327 Billion Export Backlog, SeesDrone Demand,” June 10, 2011.
  • 20. A&D 2012 year in review and 2013 forecast 17DefenseUS defense export authorizationsspiked at $264 billion in 2011, themost recent year for which datais available. It represents an $84billion increase, 48%, from 2010,and a 394% increase compared with2006. The export backlog, whichwas disclosed at $327 billion atmid-year 2011, is now estimated ataround $500 billion. The significantgrowth in defense exports shouldhelp soften the impact of US defensecuts. Much of the growth duringthis period has been in Asia, dueto concerns about China’s growingmilitary power and tensions betweenNorth Korea and South Korea, andin the Middle East, due to concernsabout Iran’s military ambitions. Andthe United States is not the onlycountry benefiting. Western Europeancountries, Israel, South Korea, andRussia are all gaining from increaseddefense exports.US foreign military sales (FMS) agreements and direct commercial sales authorizations2,3USD Billions050100150200250300201120102009200820072006200520042003200220012000199923815412310789675267625352554711 11 12 12 13 13 18 18 29 30 24 269Foreign military sales (FMS) agreements Direct commercial sales authorizationsOn March 7, 2013, the White Housesent its export control reformproposals to Congress for approval.The reforms redefine restrictedcategories on the US Munitions List(USML), with oversight responsi-bility for some categories movingfrom the State Department to theCommerce Department. Thesereforms, which have been supportedby industry, are designed to simplifyand streamline the export processand may lead to further increases inexport 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
  • 21. PwC18DefenseDefense forecastDue to sequestration, the initialeffects of which will be felt during2013, our expectation is that defenserevenue will decline by about 5percent, based on our calculationof the defense portion of seques-tration for about seven to eightmonths. But the impact on profitsmay be mitigated, because as theindustry contracts, many of thecosts to reduce capacity and restruc-ture or terminate programs will beabsorbed by the federal government.The industry drove a slight increasein margins in 2012, despite modestdeclines in revenue. According toour estimates, the industry willlikely 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 GeneralDynamics and Finmeccanica overthe last two years.Market contraction, coupled withincreasing certainty about thenature and amount of defensebudget cuts and the impact onspecific programs, is also expectedto drive significant industry consoli-dation. In recent years, the trend hasbeen toward spin-offs and divesti-tures. High-profile spin-off transac-tions have included the Huntington-Ingals split from NorthropGrumman, Exelis from ITT, andEngility from L-3. In 2013, SAIC isscheduled to complete a spin-offto be known as Leidos. The periodof spin-offs looks to be nearing itsend, to be followed by a period ofdefense consolidation. The defenseindustry is already highly concen-trated, resulting from consolidationMarket contraction, coupled with increasing certaintyabout the nature and amount of defense budget cuts andthe impact on specific programs, is also expected to drivesignificant industry consolidation.
  • 22. A&D 2012 year in review and 2013 forecast 19Defenseduring the post-Cold War era. TheDefense Department has opposedany further consolidation amongmajor prime contractors, but thatposition could soften, dependingon market conditions. Regardless ofwhether the major prime contractorsconsolidate further, expectations arefor significant consolidation of thesupply base.Contractors may also continueto respond to market conditionsin other ways. The current focusremains on affordability, and theDefense Department now listsaffordability among its procurementcriteria. Contractors should stayfocused on improving productivity,as the industry is beginning a periodof fewer new platforms. At the sametime, there is a need to recapitalizeequipment. So the focus will likelyshift from new platforms to plat-form upgrades and sustainment.Electronics and C4ISR, includingunmanned aerial vehicles andcybersecurity, will likely be amongthe areas of growth.Many companies are exploringcommercial applications for theirtechnologies. Most defense contrac-tors, and their investors, haveapproached commercial marketscautiously because of mixed experi-ences, weighted toward the nega-tive, in the past. Much of that expe-rience, though, is dated; defensecontractors have had ample opportu-nities in their core markets for morethan a decade. However, many ofthe industry’s largest commercialmarkets have their roots in defenseand space technologies, such ascomputers, computer networking,and telecommunications. Goingforward, defense contractors areexpected to seek commercial appli-cations for their technologies, evenif it means licensing or supplyingtechnology to commercial entities.The future of the defense industry isdifficult to predict, as developmentsin North Korea’s and Iran’s nuclearweapons programs, instability inthe Middle East, and other factorscould bring rapid changes in defensepriorities.During 2013, the European defensemarkets will likely begin to stabi-lize as defense ministries addressthe budget cuts initiated two yearsago. Budgetary increases are notexpected until 2015, and it maybe necessary to pare some defensebudgets, specifically procurementbudgets, still further if the Euro-zone’s austerity measures needto be tightened. According to theLondon Times, the United Kingdomhas announced plans to roll out a“balanced defense program” forthe first time in a generation; theprogram will provide clarity forOEMs after some years of uncer-tainty. At the same time, acceler-ated “transition” in Afghanistanwill likely start to manifest itself inrationalizing in-theater equipmentand logistic support and an increasein logistic movement as militarymateriel is redeployed. As a result,the next few years will likely bringan acceleration of equipment refur-bishment, although the extent andits effect on the industry has yet tobe quantified.European nations will likely continuevarious transformation programsaimed at preserving capability atlower cost and will import many ofthe ideas and concepts pioneeredin the United Kingdom a few yearsago; expectations also are for anincrease in availability contractingfor land, sea, and air platforms, plusan increasing appetite for industry-led solutions in the provision oftraining, infrastructure, and back-office shared services. Programs forindustry will likely take on morecomplex and broader roles, andthe United Kingdom’s AdvancedMaterials strategy may prove to be apioneering approach. The drive forexports will also likely continue andremain fiercely competitive as theglobal defense industry competes ingrowth markets.So while the traditional, platform,and equipment-based defensemarkets in Europe remain underintense pressure, opportunities existfor industry to more broadly deliverservice-based capabilities in manycountries. In the United Kingdom,the whole of the defense supportservices market is projected to beworth an estimated £16 billion peryear by 2020, or approximately 75percent of total MoD spend withindustry; these trends will acceleratein Europe. (PwC assessment basedon public domain sources, 2012.)
  • 23. PwC201 StrategyWhile strategy is continually evolving,the pace of significant strategic deci-sion making is expected to acceleratedue to a rapidly changing environ-ment, particularly in defense. Withthe advent of significant reductionsin US defense spending, companieswill likely make strategic decisionsregarding prioritization of marketsand technologies. Going forward,defense spending is expected toemphasize:• Lifetime affordability• Fewer new platforms• Upgrades and sustainability ofexisting platforms• Command, control, computers,communication, intelligence,surveillance and reconnaissance(C4ISR)• Energy and efficiencyMany strategic decisions havebeen made in anticipation of thesechanges; many actions have beenin the form of spin-offs and dives-titures. But the market is expectedto shift toward industry consolida-tion as spending cuts take hold. Thefailed merger between EADS andBAE Systems might be viewed as aharbinger of things to come. Whetherthe governments involved will allowmergers among any of the majorprime contractors may depend onthe extent of defense spending cuts.Regardless of whether major primesmerge, significant consolidation ofthe supply chain is expected.TrendsEight trends to watch in A&D for 2013and beyond
  • 24. A&D 2012 year in review and 2013 forecast 21TrendsIn addition, companies are expectedto have a greater focus on inter-national markets, in order to helpcompensate for the decline in USrevenues. In recent years, exportshave increased significantly.However, companies will increas-ingly focus on international strate-gies, which may include a moresignificant international footprint.These efforts may be aided by exportcontrol reforms proposed by theWhite House. Additionally, compa-nies will likely focus on adjacenttechnologies and markets. Whilemany organizations are expectedto approach commercial marketscautiously, they are expressinggreater interest in commercializa-tion of their technologies.2 InnovationInnovation is another area thatis steadily evolving. For manycompanies, innovation is the singlemost important success factor, asconfirmed by a PwC survey of morethan 20 executives from leadingA&D companies, who collectivelyranked innovation as the highestbusiness priority.Innovation, therefore, is a major riskto be addressed when examiningenterprise risk. Yet many companiesdo not view innovation as a top risk.They are focused on financial andcompliance risks, when a failure toinnovate may pose the greatest risk.Perhaps innovation is not under-stood as a risk because companiesare more adept at measuring finan-cial and compliance risks, includingoperational risks that have financialconsequences. In comparison, itis much more difficult to evaluateopportunity cost and the effective-ness of research and developmentand the innovative culture. Withreduced government funding forresearch and development, defensecompanies look to be making greaterinvestments in independent researchand development (IR&D). Thechallenge for the defense and spaceindustry is to become more commer-cial in its approach to innovation.Commercial aerospace is enjoyingits longest up cycle in history. Notonly is demand of the end marketsstrong, but successful innovationswith dramatic improvements toefficiency, reliability, and safety arehelping drive the boom. The chal-lenge lies in gaining the resources,both human and economic, to keepup with the accelerating pace ofinnovation and product develop-ment. As one company executivedescribed it, “We have more oppor-tunities with good business casesthan we can afford.”Commercial aerospace and defensecompanies should gain greaterproductivity from research and devel-opment activities as well as prioritizeinvestments. The solution dependspartly on viewing innovation as abusiness process. To learn moreabout PwC’s perspective on achievinginnovation excellence, please visitwww.pwc.com/us/gainingaltitude.
  • 25. PwC22Trends3 Talent managementDemographicsThe A&D sector continues to facetwo significant challenges related totalent: steady losses of experiencedsenior personnel and the need toattract skilled talent. While retire-ment levels for 2011 remained low,retirement eligibility—double-digitin most job categories—is growingby one to two percent annually andestimated to reach 18.5 percent in2015. And while attrition rates showsmall decreases, as well as possibledeclines among the youngestworkers, more than 45 percent ofworkers under 35 plan to switchemployers within the next five years,portending a significant talent drain.With defense spending cuts on theway, expectations are for declinesin employment levels. The industryfaces a challenge similar to thatfaced by companies during the post-Cold War era: How can businessesavoid losing the next generation ofA&D talent?4A skilled work forceThe number of US graduates withinthe critical fields of science, tech-nology, engineering, and mathematics(STEM) remains low. Shortages inthe pool of scientists and design engi-neers are particularly pronounced,with demand expected to showcontinued growth in 2013. Further-more, a majority of industry jobs arein defense and security, where UScitizenship is required, furtherlimiting the pool of available talent.According to the Aerospace Indus-tries Association, only 44,000 of the70,000 engineers that graduate eachyear in the United States are quali-fied to work in the aerospace sector,suggesting the need for strongerpartnerships between universitiesand A&D in order to identify the skillsrequired within the industry. A&Dcompanies also face competition fromorganizations and other industriesfor the available talent. This trendis mirrored in other developedaerospace nations.The resulting pressure has HRplaying an increasingly strategic rolein the talent supply chain. Mentoringprograms and training initiatives,designed to help retain key knowl-edge and skills, are growing inpopularity. Additionally, successionfosters early identification of toptalent, and recruiting partnershipsare being developed to deliberatelyattract talent from universities.Two other areas important to talentmanagement are knowledge captureand organization design. Knowledgemanagement programs are increas-ingly critical in minimizing the effectsof turnover. And firms are payingattention to the organizational designelements that compromise projectexecution and cross-functional collab-oration, which may be particularlyimportant to younger workers.4 Aviation Week, Carole Rickard Hedden,“Aviation Week Workforce Study”,Aug. 13, 2012.
  • 26. A&D 2012 year in review and 2013 forecast 23TrendsEngineering talent andUS citizenshipThe pinch is also evident abroad.In Europe, for example, only about10,000 graduates from technicaluniversities choose to work withinA&D, while the industry needs atleast 12,500 graduates every year.5Global/US citizenshipThe search for qualified talent forcesUS companies to focus increasinglyoverseas. And while organizationshave historically attracted engi-neering talent from countries such asIndia and Russia, several forces haveslowed the promise of an interna-tional labor pool.The growth of international marketsfor A&D has resulted in increasedcompetition from countries like Chinafor skilled labor. Another concern isthe US government’s restrictions onthe number of H-1B visas, a specialdesignation letting firms hire tempo-rary high-skilled workers. Addition-ally, US talent is typically preferredin organizations like the US DefenseDepartment, where security clear-ance requirements rule out inter-national talent, while laws such asthe US International Traffic In ArmsRegulations (ITAR) prevent sharingtechnical data and knowledge withforeign nationals.5 Aviation Week, Carole Rickard Hedden,“Aviation Week Workforce Study”,Aug. 13, 2012.Still, the foreign labor pool is signifi-cant, making immigration reforma major issue for the A&D industry.According to a 2007 study by theWoodrow Wilson School of Publicand International Affairs at Princeton,two countries in particular, Indiaand China, with their vast, educated,low-wage workforces, attracted morethan 100,000 H-1B visa holders ina single year. Stricter immigrationcontrols may serve to constrict thissupply of talented workers.For more information on talentmanagement, please visit us online atwww.pwc.com/us/peopleandchange.The growth of international marketsfor A&D has resulted in increasedcompetition from countries like Chinafor skilled labor.
  • 27. PwC24Trends4 Productivity and affordabilityThe Pentagon has emphasizedaffordability, including it as acriterion for procurement decisions.Accordingly, defense contractorshave strategized to reduce costs andimprove productivity. We compareddefense companies with companiesin the Dow Jones Industrial Average(DJIA) on the basis of revenueper employee, using data fromcompany earnings statements andcompany profiles. We acknowledgethat revenue per employee is animperfect measure and that a bettermeasure would be value added peremployee, but since that data is notavailable, we have used revenue peremployee as a reasonable surro-gate. In this comparison, we seethat defense contracts are abouthalf as productive as the DJIA. Webelieve there are some valid reasonswhy defense companies have lowerproductivity, including:• Limits on profitability—Muchof defense revenue is undercost-reimbursable, or cost-based, fixed-price contracts, withrevenues limited based on profitlimitations. Defense contractorprofitability is typically a littlemore than half of the DJIA.• Development of leading technolo-gies—Defense contractors arefrequently developing cutting-edge technologies, which areinherently manually intensiveand involve some degree of trialand error.• Extremely low volumes—Manydefense contracts are for singleunits or quantities measuredin the dozens or hundreds,compared with commercialenterprises that typically measurevolumes in the millions of units.The low volumes result in manu-ally intensive manufacturing andassembly and low absorption offixed costs in a capital-intensiveindustry.• Regulation—The industry is highlyregulated, which can increasecompliance costs, includingcompliance with federal acqui-sition regulations (FAR), costaccounting standards (CAS), andexport controls (ITAR).The industry is highly regulated,which can increase compliance costs.
  • 28. A&D 2012 year in review and 2013 forecast 25TrendsDespite these inherent limitations,the industry recognizes there isroom for improvement in produc-tivity. Many companies have beentaking action to reduce overheadcosts, including workforce reduc-tions, early retirements, and facili-ties consolidation. Direct productcosts will likely be more challenging.We believe the following areas offeropportunities:• Program management/short-ened development cycle• Supply chain management• Information technology• Knowledge managementImproving the speed and effective-ness of program development typi-cally produces the biggest gainsin affordability. Schedule delaysare the biggest factor in budgetoverruns. While contractors takepride in their program manage-ment abilities, the industry shouldseek continuous improvement,including unbiased, independentassessments and benchmarking.The defense supply chain hasbecome extremely complex. Typi-cally, 50 percent to 80 percent ormore of the total value of productionis rooted in a technically complex,multi-tier supply chain. Accord-ingly, any productivity improvementinitiative should address suppliers,the most significant component ofcosts. Defense contractors can nolonger accept long lead times andmarginal supplier performance asindustry norms. The industry shouldchallenge itself to get much closer to“just in time” delivery. The industrymight consider adopting leading-edgerisk management practices to regainvisibility into the supply chain thathas been lost through outsourcing.Information technology representsone of the biggest areas for discre-tionary spending at most companies,including defense firms. Many A&Dcompanies have invested millions insystems implementations but haven’tyet realized the full capabilities andproductivity enhancements that thesesystems enable. Many IT organiza-tions are still spending most of theirtime in legacy system maintenanceand enhancements. Companiesshould unlock the full capabilities oftheir IT platforms, become leaner,and migrate the IT organization awayfrom costly maintenance towardstrategic initiatives and competitiveadvantage.Finally, improved knowledgemanagement will likely becomemore critical. Talent drain, alreadya factor due to demographics, hasbeen accelerated by early retirementsand workforce reductions. Compa-nies should identify the key peopleand knowledge in their organiza-tions and capture that informationusing searchable technology tools.Organizations should also create aknowledge management culture thatpromotes and rewards the effectivecapture and use of knowledge.
  • 29. PwC26Trends5 Supply chainIn 2013, two major trends areexpected to have a significant impacton the supply chain:Commercial aircraftproduction rate ramp-up• Previously, we discussed thecommercial aircraft productionrate ramp-up of historic propor-tions. In 2012, the industrydelivered a record 1,189 largecommercial aircraft, an 18%increase over the prior year,which was also a record. In thelong term, demand is projectedto be about 1,700 aircraftannually, meaning that annualproduction rates may continue toincrease by another 40 percent.The current and projectedproduction levels will likelystrain a supply chain that canbe considered to have the mostcomplex and longest lead timesupply chain of any industry.Defense spending reductions• For the defense supply chain,the concern is that significantdefense spending cuts will drivesmall suppliers out of business.Some of these suppliers may besole source or produce uniquecomponents. Accordingly, thesupply chain could be left witha shortage of critical parts andlong lead times to qualify newsuppliers.Both commercial aerospace anddefense contractors should reeval-uate supply chain strategy andevaluate supplier performance risk.To learn more about PwC’s perspec-tive on the supply chain, please visitwww.pwc.com/us/gainingaltitude.6 GlobalizationGlobalization is driving the boomin commercial aviation. The Asia-Pacific region is expected to takemore aircraft deliveries, in unitsand value, over the next 20 yearsthan North America and Europecombined. Why?• Developing economies, particu-larly in the BRIC countries(Brazil, Russia, India, and China)are growing faster than devel-oped economies. The economyis becoming more knowledgebased, with businesses increas-ingly relying on the globaldeployment of human capital,a requirement for operating atwenty-first century business.That new paradigm is drivingstrong demand for aviation,as well as resiliency for theindustry. Aviation once was ahyper-cyclical industry, overre-acting to business cycles. Now,that dynamic has fundamen-tally changed, as demonstratedduring the most recent recession.While aviation demand did takean extreme downturn during the
  • 30. A&D 2012 year in review and 2013 forecast 27Trendsrecession, demand reboundedfaster than the overall economyand more quickly than inprevious economic cycles,rapidly returning to pre-reces-sion levels and demonstratingthat aviation demand hasbecome much less elastic thanit used to be.• Consumer air travel oncewas largely a privilege of thewealthy. As the relative cost ofair travel has declined, it hasbecome highly accessible to themiddle class and not readilyrelinquished, even during aslow economy. Aviation growthwill likely continue to be drivenby the growing middle class indeveloping economies.• Aviation is viewed as a strategicindustry in emerging marketcountries. Governments, keen topromote aviation, airports, andthe associated infrastructure, owndirect or indirect stakes in manynational carriers, enabling them toplace large orders for aircraft.As a result, aviation is expected togrow about 2 percentage pointsfaster than global GDP for the fore-seeable future. While globalizationis creating tremendous growth andopportunity for the industry, it isalso driving challenges that requirenew strategies. Among these are:• Competition—The growth in theindustry and lure of high tech-nology in aerospace is attractingsuch new competitors as Comacof China, Irkut of Russia, andMitsubishi of Japan. In addition,regional jet makers are increasingthe size and range of their jets,competing at the smaller end ofthe narrow-body market.• Globalization of customers andsuppliers is driving numerouschallenges. The aerospaceindustry once was principallya domestic industry relying onexports. But as the customerbase and supply chain havediversified, aerospace compa-nies increasingly are operatingWhile globalization is creating tremendousgrowth and opportunity for the industry,it is also driving challenges that requirenew strategies.internationally in order to driveintimacy with customers andsuppliers, improve responsive-ness and service, satisfy offsetand industrial participationrequirements, and, in somecases, take advantage of interna-tional talent or lower costs.Globalization, not limited tocommercial aerospace companies,is also having a significant impacton defense. US defense export salesauthorizations (for future deliveries)have increased more than four-foldsince 2005, from $61 billion to $264billion in 2011, as seen in the charton page 17. These arms largely aredestined for the Middle East andAsia-Pacific. Defense contractorsare expected to continue to focus oninternational markets and developglobal footprints.In a recent PwC study, aerospaceand defense companies cited thefollowing as the greatest obstaclesto becoming more international:• Safeguarding intellectualproperty• Export control compliance• Creating ethical cultures• Managing financial risks• Managing offset and industrialparticipation requirementsFor more information on strategiesto address globalization opportuni-ties and risks, please refer to A&DInsights: Accelerating global growth.
  • 31. PwC28Trends7 CybersecurityGiven their role in developingcutting-edge technologies withmilitary applications, A&D compa-nies have long faced heightenedsecurity challenges. With ubiquitousand interconnected informationtechnology (IT) systems drivingevery phase of the A&D industry,companies face complex challengesto the security and integrity oftheir operations and reputation,including ongoing efforts to stealintellectual property and othersensitive business data, as wellas attempts to sabotage opera-tions and tarnish reputations bydisrupting IT networks.Economic espionage.A&D remains the industrial sectormost targeted by economic espio-nage conducted by nation-states’intelligence services. Systemssupporting unmanned aerial vehi-cles (drones) may get particularattention from economic spiesbecause of their highly publicizeduse for intelligence gathering andkinetic strikes in war zones.Intrusions into A&D companies’IT systems have lasted for monthsor years before being detected. InFebruary 2013, one cybersecurityfirm reported how an advancedpersistent threat (APT) has “system-atically stolen hundreds of terabytesfrom at least 141 organizations…spanning 20 major industries.”Two other APTs—dubbed “ShadyRAT” and “Beebus”—may havebeen created by hackers linked to aforeign government. All three APTsappear to have been designed tosteal information from targeted ITnetworks, where they are typicallyintroduced by infected files attachedto “spearphishing” emails.6• It is likely that every company inthe A&D sector has been targetedby these APTs.• Many US A&D companies haveresponded to APTs by partneringwith the federal government.The Defense Industrial BaseCyber Security/InformationAssurance Program, underthe aegis of the Department ofDefense (DoD) and HomelandSecurity (DHS), is a forumletting A&D companies volun-tarily report cyberintrusions andletting federal authorities sharedetailed threat information.• Cybertools are not the onlymeans of conducting economicespionage. Exploiting the accessof disgruntled or corruptedinsiders—the “insider threat”—isoften just as dangerous: DongfanChung, who worked on theB-1 bomber, space shuttle, andother A&D projects for nearly 30years, was convicted in 2010 ofeconomic espionage on behalf ofthe Chinese aviation industry.The complex business ecosystemin the A&D sector, with compa-nies increasingly relying on jointventures, partnerships, and manu-facturing and R&D facilities inexpanding markets—potentiallyopening new points of access forintruders—adds to the challenge ofkeeping corporate IT systems secure.6 Mandiant, “APT1: Exposing One ofChina’s Cyber Espionage Units”,www.mandiant.com, Feb. 19, 2013.
  • 32. A&D 2012 year in review and 2013 forecast 29TrendsDisruption and sabotage.The same elements making A&Dcompanies attractive to spies alsomake them targets for cyberdisrup-tion campaigns by terrorists, roguestates, and hacktivists.Hacktivists, who have alreadyattacked financial and energycompanies, could conduct distrib-uted denial of service campaignsto disrupt IT networks or intrusionattempts aimed at exfiltrating andpublicizing sensitive data aboutcorporations or their employees.Similarly, kinetic strikes using aparticular weapons system against arogue state or terrorist group couldlead to retaliatory cyberattacksdesigned to disable or disrupt thecomputer networks of the weapon’smanufacturer.Unique and evolvingregulatory environment.Because most of the largest A&Dcompanies work on classified andmilitary-related projects, many oftheir processes for handling sensitiveinformation are subject to unusuallystrict governmental oversight. Thesecompanies should be prepared forregulatory changes, which are in theoffing in three broad areas.First, important changes stem froma White House executive order (EO),“Improving Critical Infrastructure’sCybersecurity,” published in February2013. The order calls for the creationof a framework to reduce cyber-riskto critical infrastructure, as well asprovisions letting federal agenciesshare more threat information withthe private sector. The EO alsocalls on the secretary of HomelandSecurity to identify “critical infra-structure at greatest risk”—whichmay include A&D firms with signifi-cant military contracts—and to letthe owners of such organizationsknow of that designation. Manyof the details of the order will bereleased in coming months.In addition, the Cyber Intelligence-Sharing and Protection Act hasbeen reintroduced in the Houseof Representatives, and this year’sdraft is expected to receive WhiteHouse support. Legislation may benecessary for the complete imple-mentation of the executive order.One particular concern of manycompanies is to obtain protectionfrom legal liability that could resultfrom voluntary information-sharingwith the federal government.Finally, cleared defense contractors,including most major A&D compa-nies, must soon develop insider threatprograms and enhance their capa-bilities to detect and prevent thesethreats, in accordance with ExecutiveOrder 13587, issued in October 2011and establishing a national policy andminimum standards for insider threatmitigation programs across federaldepartments and agencies.Looking ahead.Over the next decade, the A&Dindustry will likely remain a high-priority target of threat actors dueto economic factors as well as mili-tary calculations. The challenge ofprotecting corporate assets, and ITsystems in particular, will likely grow.The ultimate nature of these develop-ments is to be determined, but twobroad trends are likely to emerge.Technological and cultural shifts:smartphones, tablets, and otherdevices that can connect to theInternet are becoming ubiquitousand, with the move to a cloudcomputing paradigm, will likelydrive opportunities for theft andmanipulation of companies’ sensi-tive data. And employees and otherindividual stakeholders can expectever greater access to companies’IT systems and data from theirpersonal devices and from locationsof their choice.New threat factors are also likely toemerge, reflecting shifts in globaleconomic activity:• Governments seeking to jump-start fledgling A&D companiescould be tempted to sponsorcyber-intrusions and otherefforts to pilfer the intellectualproperty and know-how ofindustry leaders.• Similarly, the nature of criminalhacking may evolve, with socialnetworking tools potentiallyfacilitating a new black marketin stolen computer files, thuscreating powerful incentives fornewcomers to attack corporatenetworks.For more information on cybersecu-rity, please visit PwC’s Informationsecurity, privacy, and risk page.
  • 33. PwC30Trends8 The regulatory environmentThe current regulatory environmentis a key challenge facing the defenseindustry.Several reforms may help improvethe environment for defensecompanies.Acquisition reformAttempts to improve the currentdefense acquisition process havenot succeeded. One reason could bethat reforms have sought to placeever-increasing regulations on thecontractors. Acquisition reformmight benefit from addressinghow Congress funds long-termprograms on a short-term basis, andthe manner in which the customerinitially defines requirements andthe impact of subsequent modifica-tions. Some observations concerningareas ripe for reform include:• Addressing the definition andstability of requirements• Establishing realistic budgetsand funding based on theinherent risks of developingadvanced technologies• Promoting flexibility and inno-vation in the bid and proposalprocess• Using contract structuresappropriate to risk• Promoting internationalcooperation and cost sharingThe Defense ContractAudit AgencyThe purpose of the Defense ContractAudit Agency (DCAA) is to protectthe government and taxpayers fromfraud and abuse. The followingare some considerations that couldimprove the effectiveness andefficiency of DCAA audits:• Audit approach—Benchmarkthe audit approach againstcommercial practices, such asthose regulations establishedunder the American Instituteof Certified Public Accountants(AICPA) and Public CompanyAccounting Oversight Board(PCAOB).• Materiality—Establish mate-riality standards. Materialityis not defined for governmentcontracting exceptions. It iswidely accepted in commercialpractice that it is impractical andcost-prohibitive to build a controlsystem to catch minor errors.• Third-party reliance—The DCAA’sresources are limited. While DCAAstandards allow for reliance onthird parties, it seldom occurs. TheDCAA could consider establishingstandards for third-party reliancethat promote such use where thethird party is objective and compe-tent to improve the speed and effi-ciency of the regulatory process.Export control reformMany observers believe current exportcontrol regulations are outdated anddrive a competitive disadvantage forthe US defense industrial base. Manytechnologies that are broadly usedin commercial application are stillsubject to export control restrictions.On March 7, 2013, the White Housesent its proposal for export reform toCongress. Export control reform couldbe effective in promoting US exportsand preserving key skills in the indus-trial base.
  • 34. A&D 2012 year in review and 2013 forecast 31The total A&D deal value for theyear was $19.5 billion, about15 percent below the preceding10-year average of $22.9 billion.Based on our methodology,the 2012 statistics include theannouncement that HawkerBeechcraft would be purchased bySuperior Aviation Beijing; however,the deal subsequently was aban-doned. Excluding that deal, annualdeal value was $17.7 billion, or 23percent below the 10-year average.Overall, commercial aerospaceM&A had a strong year. However,the defense sector did not generateeven one mega deal (above $1billion) in 2012, while 2011 broughtfour mega deals in defense, totaling$10.6 billion.In 2012, the defense sector facedpotential US sequestration anduncertainty in defense spending,which continues into 2013. Oncethere is more certainty—or atleast less uncertainty—regardingthe future of defense budgets andthe impact on specific programs,the defense industry will be ableto value companies and betterassess M&A opportunities. Whenthis period begins, defense M&Ais expected to become much moredynamic and could lead to somehistoric deals.Defense M&A is facing a “perfectstorm” of pent-up demand, strongbalance sheets and cash positions,and, most importantly, the neces-sity to consolidate in response toa contracting market. We viewMergers and acquisitions
  • 35. PwC32Mergers and acquisitionsthe attempted merger betweenEADS and BAE Systems in 2012as a harbinger of further defensedeals. While mergers among globaldefense prime contractors willcontinue to be challenging, dueto concerns by government stake-holders, some transformative M&Atransactions are expected in defenseonce the cloud of uncertainty islifted in the United States.Looking ahead, four trends arelikely to affect M&A activity in thecoming years:• Increasing consolidation inresponse to a contracting defensemarket and cost pressuresWhile mergers among global defense primecontractors will continue to be challenging…some transformative M&A transactionsare expected in defense once the cloud ofuncertainty is lifted in the United States.• Further re-evaluation of supplychains by big manufacturers, inboth civil and military segments,as they seek to gain bettercontrol of their large programpipelines• Continuing growth in the secu-rity, surveillance, and homelandsecurity sector• Greater investment in andcompetition from fast-growingmarkets, most notably ChinaWe believe these trends willprovide the context for growth indeal volume and value in 2013.
  • 36. A&D 2012 year in review and 2013 forecast 33The performance of the top 100 A&Dcompanies is a barometer for the healthof the industry and reflects strong anddisciplined management over the pastdecade. It also reflects the strong demandfor the industry’s products and services.Aviation has become a critical part ofour global infrastructure. Businessescannot operate effectively withoutglobal deployment of human capital.Aviation is increasingly inelastic, andit demonstrated its resiliency duringthe recession. While air freight is stilldwarfed by sea and land freight, anincreasingly larger portion of the globalsupply chain now relies on air cargo.The outlook for defense is clouded bythe impact of sequestration in the UnitedStates and cuts to the defense budget. Itis still not clear how defense budget cutswill impact major defense programs.Furthermore, the security threat isdynamic and could rapidly changedefense priorities. The defense industrymust respond to the affordability chal-lenge and improve productivity.The near-term and long-term forecastfor commercial aerospace is optimistic,with expectations for significantgrowth. Aviation will continue to growfaster than the overall economy becauseof its critical role in the global economicinfrastructure, bolstered by economicgrowth in Asia, the Middle East,Eastern Europe, and Latin America.Defense faces challenges, including anextended period of budget battles anduncertainty. We believe 2013 should beanother strong year for the industry, andpossibly another record year, as avia-tion growth continues to offset a weakerdefense market.In summary
  • 37. PwC34In summaryRevenue(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%
  • 38. A&D 2012 year in review and 2013 forecast 35In summaryRevenue(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 PerformanceMetals2,191 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%
  • 39. © 2013 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the US member firm, and may sometimes refer to thePwC 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-13-0466www.pwc.comFor more information contact:Scott ThompsonUS Aerospace & Defense Leader703.918.1976scott.thompson@us.pwc.comCharles MarxUS Aerospace and Defense Advisory Leader602.364.8161charles.a.marx@us.pwc.comJames GrowUS Aerospace and Defense Tax Leader703.918.3458james.b.grow@us.pwc.com