Defense Feels Budget Squeeze, Fuel Savings Boost Civil Airframers

By Joseph C. Anselmo
Source: Aviation Week & Space Technology

A large majority of the company's revenues came from its Falcon business jet unit which was hit hard when the bottom dropped out of that market in 2008-09. In 2009, the unit's Falcon business saw 163 net cancellations worth almost $5 billion. And yet the TPC numbers indicate a strong rebound is underway, fueled by demand for the high-end 7X in markets like the U.S., where it employs 2,500, and increasingly China. “Just looking at the numbers, they come across as a well-managed company, with solid and consistent financial performance throughout,” Gelain says.

Exelis, the defense business spun off in 2011 by parent ITT, turned in an impressive second-place performance among companies with revenues of $5-20 billion, with a score of 77. Rolls-Royce rounds out the top three with a score of 71. The ailing member of the group is aerostructures producer Spirit AeroSystems, which placed last with a score of 41. The company's results were weighed down by a $590 million pre-tax charge it took after failing to meet cost targets on work for Gulfstream and Boeing. “Aerostructures is a tough business,” says Schwendinger.

The category of companies with revenues of $1-5 billion was topped by Cubic. The company's score of 86 was underpinned by strong gains in operating profit, cash flow and productivity. “Cubic benefitted from a disciplined focus on a strong balance sheet, a legacy of excellence in financial management that goes back the entire 14 years we have tracked this company,” says TPC study manager Michael K. Lowry. Cubic was followed in the rankings by perennial top-performer Rockwell Collins and Orbital Sciences, which benefitted from a 41% gain in operating income from the prior year.

The TPC study also ranks the performance of more than 100 individual business segments in 14 categories.

With the full force of the defense downturn yet to hit, TPC advisers believe steps can be taken to prepare for impact. These include best-in-class management practices, such as fostering a culture of continuous improvement, disciplined deployment of capital, rapid and continuous adoption of lower-cost manufacturing processes and rigorous supply chain management. They caution that companies can't simply cut their way to profitability. “Sustaining operational excellence requires organizations to foster a continuous improvement culture during growth phases and downturns,” says TPC adviser John Stack of The McLean Group.

Investments in research and innovation—which can be risky and take years to pay off—also will differentiate the winners from the losers when growth resumes, as it surely will. “Don't mortgage your future,” warns Markish. “Make investments that are necessary to remain competitive in the long run. You owe your current performance—for better or worse—to investments made in the past.”

A TPC analysis of the 15 U.S. A&D companies with annual sales of at least $5 billion shows they invested an average of 4% of their revenues on independent R&D in 2012, up from 3% in 2003. But raising that further to compensate for declines in government-funded research will be a tough sell for management teams, which face Wall Street's relentless demands for near-term profits.

It should also be noted that while U.S. defense spending will decline, it will remain—by far—the world's largest military market for a long time. That is why EADS, Embraer and other companies globally will continue to try to make inroads. “No matter what happens in defense, space and security, the biggest slice of the pie is still in the U.S.,” says Peter Nicholas Lengyel, president/CEO of Safran USA, an arm of France's Safran. “You have to be here.”

It also is fairly obvious that the slimmed-down defense industry is going to have too many contractors and not enough work. But the potential of new markets in places like India and Brazil is still too small to offset budget declines in the U.S. and Europe. Therefore, consolidation among mid- and lower-tier contractors is likely. Adviser Michael Finley predicts there will be a scramble among Tier 2 contractors.


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