end of year letter 2011 aerospace and defense

8/3/2019 End of Year Letter 2011 Aerospace and Defense

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2011 Aerospace & Defense Industry Perspective

We would like to offer our perspective on the current climate in the aerospaceand defense markets. As you reflect on what 2011 brings you, we hope our ideaswill contribute to an effective dialogue about the most important issues you face.

The North American aerospace and defense industries are moving in differentdirections: Commercial and general aviation markets are recovering, whiledefense markets are turning down. We have seen this pattern many times before,but market conditionsin both defense and commercial aerospacearedecidedly different this time. In the months ahead, decision makers will need tocarefully assess their positions in these changing markets and devise strategiesthat exploit what they do best.

The Defense Downturn: Affordability Is the Goal

After a prolonged period of increased military spending, the defense industryfaces shrinking investment spending in ships, aircraft, land vehicles, missilesystems, and equipment. We already have seen cuts to the Air Forces F-22fighter, the Navys future DDG-1000 destroyer, and the Armys Future CombatSystems. More may follow. Although top-line defense spending is trending

slightly upward, investment spending is being crowded out by wartime needs,including operations and maintenance (O&M) and fast-growing militarypersonnel costs.

In September, Defense Secretary Robert Gates announced plans to free upUS$100 billion over five years by cutting overhead and inefficiencies in weaponsprograms; the savings will be used to modernize and recapitalize militaryequipment and sustain troops. This effort will mitigate but not stop the decline ininvestment spending. Although some observers anticipate that a new defensesecretary will boost investment spending when Gates leaves, we believe thatO&M spending and other costs will continue eating into modernization budgets.

We have seen reductions in investment spending before, most recently when thecollapse of the Soviet Union triggered across-the-board defense cuts. But unlikethen, todays military continues to face real and persistent threats. This creates adual challenge for Americas defense establishment: reduce costs whileenhancing capabilities. As Ashton Carter, undersecretary of defense foracquisition, technology, and logistics, said when announcing the new guidancewith Gates, we must do more without more.


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Affordability is the new Pentagon watchword. Essentially, the services will setbudget targets establishing spending limits for their programs. These limits willtranslate into preset budget and schedule targets designed to constrain systemand platform designs. Although there will always be a place for exquisite

systems, the Department of Defense is increasingly favoring less elaborate, moreaffordable solutions that take advantage of new technologies, methodologies,and processes to control costs and get the job done quicker and more efficiently.

The affordability approach creates opportunities for nontraditional players, suchas truck manufacturer Oshkosh Defense, which developed and built the mine-resistant, ambush-protected all-terrain vehicle (M-ATV) for the Army.Companies have also found success offering disruptive technologiessuch asunmanned aerial vehicles and turboprop intelligence, surveillance, andreconnaissance (ISR) platformsand utilizing smart customization approachesto modify existing products to leverage global and commercial scale and scope.

The bottom line for the industry incumbents is this: Affordability demands muchmore than cutting overhead costs. It will require more affordable system design,lower supply chain costs, better program execution, and more proactive riskmanagement. But first, established players will have to decide the extent towhich they will serve two different market segmentsone for exquisite solutionsand the other for more affordable solutionsand whether they can develop andmaintain a coherent set of capabilities that will give them the right to win in eachsegment.

The Commercial Rebound: New Trends Reshape the Market

With most airlines showing a surprisingly strong improvement in their balancesheets, the commercial aerospace industry is poised for growth. But althoughprevious upturns have seen sharp V-shaped recoveries, we believe thatstructural changes in this market will result in a more gradual upturn this timethat will affect original equipment manufacturers (OEMs) and suppliers indifferent ways.

The two big OEMs, Boeing and Airbus, continued to deliver steady numbers ofaircraft through the downturn, completing the first full market cycle under a

duopolistic structure. To their credit, both manufacturers chased constantvolume as opposed to constant share by moving peak orders to backlog onthe upturn and working with airlines to firm up their future financing needs,thus dampening the impact of the recession and positioning the OEM sector for afaster return to growth. By maintaining this discipline, the sector saw onlymoderate decreases of 220 to 240 units on average from peak to trough, asopposed to past cycles when drops of 350 to 600 units were recorded.


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Boeing and Airbus currently report backlogs of more than 2,000 aircraft each forthe B737 and A320 families. Both are predicting the need for 25,000 to 30,000 newaircraft over the next 15 years across all categories, based on the anticipatedgrowth in passenger demand. The demand will be strongest for single-aisleaircraft, but the number of aircraft with more than 100 seats is expected to double

too. The demand for cargo aircraft is expected to increase at an even faster rate.Much of this demand, including more than 50 percent of the demand for verylarge aircraft, will come from the Asia/Pacific region, particularly from emergingmarkets such as China and India. We will also see a growing demand for morefuel-efficient and eco-friendly aircraft to replace older, less efficient fleets.

The downturn was not as easy for suppliers, who have little control over primarydemand. They have been beset by delays in new programs, the drop in demandin general aviation, airlines reducing inventory levels to preserve cash, andexcessive inventory levels of stranded parts. Furthermore, since many airlinesparked or retired older, less fuel-efficient aircraft during the recession, the

average fleet age has dropped significantly, which has had an adverse effect ondemand for maintenance, repair, and overhaul (MRO). Looking ahead, supplierscan expect to grow with the OEMs, but they should pay close attention tochanges in production levels, fleet mix, and the progress of new aircraftprograms.

As the commercial aerospace industry gears up for new growth, there are fourmarket trends that are reshaping the marketplace.

First, although the rebound in passenger traffic and air cargo suggests we arepast the trough and trending upward, airlines are demonstrating remarkablediscipline by holding load factors constant and managing their capacity andcosts to enhance revenues and margins. Ongoing merger activity and thestrengthening of global alliances support these efforts as well. This means thatfewer planes are flying now compared to during previous recoveriesand fewerplanes in the near term means less MRO activity.

Second, the outlook for higher fuel costs and more stringent carbon regulationwill force older aircraft out of service and spur demand for new, more fuel-efficient aircraft. As a result there will be a structural shift in the aircraft fleet mixacross the air transport and general aviation markets that will benefit OEMs and

hurt suppliers.

Third, MRO growth will be muted. As more older aircraft are put out of servicepermanently, they will be cannibalized for their parts, so we wont see a spike inspare-part demand. The lower operating costs of newer planes, along with theirwarranties, will also limit MRO growth. Adding to the pressure will be the desireof airlines for solution providers that can offer integrated MRO products andservices to help reduce internal management complexity, lower inventory levels,


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enhance higher aircraft availability, provide greater predictability in operatingcosts, and increase flexibility in financing options.

Fourth, Boeing and Airbus will face stiffer competition from new entrants in theregional and narrow-body segments, including Canadas Bombardier, Chinas

Commercial Aircraft Corporation, Japans Mitsubishi Heavy Industries, andRussias Irkut, all of which will attempt to capture market share with lower-cost,more fuel-efficient aircraft. However Boeing and Airbus respond, these newcompetitors will disrupt the pricing and production stability that has beenestablished under the duopolistic structure, potentially costing both firmsbillions of dollarseven if they eventually win the battle for market share.

Exploiting Change with a Capabilities-Driven Strategy

This is no time for aerospace and defense companies to take a wait-and-seeapproach. Despite market uncertainties, the competitive basis in many segments

is changing and could leave some companies behind. In the defense markets, forexample, international expansion may become an imperative; in commercialaerospace, OEM design selections could have ripple effects in the industry foryears to come. More than ever, companies must look beyond simple pointforecasts in an effort to fully understand market dynamics and shifting demand,define and prioritize their strategic choices, and build the underlying systemsthat will be required to achieve them.

The challenge for both defense and commercial aerospace companies will be toearn the right to win in their markets by identifying the emergingopportunities that best match their business models, capabilities, and productand service portfolios. Earning the right to win will vary among individualcompanies within each market, depending on their particular strengths andcapabilities. But a common characteristic of the most successful companies overthe long term is their ability to focus and align three basic elements of theircorporate strategy:

1. Way to play (business model): How will we face the market and create value forcustomers?

2. Capabilities system: What capabilities will we need to deliver that value?3. Product and service fit: What are we going to sell, and to whom?

Typically, companies pursue growth by identifying markets they would like toserve, often targeting new markets that are expanding. But our research hasdemonstrated that the most successful players begin by creating a businessmodel that articulates how they create value for customers and compete in themarketplace. Then they identify and align a set of mutually reinforcing and


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differentiating capabilities and a product/service portfolio that match thebusiness model. This alignment of operating model, capabilities, andproduct/service mixwhat we call a capabilities-driven strategyenablescompanies to invest and execute more effectively than their competitors. This isthe coherence premium.

We believe that defense and commercial aerospace companies canandshouldtake control of their fate, despite uncertain and challenging markets. Byaligning the three basic elements of a capabilities-driven strategyunderstanding how to create value in markets that reward what they do best,developing a coherent set of differentiated capabilities to produce and deliverthat value, and targeting market opportunities that properly fit their capabilitiesand value propositionthey can exert their right to win in the market.

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We hope this letter stimulates your thinking in that regard. In the past, ourperspectives have prompted executives to respond with their own thoughts andcomments. We would welcome the opportunity to hear your thoughts aboutfuture challenges and discuss the steps you might be interested in taking toanswer them.

Randy [email protected]

Jono [email protected]

end of year letter 2011 aerospace and defense

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