AlixPartners on Aerospace: Trends, Supplier Shifts, & Global Opportunities
Guest Article by David Fitzpatrick, Managing Director, AlixPartners
Over the last 5 years, AlixPartners’ aerospace practice has conducted an annual Global Aerospace & Defense Review of the industry. The survey evaluates financial performance, as measured by such indices as revenue growth, cash flow, and operating income, for the top 100 industry participants. Detailed analyses are conducted on topics of interest, involving examination of industry trends and interviews with senior industry executives. The entire survey typically involves 250 – 300 pages of analysis and conclusions.
While defense aerospace companies have not yet been subject to the same kinds of pressures that are already visible in civil aviation, cuts have already been announced in the 2010 defense budget. We believe that recent changes in the political, economic, and geo-strategic landscapes make it likely that those cuts are only the beginning of a long-term realignment in government spending. That realignment will be compounded by shifts within the supply chain itself, creating a set of imperatives that will put inattentive businesses at risk – even as they create opportunities for the prepared.
Since the early 2000s, there has been strong growth in the commercial, business, and defense sectors of the industry. The post 9/11 and SRAS era has delivered a very strong cycle. The industry achieved 10% average EBIT margins, and North America surpassed Europe with a 3.6 point EBIT improvement since 2005. More aggressive American cost cutting efforts, strong US defense growth, and the adverse Euro exchange effect all combined to drive this difference.
Even before the economic collapse, however, a careful study of the industry in context suggested that the boom was about to end. On the military side, many observers believed that the coming changes in the political landscape would inevitably lead to cuts in defense spending. Furthermore, the growth in commercial aviation had all the earmarks of being just the upswing of a business cycle, rather than the result of a lasting structural development. Factoring in the high debt levels of the industry’s supporting firms led us to predict turbulence ahead for 2009, as early as June 2008.
The political and cyclical stresses to the market were compounded by a series of unforeseen events, but their role was to compound the crisis, rather than creating it.
Our subsequent 2009 study showed industry EBITDA margins that are down an average of more than 20% this year vs. 2008, even as supplier debt leverage jumped 15% on average between Q2 and Q4 2008. Inventory levels in the industry have also jumped by more than 20% in the past year, due to a high number of aircraft-order cancellations. Overall financial-distress indicators for the industry have deteriorated by 24% since last year, and valuation multiples are down from over 10x EV/EBITDA in 2007 to as low as 5x today.
All told, airlines around the world are on track to lose $9 billion in 2009, and the possibility of bankruptcy for North American airlines has increased by 20% since last December. Helicopter OEMs with solid government-financed backlogs have a brighter future, thanks to those backlogs and to life-cycle opportunities in the offshore resources sector. Meanwhile, the decline in corporate profits, the credit freeze, and a negative public image of business aviation as a symbol of extravagance has led to a collapse of the business-jet market. Order backlogs have declined by 40% since the beginning of 2008, raising the question of what even the post-recovery “normal” will look like.
Beyond financial and sales measures, AlixPartners’ 2009 Global Aerospace & Defense Review(SM) found that program management has been a particular disappointment for the industry. Massive cost overruns and program delays have been more the norm than the exception for many companies, draining much-needed cash which is always needed to survive a recession.
The full impact of these changes is just beginning to be felt throughout the supply chain. Potential buyers have the means to make deals, but many appear to be waiting on the sidelines, expecting multiples to continue their decline. They could be right.
Even after the recovery, the U.S. aerospace market will remain tight, particularly in defense. Barring another major conflict, we expect to see cuts in defense spending in the next 6-9 months, and even deeper cuts in 2011 and 2012. Three distinct trends are behind this:
One is that political leadership in both the White House and the Congress has large and motivated spending priorities, which are far more geared towards domestic projects.
A second, related trend is concern over the growing deficit. The choices ahead will be stark, and thin tanks like the CSBA are already beginning to sound the warnings. Continued high levels of defense spending will need to be financed through consistently higher deficits, through spending cuts or outright abandonment of programs elsewhere, or through politically difficult tax increases.
A third trend is the wind-down of the American presence in Iraq, which is leading to a sense that there is less need to maintain defense spending at the current level.
Other possibilities, from rising global prices for raw materials to the possibility of further slides in the US dollar, could put additional pressure on existing spending and programs at a vulnerable time.
AlixPartners does not believe that defense spending will hit a a ‘like-in-the-1990’s’ down. If any of these risks materialize, however, the current defense budget, and its programs, will find themselves at risk.
Preparing for that possibility is a prudent position.
The Second Shift: The Supplier Imperative
Because of the time lag, the effect all of the downturn on suppliers, especially those in the second tier, has been largely hidden until now. For the last several years, demand had been so great that the entire supply chain was completely taut. If you were a tier I or II supplier to the industry it was practically impossible not to make money; and the market made room for even those companies whose program management, or cost basis, or quality, was less than optimum. This situation continued as late as October of 2008.
Since then, however, the cuts that have hit the OEMs have worked their way down the supply chain to create substantial excess capacity. While demand for parts had very recently exceeded supply, there is now a great deal of excess capacity. Our study finds that program delays and production-rate reductions are already impacting inventory levels all along the value chain.
To make a long story short, the leverage that suppliers once had, no longer exists. Not only does this portend bitter competition for future business, but it means that suppliers whose quality or performance are substandard are in immediate danger of losing money and customers, via contract terminations for cause.
Those shocks might even be fatal in some cases. Altman Z-scores are used to assess the overall financial health of a firm. Used properly, they’ve been found the predict the possibility of bankruptcy in a 2-year horizon with more than 70% accuracy. Based on AlixPartners’ calculations of Altman Z-scores across the industry, its financial health dropped considerably in 2008. Our research shows that OEMs are moving toward the zone of risk, which will drive some of their behaviors. Even so, many OEMs can rely on the “too big to fail” effect, and on their national strategic value, as a last-resort cushion. The same dynamics do not hold true for their twice-pressured suppliers. Based on their Altman Z-scores, many European suppliers are in particular danger, due in part to their low defense base.
The message for suppliers is clear: nothing less than excellence will suffice in program management, quality, and on-time delivery. To achieve this, companies need to engage in a thorough survey of all aspects of their operation, and apply state-of-the-art lean production and management techniques across the value chain. At the same time, suppliers need apply rigorous financial discipline to insure that their capital structure is sound for the long term.
Beyond the Storm: What’s Next
The horizon isn’t all bleak, and there are possible mid-term drivers of growth ahead. High oil prices may challenge demand, for instance, but they would also drive a need for innovative products with better operating costs. Stimulus programs are helping with financing, and this is extending out to customers, even as uncancelled backlogs offer some cushion for the industry. Even so, a number of potential risks remain, and so do the fundamentals within the industry.
The US economy as a whole may be poised for a recovery, but AlixPartners believes that the aerospace industry is set to become increasingly competitive over the next several years. This does not mean that growth is impossible, but it does mean that successful companies will need skills and expertise that the recent boom years have not demanded.
Those companies who are willing to invest in superb performance will have an opportunity to increase their market share and profits, even in a contracting market.
The one bright spot our study found is in the global market. Aerospace products are still priced in dollars, and the weakened U.S. currency is making American suppliers increasingly attractive for foreign OEMs. Many forecasters expect continued dollar weakening, and the global market is large enough that it could absorb much of the excess capacity at home – if suppliers gain an understanding of what they need to do to take advantage of it. Even relatively small companies, if they have or can develop the expertise to position themselves globally, can find important sources of revenue abroad.
Suppliers that do thrive will be those that achieve excellence in:
- Performance. Companies that can beat their competition in quality and on-time delivery will be the ones OEMs seek out.
- Capital structure: The next 6-9 months will be a time of consolidation, and those suppliers that have not adapted to the new reality will be ripe targets for companies that are in good financial shape. Transactions are using more creative structures; but some are still closing, and buyers remain interested in acquisitions.
- Globalization: This is the time for even relatively small local suppliers to look to overseas markets.
Managing Director Philip Toy, the co-leader of Alix Partners’ global Aerospace & Defense Practice, is direct:
“Ensuring that cash is under control, and that cash generation will provide full potential, must be a main priority for most industry executives. If you are cash-rich, you can look at acquisitions opportunities, debt repayment or even stock buybacks, but if you are cash-constrained in this environment, you need to think more about divesting non-core assets or even merging with other companies.”
Inventory levels all along the value chain are already consuming much-needed cash. A relentless focus on extracting cash from operations is an absolute necessity today, and companies’ boards of directors should be reviewing issues such as:
- Whether the company has sufficient confidence in, and visibility into, future cash flows;
- Whether the company’s existing financing structure is fully adapted to its current strategy and operating model; and
- Whether its cash-control environment is fully in line with its reporting and compliance requirements.
In spite of the numerous indications to the contrary, many companies still seem to believe that the current downturn is only temporary. Rather than prepare for a “new normal,” they are behaving as though business will return to previous levels in a matter of months. We cannot emphasize strongly enough that those companies are putting themselves at risk if they do not take immediate steps to prepare for a long-term realignment. Success is possible, but it will take enlightened direction and rigorous discipline, applied broadly to their operations, to carry it off.
David Fitzpatrick is a Managing Director and co-leader of the Aerospace and Defense Practice at AlixPartners. Companies who wish to set up a more in-depth discussion of AlixPartners’ 2009 industry survey should contact dfitzpatrick, over at alixpartners dot com