The world has changed remarkably in 2020. The new decade began with a sense of optimism and historically strong economies in both the commercial aerospace and defense sectors. Both sectors had seen a decade or more of continued growth. Healthy backlogs and strong demand looked unlikely to end in the foreseeable future.
Unfortunately, by March, we all realized that we were in the middle of a true “Black Swan” event. In a matter of days, the market went from continued optimism to an unprecedented decline in demand. At that point, most of the economy was put into an induced coma by governments around the world. Within weeks, 60 percent of the global commercial airline fleet was parked, and air traffic globally was down over 80 percent. This resulted in the announcement of tens of thousands of layoffs in the sector as demand for new aircraft has nearly disappeared for the time being.
The story of the decline and the impacts has been widely covered. The level of significance of the downturn has forced the industry to deal with immediate concerns facing the business, namely right-sizing staffing levels and protecting cash. While these are critical considerations, it is still important to not lose sight of the future and how to best reorient the business today to take advantage of the new market reality, and subsequent return to growth. No matter how well you handle the current problems, if you don’t position and align the business to what’s next, it may all be for naught. To get the balance right, there are six main issues the A&D sector needs to consider and address over the next six to 12 months.
The A&D market has no shortage of analysts plotting upside and downside scenarios. While that may assist with understanding how many aircraft are going to be sold over the next 24-36 months, it gives little insight into how those shifts will trickle down into revenues and supply chain demand. Additionally, with COVID-19 showing little sign of slowing down, there is significant uncertainty about how air travel resumes, what additional stimulus packages are required and what the effect on government spending will be in the medium and long terms. This has resulted in most publicly traded firms eliminating forward-looking guidance, along with public forecasts for deliveries. This makes it exceedingly challenging to plan for the future when customers don’t know what they will be doing in six months. This is compounded by estimates that there is ~40-50 percent overcapacity in the commercial aerospace supply chain. This hit is not binary, though, and the supply chain will continue to ramp down until the airlines and OEMs right size. This adds to the uncertainty as the industry waits to see how far down the bottom can go. In many places, this has led to a freeze in planning for too far into the future. However, this is a mistake: There are things that can be accomplished until the market stabilizes and the future becomes a bit less muddled.
With the uncertainty as to future market demand and the declining order books of major OEMs, the industry is burning through cash at an unsustainable rate. The International Air Transport Association stated the commercial aerospace and aviation industry would require more than $200 billion in stimulus capital to maintain stability in this crisis, which is in addition to additional loans and capital-raising strategies. Some of the market’s largest and most dominant players have sounded the alarm with respect to liquidity pressures. This has resulted in a series of successive and significant rounds of layoffs across the sector. Some of the largest firms in the industry are reducing headcount by 10-20 percent. At the moment, this pressure seems to be continuing to build, and the uncertainty has made the end to this pressure unpredictable. The French government has recently enacted a ~$8.9 billion stimulus plan for its aerospace industry. It remains to be seen if other nations will follow suit, with industry lobbying on the U.K. and U.S. in particular to match the strategy. Without cash, long-term investments will be on hold, which could delay potential programs like a narrowbody competitor to the Airbus A321neo. The industry needs to find relief from its level of cash burn, and there are only so many layoffs and cuts that can be made before different strategies need to be undertaken to slow expenses and generate new revenue.
It’s no secret that defense has become a relatively safe haven for firms with exposure to commercial aerospace and defense. Defense spending, at least in most Western nations, has remained relatively robust. Governments are using defense spending as a stimulus to compensate for the commercial decline. Some firms that have defense and commercial exposure have been protecting key suppliers by bringing commercial firms into defense supply chains to keep the workforce operating. While generating defense revenue can take time, the next 12 to 24 months will present opportunities for firms that can find a niche to exploit and invest in building a position. This plan won’t compensate for the loss of commercial revenue. But it can assist in building a more balanced portfolio. The benefit of this is that firms with a more balanced portfolio tend to have a more stable and higher ROI than companies that are aligned to one market or another. This has been forgotten. Only recently have we been reminded that commercial aerospace is a cyclical market and that historically, commercial and defense markets have been countercyclical. If you look at the last several downturns and recoveries over 10 years, you will see firms with a more balanced market exposure performed better for shareholders, and those balanced firms eliminated the high amount of beta caused by cyclical market fluctuations.
When investing in defense, remember it, too, is cyclical. We have lived through a decade-plus of growth in commercial aerospace and defense. So, now we need to again plan against cycles.
Defense, too, will reach its zenith and face a decline. This is likely to happen in the next 24 to 36 months because of the recent spate of government stimulus programs. While these infusions into the market were likely necessary, that bill will eventually come due. While debt has been a major talking point for years, the reality is we have managed well despite the mounting debt. The real issue will be net interest on the debt and, thus, a nation’s ability to service its debt. With defense spending most often the largest discretionary budget, the looming need to service debt will have a substantial impact across the board on discretionary funds, including defense. The key is to find a niche as quickly as possible and exploit it, and then get ready to ride out the downturn in balance with the commercial business, which will likely start to climb about the same time, and commit to building both businesses through future inevitable cycles.
The current pandemic and resulting economic crisis have turned digital into the single-most uttered and written about business buzzword since cyber. Like the cyber market of the early 2000s, the buzzwords have a few things in common: a lack of a clear definition, more by-lines than budget, and a lack of understanding in how to monetize the interest. The key to addressing the interest in digital transformation is dividing the market into bite-sized bits. The most useful segmentation is between revolutionary technologies and incremental technologies. The second distinction needs to be made between “stand-alone digital tools” and digital solutions that enhance a product, process, or service. These distinctions are important because the A&D industry is a highly risk-averse market, with significant regulatory requirements combined with margin pressure from the customer community. Digital solutions that are aligned to new market capabilities and require early adoption by end users will find that the market is not prepared to take the risk. However, digital tools that create operational efficiencies, reduce costs and continue to process improvement will see adoption to a much greater extent. Examples of these activities will be areas like the use of analytics for predictive maintenance, digital supply chain management, secure business communications, automation tools and select Factory of the Future/Industry 4.0 transitions. These solutions are not designed to change the nature of the market but to improve cost and efficiencies across existing capabilities and improve margin performance. The thing to take note of is that adoption will not be rapid, as spending outlays for these tools will likely be slow in developing. But incrementally, as the market stabilizes, customers will seek again to spend on the acquisition of solutions to improve performance and efficiencies.
With nearly half of the commercial aerospace supply chain under threat due to overcapacity, the ability to manage supply chains and create more flexible relationships will be critical. Besides, the movement away from just-in-time logistics may see at least a more near-term focus on more robust inventories to better manage market disruptions and shutdowns. Understanding supplier health and reliability will be more critical than ever as the entire market downsizes to meet shifts in demand. Smaller, more specialized firms will feel the most stress as they will not have the capital or flexibility to balance to the new normal. Similarly, larger firms that are overexposed to specific markets (such as aerostructures) will face similar pressures. While these pressures are largely a result of the commercial downturn and effects of the pandemic, the defense supply chain, which is closely interlinked with commercial aerospace, will not be immune. OEMs will need to understand their suppliers better, forge new relationships, and work together to protect critical capabilities that could be lost due to market pressures and declining demand. Firms that invest in digital toolsets to manage the changes and threats in the supply chain will be better prepared to deal with shifts that will inevitably take place. And suppliers that are adaptive to more flexible business models and adjust to a greater focus on revenue through savings on total ownership cost rather than through upfront payments for solutions may see more stability and trust with their customers than firms that operate more traditionally.
Once some clarity resumes in the market, future planning can begin in earnest. While little emphasis is being placed on how to rebuild after the market stabilizes, we are likely not far away from those exercises taking place. With the M&A market currently limited, and the uncertain bottom to the market, activity to position for the future is a paper exercise, if it is being considered at all. However, the history of previous downturns suggests that firms will be quick to react to new market realities, and those that move quickly will likely benefit from first-mover advantages, which most importantly is being able to buy low and riding the growth from the early stages of market recovery.
As the downturn progresses, we will begin to see distressed properties come to market. In addition, we will see some large organizations divest assets in areas that are no longer core, and reinvest in areas that are new to them, or under scaled. The most prominent case study on this strategy was General Dynamics in the early ’90s: Its leaders sold off business lines in excess of 50 percent of its revenue and reinvested in areas new to the company, such as Gulfstream, and came out of the downturn more robust and with a better ROI than their peers. What this looks like is still largely dependent on when we see some clarity to the market. But history suggests that firms that react quickly generate the highest return.
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