The global commercial aerospace sector is expected to grow significantly this year, with record-setting production, while the global defence industry is expected to continue to decline, according to a new report.
Overall global aerospace and defence industry revenue is expected to grow by 5% in 2014, mainly due to the commercial aerospace sector, according to Deloitte’s Global Aerospace and Defence Outlook for 2014.
Deloitte said that the growth in the commercial aerospace sector is driven by the need to replace obsolete aircraft with new, more fuel-efficient models, as well as increased passenger travel, especially in areas like the Middle East and Asia-Pacific. Indeed, demand in these areas is increasing leisure and business travel growth as well as freight transport. Deloitte predicts that passenger travel demand will grow 5% over the next 20 years.
The defence sector will continue to see revenues decline as a result of the withdrawal of US and allied forces from Iraq and Afghanistan and budget cuts in the West. However, regional tensions in places like the Middle East, North Korea and the East and South China Seas will see affected governments purchase military equipment.
Although defence spending is dropping in Western markets, it is increasing in several world regions, notably the Middle East, India, China, Russia, South Korea, Brazil and Japan – many of these countries have threats in their regions, driving increased defence spending.
However, the Deloitte report noted that opportunities for defence growth are likely to be diminished with the overall downward trend in global revenues for defence companies, which declined 1.3% in 2012 and 1.9% in 2011. “Although the final numbers are not yet reported for 2013, it is anticipated that global revenues for defence companies will track to similar levels as in the past two years, around an estimated minus 2.5%,” according to the report.
The main reason for the global reduction in defence spending is because of the United States’ disproportionate contribution (39% of total global spend) and sequestration in that country and subsequent reduction in defence spending. “In 2012, the top 20 US defence contractors experienced a 3.3% reduction in revenues. Through the first nine months of 2013, the top 20 US defence contractors have experienced a revenue decline of 2.5%, a trend expected to continue through the end of 2013,” Deloitte noted. Around $22 billion worth of defence budget cuts are expected in the US in 2014.
The two major challenges of the global defence industry this year will be growing profitability in a declining market and cutting costs to maintain performance, according to Deloitte. “With declining budgets, there likely will not be sufficient work to sustain current levels of revenues and earnings, requiring global defence companies to find other sources of revenue.”
Nevertheless, the report states that governments are expected to continue to spend on programmes of significant value, such as the next generation intelligence, surveillance, and reconnaissance (ISR) technologies. “The ability to know, process, and react in real time to events on the ground, in the air, and at sea will continue to be a strategic competitive advantage in armed conflict. The ability to process mega-billions of data bits provided by high resolution optics, communication sensing, and other multispectral sensors, is key to differentiating friend from foe, or tactical threat versus benign events for example. The use of advanced data analytics to sift through the data and make sense of it will be another strategic advantage in armed conflict. Innovations in these areas represent a source of potential growth for defence companies.”
“Defence companies will increasingly be required to invest their own funds in potential growth areas, including next generation ISR as indicated above. Other areas of growth that may help fill the revenue gap are foreign military sales to countries that are spending more on defence. Other promising areas of growth are in cyber-security, adjacent markets, and application of military technology innovations for civilian markets. Lastly, growth is expected to come from inorganic sources via acquisitions. Acquisitions into new markets or consolidation of weaker companies to create economies of scale are expected to accelerate in 2014,” the Deloitte report said.
In order to cut costs, defence companies are reducing staff, cutting overheads, accelerating the automation process and using digital product development and computer aided design to reduce development costs. “Lean manufacturing and six sigma initiatives have significantly cut waste and inefficiency in the production process. It is expected these initiatives and programs will accelerate in 2014 as companies manage their margins and profitability in a declining revenue environment.”
The report notes that to return to growth, defence companies will likely merge with competitors, enter adjacent markets, enter entirely different markets, concentrate on next-generation technologies and focus on international sales. “However, it can be difficult to do business in certain foreign countries with the long decision cycles, investment requirements, and inadequate indigenous capabilities to perform offset work by foreign nationals, for example,” Deloitte added.
Deloitte suggested defence companies focus on reducing life cycle costs and make equipment more affordable as “defence programmes have become extraordinarily expensive by historic standards”. Various funding models need to be developed to finance weapons, such as public private financing (funding from the private sector) and performance-based logistics (pay per use).
One thing that could drive defence spending is regional tension and conflict. Deloitte notes that, “as demonstrated over the last 50 years, armed conflict occurs on average every two and a half years, an increase from every four and a half years since the fall of the Berlin Wall. Should this trend continue, expect that defence spending will increase globally in the next two to three years, although this is highly dependent on the global defence environment, and how…potential threats…play out.”
On the commercial side, Deloitte noted that aircraft technology was improving, especially in the areas of fuel efficiency, navigation technology and materials, with fuel efficiency the main driver of new aircraft sales (many new airliners promise 15% better fuel economy). The report noted that fuel costs, as a percentage of total operating costs for airlines, have risen from an average of 13.6% in 2001 to 31% expected in 2013.
Deloitte predicts that there will be a dramatic increase in commercial aircraft production over the next two decades, reaching between 29 000 and 34 000 aircraft over the next twenty years – however, this is predicated on no global conflicts or negative economic events. If the world is stable, by 2023, annual commercial aircraft production levels are expected to grow by 25%.
Catering to this demand, Deloitte predicts at least one additional competitor will enter the market alongside Airbus and Boeing in the next 20 years and that new aircraft production programmes will likely emerge from non-US and European countries. However, Deloitte cautions that it may take some time for new entrants to build up a credible track record.
Deloitte also cautioned that the aerospace supply chain may struggle to keep up with demand for parts and the need to invest in research and development, which will lead to consolidation – this is already happening.
“It is likely that 2014 will bring high single to double-digit levels of growth in the commercial aerospace sub-sector, as experienced in 2012 and expected in 2013, given the dramatic production forecasts of the aircraft manufacturers.”