By Helen Massy-Beresford in London & Graham Warwick in Washington DC
Five years ago, the aerospace industry was at the peak of its latest cycle. A downturn was just around the corner, but no-one could predict the deep trough into which aviation would plunge after 9/11. Five years on, the industry is a picture of health and stability, according to Flight International's annual Aerospace Top 100 survey analysis, available to download in Adobe Acrobat portable document format (PDF) - compiled in association with PricewaterhouseCoopers.
Barring unforeseen events, the industry should stay on this upward trend - until at least 2008-9 if this is one of the industry's normal cycles. Revenues are continuing to grow and overall industry profit margins are heading back towards their peak of 2000. But while the prime contractors and their Tier 1 partners are solidly profitable, there are signs that not all of the Tier 2 and 3 suppliers are so successfully turning increased sales into higher earnings.
The volatility in profitability among the base of smaller suppliers on which aerospace is built is a continuing concern that underlies the industry's otherwise impressive performance. Based on publicly available data for 2005, including company reports, this year's survey shows that sales increased by 8% and operating profits by around 17% for the Top 100 aerospace companies - largely driven by the growth in commercial aircraft deliveries by Airbus and Boeing.
That growth took total 2005 sales and profits for the Top 100 to $443.5 billion and $34.1 billion respectively. "The trend since 2003-4 has been significant revenue increases and even more significant profit increases - as you would expect from a capital goods industry returning to growth," says Neil Hampson, a partner at PricewaterhouseCoopers. "But it is still pretty healthy growth."
Overall growth in 2005 was slower than in 2004, when Top 100 revenues and profits increased 13% and 22% respectively, but that is to be expected, Hampson says. "Last year  there was more growth through acquisition. This year  there is more organic growth," he says, adding: "The rate of revenue and profitability growth will inevitably decline as the industry gets larger."
With no major foreign exchange shifts and few major corporate changes in 2005 there is little movement in the Top 100 ranking by revenue this year, with the positions of nine out of the 10 highest placed players unchanged from last year's survey. As in previous years, the Top 20 companies account for around 80% of the total revenues and profits. Top 20 revenues have increased 54% over the five years 2000 to 2005, but the sales of this year's Top 20 have outpaced that growth, increasing by 59% over the same period, showing the effect of consolidation at the top of the table.
Boeing in pole position
In the revenue ranking, Boeing maintained its pole position and slightly extended its lead over European rival EADS in 2005, and the two companies continue to pull ahead of the pack as commercial aircraft sales accelerate while defence revenues stall. Boeing's revenues were up 5%, commercial aircraft returning to form with an 8% increase in sales after the 6% decrease suffered in 2004. At the same time, Boeing's defence growth slowed dramatically, from 11% in 2004 to just 1% last year, the company again showing the strength of its balanced business case.
Airbus doubled its sales growth to 12% in 2005, propelling EADS to 8% higher revenues. With delays to deliveries of the A380, the European giant is now projecting a 4.5% increase in revenues this year, to around $44.5 billion. This will see EADS lose ground against its US rival in next year's Top 100, with Boeing forecasting sales growth of 9.5-10.5% for this year, to $60-60.5 billion, on higher airliner deliveries. Whatever the final figures, for the foreseeable future increased commercial aircraft revenues at Airbus and Boeing will be the engine driving Top 100 growth.
For the next five players in the Top 10, the expected slowing of US defence spending will be the main concern. Third-ranked Lockheed Martin saw revenues increase 5% in 2005, and is projecting 3.5-6.2% growth for this year, but fourth-placed Northrop Grumman expects sales to slip slightly this year after managing a 3% increase in 2005. After an 8% increase last year, sixth-ranked Raytheon is also forecasting flat revenues this year as the US defence budget comes under pressure.
The UK's BAE Systems saw sales increase 17% last year on its acquisition of US armoured vehicle manufacturer United Defense Industries (UDI), but it stayed firmly in fifth place. BAE's ranking next year will depend on whether it succeeds in divesting its 20% stake in Airbus to EADS, at what price, and what it does with the money. The UDI acquisition boosted BAE's US defence business, but acquisitions packing a similar punch are becoming harder to find.
General Dynamics is in a similar position, stabilised in seventh place after a rapid climb up the Top 100 propelled by acquisitions, its just-completed $2.2 billion purchase of US information-technology services company Anteon unlikely to move the company up the aerospace rankings and few other large deals in prospect. That said, GD's healthy 11% revenue rise in 2005 was driven largely by strong organic growth in its aerospace business.
United Technologies outpaced rival General Electric in 2005, 12% sales growth across its Pratt & Whitney engines, Hamilton Sundstrand systems and Sikorsky helicopters businesses keeping the company firmly in eighth place and ahead of GE Aircraft Engines with its 7% revenue increase.
The one new Top 10 entrant is Italy's Finmeccanica, which saw revenues rise 24% with the full consolidation of AgustaWestland lifting helicopter sales 71% and the acquisition of BAE Systems' assets boosting defence electronics revenues 53%. The company is forecasting sales growth of 10-13% for this year across its aerospace and non-aerospace businesses. Whether this will be enough to keep the Italian giant in the Top 10 remains to be seen.
L-3 Communications, sitting at number 13 and poised to enter the Top 10 after a meteoric rise up the ranking fuelled by a multitude of acquisitions, may be taking its foot off the growth pedal after completing last year's $2.65 billion aquisition with US government information-systems specialist Titan.
This has taken L-3 to $12 billion-plus in sales, and could propel it into next year's Top 10, but meanwhile the company is focusing more on organic growth and smaller acquisitions.
Finmeccanica and L-3 are among the companies making the Top 10 growth ranking this year (see table P42), the US firm at number three with an almost 37% increase in sales and the Italian giant at eight with almost 30%. But top ranking for the fastest growing aerospace company goes to French aerostructures manufacturer Latécoère, which managed an almost 150% increase in revenues. As with composites supplier Hexcel (46%) and systems supplier Liebherr (34%), the growth was mainly driven by Airbus and Boeing work, says Hampson. US company Textron (35% growth), meanwhile, experienced substantial civil and military sales increases at its Bell Helicopter and Cessna Aircraft businesses.
Latécoère, which like Liebherr has been actively taking risk-sharing stakes in aircraft programmes, is one of the companies further down the Top 100 that made a significant move up the ranking this year, climbing from 87 to 82. Others include US firms DRS Technologies (41 to 37) and Esterline (65 to 53), both seeing 14% sales growth and Japan's Fuji Heavy Industries (74 to 57 on 8% growth), another active risk-sharer.
However, for every up there is a down, and companies dropping down the Top 100 table this year include Thales, slipping from number 10 to number 12 on flat sales. Bombardier continued its slide down the table, dropping from 15 to 16 as it eked out a 1% increase in aerospace revenues - a 52% rise in business jet sales just barely managing to offset a 17% decline in regional aircraft revenues as the 50-seat jet market evaporated.
France's Safran, created in May last year by the unlikely merger of communications company Sagem and engine manufacturer Snecma, makes its first appearance in the Top 100 at number 15, in part because the company's consolidated financial statements for 2005 include only nine months of Snecma's revenues. Using pro forma statements intended to reflect the group's financial performance would rank Safran at number 12, with aerospace revenues of $10.2 billion, up 7% from 2004.
Others moving down include the UK's GKN (28 to 45 following the sale of its AgustaWestland stake to Finmeccanica), South Africa's Denel (57 to 70 on lower contract volume) and Loral Space & Communications (59 to 81 after emerging from bankruptcy as a smaller company focused on satellite manufacturing).
Further down the table, the many smaller Tier 2 and 3 suppliers are ripe for consolidation - something the primes and Tier 1s want, Hampson says. This is also the sector of the industry where financial performance is much more variable, and where potential trouble lies when aerospace enters its next downturn. The greater variability in financial performance among the smaller suppliers is reflected not only in the wide range of rankings by revenue but, in particular, in the wider spread of their operating margins both between suppliers and from year to year.
Tier 1, 2 and 3 players performed well in the 2005 Top 100 survey as the trend towards risk- and revenue-sharing partnerships pushed value down the supply chain. This year's survey shows that they have again achieved good results when it comes to operating margins as they continue to take on more responsibility for designing, developing and supporting their products and more complex roles in programmes. Their performance is anything but consistent, however.
While the possibility of earning significantly higher revenues than available under straightforward supplier-customer contracts is attractive, the risk element of risk and revenue sharing should not be underestimated, as it leads to greater variability in margins among players who take this approach to the business. "Lower down the supply chain is a much more volatile sector of the market to be in," Hampson says.
"The primes used to be much more volatile," he adds. "But they learned their lessons from the most recent downturn, and now make sure they are well hedged where possible across different sectors of the industry such as the defence and civil markets, and across different areas of the business like original equipment manufacture and aftermarket support."
As lead systems integrators passing risk and financial volatility down the supply chain, the primes are "doing a very good job of sustaining constant margins", Hampson says. "The systems integration role of the primes allows them to manage their return better than a supplier." On the flip side, while the primes' margin variability may have reduced significantly, they have paid for this stability with a more modest increase in margins.
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There are higher margins to be made among the lower tier players, if they are willing to take on the significant risks that the primes are pushing down the supply chain towards them. There is much greater variability in the ranking by operating margin in this year's survey than in the main ranking by revenue table. While some of the same players appear year after year in the top 10 by margin - eight of this year's top 10 were included last year - others show a more erratic performance.
The average operating margin in this year's survey is 7.7% across the Top 100 companies but, for those appearing in the top 10, operating margins range from tenth-placed Precision Castpart's 15.7% to top-ranked K&F Industries' 27.1%. The highest-margin companies have certain common factors beyond the high-risk versus high reward tier of the industry that most of them occupy.
A strong presence in the aftermarket is a good indicator that a company will do well in the current market when it comes to operating margins. K&F Industries, which posted the highest score in the survey and also performed well last year, claiming second place, earns over 90% of its revenues in the aftermarket.
Tier 3 diversification
Lower-tier players generally have much more exposure to individual programmes, making their position in whatever sector of the market they inhabit more precarious. Hand in hand goes the issue of diversification across several industries. Tier 3 players will often tend to be present in a range of different industries, with their aerospace business accounting for only a proportion of their total workload.
Along with K&F, other high-margin businesses with a significant proportion of aftermarket business, particularly in the mechanical sector, include Heico in second place and Meggitt at seventh. These are also companies that operate in "consumable, low unit-cost areas" of the industry such as brakes and blades, says Hampson.
Another company from the same market segment, Precision Castparts, boosted its Top 100 ranking by revenue from 34 to 31 this year. The company should see a bigger jump next year as the impact of its acquisition of Special Metals filters through. In the meantime it has retained a place in the top 10 by margin, with a score of 15.7%.
Heico, which supplies replacement parts for aircraft and engines, is another example of a company with a strong mechanical aftermarket presence, coming in at number two with a margin of 25.6%, a leap up from the previous year's 15.3%. But as its revenues fell in 2005 to $177 million - from $216 million in 2004 - the company narrowly missed out on a place in the Top 100 by revenue, coming in at number 101. UK-based Meggitt fell four places in this year's operating margin ranking to number seven, with 16.6% compared with 17.2% last year. But the company fared better in the main Top 100 ranking, climbing five places to 48.
Primes are well aware of the importance of the aftermarket sector in improving profitability. UK-based Rolls-Royce, which earns more than half its revenues from the aftermarket, posted margins of 13.3%, almost double last year's figure of 7%. Recent developments including the launch of Boeing's GoldCare programme - which will allow the manufacturer to keep tight control over the maintenance, repair and overhaul of the new 787 - demonstrate the growing importance of aftermarket sales, and perhaps give an indication of the new approach of aircraft manufacturers to the aftermarket sector.
Elsewhere, companies with a strong presence in the electronics sector did well in margin terms, including US-based avionics and communications specialist Rockwell Collins, ranked number six fourth-placed Amphenol, a US manufacturer of electronic connectors and UK-based Ultra Electronics, which just missed out on a top 10 ranking, with the 11th-highest operating margin.
US growth sectors
Like Collins, Ultra is benefiting from high growth in the US defence electronics and information-technology sectors, and its operating margin was up from 13.8% last year to 14.9%, although its position in the Top 100 revenue rankings was unchanged at 68. UK-based Cobham also benefited from a US defence footprint: its 15.8% operating margin placing it ninth.
It is not simply the sector in which an aerospace company operates that determines how healthy its margins will be. Much is dependent on its position within the supply chain. US-based Vought Aircraft Industries, which has taken on a key role - and substantial risk as a systems integrator for its major customer Boeing - is placed at number 95 in this year's ranking by margin, compared with its much higher position of 42 when measured on revenue.
Vought announced in April it would cut between 15% and 20% of its non-touch labour force as part of "aggressive steps to improve our operating results" by reducing costs and improving cashflow. The company's results for the first quarter of 2006 showed an almost 10% increase in sales to $323 million, but a slightly greater net loss of $52 million, in part because of its heavy investment in the 787 programme.
There are other factors at play to explain the wide variations in margins. Smaller companies that still make the Top 100 (which ranges from Martin-Baker with $209 million in sales to Boeing with $55 billion) simply have less purchasing power than their larger counterparts, leaving them unable to take advantage of savings and efficiencies the larger players enjoy. "Lower tiers are just not as sophisticated in procurement," says Hampson.
When it comes to ramping up production to meet demands for increased production rates as the upswing in the industry continues, many smaller suppliers are reluctant to commit to the investment required. And as lower-tier suppliers struggle for visibility in a highly cyclical industry, this causes problems for the primes as they try to convince their suppliers to make the necessary investments to boost production and ensure they can meet their own customers' demands.
"Taking a bet on someone who's two stages removed from you in the supply chain necessarily makes you nervous," says Hampson, explaining the lower-tier suppliers' reluctance to invest. While it is easier to convince companies to invest in areas where there is not enough capacity, such as electronics, other manufacturers had their fingers burned when production was scaled back during the last downturn. "The headache for the primes is getting people to scale the business up," he says, adding: "Four to five years ago they were getting them to scale down."
The primes in general are well hedged and secure in the knowledge they can pass risk down the supply chain. Large prime contractors have learned the hard way they must balance their portfolios, spreading their order backlogs across the civil and military sectors to ensure that they take advantage of the peaks and cushion the troughs in each segment of the business.
But the primes cannot afford to rest on their laurels when it comes to their suppliers: the precarious nature of the business for lower-tier suppliers also has an impact on them - they cannot just sit back and revel in their own stability. It is crucial for the primes and first-tier suppliers that smaller players make the necessary investments in infrastructure and materials for production rates to continue to grow.
The research and development burden shouldered by players lower down the supply chain is likely to have increased in recent years, according to Hampson, although this is difficult to measure since the contributions made by governments and businesses themselves cannot easily be separated, and many companies do not publish their R&D expenditure.
There are other factors at play, too, among the lower-tier suppliers, Hampson says. "The ones that are losing money are the ones that haven't gone through restructuring." The necessary restructuring may only be carried out by the "really innovative and ambitious" smaller companies, he says.
Much has been made in recent years of the need for lower-tier suppliers to consolidate to remain competitive. There has been less of this activity than many expected over the last year, and this is perhaps the cause of some of the instability among these players. Companies that club together to address a greater portion of the market, or more programmes, could have greater clout than they would as individual, smaller players.
If actual consolidation has been put on the back burner, there is certainly a growing need for partnerships and collaboration. It is good news for primes when small and medium enterprises (SME) team up and approach programmes through partnerships, and across the industry there are measures in place to help smaller companies with less purchasing power and clout in the industry take advantage of the upswing. Regional associations are playing a valuable role, allowing SMEs to partner up to share risk on major programmes or collaborate on research and technology initiatives.
The results of the lean manufacturing and cost-saving initiatives the large players have made in recent years are likely to start filtering through to the lower-tier suppliers before long, says Hampson. There are signs that the benefits of these cost-cutting drives are starting to take effect at the top of the pile. "Lower down it is more difficult to assess, but some of the innovative companies are investing in that area. Those ones will start to pull away from the rest," he predicts. ■