China’s military ascendance and Russian regional resurgence have effectively triggered the resurgence of the great power competition between the traditional and revisionist states in the age of multi-polarity in the 21st century. The Global Defense Spending reached the record high level of $2.1 trillion for 2021 while registering a 7% year-on-year growth.
The rise of China & its military bullying in the Asia Pacific region and the ongoing Russian invasion of Ukraine have collectively led to significant turbulence and a subsequent, massive surge in defense spending across APAC & Europe which is likely to be sustained at least for over a decade.
The degree of impact of the Russia-Ukraine war and the subsequent monumental geopolitical shifts underway could easily be gauged by Germany’s recent, complete turnaround of its traditional defense posture with an upfront commitment of EUR 100+ billion towards defense and the rapid swerving of traditional neutrals of the North, Sweden & Finland, towards NATO
Total global military expenditure increased by 0.7 per cent in real terms in 2021, to reach $2113 billion. The five largest spenders in 2021 were the United States, China, India, the United Kingdom and Russia, together accounting for 62 per cent of expenditure, according to new data on global military spending published today by the Stockholm International Peace Research Institute (SIPRI).
The Aerospace/Defense Industry serves, as its name represents, two main markets: Aerospace, which largely comprises the production, sale, and service of commercial aircraft. And Defense, which is dependent on the nation’s need for military weapons and systems designed to operate on the land, sea, and in the air. Also included in this industry is the production of general aircraft (mostly for business use) and space vehicles, usually satellites, for both military and commercial use.
The Aerospace and Defense Industry (A&D) comprises of manufacturers who develop spacecraft, commercial and military aircraft, tanks, missiles, and other weapon-related equipment. They also manufacture engines and engine parts as well as landing gears, propellers, and rotors. Other companies specialize in manufacturing armed vehicles. Firearms and accessories account for about 60% of the aerospace and defense industry revenue while ammunitions cover 40% of the total revenue.
Manufacturing in the aerospace and defense industry is unique compared to other volume manufacturing sectors. The uniqueness comes from aerospace engine manufacturing. The parts in the aerospace and defense sector require longer machining times. It increases the precision of designing the elements in the engine. The engine is the most complex element in the aerospace sector as it houses the most individual components and determines fuel efficiency. The components and material used in the aerospace and defense sector consist of short-run quantities, rendering scheduling for productivity, and long lead times as compared to other industries.
The product line of the aerospace and defense sector is broad since its primary products and flight vehicles require up to millions of individual parts. The industry also requires support systems that help in the operation and maintenance of vehicles. Several companies in the A&D sector use competitive intelligence as a critical tool in identifying ideal business opportunities and possess a competitive advantage.
Customers and cycles
Most commercial aircraft are sold to the world’s airlines. A few are configured for general aviation use, serving nations, companies, or individuals that need large aircraft for transportation outside of those available to the public. The United States military comprises by far, the largest market for defense equipment, systems, and services in the world. The companies included in this sector not only serve America’s needs, but often are the suppliers most sought by our allies and friends.
The market for airliners has been very cyclical in the past, with orders surging for years, followed by a sharp decline in need, which results in airlines canceling or postponing their orders. The reason for the sharp turns is traceable to the airlines’ leverage. For example, if breakeven operating capacity is 70%, then 71% would generate a profit, which would tend to surge as the percentage rises. On the other hand, 69% would result in a deficit.
The market for weaponry has its own cycle. During a war, defense spending rises rapidly, with expenditures on procurement and research & development (the lifeblood of this industry), climbing at a fast pace, but when the war is over, and/or public perceptions of risks fade, then spending on defense stops climbing (which may result in a decline in inflation-adjusted spending) or an actual decline in current dollars. Demands for government money, which tend to rise in times of economic distress, while tax receipts fall, is another factor that may reduce the priority of defense spending.
Global Aerospace and Defense Industry trends
The A&D industry has a history of early adoption of disruptive technologies to advance both product development and manufacturing processes. There are currently several key technologies that the industry is using to meet new manufacturing challenges and deal with the pre-pandemic order backlog of aircraft.
These technologies include Industrial IoT, Manufacturing 4.0, ongoing digital transformation across the entire design/build/operate/ maintain product lifecycle of airframe manufacturing. Other technologies are advanced composite manufacturing methods, implementation of the digital twin, cognitive manufacturing and advanced analytics, robot/worker collaboration, and AI/ML, all of which are permeating many areas of the production process.
Next-generation intelligent automation along with the implementation of cognitive manufacturing powered by AI, advanced analytics, and digital twin implementation will optimize production processes, cut costs, and help A&D manufacturers reach pre-pandemic delivery rates faster and more efficiently. The emergence of material science is also spawning a range of new materials, along with additive manufacturing, and human/robot collaboration that will significantly change the face of aircraft manufacturing.
The commercial aerospace sector has been significantly affected by the COVID-19 pandemic, which has led to a dramatic reduction in passenger traffic, in turn affecting aircraft demand. According to Deloitte research, Commercial air travel is gradually recovering, albeit at a slow pace, with global passenger traffic substantially lower (-70%) in November 2020 compared with a year ago. Capacity levels also declined year over year in November 2020 (-59%), while load factors decreased to 58%. The continued impact on passenger demand is expected to result in a 61% decline in passenger numbers in 2020, with an expected rebound in 2021 (+56% year over year).
International passenger demand in 2021 was 75.5% below 2019 levels, while US domestic demand in 2021 was down by 28.2%. However, despite suppression of holiday travel due to the Omicron variant (with total traffic for December 2021 45.1% below December 2019), demand in early 2022 has surged. The recovery in passenger travel is gathering momentum, with total traffic in February 2022 (measured in RPKs) rising year-on-year by 115.9%, yet still down by 45.5% from February 2020.
On the heels of the tumult in 2020, 2021 was a year of partial recovery for aviation manufacturers, even though there is a significant way to go before returning to pre-pandemic levels of output. There’s no denying that the global COVID vaccination drive has set the path toward air travel resuming once again. There is the hope of things coming back to normal. Looking at the current trends, it seems like small and medium-sized carriers will be able to recover back to their pre-COVID times, and aircraft manufacturers are also focusing more on developing narrow-body aircraft. After the lows witnessed in 2020 and 2021, revenues are expected to rebound strongly in 2022 with the return of air travelers. However, Passenger traffic may not return to pre-pandemic levels before 2024.
In 2021, global commercial aircraft deliveries are estimated at 950 aircraft, a decline of 41% from 2018, the peak year for deliveries. The pandemic has resulted in certain behavioral changes among passengers, with an increased focus on short-haul and domestic travel. In 2020, average air travel trip length was expected to drop by about 8.5% globally—the International Air Transport Association (IATA) does not expect a return to pre pandemic trip length levels before 2025. Due to expected lower aircraft utilization rates, the sale of aftermarket parts and services could also remain weak, especially as airlines delay discretionary maintenance or upgrades to conserve cash. This is likely to have a disproportionate impact on profitability, as aftermarket parts often have higher margins.
Boeing delivered 340 commercial aircraft in 2021, a substantial improvement over 2020’s total of 157 but far below the company’s 2018 record of 806. As of December 31, 2021, Boeing reported a backlog of 4,250 commercial airplanes (3,414 of them 737s). Meanwhile, Airbus deliveries rose 8% to 609 aircraft (vs. 566 in 2020, but well below the company’s record of 863 in 2019), led by 483 A320-family craft. The total 2021 year-end order backlog stood at 7,082 commercial units (vs. 7,184 at the end 2020).
Meanwhile, the defense sector was steady, reporting modest growth in the US and significant growth in Europe, with global military expenditures hitting an all-time high of $2.1 trillion in 2021, according to the Stockholm International Peace Research Institute. Countries across the globe continue to spend on strengthening their militaries as geopolitical tensions intensify despite the global pandemic. However, given the disruption in the complex global supply chain, some defense programs could face minor cost increases and schedule delays in 2021. In February of 2022, Russia’s invasion of Ukraine reverberated throughout the defense sector.
In the United States, defense spending is likely to remain flat in 2021. However, fiscal pressures from reduced tax receipts due to the current recession and a potential need to reverse current levels of deficit spending could affect defense budgets from fiscal year 2022 onward. China announced a $178.2 billion military budget in May 2020, up 6.6% from the previous year. India is also bolstering its military, and Japan is increasing its air-sea military capabilities. Japan announced a $51.6 billion defense budget for fiscal 2021, a ninth straight increase. France did not announce any reductions in the defense budget for 2021; in fact, France’s lawmakers and the defense industry were expecting additional financial support from the government to counter the effects of the pandemic.
However, some countries are diverting spending to other social programs to revive the economy and reduce the repercussions of the pandemic. For example, Russia plans to reduce military spending by 5% between 2021 and 2023 due to the impact of the pandemic on economic growth.
Despite the ongoing pandemic, space launches for the first half of 2020 were mostly at par with previous years; the 41 successful launches were only slightly below the five-year average of successful launches (43). As funding continues to increase and costs decline, the space industry is likely to experience increased opportunities, primarily in satellite broadband internet access. In 2020, space investments remained strong at $25.6 billion, and the momentum for investments is likely to remain solid in 2021 as well. Space launch services are expected to record strong growth in 2021, with the market forecast to grow more than 15.7% year over year. Space exploration is also expected to continue to evolve and grow in 2021 due to declining launch costs and advances in technology.
Over the long term, costs will likely continue to decline, with companies in the space ecosystem focused on reaching critical mass. For example, there are over 1,000 Starlink satellites launched into orbit by SpaceX, and the company aims to deploy 4,425 satellites in orbit by 2024 as its launch costs decline, driven by reusable rockets and mass production of satellites. Launch costs for a satellite have already declined from $200 million in the past decade to nearly $60 million currently and have the potential to fall further to as low as $5 million.
In addition, the establishment in 2019 of the “Space Force,” a sixth branch of the US military, could drive public sector investment in 2021 and beyond. Furthermore, the US Space Command, which oversees space operations using personnel and assets managed by the Space Force, will likely support A&D companies in accelerating investments in innovative technologies and capabilities. China and Russia are also focusing on strengthening their military capabilities in space.
Top Risks in Global Aerospace and Defense Industry
Compliance threats originating in politics, law, regulation, or corporate governance
Volatility in the geopolitical and economic environment
Most airlines have a global footprint and are, thus, vulnerable to external factors, such as political tension and economic conjunctures. In the case of the commercial aviation sector, political stability and sustained economic growth are, according to Ernst & Young, major underlying factors driving long-term growth in air traffic. The US-China rivalry is causing instability in markets around the world, and economies have started to show signs of a potential slow-down in —including China, the world’s largest economy that recently reduced its GDP growth target.
»An economic slowdown in any of the key markets for A&D players could potentially result in tightening in the credit markets; low liquidity; and extreme volatility in the credit, currency, commodity and equity markets,« writes Ernst & Young in the report, adding that a slowdown could cause airlines to review their order intake strategies and postpone or even cancel existing aircraft orders. If orders are cancelled, it will create a domino-effect across the industry, presenting multiple issues for the aviation industry as a whole.
Compliance with a wide range of regulations and restrictions
The commercial aerospace industry has to comply with a long list of requirements for aircraft design, maintenance, pilot training activities and safety regulations. These regulations are critical for operators and passenger safety and hold the products and services of the OEMs and suppliers to the highest standard.
Aviation companies own a series of intellectual property portfolios, consisting of patents, unpatented know-how, data, software, trademarks and so forth. They enter into different types of confidentiality agreements with employees and suppliers, but these measures are not always enough to deter the misuse of IP and this could pose a threat to the aviation industry in the years to come. Furthermore, Ernst & Young notes, IP laws vary from country to country. As a result, companies operating in a large number of foreign countries may be exposing themselves to IP infringement which could ultimately pose a series of issues for all sorts of aviation companies.
Operational threats: impacting the processes, systems, people and overall value chain of business
Managing the supply chain
Aviation companies around the world are pointing to managing the supply chain as the second biggest threat in the aviation industry in 2019 and the years to come – and for good reason. A record number of new aircraft deliveries are set to keep the supply chain extremely busy during the next 8-10 years. To meet the demand, the entire supply chain must ramp up their efforts and investments, ensuring timely deliveries while, at the same time, maintaining high quality and keeping costs somewhat controlled; a challenging task that could leave many suppliers financially vulnerable.
With such a vast network of suppliers, small mistakes and delays can cause a chain reaction and, as a result, budgets and schedules could spin out of control. There’s also a risk that companies will have disputes with suppliers or subcontractors related to work specifications, quality of supply or customers concerns, Ernst & Young notes. »The A&D sector is experiencing a significant growth in demand. The growth in demand increases pressure on the production capacity for OEMs and their suppliers. In the case of critical parts and assemblies, the number of available suppliers is small. For such parts, the risk of production disruption due to supply failure is even greater,« says Bill Colbert, Partner, Advisory – US, Ernst & Young, in the report.
Niche parts and processes pose a greater risk to on-time delivery. For some parts, such as composite components and wing skins, MROs and airlines depend on a small number of suppliers, leaving them with few options in case of failures or disruptions. This challenge can be somewhat mitigated by working closely with the supplier to understand the stability and detect potential disruptions before they develop into full-scale disasters.
Implementation of new programmes and technologies ties up significant capital. The cost to develop new initiatives, such as additive manufacturing, must be recouped on volume production, but the investment might initially leave companies more financially exposed, thus posing a risk to the entire aviation supply chain.
Managing and retaining talent in the aviation industry
Due to the influx of new technologies and processes and the relentless focus on cost reduction, companies in the aviation industry will require, perhaps more than any other industries, a talented, engaged and increasingly specialised workforce in the future. The issue of work-force shortages in the aviation industry is very real indeed and it will be a challenge for the industry in the future as well. »Because of the highly specialised nature of the industry, companies must hire and retain the skilled and qualified personnel necessary to perform the business-critical processes,« notes Ernst & Young in the report.
Ability to perform in key contracts
The major OEMs in the industry are typically involved in multimillion-dollar contracts and have huge backlogs with tight deadlines. Failure to deliver on major programmes can lead to significant negative implications affecting the financial performance as well as brand value. An open business culture, ambitious but realistic targets and a strong focus on project management is vital to mitigate this risk in the aviation industry, Ernst & Young concludes.
Incapacity to innovate
One of the problems that the aviation industry is facing is its incapacity to be truly agile in terms of new business paradigmes. The demand from passengers is evolving constantly, pushing the aviation industry to adopt new work processes and technologies, but, due to the conservative nature of the industry, it’s proving to be a hard race to win. The aviation companies that fall too far behind in the great run of innovation will likely face a series of challenges in 2019 and beyond.
»Some of the technologies that A&D companies use in their manufacturing and other business processes are decades old. They need to upgrade these technologies on a regular basis as well as adopt new and advanced technologies to stay competitive,« states Ernst & Young in the report.
Exposure to cybersecurity events
The ninth biggest challenge in the aviation industry in 2019 is failure to have appropriate cybersecurity measures in place. As more airlines, OEMs and MROs pursue big data analytics and predictive maintenance, the risk of cyber breaches increases. And the problem with inappropriate cybersecurity can be very costly for the aviation industry. In fact, the total losses incurred by companies as a consequence of cyber crimes are estimated to be approximately US$400 billion per year, according to Ernst & Young.
»In the digital world that we live in today, the risks and consequences of cyber attacks get magnified by the complexities of our integrated value chain. With increased interconnection across the value chain, a cyber attack on one company can cascade across the network and affect other parts of the value chain as well, increasing risk for the entire aviation industry« says Bill Colbert, Partner, Advisory – US, Ernst & Young, in the report.
Strategic Threats related to customers, competitors and investors
Competition in domestic and international markets
Airbus and Boeing are the only players in the wide-body market, and they dominate the narrow-body-segment as well. In the medium-term, opportunities for new players in this market are unlikely, due to the duopoly of Boeing and Airbus. In the supply chain, consolidation continues to increase due to OEMs seeking stronger suppliers with access to capital. The MRO industry and broader aftermarket are also undergoing changes.
Risk 8: Failure to realise the benefits of M&As and partnerships
Collaboration and partnerships in the supply chain is a hot topic in the aviation industry these days. According to the study from Ernst & Young, M&As (mergers and acquisitions) and partnerships can complement a company’s existing products, technologies, services and customer base. At the same time, failing to collaborate with other businesses could pose a real threat to some companies in the aviation industry.
»While evaluating new M&A transactions, companies are required to make decisions regarding the value of business opportunities, technologies, other assets and cost of potential liabilities. Poor M&A decisions might result in an overvaluation of the acquired business, failure in achieving synergies, inability to retain talent, and financial challenges,« concludes Ernst & Young in their study.
Financial threats: Foreign currency and commodity price fluctuations
Fluctuations in currency exchange rates is risk that the aviation industry is facing. Given that a large amount of aviation companies operate globally, a large portion of their revenue streams are earned in a variety of currencies, making them vulnerable to fluctuations in currency exchange rates. Furthermore, Ernst & Young notes, currency fluctuation also affects the receivables, payables and return on assets denominated in foreign currencies.
Financial performance is also affected by price fluctuations in key commodities or raw materials, such as aluminium, titanium and composites that have a significant effect on the manufacturing costs as well as the profitability of the entire supply chain. »Fluctuation in commodity prices can lead to issues along the aviation supply chain. For instance, it might lead to late delivery and increased failure probability by smaller suppliers. Commodity price fluctuation risks are generally mitigated via structured contracts or financial hedges,« explains Harsh Suri, Senior Manager, Valuation and Business Modeling – US, Ernst & Young, in the report.
Aerospace & Defense Global Market
The aerospace and defense industry reported $712 billion of revenue in 2021 (up 4% over 2020), and $62 billion of operating profit (up 136%), according to PwC analysis. However, industry performance remains well below pre-pandemic record levels. Industry revenue was 6% below the 2019 record of $754 billion and industry operating profit was 24% below the 2018 record of $82 billion.
The global aerospace & defense market is expected to grow from $736.36 billion in 2020 to $774.54 billion in 2021 at a compound annual growth rate (CAGR) of 5.2%. The growth is mainly due to the companies rearranging their operations and recovering from the COVID-19 impact, which had earlier led to restrictive containment measures involving social distancing, remote working, and the closure of commercial activities that resulted in operational challenges. The market is expected to reach $973.2 billion in 2025 at a CAGR of 6%.
Increasing merger and acquisition activity, ever-changing business models, and new technologies are expected to rapidly accelerate the ongoing shift towards digital processes. Companies in the aerospace and defense industry are expected to go further digital, with smart factories taking over the supply chain eventually, giving rise to more efficient production along with a faster design-to-delivery process.
North America was the largest region in the global aerospace & defense market, accounting for 35% of the market in 2020. Asia Pacific was the second largest region accounting for 29% of the global market. Africa was the smallest region in the global aerospace & defense market. Major companies in the market include Boeing; Airbus; United Technologies; GE Aviation; Lockheed Martin.
The realignment of U.S. defense spending, with renewed focus on competing with near peer adversaries while sustaining traditional overmatch over adversaries, has accelerated the pace of recapitalization of ageing equipment with the award of several new defense contract awards over the recent years & many others in the pipeline. The same remains a key area of focus for the industry given their strategic nature, size, scale as well as scope & long term horizon.
The focus, thus, has been on equipment upgrade, modernization & recapitalization apart from capabilities revitalization and increased R&D outlays towards development of next generational & game changer technologies. The United States continues to retain & maintain its traditional overmatch over adversaries & pole position driven by the nation’s significant focus & investments towards R&D while the Chinese ascension & Russian resurgence continues unabated.
The Middle East, Eastern Europe & the Asia-Pacific regions remain the epicentre of ongoing geopolitical turbulence with political instability, ongoing conflicts & territorial disputes reigning supreme across these regions. The same has also been driving demand for military equipment across these regions which has led to a surge in arms imports & initiation of indigenous, large scale defense programs over the recent years with the Asia-Pacific region bagging the top spot, a trend which is likely to be sustained over medium term
This return to the age of multipolarity, marked by the onset of great power competition at the world stage & marking the effective resurgence of the age of realism, has simultaneously witnessed the onset of the global outbreak of the COVID-19 pandemic.
A PwC analysis of the A&D industry’s 2021 financial performance shows that Lockheed Martin remained the industry’s largest company, reporting revenue of $67 billion, up 3% from 2020. It was also the most profitable, reporting operating profits of $9.1 billion, up 6%. Raytheon Technologies reported a revenue increase of $7.8 billion, or 13%. However, this is primarily due to the reporting impacts of the merger of United Technologies (UTC) and Raytheon in the second quarter of 2020. After adjusting for the estimated impact of Raytheon’s first quarter 2020 revenue, Raytheon Technologies’ 2021 revenue was roughly flat.
Boeing reported a loss from operations of $2.9 billion, but this was nearly a $10 billion improvement over 2020’s loss of $12.8 billion—due to a combination of pandemic impacts as well as the 737 Max grounding. Meanwhile, Airbus returned to profitability of $6.3 billion after reporting a loss of $582 million in 2020. Raytheon Technologies also rebounded, reporting a profit of $5 billion compared to a $11.9 billion loss in the prior year, with an estimated $600 million of that improvement attributed to reporting impacts of its merger with UTC.