Jim Kemp, a Principal for H&A, was featured in a recent article in Trade & Industry Development magazine, a global publication serving executives within specific vertical industries to provide insight into the challenge of site selection and facility planning. Prior to joining H&A, Kemp spent decades with Lockheed Martin where he managed countless operations around the world, including a project recognized as a CoreNet Global Project of the Year.
The full article is below. To view the article on the Trade & Industry Development magazine website, please click the following link:Aerospace and Defense Industry: Navigating a Global Future.
Aerospace and Defense Industry: Navigating a Global Future
21 May, 2014
By: Jim Kemp
Last year’s focus on Airbus and Boeing plant expansions dominated the news for the aerospace and defense markets. Commercial aircraft orders have been on the upswing in their historical business cycle for several years now. The real news for site selectors in the coming months may be more focused on the redevelopment opportunities associated with consolidation in the U.S. defense market segments and the increased defense spending in Asia, Russia, the Middle East and Brazil.
This year, the global aerospace and defense industry is expected to grow about five percent. This growth will be driven mainly by the expectation of another record year for commercial aircraft sales. That strong growth will be offset somewhat by the reduction in U.S. military spending. Aircraft sales cycles tend to see a period of “over ordering” followed by a period of order delays or cancellations. Even considering this phenomenon, the commercial aircraft industry is expected to see 25 percent growth in the next 10 years. Revenues for the defense industry, which are dominated by U.S. spending, are expected to shrink by 2.5 percent next year. While aerospace and defense companies expect to see a reduction in total revenue, their margins are expected to improve. This improvement is largely attributed to improvements in operating efficiencies driven by industry consolidation and project phasing.
The reduction in defense spending for the U.S. is linked to the winding down of the wars in Iraq and Afghanistan as well as budget cuts from both the sequester and the current budget agreement signed into law this year. The U.S. defense budget is large, but when the budget does not grow adequately over time, the rising costs of medical care, employee salaries and ongoing operations eats into the availability of funds for new systems. A reduction in spacecraft, aircraft and ship orders have all combined to have a broad negative impact on U.S. aerospace and defense companies. While U.S. companies are experiencing reductions, countries like China, India, Russia and Brazil are increasing their spending. U.S. companies can share in some of those international opportunities, but certainly not all.
Recently, Lockheed Martin announced a number of plant closures for facilities in Pennsylvania, Arizona, California and Ohio. Last year, Boeing announced the closing of its Long Beach, California, site, which is finishing out its C17 build. BAE has announced the closure of its Sealy, Texas, plant. In most of these cases, any remaining workforce will be consolidated at underutilized sites within the companies and, in some cases, completely new sites are being considered. This industry has lower margins compared to other sectors. Aerospace and defense net margins are in the one to 10 percent range compared to other sectors that see 10 to 20 percent. When gross revenues start to decline, companies will look to reduce operating costs. Moving into new, smaller, more efficient factories in states with lower labor rates and state and local taxes is one way to achieve lower operating costs. Since the industry also relies on the federal budget, it can normally do a better job of forecasting than most industries. Over the last five years, the U.S. federal budget has been incrementally allocated through the continuing resolution process one year at a time. This made it hard for aerospace and defense companies to plan for the future. This tends to suppress any large investment decisions. In 2014, the U.S. finally passed a budget and companies can now move forward with investment plans. Based on this, expect to see most large aerospace and defense companies start announcing moves to improve operating costs through consolidation. This industry consolidation trend is expected to continue through 2014 and 2015.
During this latest commercial growth cycle, Boeing and its suppliers established new facilities in states where they may have not had much of a presence before. Those states were willing to offer significant tax incentives to Boeing as a means to capture thousands of new jobs. States were willing to forgo the direct tax benefits of an operation that size in order to capture larger indirect tax benefits. The same could be said for Airbus that, in 2012, announced its first U.S. plant and in 2013 broke ground on that facility in Mobile, Alabama. While there will still be more opportunity for site selection in the commercial aircraft market, most of the activity will center around the sub-tier supplier market and less on the major manufacturers. This suggests there may be more site selection and incentive activity on the defense segment of the aerospace and defense market than in the commercial aircraft segment. There is another element to consider when dealing with the defense market segment and that is the government’s property holdings.
In addition to these major defense contractors reducing their infrastructure holdings, the Department of Defense is looking to reduce its facility holdings as well. Defense Secretary Chuck Hagel indicated the Pentagon will ask for another round of base closures in 2017. Hagel further stated, “I am mindful that Congress has not agreed to our BRAC [base realignment and closure] requests for the last two years. But if Congress continues to block these requests even as they slash the overall budget, we will have to consider every tool at our disposal to reduce infrastructure.”
It is expected that budget pressures in 2014 through 2016 will also result in more opportunity for those seeking alternative uses for under-utilized government assets. In the recent budget authorization, language was included that allows base commanders to use proceeds from Enhanced Use Leases (EUL) to cover administrative costs associated with potential new EUL projects. This was added to the U.S. Code to encourage more activity on repurposing government assets, even in the absence of a BRAC authorization.
Look for commercial aircraft companies and their suppliers to try to take advantage of under-utilized government assets. In the absence of a BRAC in the next three years, the opportunity to leverage EUL as a tool to unlock the value of government assets can provide a relatively quick solution for companies experiencing rapid growth or looking to reduce their current infrastructure size and cost. Better utilization of government assets is a win-win for everyone. The government benefits from lower costs for operating their bases, which can translate to more money going to mission support and manpower. The taxpayer benefits by not seeing increased taxes to maintain current levels of military support, the commercial contractors benefit from lower investment costs during this growth period. Site selectors who have expertise in securing government assets should be in demand by commercial aircraft companies and their suppliers.
Communities that are in fear of becoming the victim of a BRAC in 2017 will most certainly be looking to help base commanders reduce their government cost. By reducing the base’s operating costs, it is assumed it will show the base to be more efficient and reduce its odds of becoming a BRAC target. This will lead the communities to provide some form of incentives for companies that may have need for the under-utilized assets. Communities that taken an even more aggressive approach toward preparing for the potential BRAC might consider creating a redevelopment plan in advance. This plan would allow the communities to evaluate the potential upside to being selected as a base closure site. The Association of Defense Communities reported that in the beginning of the last decade, 75 percent of communities that had base closures in 1995 experienced a positive economic impact. This was due mainly to the fact that the bases were located in areas that were experiencing rapid growth and had need for the less-densely populated property of the base. Communities that build an advanced redevelopment plan can also plan for the potential of becoming a receiving BRAC site, which can create strains on the local infrastructure.
The rapid growth of a small community can be just as difficult to manage as rapid shrinking. Strategies that combine the defense industry consolidation efforts and the commercial aircraft industry growth will have the most effective five- to 10-year plans because of the U.S. defense department’s need to reduce infrastructure.
U.S. aerospace and defense companies have been generating large amounts of cash reserves for quite some time. The largest aerospace and defense contractors have tens of billions of dollars in cash available to them. As we have seen orders for defense-related goods drop, these cash reserves are coming into play to increase company revenue through acquisitions. As a part of the industry consolidation, look for companies to make acquisitions both internal to the U.S. and internationally. The trend seems to show a peak of 306 disclosed acquisitions for a total value of $30.9 billion in 2011 to 242 acquisitions with a total value of $13 billion in 2013.This downward trend could be a reflection of the U.S. defense budget uncertainty. During all of the years from 2011 through 2013, the government operated under continuing resolution. Even prior to 2011, the government failed to pass a budget, but it seems companies became less convinced a budget commitment was going to happen in the near future. In some cases, the new acquisitions will result in consolidation of assets or restructuring of the acquired companies’ assets into spin-off sales. Typically, one would expect the majority of acquisitions to take place within the acquiring company’s supply chain. Implementing strategies to improve operating margins by vertically integrating a company has long been a common response to a shrinking market. When corporations can acquire their supply chain, the profit margins for those acquired companies is available to the parent company to add to its bottom line. While in some industries that amount of revenue may be relatively small, in the aerospace and defense industry that can amount to additional profit on 70 percent of product costs. Recent examples include United Technologies Corporation’s acquisition of Goodrich Corporation creating a new unit, UTC Aerospace Systems, which will allow it to gain a larger share of the aero-engine market. With the significant size of the cash reserves the large companies have generated, it would not be surprising to see larger acquisitions similar to those seen in the 1990s, although conventional wisdom says an additional large acquisition with all the new regulations is less likely to be approved by the U.S. government than in the 90s. Also, look for companies to make acquisitions in adjacent markets that could help provide for better diversity in the company’s portfolio. For example, there is an emerging trend of aerospace companies moving into the energy sectors. In most cases, the move to energy was with aerospace and defense technologies that have application to energy sectors such as oil and gas or renewables. Expansion into global cybersecurity is another adjacent market that seems to be growing. Lockheed Martin recently acquired Industrial Defender, a provider of cybersecurity products and services for the oil and gas and chemicals industry. Lockheed Martin’s stated goal is to combine its knowledge of government IT security with that of Industrial Defenders and provide it to critical infrastructure industries.
Whether it is through commercial aircraft sales, infrastructure consolidation, mergers and acquisitions or bracing for another round of BRAC, the aerospace and defense market will be very dynamic over the next few years. There is a definitively positive trend in site selection activity and those opportunities will continue to grow for the foreseeable future.