Hudson on the Hill

Some 20 months into his term as the 39th vice-president of the United States, Spiro Agnew famously characterized critics of the Republican administration of his boss, Richard Nixon, as “nattering nabobs of negativism.” The N-cubed alliteration came to mind when perusing a couple of aerospace and defence (A&D) outlooks.

One, courtesy of KPMG International in Toronto in early August, is subtitled “the dawn of a new day” while the other, published earlier by another global consultancy, UK-based Deloitte Touche Tohmatsu (DTT), uses the tagline “poised for a rebound.” Optimism abounds. Each comes across as a mostly positive proselytizer of procurement. P-cubed? Their conclusions have potentially huge implications for not only the industry but also the Department of National Defence and its counterparts elsewhere.

KPMG’s report is based on responses to a Forbes Insight survey earlier this year of 76 top-tier A&D executives (mostly in Europe and the Americas). Having used the results as a platform for interviews, the report’s authors conclude that if the executives’ expectations bear fruit, “the next few years should be thrilling” as their companies “grab hold of new opportunities.”

Aircraft OEMs (original equipment manufacturers) and major defence contractors evidently are “particularly confident” in their strategies – that includes all of the respondents with annual revenues of more than US$10 billion. Asked about their expectations for growth, 30% were “very confident” and 34% were simply “confident”. Of the balance, 18% were “not at all” or “not very” confident, and 18% neutral.

They were then asked to rate where growth stood as a priority. Fully 41% said it was “extremely high” compared with 29% for whom it was “high” and 18% for whom it was “medium”. Only 2% considered it either a low priority or not a priority at all.

“Change is everywhere […] and it is creating significant opportunities for A&D players,” says one of the report’s principal authors, Doug Gates, KPMG’s global sector chair of industrial manufacturing and global head of aerospace and defence. “Most […] can’t deliver on shareholder expectations without doing something different.” That said, he adds that the excitement is accompanied by increasing risk. “Organizations will need to think about how they drive profitable growth in new segments while […] managing costs within slower-growth segments,” he explains. “Executives are going to need to stretch their comfort zones to explore new approaches and team up with new partners.”

That has obvious implications for military buyers. KPMG’s Miles McNamee, who has advised the U.S. defence and intelligence communities since 2009, points out in the report that as his country reduces its defence spending, global cooperation becomes the name of the game.

On a page of the report featuring the Lockheed Martin F-35 joint strike fighter (Deloitte’s had it on the cover), McNamee says that regardless of the outcome of the upcoming U.S. presidential election, his country can be expected to reduce its “predominant” global military presence.

Although the U.S. likely would continue to play a leading role, his comment suggests that Canada and other allies would be “taking a different level of ownership” in many theatres. It would require the defence community to focus more on improved interoperability and “collaborative” global platforms.

But Canada, and many of the other countries that would be asked to commit public funds to global platforms, would understandably tend to expect economic payback, preferably in the form of domestic infrastructure and employment.

Another potential obstacle is the tendency for nations to “domesticate” new procurements – despite the added complexity and costs, which can mean fewer platforms than the approved funding intended.

“Contractors working on international platforms will likely need to broaden their supply bases to respond,” McNamee says. “Identifying reliable, high-standard partners will require the cultivation of insight and relationships in new markets.”

As industry prepares to capitalize on opportunities, respondents to the Forbes survey overwhelmingly indicated they plan to change the range of products and services they offer. “While A&D players are keen to improve their product range, most often through incremental improvements to existing offerings, the bigger prize lies in creating the right ecosystem of services around those products,” comments another of the report’s principal authors, Tom Mayor, KPMG’s national group leader in industrial manufacturing strategy.

The report highlights a “continued appetite” for mergers and acquisitions (M&As), it says some 70% of the respondents plan to focus on ‘organic’ internal investments to build capacity and competitiveness, 33% are assessing ‘inorganic’ M&As. “We’re already seeing very aggressive moves to partner and collaborate,” Gates says.

Adil Khan, KPMG’s deal advisory principal in the U.S., adds that all signs suggest that the defence sector is on the cusp of a “not entirely surprising,” more sophisticated M&As era, noting that many of the larger players are “sitting on growing piles of capital […] that could be put to better use.”

But Khan says the current size and influence of current major corporations suggested that “there is little chance” the U.S. Department of Defense (DoD) would be amenable to any “mega-merger” even though mergers that improve vertical and horizontal integration down the supply chain would be welcome. However, he thinks there is still “significant room” for M&As as corporate portfolios are reshaped.

As for DTT, it estimates the global A&D industry will have returned to growth in 2016 by the time all the numbers are crunched, with revenues forecast to rise by 3%. That “positive signal” follows several years of deceleration: 3.2% in 2013, 1.9% in 2014, and a 0.5% shrinkage last year. The main factor has been reduced defence revenues from the U.S. market as combat missions in Iraq and Afghanistan wound down, as well as DoD budget cuts.

“However, the five-year downturn in military expenditures in the U.S. due to the 2011 Budget Control Act […] has been moderated by the Bipartisan Budget Act of 2013 and again by a similar Congressional action in late 2015,” DTT says. It expects spending would enter a new growth cycle this year but acknowledges that future budgets depend on continued cooperation between the Republicans and Democrats.
“This will also depend on follow-through actions to increase the defense budgets of impacted countries facing sovereign security threats,” it adds. “International demand for defense and military products is increasing as uncertainties brought on by regional tensions in the Middle East, Eastern Europe, North Korea, and the East and South China Seas may lead to increases in defense budgets. Specifically, the United Arab Emirates (UAE), Saudi Arabia, India, South Korea, Japan, India, China, Russia, and other affected governments are already starting to increase purchases.”

The anticipated increase in U.S. suppliers’ business is expected to be mirrored among European and Asian suppliers.

Another growth opportunity highlighted by DTT is corporate acquisitions, which, in the last few years, have been driven by military budget cuts and pressure from shareholders to maximize their returns. “There have been many acquisitions due to subsector contraction and diminishing work to support defense employment,” it says.

“Several companies – particularly those in the government services businesses – were divested by prime defense contractors, with some degree of combinations occurring in order to gain economies of scale. In addition, there have been mergers and acquisitions in the Space subsector, as the industry becomes more fluid with the introduction of new, privately financed companies that create a dynamic competitive landscape.”

The bottom line for Canada, of course, is the possible impact on this country’s troubled defence procurement processes. Many major capital programs, notably fighter and search-and-rescue aircraft, as well as ships, are well behind schedule.

The prospect of more aggressive M&As and the concomitant reduction in the number of key players in the supply chain could be worrisome in that it would leave DND and militaries everywhere faced with the prospect of reduced competition for contracts and, inevitably, more cost escalation.

Obligations to shareholders and the markets are all very nice and, frankly, understandable. But what about obligations to taxpayers everywhere who ultimately foot the bills? Freedom clearly doesn’t come without a price, but is it reasonable, even possible, to expect a cap? Moreover, is it realistic to expect national governments to block further corporate concentration? The answer is not ‘necessarily’ – particularly if national interest is at stake.

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Hudson on the Hill
The role of Hudson is being filled by contributing editor Ken Pole.