In the commercial aerospace sector, aircraft order backlog remains at an all-time high as the demand for next-generation, fuel-efficient aircraft continues to surge with the rise in oil prices. With the aircraft backlog at its peak, manufacturers are expected to ramp up production rates, hence, driving growth in the sector. However, manufacturers could experience supply chain interruptions as some suppliers may struggle to increase production to keep up with the growing backlog. In the defence sector, heightened global tensions and geopolitical risks, recovery in the US defence budget and higher defence spending by other major regional powers such as China, India and Japan are expected to drive global defence sector growth in 2019 and beyond.
The commercial aircraft order backlog is at its peak of more than 14,000, with about 38,000 aircraft expected to be produced globally over the next 20 years. However, the demand for wide-body aircraft could further weaken in 2019 as there is already a robust wide-body backlog and airlines are deferring upgrades as they wait for more efficient next-generation wide-bodies. Also, with the introduction of 737-8 and A321neo, the capabilities of narrow-body aircraft have expanded, further impacting wide-body demand.
As we see Original Equipment Manufacturers (OEMs) increase production rates, there remains a risk of suppliers facing difficulties in ramping up production. To overcome this challenge, manufacturers should consider deepening their focus on strengthening the supply chain, effective program management and the use of advanced technologies to enhance productivity and efficiency.
With the rising demand for commercial aircraft, there are some new production programs emerging from outside the United States and Europe, especially from Russia and China. Though these new entrants could challenge the current duopoly in the long-term, there are several hurdles they would need to cross — procurement of orders from global airlines, managing cost and schedule overruns, certifications from regulators worldwide and most importantly, establishing a safe and reliable track record—before they are widely accepted.
Resurgence of global military spending
Geopolitical tensions are continuing to intensify and demand for military equipment is on the uptick, driving defence spending across the globe. Since the beginning of the Trump era, defence budgets in the United States have been on the rise; and, the new administration’s increased focus on strengthening the nation’s military is expected to keep defence spending on the higher side in 2019 as well. NATO countries also appear to be focusing on increasing defence budgets to counter potential threats from Russia and the Middle East. Moreover, there has been growth in defence spending from other nations, such as India, China and Japan, because of enduring security threats. Apart from this, heightened geopolitical tensions in the Middle East and North Korea are creating strong demand for military equipment, which is expected to be one of the key drivers of defence sector growth in the near term.
Although traditional threats (land, maritime, and air-based) continue to emerge, technological advancements and digitisation have also led to cyber-related threats. To be prepared for the future, military strategies worldwide are evolving and nations are aiming at integrating digital tools and technologies to manage both traditional and digital-age threats. This has resulted in a bigger focus on many cybersecurity programs, which are expected to play a vital role in the near term.
Moreover, space is becoming an important part of the overall defence industry ecosystem as growing global tensions could pose a threat to space assets such as satellites, which are often relied upon for military operations, including surveillance, communications and missile targeting. Because it has become important to shield these assets, this may lead to the militarisation of space. The United States, China and Russia have already begun establishing dominance in space, with other countries, such as North Korea and India, gradually following them.
Disruption of global supply change
Free trade is important to the A&D industry as aircraft and arms exports drive revenue growth, especially for companies from the developed world. But there is a possibility that brewing transatlantic and transpacific trade tensions could affect this as duties being placed on steel and aluminium impact companies’ bottom lines. Import tariffs on aluminium and steel—key raw materials imported by A&D manufacturers in the production of aircraft, missiles, rockets, tankers etc will likely increase manufacturing costs and impact profitability. Defence companies that primarily sell to foreign governments and rely on relationships could be more adversely affected. With retaliatory tariffs being imposed, some A&D companies could consider moving their manufacturing to avoid tariffs for products manufactured and exported from their home countries, disrupting supply chains and delaying deliveries. A&D companies operating in this environment of uncertainty will do well by nurturing long-term stable partnerships across the industrial base and managing their global supply chain relationships.
Cost reduction & amplified production
The A&D industry experienced significant mergers and acquisitions (M&A) activity over the last two years. OEMs continued to put pressure on suppliers to reduce costs and increase production rates, which, in turn, pushed many suppliers to consolidate for scale, cost-effectiveness and higher negotiating power. This trend is likely to continue as OEMs focus on expanding their margins. Hence, the highly fragmented supplier base is likely to become more concentrated in the near term. We may also see some megadeals as bigger players focus on vertical integration. For instance, we saw a large aerospace supplier acquire an avionics and interiors manufacturer, and more recently, the merger of two major communications and electronics contractors—one of the biggest-ever mergers in the defence sector. Apart from this, large, prime contractors are expected to consider acquiring small to mid-sized companies to gain access to new technologies and markets. The industry is likely to experience increasing M&A activity even when valuations of A&D companies are high and near pre–financial crisis levels. Specifically, the enterprise multiple—Enterprise Value (EV) on earnings before interest, tax, depreciation and amortization (EBITDA) of the A&D industry—rose from 9.9 times in 2015 to 14.2 times in 2018.
Though the A&D industry growth is primarily led by the United States, some of the other key regions that are expected to contribute to industry performance in the near term include China, France, India, Japan, the Middle East and the United Kingdom. While India and China will likely drive growth in both commercial aerospace and defence sectors, Japan is expected to be a key market primarily for the defence sector. Defence expenditure in France is also likely to expand as the United States encourages NATO countries to increase military spending to 2 percent of GDP. In the Middle East, defence spending is expected to recover as oil prices stabilise at much higher levels compared to the 2015–17 period. With respect to the United Kingdom, there is uncertainty around the impact of Brexit on the country’s A&D industry, as a hard application of Brexit might lead companies to revisit their industrial strategies.