The structure of the US aerospace and defense (A&D) industry was shaped two decades ago, when major Pentagon cuts spurred then-Secretary of Defense William Perry to strongly urge consolidation in a 1993 meeting of defense contractors that came to be known as the Last Supper.
The wars in Iraq and Afghanistan have fundamentally altered profitability across the A&D industry supply chain: The most profitable companies are those that are flexible and apply knowledge-based strategies to create or adopt innovative solutions.
As the A&D industry faces another Last Supper, structural changes in the supply chain will figure heavily in how emerging industry trends affect the A&D industry. These trends include:
■Impending Pentagon defense cuts.
■Increased demand for more efficient, next-generation assets.
■Challenging — even threatening — postures taken by Iran, China and North Korea
■Non-state political groups with enough influence to induce change.
■Poor planning, lack of capacity resulting in production backlogs.
■US A&D companies sitting on an estimated $90 billion in cash reserves.
Generally speaking, today’s supply chain is heavily concentrated on the front end and fragmented in the lower tiers. Levels of consolidation also vary significantly.
The industry’s emerging forces will work against simple consolidation by prime contractors in high-concentration programs, instead, they’ll have to reconfigure. But the fragmented lower tiers remain vulnerable, making consolidation highly complex.
The companies that survive the next Last Supper will be those equipped to operate where real profitability awaits: value-added, knowledge-based companies; those that specialize in manufacturing value-added parts, assemblies and systems; and efficient integrators.
Some industrial sectors, government and military services have initiated significant cost-reduction initiatives through what is called should-cost modeling, complexity reduction, standardizing like parts, and refinements in Tier 1 and Tier 2 sourcing. But while these are useful in a normal operating environment, navigating today’s A&D landscape demands more drastic measures.
There is no one-size-fits-all guideline for dealing with the industry’s structural changes, but the successful companies will be those flexible enough to undergo their own changes. Our analysis suggests four plausible scenarios:
■Economies-of-scale-driven consolidation by aggregation or reconfiguration. While antitrust issues are a major hurdle for traditional scale-driven consolidation, we believe that companies could reaggregate assets based on product lines, akin to what occurred in the print industry when restructuring occurred around “soft” media and “hard” printing assets. As companies reconfigure by aligning or trading similar parts of their business based on programs and economic models, it avoids anti-trust concerns — and may well fuel new competition and innovation — that benefits not only the military, but shareholders, employees and taxpayers.
■Complementary knowledge-based consolidation. Knowledge-based companies may be more prepared to deal with the structural changes, but they could still benefit from complementary consolidation. This would expand the scope of their offerings, creating greater differentiation and making it more difficult for competitors to keep pace.
■Exit of weaker, low-value-add players. There are low-concentration sectors in which many small companies produce low-value-added products, and it is difficult to envision anything other than these companies exiting the sectors.
■Merger of knowledge-based with traditional infrastructure companies. While this scenario is plausible and makes economic sense, it provides little relief if demand has sharply fallen. Nonetheless, there are some logical combinations that could create future value and eventually transform some larger infrastructure companies into stronger, higher-value companies.
For example, Navistar could try to offer complete solutions around C4 and armor, potentially making a bid for an optical imaging firm that uses composite technologies for armor products.
Today’s new realities will create three classes of A&D companies:
The Victors. Those companies that carefully plan, develop and implement effective strategies to deal with the new realities.
The Survivors. Those that devise strategies, but do so inadequately or belatedly. Such companies ultimately will move up to be Victors — or down to be Victims.
The Victims. Those that fail to devise effective strategies.
Only quick action will separate the Survivors from the Victims, and only those companies with the clearest vision will be the Victors. They are the ones that will become innovative leaders in helping ensure our security in an increasingly unstable world, which is what the A&D industry is all about.
Rene Ouimet is a principal and Bob Willen, a partner at A.T. Kearney’s Aerospace & Defense practice.