As aerospace and defense management teams look toward the next decade and beyond, they are asking fundamental questions about portfolios and cash deployment. Answering these questions requires separating the sector’s conventional wisdom about value creation from the myths that have gained currency during the past several decades.
To separate myth from fact and answer these questions empirically,
The analysis considers TSR to assess how well companies have delivered value to shareholders over the previous business cycle.
Through this analysis, we have been able to demonstrate that some beliefs about value creation in aerospace and defense are grounded in fact, but we’ve also determined that others are myths that hinder understanding of the sector and its sources of value creation. Here’s an analysis of seven widely held views about value creation in aerospace and defense:
- Aerospace and defense companies have outperformed the market over the short, medium, and long term.
Reality. Companies in the aerospace and defense sector have created more value than the overall market throughout the business cycle. In the ten-year period from 2005 through 2014, the aerospace and defense sector generated 12.1% in annual TSR, compared with 9.7% by the S&P 500.
- In the long run, growth is the most important source of value creation for aerospace and defense companies.
Reality. For the period analyzed, revenue growth was the source of more than half of the sector’s long-term value creation, as it was for companies in the S&P 500. Over the long term, growth contributes more to value creation than does margin improvement, valuation multiples, and cash returns to shareholders. The conclusion is clear: revenue growth is the key driver of long-term value creation, followed by margin expansion.
- Players with substantial exposure to both the defense and commercial-customer segments perform better than single-focus players over the long run.
Myth. Over the cycle, a company’s target end user (whether commercial aerospace or defense) has not been a major determinant of value creation. The differences are small: Companies with mostly commercial-customer exposure performed slightly better than diversified players over the past decade. During that period, pure defense players trailed by less than 1 percentage point of TSR per year.
- Suppliers further up the value chain have higher margins than those of prime OEMs.
Reality. Tier-two players, which supply components and subsystems to tier-one players and prime original equipment manufacturers (OEMs), have margins on earnings before interest and taxes (EBIT) that are 10 percentage points higher than those of prime OEM margins, and 7 points higher than those of tier-one suppliers. Factors that contributed to this disparity over the past decade include intellectual property related to design and manufacture, risk-sharing partnerships, access to aftermarket profits, long-term contracts, and the ability to serve multiple programs and regions.
- Of the industry’s subsegments, prime OEMs are the superior value creators over the long run.
Myth. Of the 13 companies in the top quartile of value creation, only two were prime OEMs. Prime OEMs were the weakest value creators, generating a median TSR of 8% from 2005 through 2014, compared with 12% for tier-one suppliers and 13% for tier-two suppliers. A pattern has emerged over the past decade: the further a company is from the end customer, the greater that company’s ability to create value for shareholders.
- A drive by prime OEMs to reduce assets has rendered them less asset-intensive than tier-one and tier-two suppliers.
Myth. Prime OEMs have lowered their asset holdings, largely through a series of high-profile spin-offs and other asset-reduction efforts. However, the process of developing and integrating platforms with an increasingly complex supply chain is costly, and requires significant assets. As these companies continue to demand better cost and quality performance from suppliers, they must determine the right level of assets, especially in cases in which supplier systems or components are brought back in-house for strategic reasons.
- Asset-light aerospace and defense companies generate the highest returns.
Myth. Generally speaking, companies with lower asset intensity tend to generate higher return on capital employed (ROCE). However, companies that consistently deliver the highest ROCE are moderate- to high-asset-intensity businesses. A low asset base is not a necessary condition for generating high returns.