Thursday, June 11, 2015

Upcoming Report on Aerospace and Defense Separates Facts From Myths

Paris June 11, 2015 - As many investors and analysts are aware, aerospace and defense companies have outperformed the broader stock market over the short, medium, and long term. But what's driving that outperformance? Profit margins? "Asset-light" business models? Dividend payouts? None of the above, according to an upcoming publication by the aerospace and defense sector of The Boston Consulting Group (BCG). Analyzing extensive data on the total shareholder return (TSR) of 51 publicly traded companies whose business is predominately in the aerospace and defense sector, Aerospace and Defense Value Creators Report 2015: Myths and Realities offers valuable insights to management teams asking fundamental portfolio and cash deployment questions as they look to the next decade and beyond.
The past decade has been a tumultuous one for the aerospace and defense industry. There have been wars followed by drawdowns, sequestration in the U.S., a boom in commercial aviation, and ongoing changes in the industry's structure. With industry dynamics in constant flux, management teams must reconsider whether to return cash to shareholders or invest in growth, whether to focus on the commercial or defense markets, and whether reducing assets would spur stronger performance. Answering these questions requires separating the sector's conventional value-creation wisdom from myths that have gained currency during the past several decades.
"Each company in this industry has its own idiosyncratic value-creation story," said Greg Mallory, a BCG partner, the global aerospace and defense sector leader, and a coauthor of the report. "But there are instructive patterns in the aggregate data that can help companies calibrate their relative exposure to commercial-aerospace and defense customers and optimize their position in the value chain."
Challenging Long-Held Beliefs
Many analysts, shareholders, and even industry insiders subscribe to a set of beliefs about the aerospace and defense industry that have become virtual articles of faith. Some of those beliefs are myths that hinder understanding of the sector and its sources of value creation. For example, it's widely believed that wide profit margins are the main driver of value creation in aerospace and defense companies. But in fact, revenue growth is the most important source of value creation for aerospace and defense companies. Revenue growth was the source of more than half of the sector's long-term value creation over the past ten years. In terms of contribution to value creation over the long term, growth trumps margin improvement, valuation multiple, and cash returns to shareholders.
It's also widely believed that asset-light aerospace and defense companies generate the highest returns. That's a myth. Companies that consistently deliver the highest return on net assets are moderate- to high-asset-intensity businesses. A low asset base is not a necessary condition for generating high returns. At the extreme, operating models with a very low asset base imply lower barriers to entry and invite competition, while a larger -- and well-managed -- asset base can be a competitive moat.
What's more, it's not true that prime original equipment manufacturers (OEMs) are the superior value creators over the long run. Of the 13 companies in BCG's sample that occupy the top quartile of value creation, only two were prime OEMs. Prime OEMs were the weakest value creators, generating a median TSR of 8 percent from 2005 through 2014, compared with 12 percent for tier one suppliers and 13 percent for tier two suppliers. A clear 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.
New industry dynamics and risks are emerging that will have implications for value creation in the next ten years and beyond. The challenges include continued uncertainty for defense budgets and low defense-sector growth, questions on the sustainability of commercial order books, cost pressures on suppliers, new technologies, affordability issues for new commercial and defense platforms, and efforts to simplify the supply chain. As aerospace and defense companies confront this changing environment, those that know the true sources of value creation will be the companies best positioned to differentiate themselves from their peers and deliver superior returns to their shareholders.

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