SUPPly CHAiN EVOlUTiON: GROwTH ANd CHANGE iN THE AEROSTRUCTURES iNdUSTRy

Bob Wiecezak, Senior Associate

Cyclicalgrowth,howeverstrong,isnottheonlystoryplayingoutacrosstheaerostructuressector.Evenasfirmsrampupproduction,thissegmentisundergoingthreesignificantchangesthatwillfundamentallyreshapeitfordecadestocome.

1. Workismigratingfromtraditionalgeographiccenterstonewlocations,drivenbyadesiretoreducecostsandsecureac-cesstonewmarkets.

2. Firmsacrossthissegmentaretakingtheopportunitytosignificantlyupgradetheiroperations,notsimplyexpandcapacity.

3. Thehistoricallyfragmentedaerostructuresmarketisstartingtoseerealconsolidation,drivenasmuchbyOEMpressureasbyattractivefinancialopportunities.

Theresultofthistransformationwillbealeaner,moreefficientsupplychainforstructuralpartsandassemblies—onethatismoreprofitableforfirmsoccupyingthemiddletiers.Thesechangeswilltakemanyyears(possiblymorethanadecade)tobefullyrealized,butsavvycompaniesaremovingnowtobuildafoundationforthesecriticalmarketshifts.

1. MIGRATION OF WORK TO NEW GEOGRAPHIES Themigrationofstructuresworktonewcountriesisnotanovelconcept.Boeing,forexample,hassourcedaerostructuresfromtheJapaneseheaviesfordecades.Butpastincentivesforrelocationhavelargelybeenpolitical,drivenbytheneedtogainmarketaccessandpositionforwinninglucrativecontractswithimportantcarriers.Insuchcases,OEMswerelessmotivatedbypotentialcostadvantages.Nowhowever,withareneweddrivebyOEMstoreducecostsacrossthesupplychain,structuresfirmsaretakingafreshlookattheirglobalfootprint.CompaniesbasedintheUSorWesternEurope,inparticular,areevaluating(orhavealreadybegun)operationsinAsia,Mexico,EasternEurope,orotherlower-costlocations.

Underthisrenewedpush,firmsarelookingfirstattheportionoftheirworkthatcontainsthehighestpercentageoftouchlaborcost(e.g.,compositehandlay-upandsheetmetalfabrication).ThecorollarytothislogicisthatUSandWesternEuropeanmanufacturingplantsshouldfocusoncapital-intensive,automatedmanufacturingprocesses.Thisisindeedtakingplace,asevidencedbytheinvestmentinautomatedtapelayingand

The outlook for aerostructures providers continues to be strong, bolstered by unprecedented demand for new commercial aircraft.

Though the present growth cycle is moderating, as evidenced by a declining rate of acceleration in deliveries, the strength of the

current order book, coupled with three main market shifts, should provide more than enough opportunity for supplier EBITDA growth.

automatedfiberplacementmachines,madebycompositestructuressupplierslikeHITCOandGKN,attheirUSandUKfacilities,respectively.

Meanwhile,thoughlaborratesinplaceslikeAsia,Mexico,andEasternEuropeareobviouslylowerthantheU.S.andUK,thekeyfigureislaborcostperunit,whichincorporatesproductivityfactors.Successherewilldependonthedevelopmentofrealmanufacturingclustersandthedevelopmentofcompetitivelocalskillsets.Whileindividualinitiativeswillcarrysomelevelofrisk,inaggregatethesatisfactionofthesebasicconditionsisonlyamatteroftimeandinvestedcapital.ChihuahuaCity,Mexicoisanexampleofalow-costlocationthatisdevelopingasignificantaerospacecluster,with36plantopeningssince2007includingsitesforFokkerAerostructuresandManoirAerospace.

Firmshavebeenrelativelycautioustodateinrelocatingmanufacturingtoemergingmarkets,meaningsignificantcostsavingshaveyettoberealized.Forexample,only2%ofSpiritAerosystem’sroughly15millionsquarefeetofmanufacturingspacearelocatedoutsidetheUSorWesternEurope.ThefigureforTriumphGroupiscomparable,whileLMIAerospacestandsatthehighendoftherangewithjustunder10%ofitstotalcapacityoutsideofthesehighercostareas.Firmsareex-perimentingwithnewsites,trustingthemwithafractionofthecompany’stotalturnovertoseewhat“sticks”andtoseewhatthetotalcostpicturewilllooklike.

2. FIRMS UPGRADING THEIR OPERATIONSIrrespectiveoflocation,acrosstheboardtherehasbeensignificantorganicinvestmentincapacityandnewaerospacemanufacturingcapabilities.Forexample,lastyearGKNopenedanewsiteinFilton,UKtofocusonwingstructuredesignengineering.LMIrecentlyexpandeditsSavannah,GAfacilityinanticipationofgrowingdemandforitskittingservices.Othercompaniesarefocusingonstreamliningtheiroperations,suchasTriumph’sstructuressiteinNashville,TNwhichintroducednewtoolingandstatisticalprocesscontroltowringcostoutofitswingstringerandpanelproduction.ADIofValencia,CAcompleteda$100Mexpansionin2012tosupportitstitaniummachiningoperationsforthe777,787andA350programs.

Inaddition,smallerfirms,especiallythoserecentlyacquiredbyprivateequity,aretakingstepstobuildouttheirmanagementteamsandsalesstaffs,orinvestinITcapabilities(e.g.enterpriseresourceplanning/materialsrequirementsplanning)toappealtothemorediscriminatingOEMslikeAirbus.

Inadditiontotheseupgrades,thereisroomforfurtherimprovementsintheoperationsarea.Manyfirms,especiallythosewhichhavemaderecentacquisitions,standtogainfromfacilitiesconsolidationandrationalization.CompanieslikeTriumphGroup,PCCandUnitedTechnologieshaveyettotakeseriousstepstorationalizetheiroperations,andcanimprovefuturemarginsbyconsolidatingworkinfewerlocations.Thisactivitymayhavetowaituntilaftercyclepeak,however,asthesefirmsarefocusedonmeetingraterequirementsandcapturingasmuchmarketshareastheycan.

3. CONTINUED CONSOLIDATIONUnlikeothersegmentssuchasengines,avionics,orlandinggear,whicharecontrolledbyasmallgroupofpowerfulplayers,thestructuresmarketiscomprisedofmorethanonehundredcompaniespopulatingthreesemi-distincttiersofproduction.Manyofthesefirmsaresmall,privatecompaniesordivisionsoflarger,diversifiedcompanieswithapotentiallycapriciouscommitmenttothecommercialaircraftbusiness.ReducingthefragmentationofthisgroupaffordsadvantagestobothstructuressuppliersandOEMs,yetasshownbelow,theincentivesofthesetwogroupsarenotalwaysaligned.

OEM-shared Incentives for ConsolidationBothgroupsseektosimplifyandrationalizetheirsupplychains.RemovingredundantG&AandCAPEXfromtheindustrywouldimproveoverallprofitabilityatatimewhenaircraftmanufacturerswillbehardpressedtofindavenuesforgrowth(perhapsfourorfiveyearsfromnow).Verticalintegrationshouldfurtherservethisgoalbyreducingcertaintransactioncosts.Forexample,in2012PrecisionCastparts(PCC)acquiredKluneIndustries,abuyerofthecompany’sowncasting,forgingandfastenersproducts.

Costreductioncanalsobeachievedbyshiftingthe“stuffing”ofstructuralcomponentsfurtherdowntoamorecost-effectivepointinthevaluechain.Additionally,consolidationenablesthepoolingoffinancialresources,whichincreasessuppliercapacitytoinvestinR&Dorbuildinventoryinadvanceofaproductlaunch.

OEM-neutral Consolidation DriversOtherconsolidationdriversfavoredbysuppliersarelikelytobemetwithindifferencebytheOEMs.Forexample,manysmallerplayersareindesperatesearchofopportunitiestodiversifytheirbooksofbusiness,especiallyiftheyareoverexposedtoasinglesegment(e.g.,military),customer(e.g.,Beechcraft),orprogram(e.g.,theC-17,forwhichproductionisscheduledtoendin2014).Manyofthesecompanieswishtodiversifytheircapabilitiesbase.Topitemsontheexpansionagendahaveincludedhigh-

SupplyChainEvolution:GrowthandChangeintheAerostructuresIndustry

SupplyChainEvolution:GrowthandChangeintheAerostructuresIndustry

speedmachiningandhardmetalmachining(titanium,InconelTM,niobium),asevidencedbyPCC’s2012acquisitionofSynchronous.Othercompanieshaveexpandedbothupanddowninpartsizeandcomplexity,givingthemtheabilitytoactasaTierI,IIorIIIasthesituationrequires,andtherebygarnergreatercontentontheaircraftplatformstheyserve.LMIacquiredValentAerostruc-turesforthisreasonin2012.

Insomecasesweseetheadditionorexpansionofdesigncapabilitiesasanattempttoshiftawayfromthebuild-to-printmodel.Thesesamefirmssometimessupplementtheirofferingswithvalueadded(e.g.kitting)andsuppliermanagementservices.Eachoftheseisabidbystructuresfirmstotakegreatercontroloftheproducttheysupplyandexertmoreinfluenceontheenvironmentinwhichtheyoperate.

Threats to OEMsSomeconsolidationdriverspittheinterestsofsuppliersagainstthoseoftheOEMs.Oneexampleisbargainingpower,whichfortheOEMsrepresentsthedownsideofsupplierscale.ThoughgrowingsupplierscalehelpstheOEMsreduceoverheadandredundancythroughoutthesupplychain,itreducescompetitionandraisestheprospectthatsupplierswillattempttoexpandmarginthroughpriceincreases.Reductionsinpricecompetitionhavealreadyoccurredatthematerialslevel(e.g.aluminum,titanium),adverselyaffectingcompaniesdownstream.Structuresfirmswilllikelylooktothismodelinthemid-term,toimprovetheirmargins.Asmallergroupofwell-capitalized,diversifiedsupplierswillbeabletopushbackonOEMdemandstoamuchgreaterdegree

thanispossibletoday.Currently,fixedpricecontractscommitsupplierstounfavorableandsometimesloss-makingterms.Forexample,Spirit’s787-8contract,whichrunsthrough2021,causedthecompanytotakea$184Mlossin3Q12.

Thoughthereareclearlymanyforcesencouragingcontinuedconsolidation,obstaclesalsoexist.Chiefamongtheseistheinflatedlevelofvaluations.Manybuyersfind10-11xmultiplesabsurd,especiallyatwhatsomeargueisnearthetopofthecycle.Otherbuyersareoptimisticthattheycanfindbargainsat5-6x;thoughfindingcompaniesattheseprices,especiallyoneswithpre-existingexposuretothecommercialmarket,isextremelydifficult.Lastly,someowners,especiallythosefromfamilieswithalonghistoryintheaerospacebusiness,maysimplybeunwillingtosell.Theyhaveseenmanycyclesbeforeandlookforwardtoguidingtheirfirmsthroughatleastafewmore.

4. STRATEGY ISSUES TO CONSIDERStructuresfirmsshouldbeactivelydevelopingstrategiestocopewiththischangingenvironment.Threekeyissuesshouldbeconsideredinplanningforthefuture:

GlobalCompetitionWillStiffen• Competitionfromforeignsourceswillcontinuetogrow

instrength,butnotentirelyduetoeconomicrationale.PoliticaldesiretosecureapieceoftheglobalsupplychainwilldriveinvestmentswithloworevennegativeROI;ifestablishedplayersintheUSandEuropedismissthese,itwillbeattheirperil.

MarginExpansion

ElevatedMultiples

CycleConcerns

Unwillingnessto Sell

CapabilityExpansion Diversification

Grow BargainingPower

Vertical Integration

HorizontalIntegration

• Reduce transaction costs• Rationalize G&A/CAPEX

• Part size/complexity• Metal/material type• R&D/design/engineeering

• Market segment• Program• Customer

ConsolidationDrivers Obstacles

➠ All firms should develop tactics to preempt, participate in, or defuse the threat from new entrants, even if those new entrants appear to be poised to enter the market with a disadvantage in technology or labor cost per unit.

NarrowbodyProspectsareKeepingMultiplesHigh• Theexcitementsurroundinganticipatedordersforthenew

narrowbodymodels(A320neoand737MAX)isputtingupwardpressureonmultiples.However,manyofthecompaniesbenefittingfromthisboosttovaluationarenottrulypositionedtowinworkontheseprograms.Inothercases,incumbentswell-positionedfromatechnicalandpastperformancestandpointbutdisadvantagedoncostarefactoringrevenueintotheirpipelinesthatisonthevergeofbeingstolenbynewentrants.

➠ Once those orders have been placed, buyers should have much better visibility into the future revenue picture for the properties they bid on. Targets with little to no neo or MAX content should trade down by the end of 2013, but could still offer many of the benefits listed above (e.g., reduced transaction cost, program diversification).

Post-PeakStrategy• Thecurrentdemandcycleislikelytopeakinthenextfourto

fiveyears,ifnotearlier.Aerostructuresfirmsshouldbethinkingseveralmovesbeyondtheirnear-tomid-termactions,incorporatingaviewoffuturedemandandtheimpactonplantoperations,resourceallocationandprofitability.

➠ The answer to this question will differ for every company based on its unique situation, ownership status and long-term vision for its role in the aerospace value chain. Some firms may simply wish to sit tight, and perhaps pull back on capacity. Others will think through cash deployment: should the firm buy back shares or acquire customers and programs at a steep discount through M&A? Still other firms will consider expansion into other product types within the aviation supply chain such as actuation or electronics; these will be compelling as long as there are strong synergies at the product integration level or opportunities for cross-selling. Many firms may wish to diversify into other markets (e.g., industrial, oil and gas) – indeed we see many firms moving in this direction today.

ABOUT THE AUTHOR: Bob Wiecezak specializesinthedevelopmentofacquisitionandmarketcapturestrategiesforfirmsintheaviationsector.Hisclientshaveincludedprivateequityinvestors,aerospaceOEMs,tier1and2suppliersandNASA.

Forfurtherinformationpleasecontact:rwiecezak@avascent.com2024160103

ABOUT THE AVASCENT GROUPTheAvascentGroupistheleadingmanagementconsultingfirmspecializinginservingseniorexecutivesandgovernmentpolicymakersinthedefense,aerospace,intelligence,homelandsecurity,logistics,technicalservicesandinfrastructuresectors.Ourconsultantscombineourdeepmarketknowledgewithprovenrigorousmarketvalidationandstrategicplanningmethodologiestoprovideinvaluabledecisionsupporttoourclients.

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SupplyChainEvolution:GrowthandChangeintheAerostructuresIndustry