2012 Global aerospace and defense industry outlook: A tale of two industries

February 2012

Contents
Overview Sector updates: Commercial aircraft production Air traffic control Defense Business jet and general aviation County updates: United States Brazil Canada China India France Germany Japan Mediterranean countries United Kingdom Trend updates: Mergers and acquisitions Talent Diversifying portfolio Contracting process Overall outlook for 2012 Contacts 3 4 6 7 9

10 11 11 12 12 13 13 14 14 15

15 17 18 18 18 20

Overview The Deloitte Touche Tohmatsu Limited (DTTL) Global Manufacturing Industry groups 2012 outlook for the global aerospace and defense (A&D) industry is a tale of two industries. On the one hand, the commercial aircraft industry is looking up, just coming off its best year ever for production and its second best year for orders1. On the other, parts of the defense industry are declining due to decreased military spending principally in the United States (U.S.) and Europe2. Overall, the financial performance of
1 Deloitte United States (Deloitte Development LLP), 2010 Global Aerospace & Defense Industry Performance Wrap-up, 12 July 2011. 2 Ibid.

the top global A&D companies in 2012 is expected to hold its own and be in line with 2011 performance (see Figure 1), with the decline in defense revenues offset by cost-cutting and aggressive growth actions taken to maintain operating margins3. Continued global economic challenges coupled with revenue gaps and cost pressures may result in margin contraction for some industry players. The sector is likely to undergo more streamlining of its cost structure, divestiture of noncore assets, and additions of gap filling, as well as game-changing acquisitions. Expect to see more aggressive competition for the fewer large
3 DTTL Global Manufacturing Industry group analysis, January 2012.

Figure 1: Top 20 global A&D companies first nine months 2011 versus 2010

Company

2011 Revenue year over year (YoY) percentage change 2.98% 3.59% 4.19% -1.40% -6.28% 9.53% 0.64% -5.20% 8.74% -0.54% 7.20% -2.37% -1.24% 8.42% 15.04% 14.90% -20.58% 10.47% 2.63% -28.71% 3.49%

2011 Operating profit YoY percentage change 9.80% 10.92% -1.23% 0.24% 15.10% 16.28% 10.76% -178.52% 7.21% NA NA -6.90% -42.19% 12.89% 12.95% 26.05% -68.91% 10.35% -11.11% NA -3.73%

2011 Operating margin YoY percentage change 6.62% 7.07% -5.20% 1.67% 22.82% 6.16% 10.05% -182.82% -1.41% NA NA -4.64% -41.46% 4.12% -1.82% 9.70% -60.85% -0.11% -13.39% NA -5.25%

Boeing EADS Lockheed Martin General Dynamics Northrop Grumman United Technologies* Raytheon Finmeccanica GE Aviation* Thales Safran L3 Communication SAIC Textron Bombardier Aerospace* Goodrich Oshkosh Corporation Honeywell Aerospace* ITT Exelis* Dassault Aviation Total

* Partial company results based on A&D activities. Note: The above companies represent the largest A&D companies (based on 2010 annual data) for which quarterly performance financials are available. Source: DTTL Global Manufacturing Industry group analysis from the first nine months of 2011 data for the U.S. companies and analogous documents for the European companies.

defense programs of record, as well as growth in commercial aircraft backlogs and a capacity challenge for suppliers to meet commercial aircraft and regional jet producers increasing requirements. The A&D industry is becoming more global due to heightened competition, growing travel demands, and security requirements in emerging markets. Globalization provides opportunities for lower cost and for technologically advanced product introductions, as these can be designed and manufactured anywhere, anytime, largely due to the Internet and digital product definition, design, and manufacturing software. Globalization is also affecting product selections, in that military and commercial customers alike are requiring that value be offset by placing work in their countries of origin. This tendency is likely to continue, as traditional countries are pressured to keep their jobs at home, but is balanced by the need for companies to grow revenues and continue to reduce labor costs. The trend in the industry toward globalization is also marked by new market entrants, some of which receive government financial support that may potentially invite World Trade Organization consideration in future years. Expect to see more governmental scrutiny and compliance requirements on acquisition practices in the areas of anti-bribery, anti-money laundering, and ethical business practices to provide a levelplaying field of competition. In the past, the A&D industry has experienced program management challenges, resulting in delayed schedules and missed budget commitments. Among other reasons, these program management struggles could have been due to intense competition, which would have necessitated optimist pricing, cost, and delivery plans. A closer look at several largescale programs that have missed their commitments in the last few years reveals many root causes, including the use of immature technologies, lack of appropriate levels of systems engineering discipline, and a plethora of complex engineering changes. Other causes for the overruns include inadequate supplier business maturity, capacity, and performance, as well

as optimistic scheduling with poor time and resources planning for contingencies. In 2009, one-time impairment charges amounted to an estimated US$10.5 billion, while in 2010 this amount was significantly reduced to an estimated US$1.7 billion, suggesting that troublesome programs are behind for now, and that the industry is learning to manage programs more efficiently.4 This positive trend likely continued into 2011 and will probably also continue into 2012. What lies ahead in 2012 for commercial aircraft production? The commercial aircraft industry is likely entering a prolonged upcycle of orders and production, as demonstrated by recent Boeing and Airbus announcements of plans for increased production, the first delivery of the B-787 Dreamliner, and the progress of new aircraft programs underway globally5. Market forecasts of top large commercial aircraft manufacturers describe an expectation of between 26,900 and 33,500 commercial aircraft to be produced over the next 20 years6. The difficulty in keeping commercial airlines profitable, principally due to the increasing cost of fuel, is generating requirements for more fuel-efficient aircraft. This is driving demand for derivative aircrafts that are equipped with next generation engine technology. The sales order success of the Airbus 320NEO and the Boeing 737MAX have demonstrated that industry technology innovations can create significant product demand. Advances in efficiency jet-engine propulsion is one of the most significant technological innovations that have come
4 Deloitte United States (Deloitte Development LLP), 2010 Global Aerospace & Defense Industry Performance Wrap-up, 12 July 2011. 5 Aviation Week and Space Technology, Analysis: Airbus, Boeing Must Weigh Production Increases With Care, 30 August 2011;Flightstory, Boeing 787 Dreamliner Date for First Delivery, 26 August 2011. 6 Airbus, Global Market Forecast 2011-2030, June 2011, www. airbus.com/company/market/forecast/; Boeing, Current Market Outlook 2011-2030, copyright 2011, www.boeing.com/commercial/ cmo/.

Figure 2: Thirty-year history and forecast for large commercial aircraft orders and production (1981-2013E)

3000 2500 2000

Orders

1500 1000 500 0

198 1981 1982 1983 1984 1985 1986 1987 1988 1999 1990 1991 1992 1993 1994 1995 1996 1997 1998 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2019 20 0 20111 2012E 3E

Years Orders Production 7 Year Moving Avg. Production

Note: The Order plot from 1981-1988 represent gross orders and from 1989-2013E represents net orders. Source: DTTL Global Manufacturing Industry group analysis, January 2012; The Boeing Company data on orders and delivery, accessed on 27 January 2012, www.active.boeing.com/commercial/orders/index.cfm?content=timeperiodselection.cfm&pageid=m15523; Airbus company data on orders and delivery, accessed on 27 January 2012, http://www.airbus.com/presscentre/corporate-information/ordersdeliveries/?contentId=%5B_TABLE%3Att_content%3B_FIELD%3Auid%5D%2C&cHash=22935adfac92fcbbd4ba4e1441d13383; DA Davidson & Company, Commercial Aerospace Industry Update, 26 May 2011; The Boeing Company, news release, Boeing Reports Strong Fourth-Quarter Results and Provides 2012 Guidance, 25 January 2012; QMT, 2012 to be Boeings year, January 2012; Airbus, news release, After a year of records, Airbus sets its sights on continued industry leadership in 2012, 17 January 2012; JP Morgan, Aerospace and Defense - All About Aerospace/Defense 2012, 5 January 2012; Credit Suisse, 2012 Aerospace & Defense Outlook, 19 December 2011; Morgan Stanley, Aerospace & Defence Takeoff, 21 December 2011.

to the commercial aviation market in the last two years, specifically with the Pratt & Whitney PurePower Geared Turbofan (GTF), as well as the CFM LEAP-X jet engines7. Because the price of jet fuel continues to impact the ability for global airlines to make a profit, the introduction of new jet power plants, which lowers fuel consumption is an industry game changer. With a claimed fuel-efficiency savings in the range of approximately 15 percent, airlines are requesting that commercial aircraft producers develop products incorporating these advances8. Thus, in the last few years, new programs, such as the Airbus A320 NEO, the Boeing 737 MAX, the Mitsubishi Regional Jet (MRJ), the AVIC ARJ21, the Irkut MS-21, and more recently the Embraer ERJ product line, are planning customer deliveries in the next several years that will incorporate these new power plants. As of mid-December 2011, these engine
7 Aspire Aviation, The engine battle heats up, 10 May 2011. 8 Aviation Week and Space Technology, Smooth Start For GTF Flight Tests, 22 August 2011; Aviation Week and Space Technology, Virgin America Launches CFM Leap On A320NEO, 15 June 2011.

producers have racked up 4,720 orders and options for new next-generation regional and single-aisle commercial aircraft power plants, making them among the best-selling products in aircraft production history9. Figure 2 illustrates a 30-year history and forecast for large commercial aircraft orders and production, including a consensus estimate for 2012 and 2013. It should be noted that the seven-year moving average for production is expected to reach 1,000 aircraft by 201310. This is quite an accomplishment given that only about 20 years ago, the seven-year moving average for aircraft production was approximately 500 aircraft per year11.

9 FlightGlobal, Narrowbody engines: Makers mark the way in 2012, 20 December 2011. 10 DTTL Global Manufacturing Industry group analysis, January 2012. 11 Ibid. 5

What is the future for advancements in air traffic control (ATC), as a way to reduce aircraft fuel burn? Global air transportation system (ATS) transformation initiatives, including the U.S. Federal Aviation Administrations (FAA) NextGen program, as well as Europes publicprivate Single European Sky ATM Research Programme (SESAR), are expected to be implemented by 202512. When fully implemented, satellite-based navigation and the transformational programs are expected to save an estimated three billion gallons of fuel, four million flight hours in delays, and 29 million metric tons of carbon emissions globally each year13. With the expectation of increased demand for travel in the next 20 years14, the new technology associated with satellite positioning, navigation, and timing systems is expected to increase fuel savings per flight by orders of magnitude, while reducing congestion and weather-related delays. Altogether, it is expected that the net benefit of implementing global transformation initiatives could result in significant financial value15. Specifically, the projected net present value of global transformation programs through to 2035 is US$897 billion16. The estimated regional breakdown is as follows17: U.S. NextGen program, US$281 billion Europes SESAR program, US$266 billion Rest of world, US$350 billion Globally, the estimated savings accrued by different beneficiaries include: Airlines, 31 percent Overall economy, 30 percent Passengers, 34 percent Air navigation service providers/airports/ATC organizations, 5 percent of the total benefits There are many challenges and risks to meeting the planned implementation date for ATS transformation initiatives. These include, but are not limited to, funding, technology risk, regulatory reform, ATC procedures, technical and certification standards, harmonization, and workforce transformation. Given the highly complex technology involved and the requirement for safety and reliability, successful deployment will likely require additional effort and possibly a new approach, such as that being proposed for the U.S. FAA
12 Eurocontrol, 10 projects that changed the face of European aviation, 8 February 2011. 13 Deloitte United States (Deloitte Development LLP), Transforming the Global Air Transportation Systems A Business Case for Program Acceleration, 10 May 2011. 14 Fox Business, Airbus lifts demand forecasts on Asian growth, 19 September 2011. 15 Deloitte United States (Deloitte Development LLP), Transforming the Global Air Transportation Systems A Business Case for Program Acceleration, 10 May 2011. 16 Ibid. 17 Ibid.

NextGen program public-private financing initiative18. There may also be significant risk that due to U.S. fiscal constraints, implementation of the NextGen program will be delayed, making 2025 potentially not achievable. Furthermore, there may be some scaling of the capabilities, which would delay the return on investment for such programs, but could also contribute to risks of global harmonization and interoperability with SESAR. Given the financial condition of the airline industry, it may be a challenge to require airlines to pay for the necessary equipage of new technologies on board the aircraft, if the timing or amount of return on investment is not assured. Lastly, plans will need to be developed and implemented to address aviation system delays attributable to the surface environment. ATS transformation and technology platform benefits are dependent on the successful resolution of capacity challenges, including the insufficient number of runways, gate shortages, and overscheduling of flights during peak traffic periods. Avoiding the cost of system delays, whether these are occasioned by airborne congestion or ground-based constraints, is a key benefit to be achieved. However, in order to achieve this, the development and implementation of plans that address surface-based delays will be critical. Where is global defense spending going in 2012? Global defense spending is expected to be flat to declining in 2012, mostly made up of reductions in the U.S., United Kingdom (UK), and the rest of Europe, offset with increases, principally in China, India, Kingdom of Saudi Arabia, the United Arab Emirates (UAE), Japan, and Brazil. In 2010, global defense spending, inclusive of armed forces personnel, was estimated to be US$1.6 trillion, with the U.S. the leader by order of magnitude, ahead of second place China, followed by the UK, France, and Russia19. Figure 3 shows the top defense spenders globally in 2010. It should be noted that nine countries spend over US$40 billion for defense each year. In terms of affordability, the nominal amount spent on defense does not necessarily equate to the importance, requirements, or priority of defense. Countries such as the Kingdom of Saudi Arabia spend a significant amount of their national economy on defense because they have national wealth created by their oil industry and security requirements based on their location in the Middle East and historical precedent. Israel spends a significant amount of its national wealth on defense for good reason their homeland has experienced major military conflict six times
18 Ibid. 19 SIPRI, SIPRI Yearbook 2011: Armaments, Disarmament and International Security, 7 June 2011. 6

Figure 3: Global military expenditures by country in 2010 (US$ millions)

World U.S. $119,400 China $59,598 UK France $59,322 $58,668 Russia $54,527 Japan Saudi Arabia $45,245 Germany $45,152 India $41,284 Italy $36,972 Brazil $33,538 South Korea $27,591 Australia $23,972 Canada $22,788 Israel $14,036

$698,281

$1,611,437

Source: Stockholm International Peace Research Institute (SIPRI), SIPRI Yearbook 2011: Armaments, Disarmament and International Security, 7 June 2011. Figure 4: Global military expenditures by country as percentage of gross domestic product in 2010

Saudi Arabia Israel U.S. Russia South Korea UK World India France China Australia Italy Brazil Canada Germany Japan

2.7% 2.6% 2.6% 2.4% 2.3% 2.0% 1.9% 1.8% 1.6% 1.4% 1.4% 1.0%

4.8% 4.0%

6.4%

10.1%

Source: SIPRI, SIPRI Yearbook 2011: Armaments, Disarmament and International Security, 7 June 2011.

since their founding in 194720. India, Brazil, South Korea, and others are increasing their defense spending rapidly due to either their wealth, creating affordability and/or significant military threats to their national security. Figure 4 illustrates affordability and importance of defense by comparing military expenditures with gross domestic product (GDP) for selected countries in 2010. As can be seen, Kingdom of Saudi Arabia spends the highest percentage of its GDP on military expenditures at 10.1 percent, followed by Israel at 6.4 percent, and then the U.S., Russia, and South Korea21. The global average GDP spent on defense is 2.7 percent which is a bit overstated considering the U.S. raises the average significantly with a large portion of total expenditures22.
20 USA Today, The Arab Israeli Conflict, 1947- present, 28 August 2001. 21 SIPRI, SIPRI Yearbook 2011: Armaments, Disarmament and International Security, 7 June 2011. 22 Ibid.

The U.S. Department of Defense (DOD) is now potentially facing up to US$1 trillion in budget cuts over the next 10 years. What could be the impact on the skilled workforce and to the industrial base if all the cuts were enacted? U.S. defense budget reductions in the order of US$487 billion over 10 years have essentially been agreed to by U.S. administration and congressional constituents23. A recent challenge of the super-committee to agree on deficit-reduction measures on 23 November, 2011 would, if implemented trigger the automatic sequester budget reduction of an additional US$500 billion over 10 years, starting in 201324. Taken altogether, that implies a reduction in force structure, (e.g., soldiers, sailors, airmen, etc.), as well as a reduction in investment accounts (e.g., research and development (R&D), new program starts, numbers of units ordered, etc.). Assuming that
23 Aerospace Industries Association, The Real Defense Budget Challenges Lie Ahead, 26 January 2012. 24 Ibid. 7

cuts will be proportional and that the entire amount is cut, it is estimated that up to 25 percent of defense and government contractor budgets are likely to be impacted, all else being equal25. The impact on the industrial base is likely to be significant, given that essentially one out of four people in the defense contractor base within the U.S. would be potentially impacted and possibly downsized out of the workforce, should the additional US$500 billion cut take effect26. This could mean that the U.S. defense industry may not be able to afford to keep certain technology capabilities alive in the industrial base. It might also mean that there may not be enough work to support two or more companies in certain technologies, thus potentially reducing competition. Since the U.S. Congress will have until 2013 to deliberate on the pending workforce cuts, it is expected that much dialogue and debate will take place in the coming year regarding the impact of the automatic budget cuts on the U.S. industrial base. Given the immediacy of the cuts beginning in 2013 as required in the U.S. Budget Control Act27, this debate will likely bring several important questions and challenges to the forefront. These include: 1. What is the U.S. strategic defense posture in terms of size of force structure? What is the U.S. capacity to fight how many conflicts at once? What threat environment should be anticipated? 2. How much defense is affordable? 3. What should the defense industrial base look like? What sectors/capabilities need government protection? What kind of competition is required? 4. How should the DOD increase productivity and efficiencies (e.g., improve and lower cost in the weapons systems acquisition process and manage programs better to deliver programs on time and on budget)? These matters are expected to be most important in 2012, as it relates to the financial performance of the defense industry. The formulation of a renewed U.S. defense strategy, coupled with the resulting war fighter requirements, and ultimately the defense budget, will likely provide the guidance necessary for defense contractors to size their workforce appropriately, to understand what revenues they can count on, and therefore, what their financial performance will be in 2012.
25 Deloitte United States (Deloitte Development LLP), The Aerospace and Defense Industry in the U.S. A financial and economic impact study, 7 March 2012. 26 Ibid. 27 U.S. Government, Budget Control Act, 1 August 2011, www.gpo. gov/fdsys/pkg/BILLS-112s365eah/pdf/BILLS-112s365eah.pdf.

What effect will the defense budget deliberations of the U.S. government have on the rest of the world? Firstly, the U.S. defense budget associated with contractor spend is still the largest in the world, accounting for approximately 53.9 percent of global procurement spend28. Even though reductions in the DOD budget are expected to be in the US$24 billion to US$50 billion per year range, the budget will still be five to six times the size of its nearest peer country29. These budget reductions are likely to have two main impacts on the global market. First, nonAmerican A&D companies doing business with the U.S. government will likely still continue to do business there, albeit at a lower level of participation, all things being equal. However, a one size fits all generalization would not adequately describe the outlook for these companies in 2012. In particular, there may be cutbacks to specific programs that could disproportionately affect certain European companies due to their program concentration. Additionally, new program down-selects may occur in 2012 that could significantly strengthen a companys U.S. presence if they win new competitions. Secondly, U.S. A&D companies, facing potential revenue shortfalls from their traditional sources in the DOD, will likely strengthen their marketing and competitive positioning in emerging markets, particularly in India, Brazil, South Korea, Japan, Kingdom of Saudi Arabia, and the UAE. These countries, with their increasing wealth and growing security concerns, are expected to increase their purchases of sophisticated weapons systems, where U.S. companies have competitive strengths. Thus, for European A&D companies, there will likely be increased and intense competition for these foreign military sales opportunities. Finally, the more strategic impact may potentially be a reduced capacity to address multiple and simultaneous expeditionary military, humanitarian, or police-action campaigns, although the DOD process for conducting a strategic defense review may provide a clearer path forward. However, past is prologue and should there be a need, the U.S. government would likely ramp up its capacity and capabilities to address defense and security requirements in time of emergency need, as they have done in the past, no matter what the budget is.

28 DTTL Global Manufacturing Industry group analysis, January 2012. 29 Deloitte United States (Deloitte Development LLP), The Aerospace and Defense Industry in the U.S. A financial and economic impact study, 7 March 2012. 8

Figure 5: First nine months 2011 shipments of business and general aviation aircraft manufactured worldwide (US$ billions)

2010 Pistons Turboprops Business jets Total shipments Total billings (US$ billions) 633 237 491 1,361 $13.5

2011 577 223 427 1,227 $12.1

Change -8.8% -5.9% -13.0% -9.8% -10.2%

Source: General Aviation Manufacturers Association (GAMA), accessed on 2 December 2011, www.gama.aero/media-center/ industry-facts-and-statistics/shipments-billings/.

What about business jets and general aviation? Where is the market going? The 2011 general aviation market was expected to rebound slightly from the devastating impact experienced to orders, employment, and revenues that began with the economic crisis in 200830. Unfortunately, this was not the case, as shipments for all segments of the general aviation sector experienced continued declines through the first three quarters of 201131. Total shipments declined 9.8 percent, while total billings dropped 10.2 percent through the first three quarters of 201132. Figure 5 shows the changes in shipments for piston, turboprop, and business jet segments, as well as total billings for the first nine months of 2011, compared to the same period in 201033. More of the same is expected in 2012 with only a slight growth in orders anticipated. Several reasons may explain the challenges the general aviation industry faces in returning to growth. These include the number of highquality previously owned general aircraft available in the market, tighter credit conditions, the smaller number of younger people obtaining pilots licenses, and finally the higher cost of fuel. On the bright side, China is in the process of liberalizing its air space and expects the general aviation industry to lead business jet aircraft growth in the country, due to the increasing number of wealthy individuals and burgeoning middle class. Sales to the Middle East also are expected to follow the same pattern and contribute to the slight increase in orders34.

Much has been reported about the A&D industrys need for cost efficiencies and overhead-cost reduction. The industry continues to experience program delays and significant cost overruns. Will there be improvement in 2012? Although one-time asset impairment charges to earnings were down significantly in 2010 compared to 2009, the U.S. Government Accountability Office (GAO) found that on average, A&D programs were 26 percent over budget and only 33 percent were on schedule35. Nevertheless, improvements have been occurring and are expected to continue in 2012. As companies are pressured by military, government, and commercial customers to focus on affordability, the need to manage costs in all phases of the product life cycle will become increasingly important. A&D companies will need to mitigate costs during R&D and initial production, and then maximize profits as operations move into full rate production and support. Starting with the R&D process, successful companies have implemented rigorous program and risk management processes coupled with effective performance metrics to manage technical risks and avoid cost overruns. As programs enter production, successful companies assess future market conditions, long-term operational flexibility, and financial return on investment when considering whether to invest in new capacity or outsource components to strategic suppliers. As an example, Gulfstream strategically outsourced production of their mid-cabin business jets to a key supplier36. Gulfstream traditionally operates a vertically integrated business, but outsourcing this piece of production allowed them to avoid making significant investments to sustain those products.

30 GAMA, General Aviation Airplane Shipment Report, 7 November 2011; Aircraft Owners and Pilots Association, GAMA: Decline in aircraft deliveries slows, 7 November 2011. 31 GAMA website, accessed on 2 December 2011, www.gama.aero/ media-center/industry-facts-and-statistics/shipments-billings/. 32 Ibid. 33 Ibid. 34 Avjet Corporation, Private Business Jets A Global Perspective, 1 December 2011.

35 GAO Report to Congressional Committees (GAO-08-467SP), Defense Acquisitions: Assessments of Selected Weapon Programs, March 2008. 36 AIN online, Outsourcing Offshore Not a Gulfstream Goal, 13 October 2010. 9

During production, improved supplier collaboration will help companies tend to manage and control costs. Forecasting, planning, and scheduling maturity has been shown to have significant impact on the ability for a company to meet customer delivery schedule demands. Working with suppliers to provide an accurate view of lead times, budgets, and forecasts will improve on-time delivery, responsiveness, and cost effectiveness. Forecasts that include high-fidelity production lead times, workflow dependencies between suppliers, and accurate due dates are critical to finding ways to reduce lead time and mitigate potential problem areas. Lastly, as production volumes drop and eventually cease, successful companies monitor sustainment requirements and continually assess the impact that the erosion in volume and infrequent demand streams can have on total program costs. For example, the infrequent demand associated with sustainment requirements can cause significant breaks in production. A break of 12 months can increase production costs by 15 percent, for example, and a break of 18 months can increase costs by 20 percent37. In order to control costs, successful companies proactively monitor product support profiles and potentially shift the business model used to deliver a product and/or service to ensure that sustainment costs for the customer are kept low, while profits are maintained by the company Significant attention is being paid to U.S. Government Defense Contractor Audit Agency (DCAA) contract compliance, with several companies having their business systems criticized by government auditors. What should the industry expect in 2012? Regulators have long held government contractors accountable for how their money is being spent; however, there are additional and more intense consequences for non-compliance based on new regulations. Contractors are already subject to numerous regulatory requirements, contract audits, investigative oversight, certifications, and sanctions. It is expected that continued scrutiny of contractor business systems, a renewed focus on access to internal audit reports, and a return of incurred cost audits. In recent years, the U.S. government has been highly focused on the role served by the DCAA in overseeing compliance with requirements, such as the Defense Federal Acquisition Regulation Supplement (DFARS). As a result, the DCAA has taken a more aggressive and comprehensive approach to their auditing of defense contractors38.

Further underscoring the situation, in May 2011, the DOD issued an Interim Rule amending DFARS in an effort to improve the effectiveness of DOD oversight over contractor business systems39. The rule establishes specific compliance requirements spanning a wide variety of defense contractor business processes, including accounting systems, earned value management systems, estimating systems, materials management and accounting systems, property management systems, and purchasing systems. With the issuance of the Interim Rule, defense contractors will likely experience even greater DCAA attention. The stakes have been raised, as the Interim Rule specifies that defense contractors may face financial consequences for non-compliance, including withholding of payments if significant deficiencies are identified40. Penalties include payment withholding of 5 percent of amounts due per system or 10 percent maximum, which can continue until such time as the significant deficiencies have been corrected, as determined by the governments contracting officer. Faced with the possibility of substantial delays in receiving payment for services rendered, successful defense contractors are proactively evaluating their compliance with the new DFARS requirements to help ensure that their business systems are not in violation41. In December 2011, the GAO issued a report regarding DCAAs access to defense company internal audit reports42. The report found that many of these internal audit reports reviewed contained information relevant to DCAA audits, but certain information was not provided or requested. While acknowledging existing case law regarding access to these confidential internal reports, the GAO recommended that DCAA take steps to facilitate access to internal audits and assess periodically whether other actions are needed. The DCAA is expected to increase its efforts in performing incurred cost audits at contractors. DCAA management has stated it will be forming dedicated teams to focus on performing these audits and decreasing the current backlog of open years43. As these audits are being conducted, contractors will likely experience challenges in providing adequate documentation in support of its transactions.

37 DTTL Global Manufacturing Industry group analysis, January 2012. 38 Deloitte United States (Deloitte & Touche Financial Advisory Services LLP) observation, December 2011.

39 U.S. DOD, Federal Register / Vol. 76, No. 96 / Wednesday, May 18, 2011 / Rules and Regulations. 40 Ibid. 41 Deloitte United States (Deloitte & Touche Financial Advisory Services LLP) observation, December 2011. 42 U.S. GAO, Actions Needed to Improve DCAAs Access to and Use of Defense Company Internal Audit Reports, 8 December 2011. 43 National Defense Industry Association, management presentation, 12 to 13 September 2011. 10

What is the emerging tax picture for U.S. A&D companies? In the past, the tax departments of A&D companies have been viewed as cost centers that manage the companys tax compliance and tax financial reporting obligations. This model may have been sufficient for U.S.-based companies operating primarily within the United States, serving primarily American customers. However, as companies expand internationally and encounter new complicated tax laws of foreign countries, in addition to the uncertain and complicated U.S. tax laws, tax departments are being asked to do more than what they are accustomed to without additional resources. Furthermore, companies may not be able to handle or coordinate their global tax compliance obligations and may require assistance in the U.S. and abroad. Proactive tax departments that are well integrated with a companys finance and operations functions and viewed as a value driver can deliver meaningful benefits exceeding department costs, including lowering effective tax rates and obtaining cash tax savings through upfront tax planning. The U.S. tax picture for beyond 2012 is still developing. There is a debate in Washington D.C. currently underway on the need to reform U.S. corporate tax rules and lower the top rate in order to make U.S. businesses more competitive internationally. However, the prospect of a reduced corporate tax rate comes with a significant amount of uncertainty for taxpayers, as Congress would likely have to make foundational changes to longstanding deductions, credits, and incentives upon which businesses have relied, such as the R&D tax credit, domestic production activities deduction, completed contract rules, and accelerated depreciation. While no action is expected until sometime after the 2012 U.S. elections, companies could be taking several actions to prepare for and successfully cope with change. What can be expected in Brazil, with increasing levels of wealth, the pending selection of new fighter aircraft, and growth in the civil aviation market? It is anticipated that the Brazilian A&D industry will continue to thrive over the next few years, driven by GDP and individual income growth, as well as wealth creation particularly in the middle class. In addition, the expansion of credit and long-term financing has been powerful drivers of economic growth. Finally, real-dollar exchange rates have stabilized, resulting in lower foreign exchange credit risk. These drivers have provided a foundation for robust economic activity and bode well for the A&D market in Brazil.

Air travel demand has increased at impressive levels and nearly tripled in the past decade, as more people can afford to fly for business and leisure44. In commercial airlines, revenue from domestic and international regular flights operated by Brazilian companies has increased from R$13.8 billion in 2003 to R$21.6 billion in 201045. In defense and security, the Brazilian Air Force budget has increased from R$4.6 billion to R$8.02 billion, signaling an increased priority for national defense46. This is one of the most significant military investments for the Brazilian government. In addition to organic market expansion, Brazils involvement in the 2014 International Federation of Association Football World Cup and 2016 Olympic games will increase travel to the country generating additional revenue for the industry. These mega events are likely to expand the interest in tourism, business, and infrastructure development. The Brazilian government plans to invest R$5.6 billion to modernize airports in preparation for the sporting events47. Another important factor driving the markets is the high-speed development of biofuels for aviation. Thus for the next year, industry sector activities in Brazil appear to be increasing. How will the Canadian industry benefit from the growth of the industry in the next years due to increasing demand for aircrafts? The Canadian A&D industry is composed of more than 400 companies, including a few original equipment manufacturers (OEMs) and many tier two and tier three suppliers48. It employs more than 80,000 employees, generates revenues of approximately CND$24 billion, and focuses primarily on the commercial aircraft sector which represents 83 percent of the industry49. This situation positions Canada to benefit from the increasing demand arising from the global commercial sector and protects it against defense spending reductions. The Canadian A&D industry is benefiting from the opportunities of the global A&D industry since more than 77 percent of its revenues are generated from sales to

44 Star Tribune, Brazil air travel triples since 2002, stoking worries about preparation for WCup, Olympics, 25 January 2012. 45 National Civil Aviation Agency, 2010 Yearbook of Air Transportation, developed in 2011, www.stats.gov.cn/english/ statisticaldata/otherdata/brics2011/P020110412517544487450.pdf. 46 Ibid. 47 Empresas Concremat, Building for a more competitive Brazil, April 2011. 48 Aerospace Industries Association of Canada (AIAC), Canadas Aerospace Industry Statistics, accessed on 2 January 2012. 49 AIAC, Backgrounder Deloitte Study Report Highlights, 26 October 2011. 11

foreign markets50. The increasing demand in developing countries such as China and India will therefore benefit Canada. Canadian companies are likely to continue to invest in those developing countries in order to maintain market share and remain competitive in these markets. In addition, industry has also focused on the development of green aerospace technology to provide fuel-efficiency relief as the price of fuel rises. As the demand for greener aircraft increases, many Canadian A&D companies that have invested heavily over the past few years will likely gain financial benefits. What impact will China have in the industry? China is expected to continue the modernization of the industry, with several development programs underway. In the commercial aircraft industry, the COMAC C-919 single aisle commercial air transport program is well under development, with first flight scheduled in 2014 and entry into service in 201651. COMAC forecasts 2,000 C-919 aircraft to be produced over the next 20 years, approaching 7 percent market share of the consensus market forecast for global production52. In addition, COMAC is developing the ARJ-21 regional aircraft, which has already undergone first flight, and is expected to be delivered to airline customers in 201253. Together, these two aircraft launch programs represent the emergence of an industry that has struggled over time, but now appears to be emerging as a credible producer of commercial air transportation products. It is expected that the Chinese commercial aircraft industry will continue to gain attention in 2012, with continued western supplier involvement and partnership creation, as well as continued technology development. In the space sector, the Chinese industry continues to advance its space program with the development of a space station. A plan announced by the Chinese government at the end of 2011 includes the launch of a space lab and collecting samples from the moon by 201654. It also includes plans for a manned spaceship and space freighters. The new space plan would include the design, manufacture, and deployment of the Beidou Satellite Navigation system, Chinas version of a global positioning systems (GPS), navigation and timing system, similar to the U.S.-based global positioning system. Recent achievements made by Chinas aerospace industry in 2011, including a
50 Ibid. 51 Flightglobal, C919 project at crucial point in detailed design Comac, 25 November 2011. 52 Defenceweb, COMAC C919 orders reach 165 aircraft, 16 November 2011. 53 Flight Global, Comac ARJ21-700 ready for type inspection authorization, 30 December 2011. 54 The New York Times, Space Plan From China Broadens Challenge to U.S., 29 December 2011.

successful docking between the Shenzhou-8 unmanned spacecraft and the Tiangong-1 space lab module55. China is also increasing its defense capitalization, expanding its submarine fleet and developing its first aircraft carrier, purchased from Russia56. It also has a fifth generation stealth fighter, the J-20, under development, which has captured the attention of global competitors57. What is expected for India in 2012? India is a nation on the ascent in terms of wealth creation, spending on space, commercial air transportation, and defense sector. First, the Indian space sector has been experiencing growth with the launch of Chandrayaan-1, the Indian Remote Sensing series and Indian National Satellite system58. The Indian Space Research Organization (ISRO) is experiencing success with the in-country design and production of spacecraft. ISRO is likely to establish new facilities and develop a host of technologies for Indias first manned mission scheduled for 201659. A new project, the Indian Regional Navigational Satellite System, has been developed for improving national intelligence, surveillance, and reconnaissance capabilities with a launch of the first satellite planned during 2012-2013. Finally, the Chandrayaan-II mission is expected to launch in 2013, with the objective to collect samples of lunar soil and conduct in situ chemical and mineralogical studies60. Second, regarding commercial aviation, India is one of the fastest growing aviation markets and is expected to be the third largest domestic market after the U.S. and China by 202061. The commercial aviation market in India during that time is expected to grow at a compound annual growth rate (CAGR) of 18 percent, and the market for new passenger aircraft in India is expected to be US$150 billion, with 1,320 new airplanes delivered over the next 20 years62. Traditional mainline as well as lowcost carriers are expected to participate in fleet renewals
55 CNN US, Space docking marks new milestone for Chinas stellar ambitions, 30 November 2011. 56 The Guardian, Chinas first aircraft carrier: From Russia with love, 10 August 2011. 57 ABC News, Chinese Stealth Fighter Could Rival U.S.s Best: Report, 9 May 2011. 58 Deloitte India (Deloitte Touche Tohmatsu India Private Limited), Antrix Corporation Limited, and Confederation of Indian Industry, Overview of the Indian Space Sector 2010, August 2010. 59 Flightglobal, Indias space sector shifts to new frontiers, 1 February 2011. 60 ISRO, website information included in Future Programme, accessed on 18 January 2012. 61 India Brand Equity Foundation, Website information included in Aviation, accessed in December 2011. 62 Indian Aviation, Sky is the limit, 18 January 2012; Boeing, Boeing values India Market for 1320 New Airplanes at $150 Billion Over Next 20 Years, 6 July 2011. 12

and additions to serve growing and new markets. In addition, the flourishing Indian private general aviation and business jet market are expected to grow to 12 percent of the global market, surpassing China and Japan63. It is expected to reach to 2,000 units purchased by 2020, up from 650 units delivered by August 2011 year to date64. Furthermore, there is an emerging demand for helicopters and unmanned aerial vehicles (UAV). Finally, increased defense spending is a welcome bright spot in India for global suppliers experiencing downturns in their home countries. Indias 2012 Defense Procurement Procedure will likely also define offset guidelines with the introduction of certain standard global practices and provision for foreign exchange risk. The indigenous Indian defense sector continues to look for favorable support from the Indian Ministry of Defense (MOD) in terms of expeditious awarding of contracts, providing tax incentives, issuing industrial licenses, increasing foreign direct investment, and building up the indigenous defense industrial base. Foreign defense contractors will likely need to continue to work with these indigenous suppliers in order to be successful in India. What changes are expected in the industry in France in 2012? The French A&D industry benefits from the presence of several large global companies, which have significant sales to the French military, global commercial airlines, and other commercial and government customers globally. However, as European countries scale back their defense purchases due to affordability reasons, French A&D companies are finding it more difficult to rely as much on the French government as the primary customer. Among other areas, sales success is increasingly being pursued with the commercial success of the Airbus product line, in particular the A320 NEO, one of the most successful aircraft product launches in history. Due to the high relative value of the Euro compared to the U.S. dollar, certain suppliers are finding it difficult to maintain cost-competitiveness and have been pursuing outsourcing opportunities in lower cost countries. In addition, mid-tier aerospace suppliers may be looking for opportunities to gain cost advantage via scale economies, gained through industry consolidation. Activity in 2011 in the merger and acquisition (M&A) marketplace has increased, particularly amongst the smaller supplier community. With Airbus commercial aircraft backlogs growing, and the anticipated rate increases taking hold,
63 Business today, Wings of their own: Growing fortunes fuel appetite for private jets, 1 May 2011. 64 Aviation India, Private aviation on boom in India,13 August 2011.

M&A activity is expected to accelerate in 2012. How is Germany responding to the economic challenges facing the industry? The German A&D industry sustained the recent global economic crises and gained an upward momentum in 201065 and likely in 201166. Nevertheless, the industry outlook for 2012 is somewhat less optimistic. Given the macroeconomic conditions, the fragile foundation for prosperity in Europe, and the ongoing Euro crisis make short-term developments difficult to forecast. Public budget constraints, aggravated by the debt crisis, are likely to continue to impact the German defense industry. In the short term though, the 2012 public defense budget is nominally flat at 31.7 billion, slightly higher level than in 201167. The suspension of conscription and the downsizing of the Bundeswehr to approximately 185,000 soldiers in the midterm will lead to lower personnel costs68. Expenses for maintenance, procurement of military equipment, and defense-related research are therefore, expected to increase. As a result, the German commercial defense industry is not yet impacted by discretionary spending and may see a slight increase in procurement. For the expected longer-term demand decrease, defense industry companies have started restructuring programs, striving to further boost their exports of military equipment (by more than 50 percent in 2009 to 2.1 billion in 2010), and accelerate their technological transformation towards more flexible and volatile threat-responsive products and services on the other69. The impact of the flat to declining global A&D industry will be cushioned in 2012 by the existing large backlog of commercial aircrafts70. In addition, some market players are likely to expand their product portfolio, striving to enter new market segments, and exploring the use of A&D technologies (e.g., carbon fiber) in other industries to gain new end-market growth opportunities for growth. This might also lead to increasing transnational M&A activity,
65 Handelsblatt, Luft- und Raumfahrt im Aufwind, 21 April 2011. 66 Deloitte Germany (Deloitte Consulting GmbH) observation, January 2012. 67 Defense News, Germany to Boost Defense Budget by 133M Euros, 7 September 2011. 68 The Local, Bundeswehr begins new era as conscription ends, 4 July 2011. 69 Frankfurter Allgemeine Politik, 50 Prozent mehr deutsche Rstungsexporte, 7 December 2011 70 Airbus, Global Market Forecast 2011-2030, June 2011, www. airbus.com/company/market/forecast/; Boeing, Current Market Outlook 2011-2030, copyright 2011, www.boeing.com/commercial/ cmo/. 13

both from German companies investing in target markets, as well as Asian investors investing in Western companies in order to gain technological know-how. In general, the German A&D industry could see some further consolidation initiatives driven by efforts for diversification, key system supplier platform capability, more risk sharing, and assistance to distressed key suppliers by OEMs. What are the emerging trends for the Japanese A&D industry? The current global role of the Japanese A&D industry is primarily as a tier-one supplier. Indeed, more than 35 percent of Boeing 787 components are made by Japanese companies, and fully 20 Japanese companies participate in the Airbus A380 program71. Although the recent appreciated Japanese Yen has resulted in profitability challenges for the industry, it is expected that rate increases in these and other programs will help grow revenues, employment, and related economic activity for the industry in Japan for several years to come. The industry is maturing and in selected cases is transitioning to a full-scale platform integrator. Major programs under development are the MRJ, a next generation regional aircraft being produced by Mitsubishi Aircraft Cooperation, Honda Jet by Honda, commercial derivatives of the XC-2 by Kawasaki Heavy, and US2 by ShinMaywa. The Japanese industry has high hopes for the commercial success of these programs because they represent an opportunity to showcase indigenous engineering and systems integration capabilities. They also represent a key pathway for economic development, job creation, and national pride. Key success factors for the Japanese A&D industry have been and continue to be technology and quality. However, the industry has also realized the criticalities of voice of customer, needs-driven engineering, and globalization to reach the next level of performance and improve global status. The largest impact to Japans A&D industry is the transition from product- driven manufacturing companies to global and customer needs-driven engineering companies.

What will the budget deficit challenges in the Mediterranean countries mean to their contributions to the NATO organization for their own countries defense budget impact and ability to be a leader? Since the end of the Cold War, military policy and expenditure have been the subject of a constant evaluation to ensure the ability to intervene efficiently. Furthermore, the U.S. and North Atlantic Treaty Organization (NATO) relationship was balanced towards greater U.S. contribution in terms of both leading crisis situations and military spending. The recent Arab Spring events and the military security campaign in Libya have demonstrated the need for Europe, particularly the UK, Italy, Germany, and France, to take the lead72. European nations are becoming more aware that security is not a zero-cost product and that they cannot enjoy the benefits of security without also helping to guarantee it. As shown earlier in Figure 2 and 3 focused on global defense spending, the UK, France, and Germany are by far, the countries that invest most on military expenses, with the UK at 2.3 percent of GDP compared to 1.7 percent for France, 1.8 percent for Germany, 0.9 percent for Italy, and 0.7 percent for Spain73. However, considering the combined European population and GDP and the corresponding U.S. figures, European expenditure on military investment is a fourth the amount spent by the U.S, while spending on military R&D amounts to just a sixth of the U.S. figure74. With the economic challenges in Europe, particularly with the Mediterranean countries of Spain and Italy, increases in defense spending are not likely in the short to medium term. According to preliminary budget projections, the gap between U.S. and European defense spending is likely to widen, as NATOs 2011 spending cuts of 18 percent in the next few years are forecasted compared to 201075. However, the term smart defense has been coined to define the trend towards selective European military spending at a time of limited available economic resources. Smart defense involves a streamlined, more efficient model with the adoption of a range of measures and armaments that will enable NATO to face up to any type of threat: From cyber war to missile defense against possible attacks by rogue countries. It will seek to increase efficiency
72 The Global Policy Institute, The Arab Spring is an Opportunity...for Europe, 2 September 2011; Deutsche Welle, European divisions on Libya hold up U.S., NATO leadership decisions, 23 March 2011. 73 SIPRI, SIPRI Yearbook 2011: Armaments, Disarmament and International Security, 7 June 2011. 74 Ibid. 75 NATO, NATO Review 2011, accessed on 3 January 2012, www. nato.int/docu/review. 14

71 The Society of Japanese Aerospace Companies, Aerospace Industry in Japan 2010, April 2011.

by encouraging member countries to cooperate on the basis of interoperability and specialization. Plans are for resources to be better allocated, no longer based on national interests, but in the more general interests of the alliance as a whole76. What is the industry in the UK doing to address the slowdown in defense spending? The UK A&D industry is the third largest globally, behind the U.S. and China, and has 520,000 direct and indirect employees dependent on the sector77. Importantly, over half of the revenues generated by UK-based firms derive from sales made to export markets, with the U.S. DOD being the primary export customer78. Thus, the industry is important to the UK industrial base as the employer of a highly skilled UK workforce and as an earner of foreign revenues. As such, understanding the UK industry going forward requires consideration of all three key revenue generators, including UK MOD, U.S. DOD, and the commercial aerospace sector, along with an understanding of the UK government response. The UK deficit reduction program has resulted in defense procurement reforms, which have delayed contract placements, and will reduce spending over the next three years by approximately 8 percent in real terms. In addition, the Currie review regarding single-source procurement is expected to be finalized in early 201279. Amongst the expected recommendations are open book accounting so that the UK MOD is in a better position to negotiate, incentivizing efficiency to encourage the industry to reduce its cost base, and a push to reduce single-source procurement and open competition. A similar picture to the UK is being seen, as discussed elsewhere in this outlook. However, it could be argued that there are still opportunities to access additional revenues in the U.S. market via a focus on small-to medium-sized acquisitions, as has been the case for the UK industry over the last decade or so. The challenge now, given what is happening in the UK market, is both securing funding and being able to meet vendor price expectations. In addition to the Currie report, the UK government is looking
76 NATO, Smart defense website, accessed on 7 February 2012, www. nato.int/cps/en/natolive/78125.htm. 77 A|D|S, Aerospace: A recipe for recession recovery, 2011; A|D|S, Defence: sound investment, strategic choice, accessed on 18 January 2012, www.engineeringcapacity.com/__data/assets/pdf_ file/0006/405168/ADS-Defence-manifesto-FINAL.pdf; The Telegraph, UK military spending, accessed on 18 January 2012, www. telegraph.co.uk/news/uknews/defence/8002911/Defence-spendingthe-worlds-biggest-armies-in-stats.html?image=2. 78 Deloitte UK observation, 14 December 2011. 79 UK MOD, Review into single-source military equipment contracts, 11 October 2011.

to support the industry in accessing new markets and growing exports. This government/industry partnership will need strong commitment on both sides as it will be up against other countries seeking a similar export-led recovery for their industrial base. In order to address the above challenges and opportunities, the UK A&D industry is preparing itself for the future by80: Increasing focus on the broader security and intelligence markets Increasing access to customers preferential areas of spend and/or customers in new geographic markets Addressing internal costs to reflect changes in customer requirements and reduced business activity Focusing on operational efficiency Looking to work more closely with the UK government for support on exports, as recognized by the UK government in its recent whitepaper81 Continuing to improve internal data capture, and leveraging this knowledge in negotiations with future upskilled government procurement agencies Enhancing the robustness and appropriateness of their business portfolios through targeted acquisitions and disposals Where do you see M&A activity in 2012? Global M&A activity in 2012 is likely to be driven by a variety of factors, including the impact of the recent global economic crisis on both corporations and private equity firms. Specifically, investible cash, as well as borrowing capacity will likely lead many companies to pursue M&A activity as a vehicle for growth and to access new markets. Many A&D companies have used their cash over the last several years to pay down debt, buy back stock, increase dividends, and to make elective contributions to pension costs. At the beginning of 2011, global A&D companies had an estimated US$49.5 billion in free cash flow, and some used this asset to participate in the M&A market82. Indeed, M&A deal value in the A&D industry in 2011 was approximately twice the level from the previous year, driven in large part by the US$16 billion Goodrich Corporation acquisition by United Technologies Corporation deal announcement83. Additionally, the vast
80 UK MOD, Spending Review 2010, covering the period to the 2014 to 2015 financial year announced on 20 October 2010. 81 UK MOD/Government, National Security Through Technology: Technology, Equipment, and Support for Defence and Security, February 2012. 82 Deloitte United States (Deloitte Development LLP), 2010 Global Aerospace & Defense Industry Performance Wrap-up, 12 July 2011. 83 DTTL Global Manufacturing Industry group analysis, January 2012; Wall Street Journal, UTC Deal Reached to Acquire Goodrich, 22 September 2011. 15

level of capital raised by private-equity firms in previous years should serve as a driver to deploying those funds in 2012. Private equity investors are likely to compete for many of the same assets as strategic buyers and in some cases paying higher values. During 2011, multiple deals, large and small, were announced and similar levels of M&A activity are expected for 2012. It is anticipated that increased activity will remain high within commercial aerospace given the anticipated overall increases to production levels and new program ramp-ups. Buyers will likely continue to use M&A to position themselves on these growing programs, as well as increasing scale and integration capabilities to become

more relevant to the customer. Within the defense world, the challenges of the U.S. Super Committee will likely lead to a decline in certain defense programs, as the U.S. government looks for ways to reduce the budget deficit. This will likely have a negative impact on overall defense industry attractiveness of certain assets. At the same time, expect ever-increasing budget support for, and therefore, M&A interest in, those areas which support new realities technologies, such as intelligence, surveillance reconnaissance, precision strike, cyber security, energy security, data fusion, mission software development, and unmanned and autonomous controlled vehicles.

Figure 6: Recent energy market investments by leading A&D companies

15 Number of companies invested 13 10 13 10 8 5 5 3 0 Biofuels Fuel cells Wind Solar Nuclear Marine

Energy markets
Source: DTTL Global Manufacturing Industry group analysis, January 2012.

Figure 7: UVA data capture

1,500 Continuous years of video feed 1200 900 600 300 0 30 2009 Year 13 10 8

1,500

3 2011

Note: The quantity of data captured by UAVs has increased 50 times over the past two years, creating a market for filtering and processing UAV sensordata. Source: DTTL Global Manufacturing Industry group analysis, January 2012. 16

What are the trends in talent recruitment, development, and retention in the A&D industry? Talent is one of the biggest challenges companies face in the coming years, particularly the A&D industry given its demographic composition. The often cited shortage of engineers in the U.S. remains a challenge, but skilled production workers are also in short supply. In the U.S., 74 percent of manufacturers indicated that workforce shortages or skills deficiencies in skilled production roles represent a major challenge to productivity84. Cuts in defense spending threaten to exacerbate this problem if diversified manufacturers and smaller companies leave thesector and skilled production workers seek employment in other sectors. The future of A&D industry talent is the generation entering the workforce today. This workforce has significantly different values and expectations than the baby boomer workforce that makes up the majority of A&D companies today. The industry is faced with the challenge of attracting this new workforce and changing some of the fundamental aspects of their culture, while retaining the elements of the culture that have made them successful for decades. Todays entry-level workers value
84 Deloitte United States (Deloitte Consulting LLP) and Manufacturing Institute, Boiling Point: The Skills Gap in U.S. Manufacturing, 17 October 2011.

open environments, rapid advancement, flexible work arrangements, diverse assignments, and non-hierarchical organizations. A&D companies have traditionally been characterized by the opposite: Facilities are at times old, utilitarian, and closed; access to information is tightly controlled, advancement can be slow and measured, hierarchies are clear and firm, and many people work a single program for 10 to more years. A&D companies have the opportunity to use the incoming workforce to catalyze culture change not only to attract the next generation, but also to address changing trends in the industry: Increased use of fixed-price and performance-based contracts, significantly increased focus on affordability, and transition away from traditional large procurement programs to new geographies and new markets (e.g., foreign military sales, information technology management, and cyber security). These changes lend themselves to culture change that aligns with the values of the future workforce. The challenge for companies is making themselves more attractive to the next generation, while retaining the core elements that have made them successful: Commitment to the mission, focus on the warfighter, and relentless pursuit of results.

Figure 8: U.S. defense contract spending by competition (US$ billion)

400 350 300 US$ billion 250 200 150 100 50 0 2001 2002 2003 2004 2005 Year Competition with multiple offers Competition with single offer No competition 2006 2007 2008 2009 2010

Source: David Berteau, Defense Contract Trends (Washington, D.C.: CSIS, May 2011), {page 24}.

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How is the global defense industry diversifying? The anticipated cuts in defense spending in the U.S. and in Europe for the foreseeable future will force companies to evolve their businesses to better suit markets outside of their traditional customer base. As seen in Figures 6 and 7, continuing energy concerns and a drastic increase in the demand for UAV data capture have created new market opportunities. In order to address these new markets, many companies have already made investments or acquired niche companies with the necessary capabilities to capitalize on these opportunities. Success in these new markets will likely require changes in business models. As companies within the industry adapt their business models to meet shifting demands, they will reorient processes for interacting with customers, suppliers, and the general marketplace. For instance, shifting from a product-orientated business model of building ships, to a service-oriented business model of analyzing captured data from UAVs, requires the rationalization of manufacturing capabilities, build-up of service operations, and customer service delivery models. Companies have successfully managed this transition in the past. For example, VT Group, originally a UK defense shipbuilding company, managed to successfully transform its business model from a traditional shipbuilder to a major provider of communications, defense, and education support services by divesting 55 percent of its shipbuilding business to BAE Systems and acquiring/integrating a portfolio of small support service companies85.
85 Shipping Times, VT and BAE Systems announce shipbuilding merger agreement, 25 July 2007. Figure 9: U.S. defense spending by contract type (US$ billion)

Will performance-based contracts become more popular as a defense industry contracting process? The A&D cost-reimbursable contracts that are currently commonplace with militaries and governments are likely to be less suitable for future commercial clients. As seen in Figure 8, for the past 10 years, cost-reimbursable contracts have made up a significant portion of defense spending. In Figure 9, due to the lack of cost-type contracts in commercial markets, and the decreased use of these contracts by the U.S. government, companies are becoming more adept at utilizing and managing to fixed price (i.e., performance-based contracts). Companies shifting from cost-type, transactional contracts to performance-based contracts successfully define upfront customer needs, accurate performance metrics, and controlled risk management. In addition, the sole-source and limited-competition contracts that military clients enjoy are less likely to happen in the commercial marketplace. GE, Rolls Royce, and Pratt and Whitney are leaders of performance-based logistics services, utilizing accurate forecast models, and proactive real-time performance data to anticipate and prevent service interruptions, while maintaining a consistent service level. What are your predictions for the future of the A&D industry? Although it has only been 108 years since the Wright Brothers first flight, the industry has contributed fundamentally to the way we live, work, travel, and communicate with the technologies created and continued

400 350 US$ billion 300 250 200 150 100 50 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Year Cost and type Fixed price

Source: David Berteau, Defense Contract Trends (Washington, D.C.: CSIS, May 2011), {page 25}. 18

innovations developed in jet aircraft, communications satellites, the Internet, and GPS, for example. Also, the industry is primarily responsible for the reduction of casualties in armed conflict due to the technology innovations that keep warfighters out of harms way with UAV, sophisticated surveillance sensors, and over the horizon strike capability. This industry has created the technology innovations that have contributed to the very fabric of society from the ability to communicate globally around the clock from our personal digital assistants, to safe and efficient air travel, to securing our borders, and defending our way of life. Past is prologue, expect game-changing technology innovations to continue to be created within the global A&D industry into the future. Some of the science and

technology being developed include directed energy and high-powered microwave weapons, supersonic missiles, long-range and high-altitude unmanned aerial systems, satellite-based high-resolution full motion video cameras, and extraordinary software that can trace financial transactions of known terrorists. Interesting technologies are being experimented that can harvest solar power from space-based solar arrays, converted to microwaves, or high-voltage wireless signals, to ground, air, and sea-based distribution networks. These kinds of innovative technologies will change the lives in society in immeasurable ways, just like during the first century, the industry has changed the way humans interact on a global basis. This is indeed something to look forward to in the near term, as well as in the future.

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Contacts: Tom Captain Global A&D sector leader Deloitte Touche Tohmatsu Limited +1 206 716 6452 tcaptain@deloitte.com Tim Bremer Partner Deloitte United States (Deloitte & Touche USA LLP) +1 703 251 3825 tbremer@deloitte.com Pauline Biddle Partner Deloitte UK +44 118 322 2452 pbiddle@deloitte.co.uk Gilbert Fayol Partner Deloitte France +33 1 55 61 66 97 gfayol@deloitte.fr Nidhi Goyal Director Deloitte India +91 124 679 2299 nigoyal@deloitte.com Dan Haynes Principal and U.S. Consulting A&D leader Deloitte United States (Deloitte Consulting LLP) +1 404 631 2155 dhaynes@deloitte.com Michael Hessenbruch Partner Deloitte Germany +49 711 16554 7311 mhessenbruch@deloitte.de John Hung Partner Deloitte China +86 21 61411828 johnhung@deloitte.com.cn Yuichiro Kirihara Senior Manager Deloitte Japan +81 3 4218 7592 ykirihara@deloitte.com Ellen MacNeil Partner Deloitte United States (Deloitte Tax LLP) +1 202 378 5220 ellenmacneil@deloitte.com Kevin McFarlane Managing Director Deloitte United States (Deloitte & Touche Corporate Finance LLP) +1 213 553 1423 kemcfarlane@deloitte.com Jose Othon Tavares de Almeida Partner Deloitte Brazil +55 11 51 86 6066 joalmeida@deloitte.com Luca Petroni Partner Deloitte Italy +39 0636749217 lpetroni@deloitte.it Martin Vezina Partner Deloitte Canada +1 514 393 7139 mvezina@deloitte.ca General (USAF retired) Charles Wald Director and Senior Advisor Deloitte United States (Deloitte Services LP) +1 571 882 7800 cwald@deloitte.com

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About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service to clients, delivering the insights they need to address their most complex business challenges. Deloittes approximately 182,000 professionals are committed to becoming the standard of excellence. Disclaimer This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively the Deloitte Network) is, by means of this publication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication. Deloitte Touche Tohmatsu Limited Global Manufacturing Industry group The Deloitte Touche Tohmatsu Limited Global Manufacturing Industry group is comprised of around 2,000 member firm partners and over 13,000 industry professionals in over 45 countries. The groups deep industry knowledge, service line experience, and thought leadership allows them to solve complex business issues with member firm clients in every corner of the globe. Deloitte member firms attract, develop, and retain the very best professionals and instill a set of shared values centered on integrity, value to clients, and commitment to each other and strength from diversity. Deloitte member firms provide professional services to 80 percent of the manufacturing industry companies on the Fortune Global 500. For more information about the Global Manufacturing Industry group, please visit www.deloitte.com/manufacturing. Copyright 2012 Deloitte Global Services Limited