Defense is reeling from a one-two punch combination. It could send the industry sprawling on the canvas, warns observer Tom Captain.

According to a new financial report, defense contractors in the leading global defense companies experienced a 1.0-percent decrease in the global revenues in the first half of 2012, which comes on top of the previous year’s decline.

“Last year, the global defense industry witnessed a 3.3-percent revenue decline. Reductions are expected to continue for the rest of 2012 and then into next year, particularly for companies in the United States and Europe,” says Tom Captain, vice chairman and US & Global A&D leader for Deloitte.

Deloitte’s report (“Mid-year 2012 Top Global Aerospace and Defense Company Financial Performance Analysis”) was released in early October. “Defense budgets compete with domestic priorities, and affordability for defense continues to be threatened by inability to provide funding for defense planners for many new technologies,” comments Captain, about the findings.

Defense contractors, he adds, have responded with stepped up foreign military sales, cost cutting, acquisition activity, growth in adjacent markets and a focus on cyber-security, intelligence, surveillance and reconnaissance technologies.

“The situation is offset by what is going on in the commercial aerospace industry,” he observes. “Last year, production in that segment reached a record high, and we’re looking at another record this year.”

According to the report, commercial aerospace grew at 14.9 percent in the first half of 2012, resulting from record production of new fuel efficient aircraft. This significant increase in revenues for this segment helped the global A&D industry enjoy a 5.5 percent increase in total revenues compared to the first half of 2011, more than making up for the decrease in defense revenues.

Overall, the global A&D industry posted increased operating earnings of 8.8 percent to $20 billion in 1H 2012, largely due to the positive impact caused by delivery of commercial aircraft, company cost cutting and efficiency initiatives in advance of expected continued declines in defense budgets, and the virtual absence of one-time charges.

Due to these reasons, the report states, operating margins increased 3.0 percent in 1H 2012 to 8.4 percent. Commercial aerospace companies enjoyed a significant jump of 29.2 percent in earnings, while the defense segment stayed flat at a nominal increase of 1.5 percent in earnings. Similarly, commercial aerospace operating margins increased 12.4 percent, while defense companies increased 2.6 percent in this important financial metric.

Captain describes ongoing defense industry challenges as a one-two punch combination. The first has already been delivered. The second is heading for the A&D industry’s chin.

“In the U.S., the first punch was the first part of the Budget Control Act,” say Captain. “It resulted in a significant reduction—$487 billion—over the next 10 years. We’ve seen a substantial number of layoffs, due to cost cutting taking place within defense companies.”

The second punch could be devastating. “The pending budget dialogue over sequestration in Washington, D.C. could result in another $492 billion of cuts over the next nine years,” says Captain. “This makes it difficult for defense industry executives. They’ll have to figure out where the cuts will be – in what programs, which locations and by how much. That kind of process is highly disruptive. This unpredictability and variability is a great cause of concern for the industry executives, as well as for Pentagon acquisition officials and defense planners.”

What could be done? “A balanced approach to the resolution of the $1.2 trillion deficit is clearly at the top of mind for the administration, as well industry and acquisition officials,” indicates Captain. “As I understand it, there is some movement in Congress to resolve this in the lame duck session coming up after this year’s national election.”

If that doesn’t happen, consequences could be serious, he points out: “In the 109 years following the Wright brothers first flight, the industry has become accustomed to iconic innovations emerging from the high-tech science and engineering that produced supersonic flight and an incredibly safe and efficient air transportation system, based on very reliable and increasingly fuel-efficient commercial aircraft. Our ability to continue the second century of innovation is in jeopardy if the U.S. defense industry suffers the second blow.”

The first punch was bad enough. “One the defense side, it will likely result in about a 12-percent reduction in personnel,” says Captain. “Another devastating 12-percent reduction, from the second blow, would mean that we have probably made an estimated 25 percent of the defense industry redundant. When there is not enough work to go around, companies will shutter their facilities and lay off people who are not part of the immediate program delivery and execution. That would affect valuable areas such as engineering and research and development, as well as the innovation labs that are a crown jewel of our nation’s technologic capability. The lay-offs are a big risk. I’m hoping to the presidential candidates discuss the issues.”

About the Report
Deloitte’s A&D sector focuses on the top issues facing the industry. The Mid-year 2012 Top 20 Global Aerospace and Defense Company Financial Performance Analysis was compiled by comparing and contrasting the performance of the top 20 global A&D companies’ commercial and defense segments on the metrics of revenue, operating earnings and operating margins. These companies represent approximately 71 percent of total global industry revenue. This report used the latest unaudited data through June 30th, 2012 for each company. For more information, visit: www.deloitte.com/us/a&d.


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