6 minute read 1 Jul 2017
Workers outside of an airplane

The top 10 risks in aerospace and defense

By

US Americas

Multidisciplinary professional services organization

6 minute read 1 Jul 2017

Those who best understand these potential pitfalls will be in a better place to win the race of sustainable, profitable growth.

As the global economy undergoes several ups and downs, and different countries change their defense priorities in the face of terrorism and political disruption, the risk universe in aerospace and defense (A&D) keeps on changing. As A&D players design and implement strategies to grow in this business environment, they need to adapt their plans to consider the key risk drivers.

We have evaluated the most important strategic challenges for leading players in the industry and rated the severity of these risks for the sector, through analyzing the annual reports for the top 15 global A&D players in terms of revenues. The radar below plots the top 10 risks for A&D players.

ma infographic

1.    Volatility in geopolitical and economic environment

Most A&D companies have a global footprint, so their operational as well as financial performance depend significantly on the geopolitical and economic conditions in their key markets.

Terrorist activities are on the rise, particularly in the Middle East, Africa and Asian countries. And unstable geopolitical situations in the Middle East and North Africa are leading to heightened threat levels, insecurity and border uncertainty with increased migration and threats to people and assets.

The ongoing need to monitor and protect borders is leading to increased defense and homeland security spending by nations with a focus on intelligence, detection and monitoring. However, an economic slowdown in any of the key markets for A&D players could result in tighter credit markets; low liquidity; and extreme volatility in credit, currency, commodity and equity markets.

2.    Managing the supply chain

As original equipment manufacturers (OEMs) ramp up production to deliver their large backlogs, suppliers across different levels in the supply chain would be under pressure for timely delivery, while maintaining quality and keeping costs under control.

In some instances, rather than depending on a number of suppliers, companies depend on a single supplier for a particular part or a particular process in the supply chain, creating a particular sore point when there are disruptions.

OEMs have expanded their footprint in emerging countries to capitalize on the increasing demand and low-cost environment, but that comes with additional risks, such as political instability, intellectual property right violations, production delays and quality issues.

Supply chain is at the heart of any A&D organization’s success. When working and operating effectively and efficiently, it enables the organization to meet its strategic and financial goals.
Bill Colbert
Partner, Advisory — US, Ernst & Young LLP

3.    Competition in domestic and international markets

The large commercial aircraft market is a duopoly market with Boeing and Airbus collectively holding approximately 80% of the market share. In the medium term, opportunities for new players are likely to be limited given the dominance and long order books of the Airbus-Boeing duopoly, which has effectively locked out new entrants.

Meanwhile, the industry is witnessing consolidation where large players are rebalancing portfolios and merging to increase their capabilities and enhance their competitive position.

4.    Managing and retaining talent

Because of the specialized nature of the business, companies depend on the continued services of key engineering personnel and executive officers. They also depend on the development of additional management personnel and the hiring of newly qualified engineering, manufacturing, marketing, sales and management personnel for operations.

Because of the highly specialized nature of the business, companies must hire and retain the skilled and qualified personnel necessary to perform the business-critical processes. In addition, certain personnel may be required to receive security clearance and substantial training in order to work on certain programs or perform certain tasks.

In addition to being a reflection of a firm’s business strategy, the R&D portfolio is also one of the primary tools to manage risk through the diversification of investments.
Bart Huthwaite
Partner, Performance Improvement — US, Ernst & Young LLP

5.    Ability to perform in key contracts

A&D players are typically involved in multimillion-dollar contracts and have huge backlogs. New development programs involve complex design and new technologies which are, in many cases, untested or unproven. As a result, A&D players can experience technological challenges and other performance hindrances resulting in delays, setbacks, cost overruns and product failures.

Failure to deliver major programs on time as well as adhering to quality and technical standards within budget, in case of both fixed price and cost performance contracts, might lead to negative consequences such as termination of orders, imposition of penalties and loss of orders.

6.    Compliance with a wide range of regulations and restrictions

As the customer base for A&D companies include government customers and defense agencies, they have to operate in a highly regulated environment. This subjects A&D companies to added scrutiny around corruption and bribery.

A&D players are also subject to risks associated with changes in accounting and revenue recognition standards. For instance, under Accounting Standards Codification Topic 606, A&D players would need to recognize revenue at a single point in time for contracts that don't qualify for revenue recognition over time.

7.    Capacity to innovate

Some of the technologies that A&D players use in their manufacturing and other business processes are decades old. Future performance depends on factors such as the ability to:

  • Recognize the emerging trends in technology and identify additional uses for existing technology
  • Develop, design, manufacture and bring innovative offerings to market at cost-effective prices
  • Enhance product designs for export that comply with regulations of the export destinations

8.    Failure to realize the benefits of M&As and partnerships

While evaluating new M&A transactions, companies are required to take decisions regarding the value of business opportunities, technologies, other assets and cost of potential liabilities. Poor M&A decisions might result into overvaluation of the acquired business, failure in achieving synergies, inability to retain talent, and financial challenges.

Many defense companies need to form JVs in developing countries as part of their offset obligations. In some arrangements, the global players need to transfer some technology know-hows to their local partners, which carries the risks of IP violations and copyright infringements.

The total losses incurred by companies across different industries because of cybercrimes is estimated to be approximately US$400 billion per year.

9.    Exposure to cybersecurity events

A&D players transfer large volume of data including flight data monitoring, flight operations quality assurance and load management between end users, manufacturer and service provider.

Companies involved the A&D value chain routinely exchange confidential data on specifications, technology and performance of equipment or services with the objective of enhancing collaboration on design, development and support.

All such data is valuable for cyber terrorists with unethical clients in the industry, who use this stolen data to copy products and undercut prices to outperform competition.

10.    Foreign currency and commodity price fluctuations

In addition to affecting the revenues earned, currency fluctuations also impact the receivables, payables and return on assets denominated in foreign currencies. Furthermore, having production in various countries adds to the risks.

Given the huge pressure companies have on the pricing side due to high negotiating power of the customers as well as the competitive nature of the industry, increased costs of production — for raw materials such as aluminum, titanium and composites — directly affects the profitability of companies too.

Summary

These risks encompass A&D companies’ strategic initiatives, their financial positions, their global operations and the compliance requirements in the different markets where they operate. Such risks must be mitigated as you seize opportunities globally.

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By

US Americas

Multidisciplinary professional services organization