2011 Aerospace & Defense Industry Perspective We would like to offer our perspective on the current climate in the

aerospace and defense markets. As you reflect on what 2011 brings you, we hope our ideas will contribute to an effective dialogue about the most important issues you face. The North American aerospace and defense industries are moving in different directions: Commercial and general aviation markets are recovering, while defense markets are turning down. We have seen this pattern many times before, but market conditionsin both defense and commercial aerospaceare decidedly different this time. In the months ahead, decision makers will need to carefully assess their positions in these changing markets and devise strategies that exploit what they do best. The Defense Downturn: Affordability Is the Goal After a prolonged period of increased military spending, the defense industry faces shrinking investment spending in ships, aircraft, land vehicles, missile systems, and equipment. We already have seen cuts to the Air Forces F-22 fighter, the Navys future DDG-1000 destroyer, and the Armys Future Combat Systems. More may follow. Although top-line defense spending is trending slightly upward, investment spending is being crowded out by wartime needs, including operations and maintenance (O&M) and fast-growing military personnel costs. In September, Defense Secretary Robert Gates announced plans to free up US$100 billion over five years by cutting overhead and inefficiencies in weapons programs; the savings will be used to modernize and recapitalize military equipment and sustain troops. This effort will mitigate but not stop the decline in investment spending. Although some observers anticipate that a new defense secretary will boost investment spending when Gates leaves, we believe that O&M spending and other costs will continue eating into modernization budgets. We have seen reductions in investment spending before, most recently when the collapse of the Soviet Union triggered across-the-board defense cuts. But unlike then, todays military continues to face real and persistent threats. This creates a dual challenge for Americas defense establishment: reduce costs while enhancing capabilities. As Ashton Carter, undersecretary of defense for acquisition, technology, and logistics, said when announcing the new guidance with Gates, we must do more without more.

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Affordability is the new Pentagon watchword. Essentially, the services will set budget targets establishing spending limits for their programs. These limits will translate into preset budget and schedule targets designed to constrain system and platform designs. Although there will always be a place for exquisite systems, the Department of Defense is increasingly favoring less elaborate, more affordable solutions that take advantage of new technologies, methodologies, and processes to control costs and get the job done quicker and more efficiently. The affordability approach creates opportunities for nontraditional players, such as truck manufacturer Oshkosh Defense, which developed and built the mineresistant, ambush-protected all-terrain vehicle (M-ATV) for the Army. Companies have also found success offering disruptive technologiessuch as unmanned aerial vehicles and turboprop intelligence, surveillance, and reconnaissance (ISR) platformsand utilizing smart customization approaches to modify existing products to leverage global and commercial scale and scope. The bottom line for the industry incumbents is this: Affordability demands much more than cutting overhead costs. It will require more affordable system design, lower supply chain costs, better program execution, and more proactive risk management. But first, established players will have to decide the extent to which they will serve two different market segmentsone for exquisite solutions and the other for more affordable solutionsand whether they can develop and maintain a coherent set of capabilities that will give them the right to win in each segment. The Commercial Rebound: New Trends Reshape the Market With most airlines showing a surprisingly strong improvement in their balance sheets, the commercial aerospace industry is poised for growth. But although previous upturns have seen sharp V-shaped recoveries, we believe that structural changes in this market will result in a more gradual upturn this time that will affect original equipment manufacturers (OEMs) and suppliers in different ways. The two big OEMs, Boeing and Airbus, continued to deliver steady numbers of aircraft through the downturn, completing the first full market cycle under a duopolistic structure. To their credit, both manufacturers chased constant volume as opposed to constant share by moving peak orders to backlog on the upturn and working with airlines to firm up their future financing needs, thus dampening the impact of the recession and positioning the OEM sector for a faster return to growth. By maintaining this discipline, the sector saw only moderate decreases of 220 to 240 units on average from peak to trough, as opposed to past cycles when drops of 350 to 600 units were recorded.

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Boeing and Airbus currently report backlogs of more than 2,000 aircraft each for the B737 and A320 families. Both are predicting the need for 25,000 to 30,000 new aircraft over the next 15 years across all categories, based on the anticipated growth in passenger demand. The demand will be strongest for single-aisle aircraft, but the number of aircraft with more than 100 seats is expected to double too. The demand for cargo aircraft is expected to increase at an even faster rate. Much of this demand, including more than 50 percent of the demand for very large aircraft, will come from the Asia/Pacific region, particularly from emerging markets such as China and India. We will also see a growing demand for more fuel-efficient and eco-friendly aircraft to replace older, less efficient fleets. The downturn was not as easy for suppliers, who have little control over primary demand. They have been beset by delays in new programs, the drop in demand in general aviation, airlines reducing inventory levels to preserve cash, and excessive inventory levels of stranded parts. Furthermore, since many airlines parked or retired older, less fuel-efficient aircraft during the recession, the average fleet age has dropped significantly, which has had an adverse effect on demand for maintenance, repair, and overhaul (MRO). Looking ahead, suppliers can expect to grow with the OEMs, but they should pay close attention to changes in production levels, fleet mix, and the progress of new aircraft programs. As the commercial aerospace industry gears up for new growth, there are four market trends that are reshaping the marketplace. First, although the rebound in passenger traffic and air cargo suggests we are past the trough and trending upward, airlines are demonstrating remarkable discipline by holding load factors constant and managing their capacity and costs to enhance revenues and margins. Ongoing merger activity and the strengthening of global alliances support these efforts as well. This means that fewer planes are flying now compared to during previous recoveriesand fewer planes in the near term means less MRO activity. Second, the outlook for higher fuel costs and more stringent carbon regulation will force older aircraft out of service and spur demand for new, more fuelefficient aircraft. As a result there will be a structural shift in the aircraft fleet mix across the air transport and general aviation markets that will benefit OEMs and hurt suppliers. Third, MRO growth will be muted. As more older aircraft are put out of service permanently, they will be cannibalized for their parts, so we wont see a spike in spare-part demand. The lower operating costs of newer planes, along with their warranties, will also limit MRO growth. Adding to the pressure will be the desire of airlines for solution providers that can offer integrated MRO products and services to help reduce internal management complexity, lower inventory levels,

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enhance higher aircraft availability, provide greater predictability in operating costs, and increase flexibility in financing options. Fourth, Boeing and Airbus will face stiffer competition from new entrants in the regional and narrow-body segments, including Canadas Bombardier, Chinas Commercial Aircraft Corporation, Japans Mitsubishi Heavy Industries, and Russias Irkut, all of which will attempt to capture market share with lower-cost, more fuel-efficient aircraft. However Boeing and Airbus respond, these new competitors will disrupt the pricing and production stability that has been established under the duopolistic structure, potentially costing both firms billions of dollarseven if they eventually win the battle for market share. Exploiting Change with a Capabilities-Driven Strategy This is no time for aerospace and defense companies to take a wait-and-see approach. Despite market uncertainties, the competitive basis in many segments is changing and could leave some companies behind. In the defense markets, for example, international expansion may become an imperative; in commercial aerospace, OEM design selections could have ripple effects in the industry for years to come. More than ever, companies must look beyond simple point forecasts in an effort to fully understand market dynamics and shifting demand, define and prioritize their strategic choices, and build the underlying systems that will be required to achieve them. The challenge for both defense and commercial aerospace companies will be to earn the right to win in their markets by identifying the emerging opportunities that best match their business models, capabilities, and product and service portfolios. Earning the right to win will vary among individual companies within each market, depending on their particular strengths and capabilities. But a common characteristic of the most successful companies over the long term is their ability to focus and align three basic elements of their corporate strategy: 1. Way to play (business model): How will we face the market and create value for customers? 2. Capabilities system: What capabilities will we need to deliver that value? 3. Product and service fit: What are we going to sell, and to whom? Typically, companies pursue growth by identifying markets they would like to serve, often targeting new markets that are expanding. But our research has demonstrated that the most successful players begin by creating a business model that articulates how they create value for customers and compete in the marketplace. Then they identify and align a set of mutually reinforcing and

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differentiating capabilities and a product/service portfolio that match the business model. This alignment of operating model, capabilities, and product/service mixwhat we call a capabilities-driven strategyenables companies to invest and execute more effectively than their competitors. This is the coherence premium. We believe that defense and commercial aerospace companies canand shouldtake control of their fate, despite uncertain and challenging markets. By aligning the three basic elements of a capabilities-driven strategy understanding how to create value in markets that reward what they do best, developing a coherent set of differentiated capabilities to produce and deliver that value, and targeting market opportunities that properly fit their capabilities and value propositionthey can exert their right to win in the market. *** We hope this letter stimulates your thinking in that regard. In the past, our perspectives have prompted executives to respond with their own thoughts and comments. We would welcome the opportunity to hear your thoughts about future challenges and discuss the steps you might be interested in taking to answer them. Randy Starr Partner randy.starr@booz.com Jono Anderson Principal jono.anderson@booz.com