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New Presidential Executive Order Puts Aerospace and Defense Risk In The Crosshairs 

Quantifying the Scope and Reach of Federal Mandates on Manufacturing and Supply Chain Risk

Co-written by R. Conway Williams, Risk Services

On July 21, the White House announced that “a healthy manufacturing and defense industrial base and resilient supply chains are essential to the economic strength and national security of the United States.”[1] Furthermore, it mandates a review and assessment of this industrial base and supply chain, including specific weaknesses such as “supply chains with single points of failure or limited resiliency.”[2]

In 2016, U.S. Aerospace and Defense (A&D) companies were responsible for $146.4 billion in exports and represented 10.1% of total exports for the U.S.[3] Recognizing that the A&D supply chain is “a matter of national security” (and an important source of jobs), President Trump likely hopes to reduce the role of foreign A&D suppliers in order to reduce the risk engrained in this industry. As a result, we have investigated the U.S. A&D supply chain to quantify the industry’s reliance on foreign suppliers and, specifically, those at risk.

There is a significant amount of credit risk concentration in the industry

Our analysis shows that both specific and country/industry credit risk play a significant role in the U.S. Aerospace & Defense supply chain, displaying risky Probability of Defaults (PDs) considerably below investment grade standards. The risk could be further increased by protectionist measures and the potential for serious trade repercussions caused by tariff reciprocation, amongst other things. In addition, since most of these firms operate in a strong market, it is reasonable to also consider the potential impact of eventual market decline.

A comprehensive analysis of credit risk needs to include the supply chain of the A&D firms and cannot be limited to rated entities

In order to quantify the potential impact on the largest public Aerospace & Defense firms, we analyzed all 27 companies within the Aerospace & Defense industry across the S&P 500, S&P 400, and S&P 600 equity indices. We then aggregated all of their suppliers tracked by S&P Global Market Intelligence and analyzed their geographic distributions and credit risk profiles.

Assessing the risk of the Aerospace & Defense industry
Of these companies, only 19 of the 27 A&D firms and 50 out of their 307 foreign suppliers are rated. Furthermore, 97% of the companies in the riskiest pool of foreign suppliers are not rated.

In order to have a comprehensive view of the risk of this industry, we used the Probability of Default (PD) Model Fundamentals, which is a quantitative credit risk model that is part of the S&P Global Market Intelligence’s Credit Analytics suite. PD Model Fundamentals assesses the risk of a firm leveraging company specific financial information, as well as systemic risk factors that take into account the firm’s industry and country.

Over the past five years, the PDs of these 27 U.S. A&D companies have on average improved, but generally ranged from 0.6% to 1.0% -- this would equate to an implied credit score range of ‘bb+’ to ‘bb.’ [Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD scores from the credit ratings used by S&P Global Ratings. S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence.]

Figure 1

Aerospace and Defence Average Probability of default

These 27 firms had 307 foreign suppliers that were also scored utilizing our PD Model Fundamentals - only 16% (50 out of 307) were rated by S&P Global Ratings. Amongst these firms, we identified 35 foreign A&D suppliers that we believe are most at risk of default. We considered “at-risk” firms as those having ‘ccc+’ or lower implied credit scores (approximating to a 9.637% or higher one year PD).

Only one company in our pool of 35 “at-risk” suppliers is rated, further stressing the need for tools that allow for a globally consistent and generally applicable assessment of credit risk across the rated and unrated universe. These suppliers could be particularly vulnerable if the U.S. A&D supply market is domesticated by President Trump’s policies. Leveraging PD Model Fundamentals has allowed us to assess the risk of a much broader range of suppliers, but also uncover more potential weak links in these supply chains.

Given the technological nature of the A&D industry, most suppliers are based in developed countries with established technology sectors (i.e. France, Canada, Australia, and England). We also found that most at-risk suppliers are in developed countries.

We have broken down the highest concentrations of at-risk suppliers by country in Figure 2.

Figure 2

Total and at risk foreign suppliers

With five of 21 suppliers deemed at-risk, Canada has the largest number of U.S. A&D suppliers identified out of all of the countries we analyzed. While companies like Boeing have requested tariffs on Canadian A&D imports, President Trump seems unlikely to execute such protectionist measures, particularly in light of Canadian Prime Minister Trudeau’s recent threats to reciprocate A&D sanctions.

In India, 30.8% (4/13) of suppliers are at-risk, three quarters of which provide industrial and commodities goods. Firms based in India are particularly interesting because India’s sovereign rating from S&P Global Ratings is ‘BBB-‘. However, its country risk score, which S&P Global Market Intelligence determines based upon the risk of doing business in a country, is two notches lower at ‘bb‘ -- second lowest only below Russia, which is scored as ‘b+’ relative to a sovereign rating of ‘BB+’.  This negatively impacts firms operating within India as this systemic risk factor is considered by the model when assessing a firm’s credit risk.

Other notable countries include the United Kingdom, which has three at-risk suppliers (7% of its suppliers), but it is worth noting that the creditworthiness of British exporting companies could potentially decrease in the event of a “Hard Brexit” due to a decline in exports. For example, as illustrated in Figure 3, before Brexit was in play (preceding the Conservative Party win in the May 2015 UK General Election, with the commitment to holding a referendum on leaving the EU), British A&D firms were less risky than their industry peers by about 0.5%. However, in the past two years their relationship has reversed with an increase in relative riskiness of up to 1%.

Figure 3

Average aerospace and defense probability of default british vs global firms

One third (4/12) of Israeli suppliers are at-risk, all of which specialize in the Technology or A&D sectors.  Finally, Australia has three at-risk suppliers, amounting to 23% (3/13) of its total.

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Interestingly, none of the 12 Chinese A&D suppliers in our sample have risky PDs. Each Chinese supplier is also better than its particular “Industry and Country Benchmark” (the median PD for an industry in a particular country). This is potentially reflective of the growing Chinese Aerospace/Defense market, driven by increased militarization and commercial air travel in the region.

As shown in Figure 4, among all foreign suppliers (every industry that we analyzed included), we observe a relatively normal distribution of credit scores.

Figure 4: Overall Credit Quality of Foreign Suppliers (All Industries):

Overall Credit Quality of Foreign Suppliers (All Industries)

Source: S&P Capital IQ platform as of August 9, 2017. For Illustrative Purposes Only. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD scores from the credit ratings used by S&P Global Ratings.

In investigating industry-specific concentrations of risk, the most at-risk foreign suppliers (10) are found in the A&D sector itself. These at-risk A&D suppliers cause a notable spike in the credit scores of at-risk companies, as seen in Figure 5 below.

Figure 5: Credit Quality of Foreign Aerospace & Defense Suppliers

Credit Quality of Foreign Aerospace & Defense Suppliers

Source: S&P Capital IQ platform as of August 9, 2017. For Illustrative Purposes Only. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD scores from the credit ratings used by S&P Global Ratings.

Protectionist measures to revamp the U.S. Aerospace & Defense supply chain could carry serious trade repercussions of tariff reciprocation, amongst other things. But even if the supply chain remains unaltered, the aforementioned firms, nonetheless, display risky PDs considerably below investment grade standards. Because these firms are operating in a strong market, it is reasonable to consider the potential impact of eventual market decline. In such a case, these supplier firms will then also be at particular risk if they do not improve their creditworthiness.

We have focused on concentrations of at-risk suppliers among different industries and countries. However, it is worth noting our general observation that such risky firms often stand in stark contrast to their more successful peers. The ability to differentiate between healthy and risky firms is paramount in assessing the risk of the Aerospace & Defense industry, or any other industry, and their supply chains.

Which 35 firms topped our list of “At-Risk” Suppliers? Contact us to learn more.

Want to learn more about the PD models that the authors highlight in this piece? Request a demo.

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[1] Source: Presidential Executive Order on Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States as of August 9, 2017.

[2] Source: Presidential Executive Order on Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States as of August 9, 2017.

[3] Source: Deloitte.  2017 US aerospace and defense sector export and labor market study.

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