UK Precision Engineering following Brexit

 

Cyrus Investment Management LLP  

Arjun Saini & Hal Cullity

This report analyses the impact of Brexit on the UK’s Precision Engineering sector. The report finds that this sector has little to no downside exposure to Brexit and in the current environment Precision Engineering may even hold upside potential. The analysis is based on an evaluation of the major key sectors which Precision Engineering companies supply: Aerospace, Defence, Security and Nuclear. Each sector’s expected performance given Brexit is considered along with analysis on their respective supply chains to evaluate UK Precision Engineering as a whole. Each sector has unique traits protecting it from Brexit risks such as Aerospace’s backlogs, Defence’s strategic importance in a period of heightened global security risks and the Nuclear sector’s long-awaited update. These industries have grown impressively and outperform major indices. The UK’s strong reputation in these sectors and the dominance of the UK in global supply chains and export markets paints a bright picture for Precision Engineering.

Executive Summary  

Following the result of the June 23rd referendum on membership of the European Union in which the UK voted to leave the EU, the implications of a Brexit on UK industries have been repeatedly questioned. A lack of specific insights into the state of negotiations between the UK and EU along with the near-zero probability of Article 50 of the Lisbon Treaty being invoked before 2017 means there is more room for speculation than supported analysis when evaluating British sectors. Many critics have warned of the downside risks Brexit could hold for the UK Manufacturing sector. Given recent events affecting the core industries Precision Engineering companies supply, the strong presence and performance of the UK in these sectors as well as future growth opportunities, Precision Engineering appears to have very little exposure to Brexit. Some of the key sectors for Precision Engineering (Aerospace, Defence, Security and Nuclear) all have good prospects for the coming years which can serve as a good indicator for their supply chains that include UK Precision Engineering companies. Since September 2003 The FTSE 350 Aerospace and Defence Index has outgrown the FTSE 350 by 151 percentage points.

This report will consider the current state and forecast performance of the aforementioned sectors globally, and with some specific consideration towards linkages with the UK and the Precision Engineering market. Each industry possesses unique factors that establish the case for little to no interference to Precision Engineering resulting from Brexit, and potentially certain upsides.

Overview  

In 2015 the UK’s Aerospace sector generated £31.1 billion in revenue having grown 39% since 2010 and employing 128,000 direct employees. 87% of this revenue was obtained via exports, as the UK’s Aerospace sector is Europe’s largest and second largest globally with 17% of the global market (the USA leading). Growth of this sector in the UK is expected to continue with 56% of firms expecting growth above 10%. A useful starting point for analysis is the Farnborough Airshow that took place in mid-July immediately following the referendum. This bi-annual trade show is used to gauge global industry sentiment and trends. Airbus obtained $35.0 billion in orders and Boeing followed with $26.8 billion in 2016’s show. While this has fallen from Airbus and Boeing’s 2015 Paris Air show orders ($57.0 billion and $50.2 billion respectively), this has been an ongoing trend as both manufacturers have suffered from extremely long backlogs in their order books: consequently new orders are being curtailed to adjust for slower delivery rates.

Thus data on deliveries is in this respect a better indicator for industry health. Boeing and Airbus’ deliveries for commercial aircraft (674 in H1 2016) have been very closely in line with H1 2015. This will likely continue as the industry’s total backlog of 13,232 aircraft would be cleared in just less than 10 years if current delivery rates were maintained and no further orders placed, and engine deliveries face a similar schedule to deliver their backlog of 21,980 engines. This poses an approximate value of £170-£195 billion for the UK, and by this point Brexit risks (if any) would be a distant memory: In effect the backlogs will be a cushion of demand for the sector throughout and long after Brexit negotiations, counteracting instability generated from trade uncertainty.

Aerospace  

Looking towards growth, Deloitte’s 2016 Aerospace Sector Outlook expects aircraft deliveries to increase consistently over the next two decades, likely a response to anticipated greater traffic with passenger and freight traffic forecast to have average annual growth rates of 4.6% and 4.4% respectively until 2035. Another cause is the necessity of meeting demand for products: 73% of Aerospace companies cite existing business as a main driver of growth. The UK’s dominance in Aerospace supply chains and as an attractive investment location should be a useful asset to domestic Precision Engineering companies. 64% of companies surveyed in ADS Group’s 2016 Aerospace Intelligence Survey reported the UK as an active supply chain location and 78% of companies intend to invest further in the UK. The UK’s Precision Engineering sector is thus well positioned to provide bespoke solutions, especially given their favourable location: the PwC 2015 Global Aerospace Manufacturing Attractiveness Index ranked the UK 5th overall. This suggests that the UK’s position in Aerospace is defended from overseas substitution in supply chains, helped further by Sterling’s depreciation following the referendum. Additionally Boeing responded to the referendum vote stating that it intends to boost its existing investment in the UK and they will continue to broaden their UK supply chain.

Political support for Aerospace in the UK is also positive. Greg Clark, the newly appointed Secretary of State for Business, Energy and Industrial Strategy, is reported to take a more determined approach in supporting industry and he has talked with senior executives at the Farnborough Air Show. Clark’s predecessor Sajid Javid announced £365 million of funding for new Aerospace technologies in July 2016 in addition to the £1.2 billion already invested into the sector which has involved over 100 SME’s. By 2026 nearly £4 billion will be invested into Aerospace.

The UK Defence sector generated £24 billion in revenue in 2015, registering 18% growth since 2010 and possessing 142,000 direct employees. The UK is a substantial exporter of Defence delivering equipment and national security services, exporting £7.7 billion in 2015 (equivalent to 32% of revenue). The Security sector is smaller than Defence posting £9 billion revenue and export sales of £4 billion, but it is growing at a faster rate: the sector is 65% larger than it was in 2010 and employs 76,000 people directly. With respect to Precision Engineering, Defence is arguably the more important sector of the two given significant overlap with Aerospace activities, thus Defence will be the focal point of this section. However, certain niche products within Security such as Access Control Systems can make use of Precision Engineering products. The demand for Defence and Security is principally driven by countries’ need to protect themselves and the consequent search for appropriate tools to do so. A useful broad indicator for demand is global threat levels which at present suggest a positive outlook for these sectors, reflecting a period of heightened national security risks.

Domestically, increased demand for Defence and Security is likely with MI5 rating the current threat level in the UK from international terrorism as Severe (this is the second highest level). The latest review from the Ministry of Defence on national security and strategic defence laid out several

Defence & Security

expansions to armed forces equipment that are relevant to the Precision Engineering sector: the report states that an additional F35 squadron (12 aircraft), two further Typhoon squadrons (24 aircraft) and nine Maritime Patrol Aircraft will be purchased. This reflects the UK’s continued objective to meet the NATO target of spending 2% of GDP on Defence, and in the wake of the referendum this April the government set the objective to increase Defence spending by 0.5% above inflation for the next 5 years. This is the first increase in real terms in 6 years, and a change in direction from the 2010-2014 trend when Defence spending was falling. Adding in planned budget additions from the Joint Security Fund, the MoD’s Defence budget will increase by 13-16% to £39.7 billion by 2021, closing in on the 2010/2011 high of £41.3 billion.

This increase in government spending should feed through to Defence companies directly, with ADS Group’s 2016 Industry Intelligence Survey finding 48% of firms in Defence expect growth in excess of 10%. The survey also reveals many industry similarities to Aerospace. The UK is again a hub for Defence supply chains and investment: 65% of respondents have supply chains located in the UK and 78% of respondents are investing into the UK. 66% of UK Defence companies also report that none of their production has occurred outside of the UK since 2013. Crucially 18% of companies responded that they are not confident with their access to design and engineering skills, and as a result the UK’s Precision Engineering sector can again benefit from filling this gap.

Looking at the Defence export market, the UK holds 12% of all Defence exports, comfortably maintaining a strong position. From 2006-2015 the UK exported $122 billion, making the UK the second largest Defence exporter globally with the US taking a comfortable lead at $236 billion, as expected. The Middle East is the dominant export region for the UK receiving 63% of the UK’s 2015 exports. As mentioned there is considerable overlap between Defence exports and the Aerospace industry, with 85% of export contracts based around this sector from 2006-2015. The UK’s expertise combined with Sterling depreciation will support exports and Precision Engineering down the supply chain. However, UKTI has highlighted that global exports can fluctuate year to year depending on the global environment.

The UK’s Security exports stand at £4 billion in 2015 compared to Defence’s £7.7 billion, but the industry is growing and Security export growth could reach 9.7% in 2020. Given the dominance of Cyber Infrastructure in Security services the involvement of Precision Engineering is limited. Despite this, in previous reports CIM have highlighted products such as Access Control Systems (worth 6% of the UK’s 2015 Security exports) which can involve bespoke engineering solutions. Ultimately for such strategically important sectors, the referendum vote will have a minimal impact on the UK’s ability to win foreign Defence and Security contracts given our prevalence and expertise. With continued demand for Defence products both within the UK and across the globe combined with the UK’s favourable export statistics, the effect of Brexit on Precision Engineering though this channel is negligible.  

The UK currently has 15 nuclear reactors generating 70 TWh of electricity in 2015, 20.7% of the UK’s electricity output, and critically half of this capacity is due to be retired by 2025. To compensate, three units are planned to begin operations in 2025 and 10 more units will follow over the next decade to develop 18 gigawatts of new nuclear power, which should support 30,000 new jobs across the UK through the supply chain.

As an industry with discrete projects as opposed to continuous orders, the primary factor affecting Precision Engineering is the construction of the projects above and the decommissioning process of the existing facilities. Decommissioning the current plants is guaranteed as they reach the end of their lifespan. Evaluating future projects following the referendum requires consideration of the Government’s position on nuclear power, as well as the positions of private companies financing these projects.

Operating  Sites

UnitPresent  Capacity  (Gross  MWe)

First  Commercial  Operation

Expected  Shutdown  

Hinkley  Point  B  1&2 1310 1976 2023Hunterston  B  1&2 1288 1976 2023Hartlepool  1&2 1310 1989 2024Heysham  I  1&2 1250 1989 2024Dungeness  B  1&2 1230 1985 2028Heysham  II  1&2 1360 1989 2030Torness  1&2 1364 1988 2030Sizewell  B 1250 1995 2035

Planned  and  Proposed  Sites

UnitPlanned  Capacity  (Gross  MWe)

Construction  Begins   Start  Up

Wylfa  Newydd  1 1380 2019 2025Wylfa  Newydd  2 1380 2019 2025Moorside  1 1135 2019(?) 2025(?)Hinkley  Point  C  1 1670 2019 2026Moorside  2 1135 -­‐ 2026(?)Hinkley  Point  C  2 1670 2020 2027Moorside  3 1135 -­‐ 2027(?)Oldbury  B  1 1380 -­‐ late  2020sOldbury  B  2 1380 -­‐ late  2020sSizewell  C  1 1670(?) -­‐ -­‐Sizewell  C  2 1670(?) -­‐ -­‐Bradwell  B  1   1150 -­‐ -­‐Bradwell  B  2 1150 -­‐ -­‐Source:  World  Nuclear  Association  UK  Country  Profile

Nuclear Energy  

Firstly, decommissioning is a valuable process for the sector as a whole and for Precision Engineering, especially given that this process faces no Brexit disruptions. In 2012 that National Audit Office estimated that the total costs of decommissioning were approximately £100 billion and the Nuclear Industry Association estimates the decommissioning programme is worth £1.5 billion a year to the UK supply chain. Amber Rudd, UK Secretary of State for Energy and Climate Change, states that the referendum has not changed the government’s ambition to develop new nuclear power stations and meet climate change goals. Rudd affirms the government’s aim to develop 18 GW of nuclear power across the six sites outlined above and support thousands of jobs across the supply chain throughout the construction period. In this case actions could speak louder than words: A final decision from the UK government on Hinkley Point C this autumn would clear a significant hurdle for the project and indicate the UK’s commitment to nuclear development. Given the surprise in the government’s decision to delay judgement it would be unwise to assume that a go-ahead is guaranteed. The delay could simply result from the desire of a new cabinet to assess the project themselves, although The Guardian and the Financial Times have noted that PM Theresa May could be holding Hinkley Point C as a bargaining chip for future Brexit negotiations with France. From the private sector perspective, statements following Brexit have been unanimously positive indicating a strong future for the development of the new sites. According to Reuters, EDF Chairman Jean-Bernard Lévy stated that the Brexit Vote has no impact on EDF’s strategy or their commitment to the Hinkley Point C projects. Successfully navigating the Hinkley C project should allow EDF to develop more concrete plans for the Sizewell C power station. In addition to taking a 33.5% stake in Hinkley Point C, China General Nuclear Power Group (CGN) agreed provisionally in October 2015 to develop the Sizewell and Bradwell sites alongside EDF. CGN will take a 20% stake in Sizewell C and a 66.5% stake in Bradwell B. China is extremely positive about their involvement with the UK’s Nuclear sector: In August ambassador Liu Xiaoming wrote “the UK could not have a better partner than the China General Nuclear Power Corporation”. NuGeneration (a joint venture between Toshiba and Engie) said its Moorside projects are unaffected by the referendum: “We firmly believe the case for new Nuclear power stations for the UK is compelling, and unchanged as a result of the referendum.”

Horizon Nuclear Power says it will assess the wider impacts of Brexit on the development of the Wylfa Newydd and Oldbury sites, nonetheless they also state “the UK needs secure, affordable, low carbon electricity as much today as it did yesterday”. As highlighted in CIM’s earlier report the Precision Engineering sector supports the construction of nuclear projects. The Nuclear Advanced Manufacturing Research Centre (NAMRC) ‘Fit For Nuclear’ Programme allows nuclear new-build developers to identify potential supply chain companies. The programme is aimed at a core area of high-precision mechanical engineering. Currently their website lists 99 companies that have completed the programme of which 21 are identified as specialist providers of precision-engineered or bespoke components. The current estimates for constructing the Hinkley Point C, Wylfa Newydd and Moorside units is £42 billion, and these reactors constitute 53% of the planned gross capacity of the 13 proposed new nuclear sites. This presents a substantial opportunity for the UK’s Precision Engineering companies. The only barrier that Brexit poses on the Nuclear sector is the potential for the Government’s approval of Hinkley Point C being repeatedly deferred to retain the project as a bargaining chip in negotiations, slowing the pipeline for future projects. However pressure continues to mount: no nuclear power stations have been constructed in the UK for 21 years and many reactors are reaching their final operational years. With nuclear power contributing strongly to electricity and total energy generation, this energy source will continue to be important for the UK through and beyond Brexit talks.

Total Energy - Indigenous Production of Primary Fuels

Coal

Oil

Gas

Nuclear

Renewables

Source: DECC Total Energy Statistics (DUKES)

•   UK Trade and Investment: Defence And Security Export Statistics for 2015 •   ADS Group: UK Defence Outlook 2016 •   ADS Group: Economics Briefing, Commercial Aircraft & Engine Data

(25/07/16) •   ADS Group: 2016 Industry Facts and Figures •   ADS Group: UK AerospaceAerospace Outlook 2016 •   Airbus: Global Market Forecast, Mapping Demand – 2016/2035 •   BDO: The Aerospace Report, July 2015 •   Cyrus Investment Management: Sector Intelligence Report – The UK

Nuclear Sector •   Cyrus Investment Management: Sector Intelligence Report – The UK

Security Sector •   Intelligent Partnership: Alternative Investment Report – Precision

Engineering Report 2015-16 •   Deloitte: 2016 Global Aerospace and Defence Sector Outlook •   HM Government: National Security Strategy and Strategic Defence and

Security Review 2015 •   PwC: 2015 Aerospace Manufacturing Attractiveness Rankings •   HM Government: The UK’s Nuclear Future •   Nuclear Decommissioning Authority: Insight Into Nuclear Decommissioning

(Issue 13, 2014) •   This Is Money: American aircraft maker Boeing: Leave vote won't stop us

investing in UK and we will continue to broaden our supply chain •   Financial Times: Boeing and Airbus face mammoth task to clear order

backlog (Peggy Hollinger, June 12 2015). •   Financial Times: UK to close Aerospace deal at Farnborough despite EU

vote (Peggy Hollinger, July 11 2016). •   The Telegraph: Britain’s high-flying Aerospace sector hits record order book

(Alan Tovey, 28 August 2014). •   Theengineer.co.uk: How the UK Aerospace industry can fly post-Brexit

(Barry Warburton, August 16 2016). •   The Telegraph: Mapped Terror threat around the world (Oliver Smith, 15

July 2016) •   DefenceNews: NATO Says UK To Stay ‘Strong’ Ally Despite Brexit •   Airbus: Press Centre – Airbus wins $57 billion of aircraft orders at Paris Air

Show 2015 (18 June 2015) •   Boeing: News Releases - Boeing, UK Government announce long-term

initiative for prosperity and growth (July 11 2016) •   Gov.uk: Press Release – New Aerospace technologies to get £365 million

funding (The Rt Hon Sajid Javid MP, 12 July 2016) •   The Guardian: UK Defence spending to be kept at 2% of GDP (Ami Sedghi,

8 July 2015) •   NAMRC: http://namrc.co.uk/intelligence/decommissioning/

References  

•   Gov.uk: Defence budget increases for the first time in six years (Ministry of Defence and The Rt Hon Michael Fallon MP, 1 April 2016)

•   The Guardian: why have ministers delayed final approval for Hinkley Point C? (Graham Ruddick, 29 July 2016)

•   ITV: Moorside Nuclear plans unchanged following Brexit (27 June 2016) •   Reuters: EDF says committed to Hinkley Point following Brexit Vote (Geert

De Clercq, 24 June 2016). •   World Nuclear News: (Full text of speech by Amber Rudd, UK Secretary of

State for Energy and Climate Change) UK remains committed to low-carbon strategy (29 June 2016)

•   World Nuclear Association: Nuclear Power in the United Kingdom (accessed version updated last on 10 August 2016).

•   World Nuclear News: The Brexit effect on UK Nuclear (24 June 2016) •   Energypost.eu: Nuclear energy in the UK after Brexit (Dan Yurman, 5 July

2015). •   Financial Times: Hinkley Point is a test of mutual trust between UK and

China (Liu Xaoming, China’s ambassador to Britain, 8 August 2016)