Canadian Defence Review

September 12, 2015

Ontario Aerospace and Defence Report 2015
The continued fall in the Canadian dollar is changing the competitive landscape in Ontario’s defence industry. Sensing export opportunities, SMEs are clamoring to get in. However legacy Harper Government regulations remain a barrier.

Profiles of Ontario’s aerospace and defence sector typically share a similar challenge. Canada’s largest province in population and economic terms, also hosts most of the major industry players. Companies as varied as General Dynamics, Lockheed Martin, L-3 Communications, Raytheon as well as Defence Research Development Canada, Canadian Commercial Corporation and many other organizations have significant presences there.

As if that were not enough, Ontario is also home to the nation’s political and economic capitals (Ottawa and Toronto). In short, profiles of Ontario’s aerospace and defence sector often tackle many of same themes as profiles Canada’s defence sector as a whole. This past year has been no exception. Uncertainty surrounding the October election, the new government’s proposed actions on the defence front, and, most importantly, shifts in the overall economy, are top of mind. Yet industry players we spoke to are broadly bullish.

“Ontario is a great place to do business,” says David Fraser, chief operating officer at INKAS Armored Vehicle Manufacturing, which operates a production facility just outside of Toronto that houses a significant portion of its 200 employees. “Our central location means that we are closely tied in with the sector’s key players and we build off each other’s skills and strengths.”

Hard hit manufacturing could bounce back
However Ontario differs from other provinces in one major respect. The province’s role as Canada’s manufacturing hub leaves it in an ideal position to disproportionately benefit from one of the most dramatic economic shifts in decades: the nearly 30 percent drop in the Canadian dollar relative to the greenback during the past four years. By mid-September, the drop, which included an 18 percent plunge during the past 12 months, had the loony trading in the USD $0.75 range. By making Canadian exports cheaper in US dollar terms, and imports more expensive in local currency, the shift has drastically altered the Canadian defence sector’s competitive landscape.

The stakes for the province are high. Ontario houses the core of the country’s defence industry, both in terms of production facilities and military installations, which include CFB Petawawa, Canada’s largest military base. The province’s 13.7 million inhabitants and $720 billion share of Canada’s gross domestic product, give it huge political and economic clout. In short how Ontario defence players adjust to the new currency dynamic will affect the industry’s competiveness, and thus its future, both there and across the country.

At first glance, the loony’s plunge should be great news for defence production facilities, many of which, such as L-3 WESCAM, whose 350 Burlington and Don Mills-based employees, manufacture stabilized, multi-spectrum imaging systems, export the lion’s share of their production. The US market, which absorbs 80 percent of Ontario’s manufacturers’ shipments, is particularly important in that respect.

INKAS: Exporters win, importers hit hard
However other markets are also affected by the new currency environment. For example INKAS, which recently inked a deal to sell its new Sentry Armoured Personnel Carriers to Nigeria, also benefits, because the results of international defence tenders are almost all evaluated in US dollar terms.

According to Fraser, who served as a major general in the Canadian Armed Forces prior to joining INKAS, the company has been further boosted by the fact that reaction to the Sentry, which it bills as a “tactical attack and defence vehicle,” has been strong. “Many countries face domestic threats from their local populations that are just as serious, if not more so than those from foreign countries,” said Fraser. “Our equipment helps them tackle those challenges.”

The fall in the loony could not have come at a better time for Ontario’s manufacturing sector, which has been brutally hit by globalization during the past decade. Total employment in the sector, which fell by 28% during the past ten years to 748,000 jobs in 2014, appears to have bottomed out so far in 2015.

However Ontario’s defence sector manufacturers have been hit particularly hard. Harper Government cuts in defence readiness have been echoed south of the border and across much of the developed world. Getting precise figures on how defence players will be affected by the currency swings is not easy. Numerous economists, and industry leaders, such as the Ontario Aerospace Council, contacted by CDR, did not respond to requests for on-the-record comments.

An initial assessment, based on back-channel discussions with industry leaders, suggests that defence manufacturers, particularly those with long-term sales contracts priced in US dollars, and which incur costs in loonies, (a typical profile among exporters) should benefit.  

The currency shifts, combine with another competitive advantage accruing to Canadian defence exporters: new “Obama care” regulations, which imposes huge healthcare costs on their US competitors. The fact that three of Ontario’s five top export categories (motor vehicles & parts, mechanical equipment and electrical machinery), include defence-related goods, provides further indication of potential upside for the industry.

However defence related products are by definition “sticky.”  When a country goes to war it needs kit and during those times price becomes somewhat less of an issue. According to Fraser, rising global unrest, plus the increase in civil, as opposed to state-on-state actions, are boosting demand for INKAS’s protective vehicles. As such, the currency swings pose less of an opportunity for the company than they might otherwise have.

DND procurement costs could rise on imported goods
On the other hand, the weak loony, if it persists, will make imported goods, such as the 65 Lockheed Martin F-35 Lightning II fighter jets, that the Harper Government had been hoping to buy, substantially more expensive. Neither Public Works and Government Services Canada nor Lockheed have released any information as to how the currency swings would affect the projected procurement, which is now under review.

However initial speculation suggests the effects could be significant and could put the fighter jet purchase, which would almost certainly be priced in US dollars, in jeopardy. Worse for the plan’s proponents, such as the Canadian JSF Industry Group,  the relative cost of alternate options, such as further upgrades and life extension work to Canada’s existing CF-18 Hornets, has decreased, because much of the work could be done by Canadian workers, and thus priced in cheaper Canadian dollars. This will leave the Canadian JSF Industry Group with the additional burden of outlining to the government an attractive F-35 purchase value proposition that takes into account the new currency environment.

Similarly, much of the “metal banging” to be done in Canada’s projected National Shipbuilding Procurement Strategy projects, (programs which will spur considerable industrial and regional benefits work in Ontario), would also be priced in loonies. Mitigating this, many inputs in the vessels, such as software and components in the navigation and fire control systems, will almost certainly be priced in US dollars.

In short, the fact that experts are reluctant to comment on how the falling loony has affected Canada’s defence industry, should hardly come as a surprise: the impact appears to differ depending on the contractor involved and the specific product or service supplied.

General Dynamics Land Systems: a new push in Australia
General Dynamics Land Systems, which produces the backbone light armored vehicles used by the Canadian Armed Forces, and is thus one of the country’s defence sector’s most important original equipment manufacturers, provides a perfect example of the challenges involved in estimating the opportunities and threats that a cheaper loony spurs.

According to Doug Wilson-Hodge, its manager of corporate affairs, the Light Armored Vehicle manufacturer ships more than 80 percent of its production outside of Canada. However that total would presumably change somewhat if the company’s recent teaming with Thales, to bid on new work in Australia proves successful.

GDLS, whose financial results are included with those of its parent company, and are thus not reported individually, would not comment on the currency swings, whose impact on the company is thus hard to measure. What we do know is that the large contracts that GDLS concludes tend to be long-term in nature. That suggests the company may hedge against the impact of currency swings. On the other hand, currency hedges rarely extend more than a year or two, while sales contracts extend far further. The effect that currency swings have on GDLS, thus would presumably depend on the work that it is bidding on, the nature of the deals and the hedges already in place.

DRS: a key part of the LAV supply chain
Steve Zuber, vice-president and general manager of DRS Technologies Canada, for his part, is categorical about the effects of the recent currency swings. “The fall in the Canadian dollar makes our manufacturing labor rates more attractive for export opportunities,” says Zuber.

During the past year, DRS won a contract from GDLS for the provision of a Light Armored Vehicle situational awareness surveillance system, which includes EO/IR cameras placed around the vehicle. Were GDLS to include DRS components in vehicles that it exports, it would also benefit, as these parts are now cheaper in US dollar terms.

However Zuber admits that gains from a weaker loony need to be weighed against less positive trends. “The protracted (Canadian) procurement processes and constrained budgets, means that defence capital spending will not likely increase over the next few years. Significant programs such as the Canadian Surface Combattant and Next Generation Fighter capability are still years away.”

IMT: customers not sure if the currency swing is for real
According to Remo Assini, president of IMT, the other key unknown in measuring the impact of loonie’s fall relates to the fact that the costs and benefits have not yet fully flowed through the system. “On balance for us the change has been positive,” says Assini. “But customers are unwilling to fully take advantage of it. The last thing they want to do is to change suppliers, only to have the loony bounce back up again.”
Like almost all Canadian defence contractors, IMT, whose Ingersoll and Port Colborne facilities supply medium and large caliber ammunition and other components to the Canadian and US Armed Forces, has been hit hard by government procurement cutbacks in defence readiness allocations.
However unlike many other players, IMT has been able to boost sales at its commercial division, to make up the slack. For example the cheaper loony recently helped IMT win back a contract to build an automotive part (which the client had previously awarded to a Chinese competitor), though Assini also credits IMT’s quality and the proximity benefits local clients get when they deal with local suppliers, as reasons for the win.
SODA: battling the controlled goods handcuffs
One new player that is increasingly making its presence felt on the provincial scene, during the past few years has been the Southern Ontario Defence Association. When Henrik Noesgaard, the association’s president took over the role, he vowed to build on the organization’s momentum in fulfilling its main mission: to help increase innovative small and medium sized business’s contribution to the country’s defence.

By all accounts, Noesgaard is succeeding. SODA’s “Made in Canada,” event, held earlier this year, to bring together the organization’s 40 or so SME members and other firms interested in doing business in the defence sector, with larger prime manufacturers and systems integrators such as Oshkosh, Mercedes-Benz, Colt Canada and many others, attracted nearly 200 people. According to Noesgaard, who does contract work for Mgmt2Go, a consultancy, for his day job, the Association’s move of the event’s location from Toronto, where it was held last year, to London, where the 2016 version will also be held, generated considerable positive response.

Another area in which SODA continues to push is in raising public awareness about the increasingly negative affects that legacy Harper Government controlled goods regulations, are having on defence manufacturers. According to Noesgaard while the US has moved to reduce the impact of controlled goods regulations, Canada’s regulations have led to the rise of a substantial bureaucracy and other interest groups that earn their living off of the resulting paperwork and the spurious rules that such initiatives tend to generate.

One example: according to one industry insider, in order to do sub-contract work on controlled defence goods, a company needs to be registered in the Canadian Controlled Goods Directorate. However a company cannot get registered unless it already has controlled goods related work. These kinds of circular logic, which are typical in large bureaucracies, are anathema to SMEs, and provide huge barriers to entry. The direct costs involved, which according to one expert appear to average about $300 per employee are another significant hindrance. “Canadian controlled goods restrictions penalize industry, stifle innovation and end up raising costs at the Department of National Defence,” says Noesgaard. “They no longer perform any useful function and they need to go.”

OMX: Value propositions spur new capital, software upgrades
Another company that clearly stands to benefit from recent developments is OMX, which its president Nicole Verkindt, bills as a “secure, subscription-based, industry-led software platform, for connecting businesses in the international defence, aerospace and security industries.” Demand for the company’s services has skyrocketed in the wake of new federal government Industrial and Technical Benefits guidelines that require defence contractors that want to sell to the Canadian government, to demonstrate a tangible value proposition.

OMX clients include many foreign based defence contractors who want to prepare attractive value propositions as part of their sales efforts, or who need to connect with Canadian businesses to help fulfill their ITB requirements. OMX technology helps clients to track and document the degree to which they are succeeding in such efforts. The good news is that many of OMX’s sales are in US dollars, though costs related to the company’s 12 employees (up from four last year), are in loonies. That means the company wins two ways from the recent currency swings. Investors, not surprisingly, have taken notice. Earlier this year the company raised an additional $1 million in venture capital, including $250,000 from FedDev.

Moving forward: innovation remains key
Lee Obst, who is managing director of Rockwell Collins Canada, and a long-time industry player, sees the broad overall trends in the defence sector favourably. Although he concedes that “government demands for a balanced budget, decreased oil prices and the falling exchange rate have led to delays in government/ military procurement,” Obst nevertheless expects large capital programs, such as the Fixed Wing Search and Rescue Aircraft, NSPS and the next generation fighter to drive DND spending. As such he characterizes the sector’s outlook as “positive” during the next three to five years.

Obst’s optimism has been no doubt influenced by progress at Rockwell Collins’s operations. In addition to booking a slew of orders from DND and on the international stage, during the past year the communications, avionics, simulation and training systems provider rolled out its TruNet radios. Rockwell Collins bills the product suite as “the first software defined network communications solution that includes ground, airborne and handheld radios.”

In short, although the cheaper loony will be a huge boon to Ontario, the degree to which this will spill over into the country’s defence sector is unclear, due in part to differences throughout the sector’s business model. Exacerbating this complexity is the fact that a large part of the Canadian manufacturing industry’s past decline was related to union-inflated salaries and inflexible and unproductive workforces, particularly amongst low-skilled and semi-skilled workers.

The fall in the loony helps to rectify that trend, as does the increasing technical nature of current defence production technology, which makes it easier to justify higher wages. That combined with the fact that defence forces, by definition, are always trying to seek advantage, will continue to drive innovation going forward.

It’s yet one more trend that applies to both Ontarian and Canadian defence suppliers.

*****

Highlight this quote:
“Canadian controlled goods restrictions penalize industry, stifle innovation and end up raising costs at the Department of National Defence.”
Henrik Noesgaard, president, Southern Ontario Defence Association



Sidebar: Key Ontario aerospace and defence sector capabilities*
•    Complete aircraft production  
•    Integrated equipment and environmental control systems
•    Landing-gear systems and turbine jet engine
•    Specialized services and maintenance
•    Repair and overhaul
•    Unmanned Aerial Vehicles (UAVs)
•    Military and surveillance equipment
* Canadian Trade Commissioner Service



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