Aerospace & Defense Stock Overview - Aug. 2011

The growth of the Aerospace and Defense industry depends largely on the spending outlook of government departments, with the U.S. defense budget being the primary driver. The U.S. is the world’s largest aerospace and defense market, and also home to the world’s largest military budget.

In 2010, the total global defense expenditure of $1.6 trillion grew 1.3% from 2009 levels in real terms. The majority of this growth came from the U.S. Defense spending, which was $698 billion in 2010, accounting for roughly 43% of the global total.

The U.S. defense budget for 2011 is $670.8 billion, out of which the base budget comprises $513 billion with another $157.8 billion approved as supplementary defense spending mainly to fund the wars in Iraq and Afghanistan.

Given the growing debate over deficits and spending cuts, the outlook for defense outlays remains quite uncertain. The Congressional Super Committee was tasked by the debt-ceiling deal to look for at least $1.2 trillion in spending cuts over the coming decade from all sources. In fact, if the committee is unable to come to an agreement, then automatic cuts would ensue, with a significant portion of the cuts from the Pentagon budget.

The fiscal 2012 defense appropriate bill passed by the U.S. House of Representatives for $649 billion defense bill includes $530 billion for core spending, reflecting a growth of 3.3% from the fiscal 2011 level. However, the bill signficantly trims supplementary defense spending to $119 billion, a sharp 24.6% decline from fiscal 2011.

Since the September 2001 attacks, the U.S. government has spent significant amounts on military campaigns overseas. The country has already decided to gradually move out of Iraq and Afghanistan, which is expected to lower its expenditure on foreign campaigns. However, U.S. military involvement in Libya as part of the NATO-led coalition and its clandestine military operations in other nations as part of anti-terrorism operations will continue to continue to add to foreign war expenses. However, the overall trend in overseas military spending is unmistakably to the downside.

Defense spending is the major source of revenue for the top nine global aerospace companies. But with the U.S. government expected to institute greater austerity in its defense budget going forward, defense companies will need to source more orders from global clients. The geostrategic significance of the industry and the related heavy export restrictions will come in the way, to some extent, of those marketing efforts by U.S.-based operators.

OPPORTUNITIES

Lockheed Martin Corporation (LMT - Analyst Report) was the biggest recipient of U.S. defense contracts in 2010 with orders worth $35.9 billion, followed by The Boeing Company (BA - Analyst Report) and Northrop Grumman Corp. (NOC - Analyst Report). The big operators, in order to counter the expected defense budget cuts, will most likely target mergers and acquisitions to bolster their operating prospects.

At the macro level, a gradual shift in defense spending patterns can be discerned. In response to the asymmetric terrorist threats, the emphasis appears to have shifted to high-tech intelligence equipment, replacing demand for conventional big guns and heavy armor. The major industry players have, in response, resorted to bolt-on acquisitions to plug gaps in their product offerings.

Acquisitions

The U.S. defense companies went on an acquisition spree in 2010, with 255 completed transactions in the year, worth $24 billion. The acquisition spree has carried into 2011, possibly eclipsing the previous year’s level. The U.S. Defense department also endorses mergers among U.S. defense companies, provided they don’t involve the top five or six suppliers acquiring each other.

Boeing has been particularly active on this front, having acquired Argon ST, a premier developer of intelligence equipment, Narus, a provider of real-time network traffic and analytics software, and CDM Technologies, a software engineering company that specializes in real-time transportation and logistics planning systems for the U.S. military. Recently, Boeing completed the acquisition of Solutions Made Simple Inc., an information services provider for the U.S. government and the Intelligence Community.

Another defense operator General Dynamics (GD - Analyst Report) decided to acquire Fortress Technologies, Inc., which has expertise in providing secured wireless networking equipment for the U.S. military and other government customers. The company also acquired Network Connectivity Solutions, Corp., a provider of enterprise services and cloud computing to the U.S. Department of Defense (DoD).

Strategic Alliance

Besides outright buys, these defense operators are also forming strategic alliances and partnerships with competitors to improve prospects.

General Dynamics teamed up with Lockheed Martin Corporation, Raytheon Company (RTN - Analyst Report) and Tognum America, Inc. for a contract worth $439.7 million for the technology development of the U.S. Army's Ground Combat Vehicle (“GCV”) Infantry Fighting Vehicle (“IFV”) program. The goal of the team entails the development of a ground combat vehicle which is affordable and at the same time ensures optimal soldier protection.

In a separate development, Boeing and Siemens AG (SI - Analyst Report) entered into an alliance for the development and marketing of "smart grid" technologies to improve energy access and security for the U.S. DoD.

Raytheon and Boeing combined their expertise and submitted a proposal for the U.S. Army and Navy's Joint Air-to-Ground Missile competition. The team showed that it is possible to give the warfighter a single rocket motor solution capable of withstanding the rigors of fixed- and rotary-wing flight.

Raytheon entered into yet another strategic alliance with the Norwegian defense company NAMMO to secure a second source for its AIM-120 Advanced Medium Range Air-to-Air Missile. This alliance will allow Raytheon to meet the demand for this missile from the U.S. and its allies.

Divestitures

Divestitures are also an integral part of these defense operators’ strategies to remain trim and profitable and better cater to customer demand. Northrop has successfully spun off its Shipbuilding business in March 2011. This has resulted in its revenue base being heavily skewed toward short business cycle programs that have a fast turnaround in capital resulting in higher earnings.

After a comprehensive strategic review of its business units, L-3 Communications Holdings (LLL - Analyst Report) has planned to spin off 100% of a new, independent, publicly traded government services company, named Engility, to L-3 shareholders. The new company will be a leader in Systems Engineering and Technical Assistance, Training and Operational Support services for DoD and other U.S. government agencies.

Lockheed Martin has divested its Enterprise Integration Group business due to the U.S. government’s increased concerns about perceived organizational conflicts of interest within the defense contracting community, while the company also divested its Pacific Architects and Engineers Inc. business so as to cater to a different mix of services sought by customers.

The Pentagon continues to invest in military space and is expected to spend $4.1 billion in military space research and development work and another $4.2 billion in space procurement in 2011. Over the next decade, the U.S. will account for 77% of the global military satellite sales market, with Asian countries grabbing 12.5% of the market share and European countries 9.3% of the pie.

WEAKNESSES

The global economic downturn that started in late 2008 has significantly weakened the financial profiles of all major industrialized countries. The growth and development of the Aerospace and Defense industry is tied to the defense budgets of the different nations around the globe besides the U.S. The general trend in this context is to cut national defense expenditures.

The U.S. defense department is planning to reduce the defense budget by $100 billion over the next five years. These cutbacks will impact the big contractors as the lion’s share of their revenues comes from domestic defense spending. With deficit reduction expected to remain a hot political topic for quite some time, defense spending may have to come down more than the projected $100 billion despite Pentagon’s evergreen bipartisan political support base. The Congressional Super Committee currently, specifically mandated to look for spending cuts, will find it very hard to come up with measures that leave out the Pentagon.

United Kingdom is likewise planning to slash its defense budget by 20%. Moreover, Italy has decided to follow a similar path. There is also pressure on France, Germany and Spain to review and trim their defense spending.

PROSPECTS

As a smart move to counter federal defense budget cuts, these players might explore the option of leasing out their heavy weapon systems rather than selling them to the Defense department, leading to a win-win deal for both the government and defense operators.

There is a new buzz in the health care IT market and the defense majors are trying to seize the benefits of this fast-growing market by making strategic acquisitions. General Dynamics has entered into a definitive agreement to acquire Vangent Holding Corp., a leading provider of health care information-technology and business systems to federal agencies. Lockheed Martin expanded its presence in the market by entering into an agreement to acquire QTC Holdings Inc. -- the largest provider of outsourced medical evaluation services to the U.S. government and the U.S. Department of Veterans Affairs.

Besides these developments, the growing demands in the international markets like South America, the Middle East and Asia will help the defense players counter cuts in U.S. government spending. It is estimated that U.S. arms exports for fiscal 2011 would surpass $46 billion. Lockheed Martin and Boeing are likely to be the main beneficiaries, as the demand for C-17’s, C-130Js, aerial drones and F-35 fighter jets are on the rise. Arms exports from the U.S. are expected to exceed $40 billion annually, on average, in the next several years.

The Brazilian government has decided to move forward with its much-awaited 36 jet orders, which has an estimated value of $4 billion. Boeing is one of the frontrunners among its international peers to win the contract.

Although the Asian defense markets do not compare in size with the US and European counterparts, the big Asian players are increasing their defense spending. China has decided to increase its defense spending for 2011 to $91.5 billion, a growth of 12.7% from 2010.

India, too, has raised its defense spending for 2011 to $36.3 billion, up 11.6% year over year. The country is planning to spend $80 billion on defense in the next five years for acquiring new equipment.

NEW DEVELOPMENTS

In April, the Indian government declared it will not consider U.S.-based defense operators Boeing and Lockheed for its planned purchase of 126 fighter jets, and has already shortlisted a European manufacturer for this deal. India rejected the offer from the two big U.S. defense firms as they were offering old variants of fighter jets, which can remain operational, albeit with upgrades, for the next 10 years whereas India was looking for current technology and jets which can work in its fleet for another 30 years.

Boeing was finally able to sort out its differences with the Indian government, and got the necessary clearance to sell 10 of its C-17 Globemaster III heavy transport aircraft for $4 billion. The deal is no doubt much welcomed by the defense pro, considering the initial rejection.

In June, Raytheon received a contract worth $1.7 billion from the Saudi Arabian government to update the Patriot Air and Missile Defense System to the latest Configuration-3. Per the contract, the company will provide ground-system hardware, a full training package and support equipment upgrades.

OUR TAKE

In the recently concluded second quarter, the top seven defense contractors for the U.S. government were able to beat our earnings per share expectations. However, we still maintain our Neutral stance on the U.S. Aerospace & Defense industry, which is reflected in our long-term ratings on U.S. based defense operators like Lockheed Martin Corp., The Boeing Company, Northrop Grumman, Raytheon Co., General Dynamics Corp, L-3 Communications Holdings and United Technologies (UTX - Analyst Report). Curtailment in defense spending by the European countries and the U.S. force us to remain cautious on the industry for the time being.

Read the full analyst report on NOC

Read the full analyst report on UTX

Read the full analyst report on LMT

Read the full analyst report on GD

Read the full analyst report on BA

Read the full analyst report on SI

Read the full analyst report on LLL

Read the full analyst report on RTN