The U.S. is the world’s largest aerospace and defense market, and also home to the world’s largest military budget. 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 industry largely depends on U.S. government contracts.
Given the uncertain macroeconomic environment, not just in the U.S. but also globally, the industry faces the risk of fewer new orders as customers are more likely to postpone or cancel contractual orders and/or payments.
Defense spending is the major source of revenue for the top nine global aerospace and defense companies, with the US accounting for more than 40% of total global defense spending. However, 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.
The U.S. defense budget for 2012 was $645.7 billion, with the base budget at $530.6 billion and $115.1 billion approved for Overseas Contingency Operations (“OCO”) as supplementary defense spending, mainly to fund ongoing wars.
In February this year, the Department of Defense (DoD) requested a Pentagon base budget of $525.4 billion for 2013, which is approximately $5.1 billion or 1% less than what is approved for fiscal 2012, with $88.5 billion earmarked for OCO spending. The significant reduction in OCO funding is mainly due to the decline of U.S. military operations in Iraq in 2011. Going forward, OCO funding is expected to continue to decline as troops redeploy out of Afghanistan.
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 Afghanistan, and the war in Iraq has finally ended, which is expected to lower its expenditure on foreign campaigns. However, its clandestine military operations in other nations as part of anti-terrorism operations will continue to add to foreign war expenses. However, the overall trend in overseas military spending is unmistakably on the downtrend.
Acquisition, Merger and Strategic Alliance
The big defense operators armed with a strong balance sheets are expanding their operations inorganically through acquisitions. 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.
Lockheed Martin Corporation (LMT - Analyst Report) bolstered its product portfolio by acquiring Procerus Technologies, a company specializing in autopilot and other avionics for micro unmanned aerial systems. In November 2011, it had acquired Sim-Industries B.V., a commercial aviation simulation company located in the Netherlands. This acquisition would expand both companies’ closely related markets and expand the customer base.
Another defense major, L-3 Communications Holdings Inc. (LLL - Analyst Report), acquired the Kollmorgen Electro-Optical (“KEO”) unit of Danaher Corporation (DHR). This unit will improve L-3’s product suite with products like submarine photonics systems and periscopes, ship fire control systems, visual landing aids, ground electro-optical and sensor-cueing systems.
In December 2011, General Dynamics Corporation (GD - Analyst Report) completed the acquisition of Force Protection, Inc. The latter provides blast- and ballistic-protected platforms that support the armed forces of the U.S. and its allies.
In December 2011, Raytheon Company (RTN - Analyst Report) announced that it has acquired Pikewerks Corporation, a privately held company, to further extend Raytheon’s capabilities to defend against sophisticated cyber-security threats facing customers in the intelligence community, the DoD and commercial organizations.
Recently, The Boeing Company (BA - Analyst Report) completed the acquisition of Inmedius. It provides software applications and services for managing and sharing information and learning content.
These acquisitions appear beneficial for the companies. For instance, MetroMachine Corp., in the General Dynamics portfolio, would aid the defense major in completing submarine contracts. Buying Pikewerks will help Raytheon in better defending its customers against sophisticated cyber-security threats.
Another way to share the defense order pie is via strategic alliances. The defense operators often join forces with each other, bring along their individual expertise and work as a cohesive unit for big defense deals.
Moreover, these companies shed their unprofitable segments to focus more on core businesses. In July last year, L-3 Communications had decided to partly spin off to L-3 shareholders 100% of a new, independent, publicly traded government services company. The new public company will be named as Engility. The company expects to complete the spin-off by mid-2012.
These strategic deals, besides increasing the size of the entities, allow access to new markets. They also help to cut down on competition in a densely competitive space.
The rapidly evolving security challenges and the need for countries to modernize aging inventories keep demand alive in international markets.
However, in Europe, the continuous financial crisis is forcing governments to institute austerity measures that will negatively impact defense spending in the near term. The initiatives taken up would constrain their defense budgets and fiscal priorities in current and future periods.
The defense operators are nevertheless clinching international orders that to some extent are making up for the lost ground from the US budget cuts and uncertainty in Europe.
Sales of military weapons to foreign countries have risen dramatically. The DoD has ramped up foreign military sales to Middle Eastern countries that can protect U.S. interests in the region, which is crucial for the global economy. Saudi Arabia, UAE, Egypt, Iraq, Pakistan and Turkey are the top buyers in foreign military sales deals.
Among the recent foreign contracts, in April 2012, Lockheed Martin received a firm fixed-price contract to supply 95 Sniper advanced targeting pods, 35 compact multi-band data-links, 70 infrared search and track (IRST) systems, 75 IRST pylons and spare-parts to Saudi Arabia. In March 2012, Boeing had received a firm fixed-price contract from the United Arab Emirates-based multipurpose satellite operator to design and build active electronically steered phased array antenna systems.
The other allies that are buying military hardware from the U.S. are Poland, Japan and Israel. The overall growth in overseas arms sales bodes well for the U.S. Defense companies given the looming cuts in the U.S. defense budget.
Cutting-Edge Innovation and New Products
At the macro level, a gradual shift in defense spending patterns can be discerned. In response to 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.
Among state-of-the-art products, the latest radar and telecommunication systems, new ballistic missiles, unmanned warplanes, development of fighter jets, and sophisticated surveillance equipment are in the priority list of most countries. These help enhance the preparedness of a nation to detect, preempt and counter hostile situations.
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, especially the U.S. The general trend in this context is to cut national defense expenditures.
The major defense spenders throughout the world are going for an austerity drive. The big spenders are gradually lowering their defense budgets and concentrating on other avenues to fix their ailing economies. The U.S. defense department has reduced the defense budget significantly. These cutbacks will impact the big contractors, as the lion’s share of their revenues comes from domestic defense spending.
There is also pressure on France, Germany and Spain to review and trim their defense spending.
Long-Term and Specific Program Cuts
The amount allocated for U.S. wars abroad would also witness a sharp, fall mainly owing to troop withdrawal from Iraq and a drawdown in Afghanistan. The Pentagon has also made spending cuts of $487 billion over the next 10 years to meet deficit reduction targets.
Particularly for the F-35 Joint Strike fighter program, it has decided to slow down its production. The budget proposal for fiscal 2013 suggests a deduction of $1.6 billion at one go from the F-35 program by eliminating 13 planned aircrafts. The budget proposal provides $9.17 billion for 29 F-35 aircrafts, two fewer than what were sanctioned for fiscal 2012.
Proposals may also delay the procurement plan under the F-35 program, reducing its planned purchase order from 423 to 244 during the period between fiscals 2013 to 2017. The DoD expects that this would bring in a total of $15.1 billion in savings.
Undoubtedly, any cuts at the F-35 program would greatly affect the fortunes of the world’s largest stand-alone defense company, Lockheed Martin (LMT - Analyst Report). The F-35 is Pentagon’s biggest weapons program, at an estimated cost of $382 billion, for development and the purchase of planes.
The downside on the F-35 program is bad news for another defense giant, Northrop Grumman Corporation (NOC - Analyst Report), which has substantial exposure to the program on account of its role as a subcontractor. Northrop will be in more trouble with the proposed $800 million cutback on the unmanned aerial vehicle Global Hawk program and the cancellation of the Defense Weather Satellite System.
As a consequence of budget cuts and uncertainty related to F-35, some contractors seem to be pulling back their orders from the purchase of the aircraft. In February 2012, Italy indicated that it is planning to scale back its major investment in Lockheed Martin’s F-35 Joint Strike Fighter. A month later the government of Canada signaled that it may not proceed with a planned purchase of the F-35 stealth jet.
Further cost cuts hurting defense primes is the proposed delay of the $1.3 billion U.S. Army’s new Ground Combat Vehicles program, and delaying the development of a $600 million new ballistic missile submarine, the SSBN-X Future Follow-on Submarine program. The delay in the submarine program is also a bad news for General Dynamics (GD - Analyst Report) and Huntington Ingalls Industries Inc. (HII - Analyst Report).
Boeing (BA - Analyst Report), too, had to face the brunt of budget cuts through lower purchases of the tilt-rotor aircraft, V-22 Osprey. Similarly, Textron Inc. (TXT - Analyst Report) would be affected by lower purchases of Bell Helicopters. It is important to note here that the 2012 budget proposal contains only $8 billion for purchase and launch of Lockheed Martin and Boeing satellites, reflecting a sharp 22% fall year over year.
However, the DoD increased their expenditure for electronic warfare and electro-optics. On electro-optic and electronic warfare work, it plans to increase its spending to $4.95 billion for fiscal 2013, up from $4.6 billion in fiscal 2012.
As a smart move to counter federal defense budget cuts, the defense majors 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 the defense operators.
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 is gradually strengthening its defense capability and continues to increase its defense budget. India, too, has been raising its defense spending and is planning to spend $80 billion on defense in the next five years for acquiring new equipment.
There has been a rise in global spending on cyber security. Government and private sectors alike are investing heavily to safeguard against cyber attacks. Increasing awareness of cyber threats can create a window of opportunity for the defense majors.
Earnings and Dividend Trends
The aerospace and defense companies recently reported their earnings for the first quarter of 2012. The earnings trend has remained overall upbeat with the companies beating market optimism both on the top and the bottom line. The good performance is mainly attributed to strong orders and deliveries supported by suitable acquisitions.
Another reason to cheer for shareholders is the trend of raising dividend payments. Lockheed increased its dividend in September 2011, General Dynamics and Raytheon in March 2012, L-3 Communications made it in February 2012 and Rockwell Collins (COL - Analyst Report) in April 2012.
The U.S. is the leader in global defense spending. The country is not only a major super power, it has strategic alliances in place with other foreign nations with major military strengths. The country sometimes shares its military technology and supplies sophisticated weapons to its allies. These activities, in turn, boost the revenue of the defense operators.
Despite the relatively good earnings season and a trend of continuous dividend increase, we maintain our Neutral stance on the U.S. Aerospace & Defense industry due to the significant budget cuts and cancellation of orders. This is reflected in our long-term Neutral ratings on U.S. based defense operators like Lockheed Martin Corp., The Boeing Company, Northrop Grumman, Textron Inc., Raytheon Co., General Dynamics Corp, L-3 Communications Holdings, Alliant Techsystems Inc. (ATK) and United Technologies (UTX - Analyst Report).