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Zacks Analyst Interviews

Overview

The aerospace and defense industry found its largest base in the U.S. with a military budget fittingly impressive. The country's global leadership position requires it to maintain the capacity to respond to the ever-changing national security environment. But unlike many other countries, the U.S. relies on the private sector to meet its defense needs.

The U.S. Army, Air, and Naval forces enter into long-term contracts with aerospace and defense companies to meet their various needs for systems and equipment. As such, the outlook for the industry is closely tied to the outlook for defense spending by the U.S. government.

Earlier this month, the Obama administration proposed defense budget for FY14 of $526.6 billion, down $0.9 billion from the FY13 annualized continuing resolution level of $527.5 billion. However, the FY14 request does not yet include a detailed budget for Overseas Contingency Operations ("OCO"), which is essentially government-speak for foreign wars and war on terror operations. The government is preparing a separate OCO request that is expected to be released soon.

Under the continuing resolution, OCO funding for FY13 is $88 billion. This is lower than the $115 billion enacted for FY12 OCO activities as a result of reduced operations in Afghanistan and conclusion of operations in Iraq. Going forward, OCO funding is expected to continue to decline as troops redeploy out of Afghanistan. In fact, the request for future OCO funding will likely be closely correlated to the amount of troops required for each operation.

Budget Issues - the Sequester

The budget sequester that went into effect at the start of March 2013 and that has a direct bearing on the U.S. government's defense spending is a function of the country's fiscal and economic challenges.

As a background, Congress passed the Budget Control Act of 2011 in order to resolve the debt-ceiling crisis. The Act provided for a Joint Select Committee on Deficit Reduction known as the super committee to produce legislation by late Nov 2012 that would decrease deficit by $1.2 trillion over ten years.

However, Congress failed to reach an agreement. This would have led to automatic cuts known as sequestrations, split evenly between defense and domestic spending, beginning on Jan 2, 2013. However, the 'Fiscal Cliff' was averted at the last moment and the date was postponed by two months by the American Taxpayer Relief Act of 2012.

But it finally took effect last month. The cuts as a result of the budget sequester are evenly between the defense and non-defense categories. The spending reductions are approximately $85.4 billion during fiscal year 2013, with similar cuts for years 2014 through 2021.

Some major programs like Social Security, Medicaid and federal pay (including military pay and pensions and veterans' benefits), however, have been exempted from these cuts. Over the 2014-2023 period, sequester would reduce planned spending outlays by $995 billion with interest savings of $228 billion leading to approximately $1.2 billion in debt reduction.

Zacks Rank

The Zacks Industry Rank, which relies on the same estimate revisions methodology that drives the Zacks Rank for stocks. The way to look at the complete list of 260+ industries is that the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.' Zacks Industry Rank for the Aerospace industry is at #93 out of 261 industries, which puts it in the Neutral zone.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Outlook, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months).

Only one of the 11 companies in the industry has a Zacks Rank #1 (Strong Buy). While 2 carry a Zacks Rank #2 (Buy), seven hold a Zacks Rank #3 (Hold). Only one company has a Zacks Rank #4 (Sell).

MTU Aero Engines Holding AG (MTUAY) boasts a Zacks Rank #1 (Strong Buy). Safran SA (SAFRY) and Wesco Aircraft Holdings, Inc. (WAIR - Snapshot Report) carry a Zacks Rank #2 (Buy).

The Boeing Company (BA), Lockheed Martin Corp. (LMT - Analyst Report), Northrop Grumman Corp. (NOC - Analyst Report), Huntington Ingalls Industries, Inc. (HII - Snapshot Report), Erickson Air-Crane Inc. (EAC - Snapshot Report) and Embraer SA (ERJ - Analyst Report) carry a Zacks Rank #3 (Hold). General Dynamics Corp. (GD - Analyst Report) is a Zacks Rank #4 (Sell).

Earnings Outlook

A few companies have started reporting March ending numbers. Boeing came out with a solid Q1 results, as did Northrop Grumman, Rockwell Collins (COL - Analyst Report), Lockheed Martin and General Dynamics, though Textron came up short. The Q1 results don't show much impact from the budget sequester, though it will be interesting to see how these companies cope in the coming quarters. The expectation is for Aerospace sector's earnings this year to be up 6.8% after declining 4.5% in 2012.

Going forward, a number of contracts, sizeable acquisitions, beneficial spin-offs and restructuring of the companies are expected to counter the budgetary uncertainty. This leads us to keep a keep a Neutral outlook on the aerospace and defense sector.

TAILWINDS

Mergers & Acquisitions, Spin-offs and Strategic Alliances


The big defense operators armed with strong balance sheets are expanding their operations 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. For that matter, the industry encourages acquisitions as the highest-priority investment area for a company with a sizeable cash balance looking for growth amid significant defense budget cuts.

In fact, the four main strategies to stimulate growth are joint ventures, foreign military sales, international expansion and mergers and alliances. Among important mergers and acquisitions, we begin with The Boeing Company which acquired CPU Technology Inc.'s Acalis business in February this year. The acquisition would address the need of Boeing's global customers to protect warfighters from information-assurance attacks.

Acalis provides security-on-a-chip that can help defend manned and unmanned aircrafts. This acquisition will help the company to better differentiate its offerings and provide long-term value for its global aerospace and defense customers.

Last month, Triumph Group, Inc. (TGI) completed the acquisition of Goodrich Corporation (Goodrich Pump & Engine Control Systems) from United Technologies Corporation (UTX). We also saw last month Erickson Air-Crane acquire Evergreen Helicopters, Inc.

Sometimes, instead of acquiring a particular firm, defense companies enter into contracts to purchase certain assets in order to acquire capabilities that enhance their ability to expand into attractive adjacent market opportunities. For instance, in January this year, Lockheed Martin entered into an agreement with Aveos Fleet Performance, Inc. to purchase certain assets of the engine maintenance, repair and overhaul ("MRO") business.

Meanwhile, SAIC Inc. (SAI) is progressing well on its plan to split SAIC into two independent, publicly traded companies. In its announcement, SAIC said it intends one company to focus on government technical services and enterprise information technology. The other will focus on science and technology solutions in national security, engineering and health. The split is expected to occur in the second half of fiscal year 2014.

Overall, these acquisitions and even spin-offs help the defense pros in fulfilling task orders and contracts.

Agreements and Contracts

International Orders

Currently, the world's five largest military spenders are the U.S., China, Russia, U.K. and France. Following suit are Saudi Arabia, India, Germany, Italy, Brazil, South Korea, Australia, Canada and Turkey.

The aerospace and defense companies generate revenue from international orders and foreign military sales ("FMS"). Since the domestic defense sector is faced by budget cuts and a constrained spending environment from the U.S. government, the industry is looking for growth from international orders.

In January this year, General Dynamics received a contract for the procurement and production of 69 Saudi M1A2 Abrams tanks for the Kingdom of Saudi Arabia. The Foreign Military Sales contract was awarded by the U.S. Army TACOM Life Cycle Management Command for the Royal Saudi Land Forces. Again, in Jan 2013, Alliant Techsystems Inc. (ATK) entered into a contract with Israel Aerospace Industries under which it will provide the solar array to power the flagship Israeli company's 5-ton Earth satellite AMOS-6.

In February, under another FMS sales program, Alliant Techsystems received a contract for the production of rocket motors for AIM-9P Sidewinder customers.

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.

Over the next few years, demand for U.S. military exports is expected to remain strong. A truculent Iran, with increasing potential for nuclear capacity and relatively strong oil prices, has of late spurred the demand for U.S. military aerospace products by Gulf countries.

Similarly, increasing Chinese defense budgets have led to significant new U.S. sales in South and East Asia. Going forward, these sales would more than offset diminishing sales to European countries that have significantly cut their defense budgets.

DARPA Contracts

A trend very much noticeable among recent contract wins is that most of these awards come from the Defense Advanced Research Projects Agency (DARPA). DARPA is an agency of the United States Department of Defense responsible for the development of new technologies for use by the military.

In March this year, Lockheed received a Long Range Anti-Ship Missile modification contract from DARPA to conduct air- and surface-launched flight tests and other risk reduction activities. Again in the same month, Northrop Grumman received a contract for the DARPA ASPN phase 2 project that develops algorithms and a prototype sensor-fusion system to enable low-cost navigation for military users on any operational platform and in any environment.

Modification Contracts

Modification contracts are extended contracts that increase the value of original contracts. In fact, they demonstrate the ability of these defense companies of performing the contracts well in time. In April this year, Northrop Grumman received a modification contract from the U.S. Air Force for its Global Hawk unmanned aircraft system. Recently, L-3 Communications (LLL - Analyst Report) also received a firm-fixed-price modification to a previously awarded contract for the production of 16 universal modular masts for Virginia-class nuclear fast-attack submarines.

Busy Repositioning

The aerospace and defense industry is experiencing continued consolidation. The companies are also busy restructuring in order to streamline their operations. A few days back, Raytheon Company (RTN - Analyst Report) decided to reorganize its business through segment realignment, announcement of key executive roles and job cuts. The restructuring would aim to streamline operations, increase productivity and achieve stronger alignment with customer preferences.

The other way out for U.S. weapon makers who are under pressure to cut costs and preserve profit margins amid dwindling defense spending in the U.S is layoffs. In January this year, Boeing announced that it will consolidate its El Paso facilities and reduce the workforce there by the end of 2014.

The move again comes on the heels of the company's strategy to increase affordability for government customers and become more competitive in an increasingly global marketplace. Boeing intends to reduce occupied square footage 50% by moving from three buildings into one, and will reduce employment by up to 160 positions.

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 on the priority list of most countries. These help enhance the preparedness of a nation to detect, preempt and counter hostile situations.

Contemporary warfare has seen a paradigm shift from traditional forms of waging a war. There is high demand for new defense products that help the military in locating and eliminating terrorists before they strike. Moreover, the success of these defense companies depend on the ability to develop, market and produce products and services at a cost which is consistent with the defense budget.

Indeed, the defense pros can barely survive in this competitive industry without these innovations. In March this year, Northrop launched its Fourth Generation Tracking Adjunct Sensor (4G TAS), the latest upgrade to the company's range of high-resolution electro-optical/infrared (EO/IR) sensors for the Hawk air defense system. In March again, Raytheon announced the release of SureView Version 6.7 aimed at implementing an insider threat detection program to address national security threats while protecting privacy rights.

HEADWINDS

Global Downturn


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.

Austerity Drive

Needless to say, the major defense spenders throughout the world are on an austerity drive. They 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.

Acquisition and Program Risk

Taking into account the huge number of acquisition deals in progress, the industry faces risks associated with the completion, integration, and financing of these acquisitions. Then with the majority of revenue coming from government contracts, the industry could be adversely affected by the cancellation and delay of major government contracts.

Intense Competition

The aerospace and defense companies compete amongst themselves in the information and services markets for a number of small and large programs. The major defense players are Boeing, Raytheon, General Dynamics, L-3 Communications, BAE Systems plc, European Aeronautic Defense and Space Company, Finmeccanica SpA, Airbus, Embraer SA and Bombardier Inc. Therefore, with new competitors coming in, it has become important for the U.S. pros to stay ahead in technology.

Our Take

The aerospace & defense industry has been a keystone of the U.S. economy for decades and has provided well paying jobs for a variety of skill levels. The U.S. aerospace industry continues to contribute significantly to the country's economy and provides capabilities vital for national security. It generates new technology in fields such as advanced materials, sensors, information processing and sharing. Finally, aerospace continues to generate the largest positive trade balance of any U.S. manufacturing sector.

The U.S. is the leader in global defense spending. The major super power also has strategic alliances in place with other foreign nations with considerable military strengths. The country shares its military technology and supplies sophisticated weapons to its allies. These activities, in turn, boost the revenue of the defense operators.

However, on the flip side, the industry's position is now challenged by global competition, changes in technology, national and worldwide economic conditions, and global policies affecting defense, civilian and commercial aviation.

However, the costs incurred by aerospace and defense companies for executing projects due to order delays would increase leading to an imbalance between the cost and revenue structure. This would not only hurt profitability but also lead to delays and even cancellations of orders and/or programs.

Moreover, in the forthcoming years, the industry will face challenges, particularly in the defense sector, as the federal government looks for solutions to an ongoing budget crisis. In addition to budgetary constraints, including the Budget Control Act, defense spending will come down due to the draw-down of U.S. forces from major overseas deployments.

Sequestration still remains an overhang both in the civil and military sectors. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration. On the other hand, those with an international order book would find it less difficult to face the brunt of sequestration.

Despite the uncertainty related to sequestration, huge defense budget cuts and cancellation of big-ticket programs, we have a mixed outlook for the sector based on product progress, opportunities, acquisition benefits and cost-cutting efforts of individual companies.

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