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Defense Firms Hunt for Alternatives on Lower Military Spend

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With renewed concerns about terrorism and the threat of ISIS, how will America stay safe?

No country in the world can match the U.S. when it comes to military spending. In 2014, U.S. military spending reached $571 billion, way ahead of the second-spot occupant China’s $129.4 billion.

Increasing threats and the need to safeguard the interest of nations and people have pushed up demand for U.S. weapons exports, benefiting the U.S. defense manufacturers. While the U.S. and Europe have been deliberately staying out of situations that will lead to armed conflict, there is no dearth of armed confrontations involving regional actors. The ISIS and Syrian conflict, continued saber-rattling by the North Korean leadership and high tensions over the disputed ownership of islands in the East and South China Sea are some of the ongoing global flashpoints.

Although sequestration is still a headwind, defense occupies the largest share of the spending pie in the U.S. as military spending is projected to account for 54% of all federal discretionary spending for fiscal 2015.

Given the budget constraints, the defense majors are working on (i) how to grow profitably from diminishing budgets and (ii) slash costs for maintaining a satisfactory financial condition. In this context, General Dynamics Corp.’s (GD - Free Report) second quarter earnings were especially noteworthy, rising 20.7% from the prior year while margins expanded 100 basis points to 13.7%.

Many of the defense majors are doing a decent job, propelled by the following strategies:

Foreign Military Sales (FMS): The big defense operators are expanding their operations through acquisitions and foreign orders, with foreign sales as a key boost for top-line growth. Driving the demand for foreign sales is a number of escalating regional conflicts, such as the ongoing Syrian civil war, the unsettled situation in Iraq, Yemen and Libya, and tensions in Eastern Europe. A number of emerging markets as well as nations such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil are increasing defense spending and generating business for the U.S. aerospace and defense companies.

In fiscal 2014, U.S. military sales to its allies were $34.2 billion, according to the Defense Security Cooperation Agency. This marked a slight uptick from approximately $30 billion in fiscal 2013 sales.

Foreign military contracts are a vital growth driver at Raytheon Company (RTN - Free Report) . The company has been witnessing a steady rise in international sales over the past few years. International bookings comprised 46% and 41% of total company bookings in the second quarter and the first half of 2015, respectively. In the year-ago period, it was a respective 24% and 30%. Rising demand from the Gulf countries as well as the Asia-Pacific region will likely be the company’s key revenue driver.

Boeing (BA - Free Report) is on the lookout for more international contracts to keep its top line rolling. The company is expanding its presence in cyber security, intelligence and surveillance and unmanned systems, where growth rates are higher than the overall defense budget.

Restructuring/Diversification/Acquisition: To maintain margins in a tough business environment, companies are squeezing costs out of their operations and diversifying into new business areas. Commercial aviation is one such diversification play, with opportunities in the emerging markets driving the trend.

New macro challenges are prompting industry players to revisit their business models. One such example is Lockheed Martin’s (LMT - Free Report) two recent strategic moves – a planned spin-off or sale of its government IT and technical services businesses and the acquisition of Sikorsky. This prime defense contractor will become an even bigger aerospace powerhouse as it scoops up Black Hawk helicopter maker Sikorsky Aircraft from United Technologies (UTX - Free Report) for $9 billion in cash.

Another defense contractor, Rockwell Collins Inc. (COL) is known to acquire assets having the same line of business, thus helping it to expand its core offerings. The 2013 ARINC Inc. acquisition was a major leap forward for the company. More recently, the company expanded its Information Management Services portfolio by adding Pacific Avionics in Mar 2015.

Next-Generation Technology: At the macro level, there has been a gradual shift in defense spending patterns. 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. A focus on R&D is also helping these companies to develop next-generation technologies essential in a climate of fewer programs and reduced budgets.

In May 2015, Raytheon completed its agreement with Vista Equity Partners LLC to form a new reportable segment, blending its own cyber assets with Websense. The newly formed unit – Raytheon|Websense – combined Raytheon's advanced cyber security technologies and Websense's TRITON platform to come up with a new level of defense-grade cyber security solution.

Defense companies will increasingly be required to come up with more sophisticated intelligence, surveillance and reconnaissance (“ISR”) technologies. The contractors specializing in space systems will continue to gain from the Pentagon’s increasing focus on its space division to counter emerging security threats.

Given the vital role played by satellites in the military space, Lockheed Martin is looking to bolster its satellite product coverage by increasingly investing in R&D and acquisitions.

Northrop Grumman (NOC - Free Report) is bringing more focus to its airborne and space ISR business by realigning its divisions. In particular, the emphasis is on ISR systems, advanced electronics and software development technologies. It is the proud owner of the popular Global Hawk, an unmanned system with the ability to transform itself into an operational weapons system when required. Northrop also boasts products like the E-2D Advanced Hawkeye, which provides 360-degree surveillance at all times.

Export of U.S. Drones: The Obama administration unveiled new plans for the international export of U.S. military drones, including armed drones, to U.S. allies in February this year. As per the new policy, the export of U.S. drones will be approved on a case-by-case basis following export requests made by allied countries. And the export must essentially be made through government programs, as is the case with all weapon exports.

This shift in U.S. policy has an ulterior aim of curbing the import of drones by allied nations from other countries such as Israel and China. Both nations also manufacture exportable unmanned aerial vehicles (“UAVs”), also referred to as unmanned military aircraft. Although U.S. sales of military drones go back decades, the new policy will lead to simpler and more hassle free adaptation of drone exports. This would open up a window of opportunity for those developing unmanned systems or building sensors and missiles for use on those systems.

Notable among these companies are Raytheon and Textron Inc. (TXT - Free Report) .

Although sequestration casts a shadow of uncertainty on long-term funding for periods beyond fiscal 2015, we are positive on Leidos Holdings, Inc. (LDOS), Engility Holdings, Inc. (EGL), Northrop Grumman, Ducommun Inc. (DCO), LMI Aerospace Inc. (LMIA), Orbital ATK, Inc. (OA) and Spirit AeroSystems Holdings, Inc. (SPR).

While Leidos Holdings, Ducommun, Leidos Holdings and LMI Aerospace sport a Zacks Rank #1 (Strong Buy), the others carry a Zacks Rank #2.

Bottom Line

It is evident that the defense sector is doing well to combat budget austerity by various means. In the end, they’re growing profitably and lifting their outlook. This is clear from the sector’s stock-price performance year to date. But what about investing in the space right now – will the opportunities outweigh the risks to lure in short-term investors? The answer might very well be yes.

Check out our latest “Aerospace & Defense Stock Outlook” for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.