OVERVIEW
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.
After much speculation, the 2011 defense budget was finally approved by the US Congress. The base budget approved was $513 billion with another $157.8 billion approved as supplementary defense spending mainly to fund the wars in Iraq and Afghanistan.
This defense spending is the major source of revenue for the top nine global aerospace companies. However, the U.S. defense department is planning to trim its defense expenditure by cutting down investments on defense programs, which are not absolutely essential. In this changed scenario, sourcing more orders from global clients will enable the defense companies to grow their businesses going forward.
OPPORTUNITIES
Lockheed Martin Corporation (LMT) is the biggest recipient of U.S. defense contracts, followed by The Boeing Company (BA) and Northrop Grumman Corp. (NOC). With the wars in Iraq and Afghanistan expected to wind down in the coming years, core defense spending is also expected to trend downward. The big operators, in order to counter 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.
This saw the U.S. defense companies going on an acquisition spree, in 2010, with 255 completed transactions in the year worth $24 billion. The defense pros are expected to sustain the momentum in 2011, 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, and Narus, a provider of real-time network traffic and analytics software. Boeing further strengthened its position in the logistic command and control business through the acquisition of CDM Technologies, a software engineering company that specializes in real-time transportation and logistics planning systems for the U.S. military.
These defense operators are also entering into strategic alliances and partnerships with competitors to improve their prospects of clinching major contracts. Lockheed Martin has teamed up with URS Corporation (URS) and InDyne to pursue the Launch & Test Range System Integrated Support Contract (LISC), which the U.S. Air Force expects to award in 2012.
Boeing and Northrop Grumman have also joined hands, submitting a joint proposal for the U.S. Missile Defense Agency (MDA) Objective Simulation Framework (OSF) program. The contract is expected to be awarded in July 2011, with an estimated value of $595 million spread over a five-year period.
These operators are also making planned divestitures to remain profitable and better meet 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.
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 the 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.
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 spends.
New Developments
The U.S. Air Force finally awarded the much awaited contract for the aerial tankers to Boeing. The contract worth $35 billion involves the supply of 179 refueling planes.
The Indian government has decided to purchase 10 of Boeing’s C 17 Globemaster III heavy transport aircraft. However, the aircraft deal is presently on hold due to the prices quoted by the company. Once Boeing is able to sort out the price issue with the Indian government, the deal will come as a further boost to its top-line.
Recently, the U.S military intervened in Libya as part of the NATO-led coalition to enforce a UN Security Council resolution. The involvement has already cost the U.S. $600 million, which is likely to cross $1 billion in the near future. Contrary to initial expectations, the conflict is fast becoming a stalemate and a potential financial liability.
The new defense budget for 2011 approved a cut of $2.16 billion from the F-35 program, which is headed by Lockheed Martin, mainly due to delay in production and aircraft testing.
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.
The growing demands in the international markets, like South America, Middle East and Asia, will help the defense players counter cuts in U.S. government spending. It is estimated that U.S. arms export 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 an 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 there 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.
On the cards is the Indian government’s $10.5 billion contract for 126 fighter jets by the end of the fiscal year. International firms like Boeing, Lockheed and other Russian firms are in the fray, competing for the top-line boosting deal.
Our Take
With the first quarter earnings releases currently underway, we are presently maintaining a neutral outlook on the U.S. Aerospace & Defense industry. The same is reflected in our long-term ratings on U.S. based defense operators like Lockheed Martin Corp., Northrop Grumman, The Boeing Company, General Dynamics Corp. (GD), Raytheon Co. (RTN) and L-3 Communications Holdings (LLL).
BOEING CO (BA): Free Stock Analysis Report
GENL DYNAMICS (GD): Free Stock Analysis Report
L-3 COMM HLDGS (LLL): Free Stock Analysis Report
LOCKHEED MARTIN (LMT): Free Stock Analysis Report
NORTHROP GRUMMN (NOC): Free Stock Analysis Report
RAYTHEON CO (RTN): Free Stock Analysis Report
URS CORP (URS): Free Stock Analysis Report
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