OVERVIEW

Inherently, big defense contractors are expected to eliminate jobs as the Pentagon has lowered spending on traditional weapon systems, while smaller, niche companies may accelerate hiring as the United States garners resources to protect ground troops and strategic computer networks.

Industry pioneer Lockheed Martin Corporation (LMT) aims to reduce 600 jobs as a result of the US Defense Department’s decision to terminate the VH-71 presidential helicopter program. The Boeing Company (BA) hinted that Pentagon cuts would claim 1,000 jobs in its defense business, affecting staffing at various work sites in the United States in missile defense and in the Army’s Future Combat Systems modernization program, which is now being opened to more competition.

The large commercial aircraft sector is expected to generate most of its revenue from Asia Pacific Japan (APJ) and the Middle East, relying less on U.S. orders because of the current economic climate. However, airline companies worldwide will continue to struggle with the global economic recession, fuel price fluctuations and the difficulty in raising ticket prices, which might have an impact on airplane and engine purchase orders in 2009.

Despite robust business aviation forecasts, there may be short-term customer financing challenges for the business jets segment. Thus, we would generally expect that 2009 to see a fall-off in business jet orders, production and deliveries.

The appetite for both US and non-US Aerospace & Defense assets has been significantly constrained by the ongoing global recession and the resulting squeeze on corporate profits, lack of liquidity and continuing uncertainty about when a recovery is likely to begin. Year-to-date, there have been just six deals with values at or greater than $50 million.

The total value for deals announced during the first half of 2009 with a disclosed value of at least $50 million was just under $600 million, substantially less than total deal values in the first half of 2008 ($11.7 billion), representing a decline of 95% year-over-year. Notably, the largest transaction in 2008 — Finmeccanica’s acquisition of DRS Technologies, announced in May 2008 for $5 billion — occurred in the first half of that year. Excluding this transaction, the total deal value for the first half of 2008 was $6.6 billion, which is still much higher than the value of transactions during the first half of 2009.

Financial investors remain on the sidelines as financing remains challenging compared with the same period a year ago. Strategic investors have also experienced a decrease in deal activity involving acquisitions of $50 million or more. To date, there have been four deals announced involving strategic investors. This compares with the 20 deals in the first half of 2008, an 80% decrease over the same period a year ago. Strategic investors have redirected their focus on internal restructuring initiatives.

On an annualized basis, the actual number of deals in 2009 is in line with 2008 (270 compared with 275, respectively). But as the economic downturn intensified in the first half of 2009, the value of those transactions has decreased drastically. The average transaction value for first-half 2008 was $85 million compared with $7.5 million for first-half 2009, representing an approximate 91% decrease.

OPPORTUNITIES

With core defense spending expected to slow, U.S. defense contractors need to identify additional revenue sources for the coming years. 2009 holds potential for interesting merger and acquisition (M&A) activity, mostly smaller deals by larger A&D firms to fill in capability gaps — particularly in the security, defense electronics and aftermarket services business areas. U.S. defense firms may see opportunities in credit-squeezed markets to pick up U.S. assets at historically low price-to-earnings multiples.

Some large companies are expanding into the adjacent markets of mission support and services, such as performance-based logistics, or PBL, which can provide a more consistent — albeit riskier though perhaps more profitable — revenue stream.

Building on the example set by engine manufacturers — Pratt & Whitney, a United Technologies Corporation (UTX) company, and Rolls-Royce Group — to get 50% of revenues and 60% of profits from their services business, Aerospace & Defense contractors are learning how to take on, measure and internalize risk and to make support and services offerings profitable. This includes understanding how to service the equipment they manufacture, and assembling the necessary infrastructure, capabilities and people to operate it.

Shifting defense priorities could prove to be a boon for some manufacturers as the Pentagon looks to beef up protection for US ground soldiers. Oshkosh Corporation (OSK) is aiming to induct 300 to 500 workers in Wisconsin and calling back as many as 650 it had let go at a Pennsylvania facility as it looks to fill orders for armored trucks that can deflect roadside bombs. The truck manufacturer also won a $1.1 billion contract to build more than 2,200 Mine Resistant Ambush Protect All Terrain Vehicles for use by US troops in Afghanistan.

Companies are also leveraging strong balance sheets to grow organically and acquire new services business. As product development transitions to production program deliveries, it is anticipated that companies will ramp up their services businesses and profitability should improve.

Overall, in the next two decades, The Boeing Company (BA) forecasts delivery of 29,400 new commercial aircraft worth $3.2 trillion. Honeywell International Inc’s (HON) 2008 forecast predicts 17,000 new business aircraft valued at $300 billion. While we currently don’t have Outperform recommendation on aircraft and engine manufacturers, we have positive outlooks on UTX, BA and HON.

WEAKNESSES

A major Aerospace & Defense sector challenge for 2009 is improving program management and execution. For the past few years, commercial aircraft programs have run late due to global supply chain or design problems. In addition, government aerospace procurements have overrun their budgets.

The root causes for this problem are as follows:

  • Technical complexity – Today’s programs rely on the use of leading-edge, still-maturing software-based technologies, which require infinitely higher levels of functionality, interoperability and integration. This technical complexity has resulted in increased development time vs. historical programs.
  • Talent crisis – Twenty-seven percent of employees in the sector are estimated to retire in the next five years. In addition, the National Science Foundation expects the number of science, technology and engineering retirements to increase threefold annually in the next 10 years. Unfortunately, the industry may not be able to attract sufficient new talent to make up for the deficit.
  • Supply chain challenges – The Aerospace & Defense supply chain management model is transitioning to a global, super-supplier model for the Tier 1 suppliers and original equipment manufacturers (OEMs). These organizations are shedding manufacturing and subsystem assembly work, relying on super- or middle-tier suppliers to take on increasingly complex design and manufacturing tasks.
  • Politics – Aerospace & Defense programs span multiple years but are budgeted annually. In times of economic stress, other government priorities may prompt cuts in multiyear projects for a number of units. This approach typically results in increased fly-away unit costs.
  • Program management challenges – Many Aerospace & Defense program schedules are based on a “sunny day” scenario, rather than a more realistic “cloudy day” scenario that contemplates program delays, technical difficulties, supply chain problems and changing requirements. These program management challenges and associated cost overruns need to be addressed by improving cost, schedule, and risk management processes and techniques.

With an increase in passenger traffic and competitors, commercial airplanes have become more commoditized, requiring companies to improve differentiation. Airline manufacturers therefore should promote product and process innovation.

The new Boeing 787 Dreamliner is a good example: It will be the first major aircraft to use composite materials for most of its construction. Featuring an estimated 20% lower direct operating cost, better passenger comfort via higher air pressure and humidity, larger windows and less-frequent maintenance requirements, the 787 has become the most successful aircraft product launch in aviation history, as measured by the number of aircraft ordered prior to first flight.Zacks Investment Research