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. 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. Despite robust business aviation forecasts, there may be short-term customer financing challenges for business jets segment.
OPPORTUNITIES
With core defense spending expected to slow, U.S. defense contractors need to identify additional revenue sources for the coming years. There is 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-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, and 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.
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, Boeing Company forecasts delivery of 29,400 new commercial aircraft worth $3.2 trillion. Honeywell International Inc’s (HON) forecast predicts 17,000 new business aircraft valued at $300 billion. While we currently don’t have an Outperform recommendation on aircraft and engine manufacturers, we have positive outlooks on UTX, BA and HON.
WEAKNESSES
The near-term outlook is for falling production rates despite the large backlog. Airbus, for example, recently announced a 24 per year reduction for the A320 family. More production cutbacks will be announced in the months ahead; total production should fall below 1,000 by 2010.
For the military fixed-wing market, near-term outlook is for relatively steady production rates. The current emphasis on Keynesian stimulation could support sustained production.
The business aviation sector is the fastest changing group within Aerospace. Production rates are falling rapidly; light jets and VLJs are particularly vulnerable. Cessna and Hawker are both cutting production rates (and work forces) by more than 20%; Eclipse recently declared bankruptcy. The final drop down could be more than 30% below the 2008 peak.
THE FUTURE
A major Aerospace & Defense sector challenge for 2010 is improving program management and execution. If aerospace and defense companies are to deliver on the demand for asset readiness, customer-centric outcomes and cost reduction, they will need to match their already advanced manufacturing capabilities with equally advanced and innovative offerings for service and support.
Customer service strategy, customer program management, product lifecycle management and service management are the foundation of the emerging customer service and support model for aerospace and defense. The largest share of the service and support revenue opportunity awaits those aerospace and defense companies that are able to build, acquire and integrate these capabilities into their already extensive competencies — taking advantage of them to drive innovation, growth and high performance.Zacks Investment Research
