The growth of the Aerospace and Defense industry depends largely on the spending outlook of government defense departments, with the U.S. defense budget as 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.
On December 17, 2010, the U.S. House of Representatives passed a $725 billion bill for Defense spending in fiscal 2011. This surpassed the earlier estimated $708 billion, and will include roughly $160 billion to continue fighting wars in both Afghanistan and Iraq.
Such 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 down its defense expenditure by cutting down investments on defense programs, which are not absolutely essential. In this charged scenario, sourcing more orders from global clients will enable the defense companies to grow their businesses going forward.
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 follow a downtrend. 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. Major industry players have, in response, resorted to bolt-on acquisitions to plug holes in their product offerings.
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 to clinch major contracts. Boeing and Northrop Grumman are in a strategic partnership to pursue the competitive development and sustainment contract for future work on the Ground-based Midcourse Defense (GMD) system for the U.S. Missile Defense Agency (MDA).
These operators are also making planned divestitures to remain profitable and better meet customer demands. Lockheed Martin has thus decided to divest 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 decided to divest its Pacific Architects and Engineers Inc. business so as to cater to a different mix of services sought by customers.
Defense aircraft sales during the year were boosted by record U.S. defense spending and higher demand from international consumers. Year to date, military aircraft sales, at $64.5 billion, grew a sharp 8% from 2009 levels.
Space sector sales during the year were relatively flat compared to the previous year. Space sales for 2010 are pegged at $45.5 billion. However, NASA is expecting to increase its expenses by an average 2.5% from fiscal 2011 to fiscal 2015, with spends being skewed toward the commercial space sector.
The long-delayed $35 billion contract from the U.S. Air Force for aerial tankers remains a major hope for the defense industry. Boeing and European Aeronautics, Defense & Space Co. are two major contenders for the contract and a decision from the department is expected later this year.
The global economic downturn that started in late 2008 has significantly weakened the financial profiles of all major industrialized countries. While the industry has historically been very successful in the “guns vs. butter” debate, particularly in the all-important U.S. market, it remains to be seen how it will fare in the changed backdrop characterized by growing calls for increased domestic spending needs.
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 defense spending.
In Europe, United Kingdom is 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 budgets.
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 international markets of China, India and South America provide an opportunity for defense operators to bolster their top line. Defense expenditure is gradually on an upward curve in India . The country is planning to spend $80 billion on defense in the next five years for acquisitions of new equipment.
Demand for defense equipment is also high in Middle-East Asia. During October 2010, the U.S. administration formally approved $60 billion arms sales to Saudi Arabia, which will help create new jobs. Boeing will be the biggest beneficiary, as it will sell 84 F-15 fighter aircraft and upgrade 70 F-15s, along with advanced missiles, night vision goggles and guided munitions.
We presently have a neutral outlook on the U.S. Aerospace & Defense industry, the same 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), unless we see additional positive catalysts driving the industry.