A few years ago, the U.S. was waging war on two fronts and
demanded a sharp rise in federal defense spending. At that time,
with the global economy largely on the fritz, military contracts
drove the bulk of the growth in the aerospace industry.
But defense spending is now on the decline. Downsized U.S.
military operations and proposed budget cuts tied to
sequestration are raising questions about impact on aerospace
contractors, and how well the industry is poised to handle such
The trend will likely lead to a significant slowdown,
according to analysts, particularly for companies on the lower
end of the supply chain. Contractors specializing in parts for
weapons systems and military aircraft will probably get hit
hardest, experts say.
But even large contractors likeLockheed Martin (
) andNorthrop Grumman (
) are feeling the pinch.
"There has already been an impact on the big, prime
contractors," said Richard Whittington, aerospace analyst at
Drexel Hamilton. "Their revenues have stopped going up, they have
reduced head counts and internalized some manufacturing that was
A Commercial Break
On the positive side, companies that get a large part of their
revenue from the commercial aircraft sector are seeing increasing
benefits as airlines boost spending and race to buy newer, more
These include top names likeBoeing (
),BE Aerospace (
) andEmbraer (ERJ).
"The companies with more diverse portfolios, who have
significant investments in the commercial side, are doing well
because that side of the industry is going gangbusters right
now," said Dan Stohr, a spokesman at the Aerospace Industries
Association. "Southwest Asia is a huge growth market for
commercial airlines, and demand is still going quite strong
According to a report from PricewaterhouseCoopers, the
aviation industry last year delivered a record 1,189 large
commercial aircraft. That was up 18% from 2011, which was also a
"In the long term, demand is projected to be about 1,700
aircraft annually, meaning that annual production rates may
continue to increase by another 40%," the PwC report said.
There is much less certainty on the defense side of the
industry. That's partly because lawmakers continue to quibble
over when, how and even whether to implement federal budget cuts
tied to sequestration.
About $37 billion in defense sequestration cuts are targeted
for fiscal year 2013. But there is "still no detail" being
provided by Congress or the Obama administration on what to
reduce and how to implement the cuts, says Gregory Kiley, an
associate at the Silverline Group, which provides strategic
consulting and advisory services to the aerospace, defense and
"They are taking the typical approach with sequester that they
do with everything in Washington, which is to delay making
decisions and just kick the can down the road," Kiley said. "So
the immediate impact on the defense industry is uncertain."
While Congressional Republicans have introduced legislation
that would allocate more money to defense than is allowed under
sequestration, the Obama administration has threatened to veto
any such efforts.
Meanwhile, aerospace and defense companies are preparing for
"The defense companies have been hoarding cash, cutting their
overhead back, and gotten themselves leaner in anticipation of a
downturn," Kiley said. "They are very strong cashwise, but have
held back on research and development. There is sort of an
uncertainty regarding sequester."
Smaller firms that depend on military spending for their
livelihoods might face an especially grim future over the next
According to the PwC report, spending cuts will likely drive
some small suppliers out of business. That in turn could leave
larger companies with "a shortage of critical parts and long lead
times to qualify new suppliers."
Department of Defense Comptroller Robert Hale voiced similar
concerns in recent statements, saying that the $37 billion in
sequestration cuts would likely result in a "sharp drop" in the
number of contractors.
Companies in the aerospace and defense sector range from
commercial aircraft behemoths such as Boeing, which had more than
$80 billion in revenue last year, to small niche players
likeApplied Energetics (AERG), a maker of laser-guided weapons
with about $1 million in 2012 revenue.
BE Aerospace, which has a strong commercial sector focus, has
run off 10 straight quarters of double-digit sales and earnings
growth.Precision Castparts (PCP), which makes components for
Boeing 737s and 787s, has grown the top and bottom lines in
double digits in 10 of the last 11 quarters.
Large defense contractors have had a rougher go of it.
Northrop Grumman, Lockheed Martin andGeneral Dynamics (GD) are
all having a hard time producing consistent revenue and profit
Still, most of the 55 stocks in IBD's Aerospace/Defense group
are trading near record highs and, as a group, are up about 19%
since the beginning of the year. This is partly due to the fact
that while there will almost certainly be a slowdown in defense
spending, the cuts might not be as deep as people once
"A few months ago I was much more negative about defense
spending," analyst Whittington said. "But it turns out that the
budget deficits are much less onerous than previously described,
and the economy is much better than people anticipated."
According to the PricewaterhouseCoopers report, the aerospace
and defense industry reported its best year ever in 2012 in terms
of revenue and profit as the surging commercial aviation market
more than offset a soft defense performance.
For 2012, the top 100 A&D companies reported a
record-setting $695 billion in revenue and $59.8 billion in
operating profit. Revenue rose 4% from the prior year, while
operating profit climbed 2%.
Strength in the market for large commercial aircraft was on
display at last week's Paris Air Show, where Boeing and Airbus
both announced large orders for long-haul planes.
Gecas, the aircraft leasing unit ofGeneral Electric (GE), said
it would buy 10 Boeing 787-10X jets. The deal's list price is
$2.4 billion. Qatar Airways ordered nine more Boeing 777-300ER
planes with a face value of $2.8 billion. That deal includes a
firm order for two planes with the option of seven more.
Airbus announced a potential order from Doric Lease for 20 of
the A380 jumbo jets at a list price of $8 billion.
Meanwhile, the market for military goods is still pretty big,
even in the face of U.S. budget cuts.
"A $600 billion-plus defense budget is nothing to sneeze at,"
Silverline's Kiley said. "I'm more bullish on defense than some
of the industry people."
While suppliers to the commercial aviation sector are gearing
up for a rise in business in coming quarters, defense contractors
are just hoping to hold serve.
According to Deloitte's 2013 Global Aerospace and Defense
Industry Outlook report, only three of the top 13 defense
contractors doing business with the Department of Defense posted
revenue growth last year.
The outlook for the sector isn't any better this year.
"Continued global economic challenges, coupled with revenue
gaps and cost pressures in 2013, might result in additional
decreases in revenue, lower returns on invested capital, as well
as margin contraction for many defense industry companies," the
Deloitte report said.
The wild card is how sequestration will impact the industry.
The AIA's Stohr says the effects of sequestration won't take
effect until the period from September 2013 through September
"There is expected to be a slash of a little under 10% for
both procurement and R&D," he said. "It's spreading down
through the supply chain."
The impact of that slowdown will be softened by robust
business elsewhere, at least for companies with diversified end
Analysts at Deloitte expect growth in sales of commercial
aircraft to reach record levels this year, based on increased
production rates and the introduction of next-generation
Backlogs should keep growing as airlines continue to update
their fleets with new fuel-efficient aircraft in order to stay
And suppliers to aircraft manufacturers "are likely to be
challenged to keep pace with production requirements and are
expected to invest in skills development, tooling, and
manufacturing capacity," the Deloitte report said.
And, for the first time in several years, there might even be
an increase in demand for business aircraft.
On the defense side, the combination of less business from the
Defense Department and tightening margins will put pressure on
companies to consolidate "in order to squeeze out excess defense
segment capacity," the Deloitte report said. "In response, the
segment is likely to undergo more streamlining of its cost
structure, divestiture of non-core assets, and additions of gap
filling, as well as game-changing acquisitions."