The U.S. is the world's largest aerospace and defense market,
and also home to the world's largest military budget. 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 industry largely depends on U.S.
Given the uncertain macroeconomic environment, not just in the U.S.
but also globally, the industry faces the risk of fewer new orders
as customers are more likely to postpone or cancel contractual
orders and/or payments.
Defense spending is the major source of revenue for the top nine
global aerospace and defense companies, with the US accounting for
more than 40% of total global defense spending. However, with the
U.S. government expected to institute greater austerity in its
defense budget going forward, defense companies will need to source
more orders from global clients. The geostrategic significance of
the industry and the related heavy export restrictions will come in
the way, to some extent, of those marketing efforts by U.S.-based
The U.S. defense budget for 2012 was $645.7 billion, with the base
budget at $530.6 billion and $115.1 billion approved for Overseas
Contingency Operations ("OCO") as supplementary defense spending,
mainly to fund ongoing wars.
In February this year, the Department of Defense (DoD) requested a
Pentagon base budget of $525.4 billion for 2013, which is
approximately $5.1 billion or 1% less than what is approved for
fiscal 2012, with $88.5 billion earmarked for OCO spending. The
significant reduction in OCO funding is mainly due to the decline
of U.S. military operations in Iraq in 2011. Going forward, OCO
funding is expected to continue to decline as troops redeploy out
Since the September 2001 attacks, the U.S. government has spent
significant amounts on military campaigns overseas. The country has
already decided to gradually move out of Afghanistan, and the war
in Iraq has finally ended, which is expected to lower its
expenditure on foreign campaigns. However, its clandestine military
operations in other nations as part of anti-terrorism operations
will continue to add to foreign war expenses. However, the overall
trend in overseas military spending is unmistakably on the
Acquisition, Merger and Strategic Alliance
The big defense operators armed with a strong balance sheets are
expanding their operations inorganically through acquisitions. 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.
Lockheed Martin Corporation
) bolstered its product portfolio by acquiring Procerus
Technologies, a company specializing in autopilot and other
avionics for micro unmanned aerial systems. In November 2011, it
had acquired Sim-Industries B.V., a commercial aviation simulation
company located in the Netherlands. This acquisition would expand
both companies' closely related markets and expand the customer
Another defense major,
L-3 Communications Holdings Inc.
), acquired the Kollmorgen Electro-Optical ("KEO") unit of
). This unit will improve L-3's product suite with products like
submarine photonics systems and periscopes, ship fire control
systems, visual landing aids, ground electro-optical and
In December 2011,
General Dynamics Corporation
) completed the acquisition of Force Protection, Inc. The latter
provides blast- and ballistic-protected platforms that support the
armed forces of the U.S. and its allies.
In December 2011,
) announced that it has acquired Pikewerks Corporation, a privately
held company, to further extend Raytheon's capabilities to defend
against sophisticated cyber-security threats facing customers in
the intelligence community, the DoD and commercial organizations.
The Boeing Company
) completed the acquisition of Inmedius. It provides software
applications and services for managing and sharing information and
These acquisitions appear beneficial for the companies. For
instance, MetroMachine Corp., in the General Dynamics portfolio,
would aid the defense major in completing submarine contracts.
Buying Pikewerks will help Raytheon in better defending its
customers against sophisticated cyber-security threats.
Another way to share the defense order pie is via strategic
alliances. The defense operators often join forces with each other,
bring along their individual expertise and work as a cohesive unit
for big defense deals.
Moreover, these companies shed their unprofitable segments to focus
more on core businesses. In July last year, L-3 Communications had
decided to partly spin off to L-3 shareholders 100% of a new,
independent, publicly traded government services company. The
new public company will be named as Engility. The company expects
to complete the spin-off by mid-2012.
These strategic deals, besides increasing the size of the entities,
allow access to new markets. They also help to cut down on
competition in a densely competitive space.
The rapidly evolving security challenges and the need for countries
to modernize aging inventories keep demand alive in international
However, in Europe, the continuous financial crisis is forcing
governments to institute austerity measures that will negatively
impact defense spending in the near term. The initiatives taken up
would constrain their defense budgets and fiscal priorities in
current and future periods.
The defense operators are nevertheless clinching international
orders that to some extent are making up for the lost ground from
the US budget cuts and uncertainty in Europe.
Sales of military weapons to foreign countries have risen
dramatically. The DoD has ramped up foreign military sales to
Middle Eastern countries that can protect U.S. interests in the
region, which is crucial for the global economy. Saudi Arabia, UAE,
Egypt, Iraq, Pakistan and Turkey are the top buyers in foreign
military sales deals.
Among the recent foreign contracts, in April 2012, Lockheed Martin
received a firm fixed-price contract to supply 95 Sniper advanced
targeting pods, 35 compact multi-band data-links, 70 infrared
search and track (IRST) systems, 75 IRST pylons and spare-parts to
Saudi Arabia. In March 2012, Boeing had received a firm fixed-price
contract from the United Arab Emirates-based multipurpose satellite
operator to design and build active electronically steered phased
array antenna systems.
The other allies that are buying military hardware from the U.S.
are Poland, Japan and Israel. The overall growth in overseas arms
sales bodes well for the U.S. Defense companies given the looming
cuts in the U.S. defense budget.
Cutting-Edge Innovation and New Products
At the macro level, a gradual shift in defense spending patterns
can be discerned. In response to 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.
Among state-of-the-art products, the latest radar and
telecommunication systems, new ballistic missiles, unmanned
warplanes, development of fighter jets, and sophisticated
surveillance equipment are in the priority list of most countries.
These help enhance the preparedness of a nation to detect, preempt
and counter hostile situations.
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, especially the U.S. The
general trend in this context is to cut national defense
The major defense spenders throughout the world are going for an
austerity drive. The big spenders are gradually lowering their
defense budgets and concentrating on other avenues to fix their
ailing economies. The U.S. defense department has reduced the
defense budget significantly. These cutbacks will impact the big
contractors, as the lion's share of their revenues comes from
domestic defense spending.
There is also pressure on France, Germany and Spain to review and
trim their defense spending.
Long-Term and Specific Program Cuts
The amount allocated for U.S. wars abroad would also witness a
sharp, fall mainly owing to troop withdrawal from Iraq and a
drawdown in Afghanistan. The Pentagon has also made spending cuts
of $487 billion over the next 10 years to meet deficit reduction
Particularly for the F-35 Joint Strike fighter program, it has
decided to slow down its production. The budget proposal for fiscal
2013 suggests a deduction of $1.6 billion at one go from the F-35
program by eliminating 13 planned aircrafts. The budget proposal
provides $9.17 billion for 29 F-35 aircrafts, two fewer than what
were sanctioned for fiscal 2012.
Proposals may also delay the procurement plan under the F-35
program, reducing its planned purchase order from 423 to 244 during
the period between fiscals 2013 to 2017. The DoD expects that this
would bring in a total of $15.1 billion in savings.
Undoubtedly, any cuts at the F-35 program would greatly affect the
fortunes of the world's largest stand-alone defense company,
). The F-35 is Pentagon's biggest weapons program, at an estimated
cost of $382 billion, for development and the purchase of planes.
The downside on the F-35 program is bad news for another defense
Northrop Grumman Corporation
), which has substantial exposure to the program on account of its
role as a subcontractor. Northrop will be in more trouble with the
proposed $800 million cutback on the unmanned aerial vehicle Global
Hawk program and the cancellation of the Defense Weather Satellite
As a consequence of budget cuts and uncertainty related to F-35,
some contractors seem to be pulling back their orders from the
purchase of the aircraft. In February 2012, Italy indicated that it
is planning to scale back its major investment in Lockheed Martin's
F-35 Joint Strike Fighter. A month later the government of Canada
signaled that it may not proceed with a planned purchase of the
F-35 stealth jet.
Further cost cuts hurting defense primes is the proposed delay of
the $1.3 billion U.S. Army's new Ground Combat Vehicles program,
and delaying the development of a $600 million new ballistic
missile submarine, the SSBN-X Future Follow-on Submarine program.
The delay in the submarine program is also a bad news for
Huntington Ingalls Industries Inc.
), too, had to face the brunt of budget cuts through lower
purchases of the tilt-rotor aircraft, V-22 Osprey. Similarly,
) would be affected by lower purchases of Bell Helicopters. It is
important to note here that the 2012 budget proposal contains only
$8 billion for purchase and launch of Lockheed Martin and Boeing
satellites, reflecting a sharp 22% fall year over year.
However, the DoD increased their expenditure for electronic warfare
and electro-optics. On electro-optic and electronic warfare work,
it plans to increase its spending to $4.95 billion for fiscal 2013,
up from $4.6 billion in fiscal 2012.
As a smart move to counter federal defense budget cuts, the defense
majors 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 the defense
Although the Asian defense markets do not compare in size with the
US and European counterparts, the big Asian players are increasing
their defense spending. China is gradually strengthening its
defense capability and continues to increase its defense budget.
India, too, has been raising its defense spending and is planning
to spend $80 billion on defense in the next five years for
acquiring new equipment.
There has been a rise in global spending on cyber security.
Government and private sectors alike are investing heavily to
safeguard against cyber attacks. Increasing awareness of cyber
threats can create a window of opportunity for the defense majors.
Earnings and Dividend Trends
The aerospace and defense companies recently reported their
earnings for the first quarter of 2012. The earnings trend has
remained overall upbeat with the companies beating market optimism
both on the top and the bottom line. The good performance is mainly
attributed to strong orders and deliveries supported by suitable
Another reason to cheer for shareholders is the trend of raising
dividend payments. Lockheed increased its dividend in September
2011, General Dynamics and Raytheon in March 2012, L-3
Communications made it in February 2012 and
) in April 2012.
The U.S. is the leader in global defense spending. The country is
not only a major super power, it has strategic alliances in place
with other foreign nations with major military strengths. The
country sometimes shares its military technology and supplies
sophisticated weapons to its allies. These activities, in turn,
boost the revenue of the defense operators.
Despite the relatively good earnings season and a trend of
continuous dividend increase, we maintain our Neutral stance on the
U.S. Aerospace & Defense industry due to the significant budget
cuts and cancellation of orders. This is reflected in our long-term
Neutral ratings on U.S. based defense operators like Lockheed
Martin Corp., The Boeing Company, Northrop Grumman, Textron Inc.,
Raytheon Co., General Dynamics Corp, L-3 Communications Holdings,
Alliant Techsystems Inc.
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