The aerospace and defense industry found its largest base in the
U.S. with a military budget fittingly impressive. The country's
global leadership position requires it to maintain the capacity to
respond to the ever-changing national security environment. But
unlike many other countries, the U.S. relies on the private sector
to meet its defense needs.
The U.S. Army, Air, and Naval forces enter into long-term contracts
with aerospace and defense companies to meet their various needs
for systems and equipment. As such, the outlook for the industry is
closely tied to the outlook for defense spending by the U.S.
Earlier this month, the Obama administration proposed defense
budget for FY14 of $526.6 billion, down $0.9 billion from the FY13
annualized continuing resolution level of $527.5 billion. However,
the FY14 request does not yet include a detailed budget for
Overseas Contingency Operations ("OCO"), which is essentially
government-speak for foreign wars and war on terror operations. The
government is preparing a separate OCO request that is expected to
be released soon.
Under the continuing resolution, OCO funding for FY13 is $88
billion. This is lower than the $115 billion enacted for FY12 OCO
activities as a result of reduced operations in Afghanistan and
conclusion of operations in Iraq. Going forward, OCO funding is
expected to continue to decline as troops redeploy out of
Afghanistan. In fact, the request for future OCO funding will
likely be closely correlated to the amount of troops required for
Budget Issues - the Sequester
The budget sequester that went into effect at the start of March
2013 and that has a direct bearing on the U.S. government's defense
spending is a function of the country's fiscal and economic
As a background, Congress passed the Budget Control Act of 2011 in
order to resolve the debt-ceiling crisis. The Act provided for a
Joint Select Committee on Deficit Reduction known as the super
committee to produce legislation by late Nov 2012 that would
decrease deficit by $1.2 trillion over ten years.
However, Congress failed to reach an agreement. This would have led
to automatic cuts known as sequestrations, split evenly between
defense and domestic spending, beginning on Jan 2, 2013. However,
the 'Fiscal Cliff' was averted at the last moment and the date was
postponed by two months by the American Taxpayer Relief Act of
But it finally took effect last month. The cuts as a result of the
budget sequester are evenly between the defense and non-defense
categories. The spending reductions are approximately $85.4 billion
during fiscal year 2013, with similar cuts for years 2014 through
Some major programs like Social Security, Medicaid and federal pay
(including military pay and pensions and veterans' benefits),
however, have been exempted from these cuts. Over the 2014-2023
period, sequester would reduce planned spending outlays by $995
billion with interest savings of $228 billion leading to
approximately $1.2 billion in debt reduction.
The Zacks Industry Rank, which relies on the same estimate
revisions methodology that drives the Zacks Rank for stocks. The
way to look at the complete list of 260+ industries is that the
outlook for industries with Zacks Industry Rank of #88 and lower is
'Positive,' between #89 and #176 is 'Neutral' and #177 and higher
is 'Negative.' Zacks Industry Rank for the Aerospace industry is at
#93 out of 261 industries, which puts it in the Neutral zone.
Please note that the Zacks Rank for stocks, which is at the core of
our Industry Outlook, has an impressive track record going back
years, verified by outside auditors, to foretell stock prices,
particularly over the short term (1 to 3 months).
Only one of the 11 companies in the industry has a Zacks Rank #1
(Strong Buy). While 2 carry a Zacks Rank #2 (Buy), seven hold a
Zacks Rank #3 (Hold). Only one company has a Zacks Rank #4 (Sell).
MTU Aero Engines Holding AG (
) boasts a Zacks Rank #1 (Strong Buy). Safran SA (
Wesco Aircraft Holdings, Inc.
) carry a Zacks Rank #2 (Buy).
The Boeing Company
Lockheed Martin Corp.
Northrop Grumman Corp.
Huntington Ingalls Industries, Inc.
Erickson Air-Crane Inc.
) carry a Zacks Rank #3 (Hold).
General Dynamics Corp.
) is a Zacks Rank #4 (Sell).
A few companies have started reporting March ending numbers. Boeing
came out with a solid Q1 results, as did Northrop Grumman,
), Lockheed Martin and General Dynamics, though Textron came up
short. The Q1 results don't show much impact from the budget
sequester, though it will be interesting to see how these companies
cope in the coming quarters. The expectation is for Aerospace
sector's earnings this year to be up 6.8% after declining 4.5% in
Going forward, a number of contracts, sizeable acquisitions,
beneficial spin-offs and restructuring of the companies are
expected to counter the budgetary uncertainty. This leads us to
keep a keep a Neutral outlook on the aerospace and defense sector.
Mergers & Acquisitions, Spin-offs and Strategic
The big defense operators armed with strong balance sheets are
expanding their operations 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. For that matter, the industry encourages acquisitions
as the highest-priority investment area for a company with a
sizeable cash balance looking for growth amid significant defense
In fact, the four main strategies to stimulate growth are joint
ventures, foreign military sales, international expansion and
mergers and alliances. Among important mergers and acquisitions, we
begin with The Boeing Company which acquired CPU Technology Inc.'s
Acalis business in February this year. The acquisition would
address the need of Boeing's global customers to protect
warfighters from information-assurance attacks.
Acalis provides security-on-a-chip that can help defend manned and
unmanned aircrafts. This acquisition will help the company to
better differentiate its offerings and provide long-term value for
its global aerospace and defense customers.
Triumph Group, Inc.
) completed the acquisition of Goodrich Corporation (Goodrich Pump
& Engine Control Systems) from
United Technologies Corporation
). We also saw last month Erickson Air-Crane acquire Evergreen
Sometimes, instead of acquiring a particular firm, defense
companies enter into contracts to purchase certain assets in order
to acquire capabilities that enhance their ability to expand into
attractive adjacent market opportunities. For instance, in January
this year, Lockheed Martin entered into an agreement with Aveos
Fleet Performance, Inc. to purchase certain assets of the engine
maintenance, repair and overhaul ("MRO") business.
) is progressing well on its plan to split SAIC into two
independent, publicly traded companies. In its announcement, SAIC
said it intends one company to focus on government technical
services and enterprise information technology. The other will
focus on science and technology solutions in national security,
engineering and health. The split is expected to occur in the
second half of fiscal year 2014.
Overall, these acquisitions and even spin-offs help the defense
pros in fulfilling task orders and contracts.
Agreements and Contracts
Currently, the world's five largest military spenders are the U.S.,
China, Russia, U.K. and France. Following suit are Saudi Arabia,
India, Germany, Italy, Brazil, South Korea, Australia, Canada and
The aerospace and defense companies generate revenue from
international orders and foreign military sales ("FMS"). Since the
domestic defense sector is faced by budget cuts and a constrained
spending environment from the U.S. government, the industry is
looking for growth from international orders.
In January this year, General Dynamics received a contract for the
procurement and production of 69 Saudi M1A2 Abrams tanks for the
Kingdom of Saudi Arabia. The Foreign Military Sales contract was
awarded by the U.S. Army TACOM Life Cycle Management Command for
the Royal Saudi Land Forces. Again, in Jan 2013,
Alliant Techsystems Inc.
) entered into a contract with Israel Aerospace Industries under
which it will provide the solar array to power the flagship Israeli
company's 5-ton Earth satellite AMOS-6.
In February, under another FMS sales program, Alliant Techsystems
received a contract for the production of rocket motors for AIM-9P
The rapidly evolving security challenges and the need for countries
to modernize aging inventories keep demand alive in international
markets. 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.
Over the next few years, demand for U.S. military exports is
expected to remain strong. A truculent Iran, with increasing
potential for nuclear capacity and relatively strong oil prices,
has of late spurred the demand for U.S. military aerospace products
by Gulf countries.
Similarly, increasing Chinese defense budgets have led to
significant new U.S. sales in South and East Asia. Going forward,
these sales would more than offset diminishing sales to European
countries that have significantly cut their defense budgets.
A trend very much noticeable among recent contract wins is that
most of these awards come from the Defense Advanced Research
Projects Agency (DARPA). DARPA is an agency of the United States
Department of Defense responsible for the development of new
technologies for use by the military.
In March this year, Lockheed received a Long Range Anti-Ship
Missile modification contract from DARPA to conduct air- and
surface-launched flight tests and other risk reduction activities.
Again in the same month, Northrop Grumman received a contract for
the DARPA ASPN phase 2 project that develops algorithms and a
prototype sensor-fusion system to enable low-cost navigation for
military users on any operational platform and in any environment.
Modification contracts are extended contracts that increase the
value of original contracts. In fact, they demonstrate the ability
of these defense companies of performing the contracts well in
time. In April this year, Northrop Grumman received a modification
contract from the U.S. Air Force for its Global Hawk unmanned
aircraft system. Recently,
(LLL) also received a firm-fixed-price modification to a previously
awarded contract for the production of 16 universal modular masts
for Virginia-class nuclear fast-attack submarines.
The aerospace and defense industry is experiencing continued
consolidation. The companies are also busy restructuring in order
to streamline their operations. A few days back,
) decided to reorganize its business through segment realignment,
announcement of key executive roles and job cuts. The restructuring
would aim to streamline operations, increase productivity and
achieve stronger alignment with customer preferences.
The other way out for U.S. weapon makers who are under pressure to
cut costs and preserve profit margins amid dwindling defense
spending in the U.S is layoffs. In January this year, Boeing
announced that it will consolidate its El Paso facilities and
reduce the workforce there by the end of 2014.
The move again comes on the heels of the company's strategy to
increase affordability for government customers and become more
competitive in an increasingly global marketplace. Boeing intends
to reduce occupied square footage 50% by moving from three
buildings into one, and will reduce employment by up to 160
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 on the priority list of most countries.
These help enhance the preparedness of a nation to detect, preempt
and counter hostile situations.
Contemporary warfare has seen a paradigm shift from traditional
forms of waging a war. There is high demand for new defense
products that help the military in locating and eliminating
terrorists before they strike. Moreover, the success of these
defense companies depend on the ability to develop, market and
produce products and services at a cost which is consistent with
the defense budget.
Indeed, the defense pros can barely survive in this competitive
industry without these innovations. In March this year, Northrop
launched its Fourth Generation Tracking Adjunct Sensor (4G TAS),
the latest upgrade to the company's range of high-resolution
electro-optical/infrared (EO/IR) sensors for the Hawk air defense
system. In March again, Raytheon announced the release of SureView
Version 6.7 aimed at implementing an insider threat detection
program to address national security threats while protecting
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
Needless to say, the major defense spenders throughout the world
are on an austerity drive. They 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.
Acquisition and Program Risk
Taking into account the huge number of acquisition deals in
progress, the industry faces risks associated with the completion,
integration, and financing of these acquisitions. Then with the
majority of revenue coming from government contracts, the industry
could be adversely affected by the cancellation and delay of major
The aerospace and defense companies compete amongst themselves in
the information and services markets for a number of small and
large programs. The major defense players are Boeing, Raytheon,
General Dynamics, L-3 Communications, BAE Systems plc, European
Aeronautic Defense and Space Company, Finmeccanica SpA, Airbus,
Embraer SA and Bombardier Inc. Therefore, with new competitors
coming in, it has become important for the U.S. pros to stay ahead
The aerospace & defense industry has been a keystone of the
U.S. economy for decades and has provided well paying jobs for a
variety of skill levels. The U.S. aerospace industry continues to
contribute significantly to the country's economy and provides
capabilities vital for national security. It generates new
technology in fields such as advanced materials, sensors,
information processing and sharing. Finally, aerospace continues to
generate the largest positive trade balance of any U.S.
The U.S. is the leader in global defense spending. The major super
power also has strategic alliances in place with other foreign
nations with considerable military strengths. The country shares
its military technology and supplies sophisticated weapons to its
allies. These activities, in turn, boost the revenue of the defense
However, on the flip side, the industry's position is now
challenged by global competition, changes in technology, national
and worldwide economic conditions, and global policies affecting
defense, civilian and commercial aviation.
However, the costs incurred by aerospace and defense companies for
executing projects due to order delays would increase leading to an
imbalance between the cost and revenue structure. This would not
only hurt profitability but also lead to delays and even
cancellations of orders and/or programs.
Moreover, in the forthcoming years, the industry will face
challenges, particularly in the defense sector, as the federal
government looks for solutions to an ongoing budget crisis. In
addition to budgetary constraints, including the Budget Control
Act, defense spending will come down due to the draw-down of U.S.
forces from major overseas deployments.
Sequestration still remains an overhang both in the civil and
military sectors. The companies that have little diversification
outside the U.S. are highly susceptible to spending cuts from
sequestration. On the other hand, those with an international order
book would find it less difficult to face the brunt of
Despite the uncertainty related to sequestration, huge defense
budget cuts and cancellation of big-ticket programs, we have a
mixed outlook for the sector based on product progress,
opportunities, acquisition benefits and cost-cutting efforts of
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