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 U.S. is the world's
largest aerospace and defense market, and also home to the world's
largest military budget. The industry largely depends on U.S.
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. 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
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 geo-strategic
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 operators.
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.
In early August 2012, the subcommittee recommended $511 billion for
DoD's base budget and $93 billion for OCO spending, for a total of
$604.5 billion for fiscal 2013.
The general trend is approving an amount less than requested.
However, here the government has outstripped OCO spending more than
requested. In this case, the money has been transferred from one
bill to the other in order to keep the base budget within the
budget law's spending limits.
Since the September 2001 WTC and Pentagon 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. The overall trend in overseas military spending is
unmistakably on the downtrend.
Acquisition, Merger, Spin-offs and Strategic Alliance
The big defense operators armed with 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. 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 budget cuts.
In fact, the four main strategies to stimulate that growth are
joint ventures, foreign military sales, international expansion and
mergers and alliances.
General Dynamics Corp.
) entered into a definitive agreement to acquire Fidelis Security
Systems Inc. The acquisition will make the company well positioned
to deliver relevant and innovative cyber security solutions that
help customers to respond to dynamic cyber threats.
General Dynamics in August 2012 has also completed the acquisition
of the Ship Repair and Coatings Division of Earl Industries. Earl
Industries is a leading East Coast ship-repair company that
supports the U.S. Navy fleet in Norfolk, Virginia and Mayport,
Florida. This acquisition will improve the company's ability to
compete in the growing naval ship-repair market.
In another deal, on June 7, 2012,
Northrop Grumman Corp.
) agreed to acquire privately held M5 Network Security Pty Ltd, at
Canberra. Australia-based M5 Network Security provides cyber
security and secure mobile communications products and services,
and advanced analytics to Australian military and intelligence
In August 2012,
L-3 Communications Holdings Inc.
) completed the acquisition of Thales Training & Simulation
Ltd's civil aircraft simulation and training business for
approximately $130 million. The business is now a part of L-3's
Electronic Systems Group and is known as L-3 Link Simulation &
Training U.K. Limited.
Post-acquisition, the business will strengthen L-3's Electronic
Systems Group with its full flight simulator capability and help
expand into the civil simulation market. The company will thus be
able to offer a full range of total training system solutions to
its military as well as commercial customers. This would not only
expand the company's global presence, but will diversify its
In July 2012, L-3 Communications completed the spin-off of 100% of
a new, independent, publicly traded government services company --
Engility Holdings, Inc. (
) -- to L-3 shareholders. The spin-off has brought ample
opportunity for growth and profit expansion for the company. The
spin-off removed a lot of uncertainty with respect to revenue and
will also take away some of the lowest margins at the company.
These acquisitions and strategic spin-offs help the defense pros in
fulfilling the task orders and contracts entered by them. For
instance, Northrop has received a multimillion-dollar cyber
security contract from the Maryland Procurement Office to develop,
integrate and sustain cloud-based information repositories in an
integrated product development team environment with the
government. Buying M5 Network Security Pty Ltd would help the
company to complete its cyber security contracts.
) received a contract from the U.S. Army's Communications,
Electronics, Research, Development and Engineering Center Space and
Terrestrial Communications Directorate to develop technology for
Morphing Network Assets to Restrict Adversarial Reconnaissance. Per
the contract, the company will develop cyber maneuvering techniques
to thwart potential attackers in high-threat environments.
The company would be helped by Pikewerks Corporation that was
acquired in December 2011. The acquired unit is helping Raytheon to
find a solution to sophisticated cyber-security threats facing
customers in the intelligence community, the DoD and commercial
The aerospace and defense companies also generate revenue form
international orders and foreign military sales ("FMS"). With a
continually challenged domestic defense sector and decline in
contracts from the U.S. government, the industry remains focused on
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.
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 FMS 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 FMS deals.
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.
In June this year, Northrop received an FMS contract to provide the
APG-68(V) 9 airborne fire control radar to Thailand, Iraq and Oman
for use on F-16 fighter aircraft. Per the contract, the
company will deliver 6 radar systems to the Royal Thai Air Force,
22 radar systems to the Iraqi Air Force and 15 radar systems to the
Royal Air Force of Oman.
Again in July, Northrop received a contract from the civil aviation
authority of Chile, Direccion General de la Aeronautica Civil to
supply complete ground-to-air communication systems at multiple
sites across the country. Per the contract, the company will
deliver its latest T6 VHF radios with local technical support.
A trend quite noticeable among 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 July 2012, Raytheon received a contract from DARPA under the
Multilingual Automatic Document Classification, Analysis and
Translation ("MADCAT") program. Per the contract, the company will
integrate optical character recognition, develop novel methods to
process handwritten text and will develop a laptop-deployable
prototype translation system. In July 2012,
Alliant Techsystems Inc.
) also received a contract from DARPA to support its Tactical
Technologies Office ("TTO") Phoenix Technologies Program.
In the light of defense budget cuts and risks to high-budget
programs, the companies often fall back on joint ventures and
strategic alliances to pool their resources giving them access to
new markets. Moreover, these alliances help to cut down on
competition in a densely competitive space.
In June 2012, Alliant Techsystems and Astrium North America entered
into an agreement with NanoRacks, LLC, under which NanoRacks will
market opportunities for both astronaut explorers and the
experiments they plan to carry into space on board the Liberty
In July this year, AREVA Inc. and Northrop Grumman entered into an
agreement to provide cyber security protection support for the
nuclear industry. In July,
Lockheed Martin Corp.
) entered into an agreement with Ocean Power Technologies, Inc. to
develop a 19 megawatt wave-energy project in Victoria, Australia.
Again, in July this year, Raytheon Company received a development
and sustainment contract from
The Boeing Company
) to provide the Exo-atmospheric Kill Vehicle (EKV). Per the
contract, the company will provide EKV development, fielding,
testing, system engineering, integration, configuration management,
equipment manufacturing and refurbishment, and operation and
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 moving toward
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.
Moreover, additional cuts of $500 billion over the next ten years
would result in less and delayed purchasing decisions by U.S.
government customers. There is also pressure on France, Germany and
Spain to review and trim their defense spending.
Going forward, regulatory and legislative pressures are the most
significant barrier to growth. Overall, energy prices and lack of
consumer demand could act as obstacles hindering the growth of the
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.
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.
The aerospace and defense companies recently reported their
earnings for the second quarter of 2012. Most of the aerospace
companies beat our expectations, with mixed outlooks and forecasts.
The performance reflects proper execution of the programs, increase
in sales volume, continuous order flow, operational improvements
and capital deployment actions.
Despite the relatively good earnings season, we have a mixed
outlook for the sector. The cautious stance largely emanates from
the threat of budget cuts and a concomitant delay and even
cancellation of big-ticket programs. This is reflected in our
long-term Neutral ratings on U.S.-based operators like
Rockwell Collins Inc.
), Boeing Company, General Dynamics, L-3 Communications, Raytheon,
Erickson Air-Crane Inc.
Wesco Aircraft Holdings, Inc.
Over the next 1 to 3 months, the defense majors look more bullish
with Alliant Techsystems, retaining a Zacks #1 Rank (Strong Buy
), Lockheed, Northrop, Erickson Air-Crane, and
Huntington Ingalls Industries, Inc.
) carrying a Zacks #2 Rank equivalent to a Buy rating in the short
However, the companies that hold a Zacks #3 Rank (short-term Hold
rating) include The Boeing Company,
), General Dynamics, Wesco Aircraft Holdings, L-3 Communications,
Raytheon, and Rockwell Collins, with only
) retaining a Sell rating in the short run.
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 major 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
Currently, the senate committee has entered into an agreement to
extend government funding for six months instead of passing
appropriations bills for fiscal 2013. The defense spending for the
first six month of fiscal 2013 will remain unchanged from the first
six month of fiscal 2012 levels. As a result, of this makeshift
measure these defense majors will likely have to wait to see the
funding for the upcoming fiscal year.
In the end, for the aerospace and defense companies, the costs for
executing projects would undoubtedly rise 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. Nevertheless, the defense majors would
strive to counter these headwinds with prudent cost management.
ALLIANT TECHSYS (ATK): Free Stock Analysis
BOEING CO (BA): Free Stock Analysis Report
ROCKWELL COLLIN (COL): Free Stock Analysis
ERICKSON AIR-CR (EAC): Free Stock Analysis
(EGL): ETF Research Reports
GENL DYNAMICS (GD): Free Stock Analysis Report
HUNTINGTON INGL (HII): Free Stock Analysis
L-3 COMM HLDGS (LLL): Free Stock Analysis
LOCKHEED MARTIN (LMT): Free Stock Analysis
NORTHROP GRUMMN (NOC): Free Stock Analysis
RAYTHEON CO (RTN): Free Stock Analysis Report
TEXTRON INC (TXT): Free Stock Analysis Report
WESCO AIRCRAFT (WAIR): Free Stock Analysis
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