Aerospace & Defense Stock Outlook - Dec 2012 - Industry Outlook

By Zacks | December 26, 2012 AAA

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. government contracts. As such, the outlook for the industry is closely tied to the outlook for defense spending by the government. The spending component of the ongoing budget debate and the 'Fiscal Cliff' is heavily weighted towards the defense budget.

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 payments.

In December this year, the U.S. Senate unanimously approved the fiscal 2013 budget worth $633.3 billion. Of this, $527.5 billion was allotted to fund basic national defense and the Energy Department, $17.4 billion was for nuclear weapons projects and $88.5 billion more for overseas operations.

Currently, the U.S. defense spending is negatively impacted by the Budget Control Act of 2011. The Budget Control Act of 2011 has two main parts that would affect future defense spending. The first part dictates a $487.0 billion reduction to previously-planned defense spending over the next decade. The second part is a sequester mechanism that would impose an additional $500.0 billion of cuts on defense spending if Congress is not able to reduce the U.S. deficit by $1.2 trillion by January 2, 2013.

With just days to go before the deadline hits, the issue is as uncertain now as it was immediately after the November elections. While a 'grand bargain' doesn't appear to be on the table anymore, a non-resolution of the 'Cliff' issue would be a major blow to the aerospace industry. In fact, the Congressional Budget Office expects the economy to slide into a recession if the automatic spending cuts and tax increases associated with the 'Fiscal Cliff' are not averted.

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 already ended, which is expected to lower its expenditure on foreign campaigns. In addition to budgetary constraints, including the Budget Control Act, defense spending will come down with the draw-down of U.S. force levels tied to current major overseas deployments.

OPPORTUNITIES

Acquisition, Merger, Spin-offs and Strategic Alliances


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.

Recently, Lockheed Martin Corporation (LMT) announced the acquisition of Chandler/May Inc., an unmanned aerial systems manufacturer. Lockheed Martin's prudent acquisition of Chandler/May would expand its expertise in the design, development, integration, manufacturing and support of fully integrated mission critical systems for unmanned aerial systems ("UAS") and Command, Control, Communications, Computers, Intelligence, Surveillance, Reconnaissance ("C4ISR") missions. Lockheed would leverage the expertise of Chandler/May Inc. to carry out the October contract for Coast Guard Super Hercules C4ISR planes.

The Boeing Corporation (BA) recently completed the acquisition of Miro Technologies. Miro is a privately held software company that specializes in enterprise asset and supply chain management; MRO services; and Performance-Based Logistics ("PBL") management for government and commercial customers worldwide. This acquisition would bolster the company's defense logistics support strategies. Prior deals made by the company include acquisition of Tapestry Solutions, Federated Software Group, and CDM Technologies.

In December this year, General Dynamics Corporation (GD) completed the acquisition of Applied Physical Sciences Corp. of Groton, Connecticut. Applied Physical Sciences is a leading provider of applied research and development services. It will become a part of General Dynamics Electric Boat and help in various engineering programs.

Again in December, Raytheon Company (RTN) completed the acquisition of the Government Solutions business of SafeNet Inc. for an undisclosed amount. The need for acquiring a privately held data security firm comes in the light of supporting the U.S. government's growing need for protected and encrypted data. In October 2012, Raytheon had also completed the acquisition of Teligy, Inc. that has improved the company's cybersecurity offerings in wireless communications, vulnerability analysis, reverse engineering and custom kernel software/device driver development.

In September, Northrop Grumman Corporation (NOC) completed the acquisition of M5 Network Security Pty Ltd. Australia-based M5 Network Security is a provider of cybersecurity and secure mobile communications products and services, and advanced analytics to Australian military and intelligence organizations.

These acquisitions help the defense pros in fulfilling task orders and contracts. For instance, in December 2012, Raytheon received a contract to develop new techniques to perform research and develop tools to integrate new and individual facts into existing large information stores. In this case, the company would be helped by the acquisition of SafeNet Inc. The acquired unit would help the company in performing this task order while maintaining its relationship with various customers.

Agreements and Contracts

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.

Sometimes two aerospace companies that are in a strategic alliance benefit from a single contract. Boeing and Textron Inc. (TXT) together recently received a contract from the U.S. Marine Corps for seven Osprey ground-based trainers, which will reduce fuel usage and aircraft wear-and-tear, maximizing lifecycle cost savings. In this case both the parties were benefited.

Also, aerospace majors are known to venture beyond the pale of their universe to find future aerospace solutions. These domestic and international agreements are made to bring in new technology and expertise. In November this year, Lockheed Martin had signed a three-year agreement under the Department of Defense ("DoD") Mentor-Protégé Program. Per the agreement, Lockheed will assist IERUS Technologies in further developing its government contract accounting system, quality and procurement processes and export control processes.

In December this year, Boeing signed a collaboration agreement with BMW Group as per which they will make a joint research on carbon fiber recycling. Moreover, they will also share information about carbon fiber materials and manufacturing. This would allow Boeing to develop the use and end use of carbon fiber materials.

Then there are international agreements that are done in order to bring in new technology and expertise. In September this year, Boeing entered into an agreement with Sojitz Corporation, a Japanese company. Per the agreement, Boeing will provide training to support Japan's need for more cybersecurity experts. In turn, Sojitz will contribute its Japanese market expertise, information technology professionals and strong local partnerships.

To respond to anticipated requests for both the new U.S. Air Force Combat Rescue Helicopter and the U.S. Navy's recently announced program to develop a new "Marine One" presidential helicopter, Northrop Grumman entered into an agreement with Finmeccanica SpA.

In November this year, General Dynamics received a contract modification from the government of Canada for the upgrade of 66 more LAV III vehicles. Meanwhile Huntington Ingalls Industries (HII) in December received a cost-plus-fixed-fee contract to provide life-cycle engineering and support services for USS San Antonio (LPD 17) class of amphibious transport docks of the U.S. Navy. The contract is the third of the four annual options that was associated with a base contract awarded in February 2010.

These types of contract modifications and execution of options indicate the U.S. Navy's as well as other federal bodies' confidence in the aerospace and defense companies.

International Orders

The aerospace and defense companies generate revenue from 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 international growth. Foreign sales of U.S. military aircraft provide an important growth area. Currently, the C-17, F-15 and F-16 have huge international export demand.

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.

In November this year, Northrop Grumman announced that it will supply advanced shipboard navigation systems for 20 fast patrol vessels under a contract with Indian reseller Marine Electricals Ltd. The systems will be supplied to Indian Coast Guard. Then in September this year, Northrop Grumman received a contract to supply navigation bridge equipment for a series of 39,500-dwt dry bulk cargo ships from China Navigation Company Pte. Ltd., Singapore.

In November this year, Raytheon has received a contract from the Kingdom of Saudi Arabia to deliver a Command, Control, Communications, Computers and Intelligence (C4I) system.

Recently, in December, Lockheed has received an FMS contract to support integration of the Joint Air-to-Surface Standoff Missile ("JASSM") onto the Finnish Air Force ("FiAF") F-18C/D aircraft.

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.

Busy Repositioning

The aerospace and defense industry is experiencing continued consolidation. The companies are also busy restructuring in order to streamline their operations. Lockheed Martin announced such a restructuring in October this year which would enhance customer alignment.

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. Recently, Boeing reduced the number of defense executives by 30% from 2010 levels, closed facilities in California and consolidated several business units to cut costs. After almost completing work on special armor for military vehicles and a decline in demand for its guns, General Dynamics has also decided to lay off about 50 employees in Vermont and 30 in Maine.

Closure of the F-22 production line and decisions not to fund additional C-17 transport purchases or development of a future strategic lifter cast a negative impact on the industry. However, the F-35 Joint Strike Fighter program, the KC-46 tanker, the P-8 maritime patrol aircraft and other platforms continue to receive funding.

Meanwhile, Northrop Grumman is also planning to cut up to 350 jobs from its electronics systems sector, with most of the reductions likely in the Baltimore area. These companies are also contemplating additional layoffs.

Headwinds

Global Downturn


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 expenditures.

Austerity Drive

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, 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 government contracts.

Others

Going forward, regulatory and legislative pressures are the most significant barrier to growth. Besides, energy prices and a lack of consumer demand could act as obstacles to the growth curve.

Intense Competition

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 (LLL), SAIC, Inc. (SAI), BAE Systems plc, European Aeronautic Defense and Space Company EADS N.V., Finmeccanica SpA, Airbus, Embraer SA (ERJ) and Bombardier Inc. In addition, Canada, China, Japan and Russia are all making efforts to enter or re-enter the large civil aircraft market. Therefore, with new competitors coming in, it has become important for the U.S. pros to stay ahead in technology.

Earnings Review and Zacks Rank

The Zacks Industry Rank, which relies on the same estimate revisions methodology that drives the Zacks Rank for stocks, currently puts the aerospace industry at 101 out of 259 industries in our expanded industry classification, broadly qualifying the industry in the Neutral category. None of the 16 companies in the aerospace industry has the coveted Zacks Rank #1 (Strong Buy). However, 2 have Zacks Rank #2 (Buy), 1 has a Zacks Rank #4 (Sell) rating and the remaining 13 hold a Zacks Rank #3 (Hold).

The majority of stocks in the aerospace industry, such as Boeing, General Dynamics, Raytheon, Lockheed, Rockwell Collins Inc. (COL), L-3 Communications, Northrop, Huntington Ingalls Industries, MTU Aero Engines Holding AG, Safran SA, Wesco Aircraft Holdings, Inc. (WAIR), Embraer SA, European Aeronautic Defense and Space Company, presently retain a Zacks #3 Rank (Hold). However, we have Alliant Techsystems Inc. (ATK) and Erickson Air-Crane Incorporated (EAC) on the Zacks #2 Rank (Buy) list, with Textron at Zacks Rank #4 (Sell).

The earnings results of Boeing, Raytheon, Lockheed, Rockwell Collins, L-3 Communications and Northrop surpassed the Zacks Consensus Estimates. The highest positive surprise of 46 cents came from Lockheed, while General Dynamics and Textron missed expectations. Overall, total aerospace industry earnings were down 3.3% in the third quarter, but are expected to be down 16.9% in the fourth quarter. For full-year 2013, the industry is expected to see a modest earnings growth of about 1.1%.

Our Take

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 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. To maintain this important sector of the U.S. economy, the U.S. Commercial Service strives to provide assistance to increase the industry's competitiveness.

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. manufacturing sector.

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 operators.

However, on the flip side, the costs for executing projects for the aerospace and defense companies 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. Sequestration is creating uncertainty in both the civil and military sectors.

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 individual companies.

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