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. government contracts.
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.
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.
Recently, General Dynamics Corp. (GD) 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. (NOC) 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 organizations.
In August 2012, L-3 Communications Holdings Inc. (LLL) 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 product offering.
In July 2012, L-3 Communications completed the spin-off of 100% of a new, independent, publicly traded government services company -- Engility Holdings, Inc. (EGL) -- 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.
In July, Raytheon Company (RTN) 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 organizations.
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 international growth.
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. (ATK) 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 Transportation Service.
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. (LMT) 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 (BA) 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 sustainment.
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 expenditures.
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 industry.
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 operators.
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. (COL), Boeing Company, General Dynamics, L-3 Communications, Raytheon, Erickson Air-Crane Inc. (EAC) and Wesco Aircraft Holdings, Inc. (WAIR).
Over the next 1 to 3 months, the defense majors look more bullish with Alliant Techsystems, retaining a Zacks #1 Rank (Strong Buy rating) and Textron Inc. (TXT), Lockheed, Northrop, Erickson Air-Crane, and Huntington Ingalls Industries, Inc. (HII) carrying a Zacks #2 Rank equivalent to a Buy rating in the short run.
However, the companies that hold a Zacks #3 Rank (short-term Hold rating) include The Boeing Company, Embraer SA (ERJ), General Dynamics, Wesco Aircraft Holdings, L-3 Communications, Raytheon, and Rockwell Collins, with only Safran SA (SAFRY) 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 operators.
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.