(LMT) Aerospace & Defense Stock Overview – January 2012 – Zacks Analyst Interviews

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 U.S. defense budget for 2011 was $670.8 billion, with the base budget at $513 billion and another $157.8 billion approved as supplementary defense spending mainly to fund the wars in Iraq and Afghanistan.

The fiscal 2012 defense authorization bill passed by the U.S. Congress for $662 billion in defense spending includes $529.6 billion for core spending, reflecting a growth of 3.2% from the fiscal 2011 level. This bill includes a provision of $115.5 billion for the wars in Afghanistan and Iraq and another $16.9 billion for the Department of Energy defense programs.

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 downside.

Defense spending by governments is the major source of revenue for the top nine global aerospace companies, with the U.S. accounting for more than 40% of the 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 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.


Acquisition, Merger 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.

These strategic deals besides increasing the size of the combined entity allow access to new markets. It also helps cut down on competition at least by one in a thickly competitive space.

Lockheed Martin Corporation (LMT) bolstered its product portfolio by acquiring Procerus Technologies, a company specializing in autopilot and other avionics for micro unmanned aerial systems.

Another defense major L-3 Communications (LLL) decided to acquire the Kollmorgen Electro-Optical (KEO) unit of Danaher Corporation. This unit will enhance L-3’s product suite with products like submarine photonics systems and periscopes, ship fire control systems, visual landing aids, ground electro-optical and sensor-cueing systems.

General Dynamics (GD) acquired Microtecnica, a leading provider of flight control actuation systems for helicopter and Winslow, a provider of life rafts to the corporate aviation, helicopter and marine markets. These two acquisitions will further help the company to make headway in the aviation industry.

Another way to share the defense order pie is via strategic alliances. The defense operators at times join forces with each other, bring along their individual expertise in the table and work as a cohesive unit for big defense deals.

The Boeing Company (BA) teamed up with Northrop Grumman Corp. (NOC) for a development and sustainment contract from the U.S. Missile Defense Agency. The skills and expertise of the defense majors were needed for the development, integration, testing on the Ground-based Midcourse Defense element of the United States’ ballistic missile defense system.

Boeing also allies with international partners to increase efficiency through exchange of technology. To explore and develop new opportunities in the missile defense arena, Boeing has had an alliance with Israel Aerospace Industries for the past 10 years.

The U.S. Army awarded a contract to Lockheed Martin and Northrop’s joint venture company, LONGBOW Limited Liability Company, to enhance the Lethality of the Apache helicopter. This new contract will upgrade the fire control radar system of the Apache and provide situational awareness and actionable intelligence to the war fighters.

International Orders

The defense operators are clinching international orders that to some extent are making up for the lost ground from the US budget cuts. One of the big developments is Japan Ministry of Defense’s selection of Lockheed’s F-35 Lightning II as Japan Air Self Defense Force’s next generation fighter aircraft. The award win resulted from a competitive bid process.

Boeing received an order from the Kingdom of Saudi Arabia for 84 new F-15 fighter aircraft and to upgrade 70 existing F-15s. Besides, Boeing also received orders for 70 new AH-64 Apache strike helicopters and 36 AH-6i helicopters, plus support and training. This slew of orders would boost Boeing’s top line by $24 billion.

General Dynamics’ business unit in Europe received a contract from the Swiss Army to supply 70 DURO Armored Personnel Carriers, having a capacity to carry up to 11 soldiers. These vehicles will help the Swiss Army to protect its personnel and carry on with its peace-keeping missions.

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.

The defense operators are working continuously to improve its existing product offering and refashion tailor-made products to cater to the critical needs of customers. Technological advancement is key to upgrading defense operations of whole nations.

Among state-of-the-art products, the latest radar and telecommunication systems, new ballistic missiles, unmanned warplanes, development of fighter jets, and sophisticated surveillance equipments are in the priority list of most countries. These help enhance the preparedness of a nation to detect, preempt and counter hostile situations.

New Sovereign Nations

The past two decades have seen a dramatic change in the geo-political landscape with the formation of 34 new countries. A new country comes into existence from the erstwhile undivided country mainly due to political difference and demand of the people living in that region. These countries also bring in fresh demand of weapons to protect their sovereignty, which boosts the order books of the defense operators. The latest addition to the list of new nation is South Sudan, which gained independence in 2011.


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 besides 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 going for an austerity drive. The big spenders are gradually lowering their defense budgets and concentrating on other avenues to fix their ailing economy. The U.S. defense department is planning to reduce the defense budget by $100 billion over the next five years. These cutbacks will impact the big contractors as the lion’s share of their revenues comes from domestic defense spending.

United Kingdom is likewise planning to slash its defense budget by 20%. Moreover, Italy has decided to follow a similar path. There is also pressure on France, Germany and Spain to review and trim their defense spending.

Funding Delays

It is common knowledge that the US government has decided to trim its defense expenditure. The Obama administration stopped or delayed the funding of a few mega projects which were in the research and development stage. Accordingly, after assessing the current and future market potential, Boeing decided to shut down its Boeing Defense, Space & Security facility in Wichita by the end of 2013 on the back of continuous reduction in U.S. defense spending.


As a smart move to counter federal defense budget cuts, these players 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 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 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 Trends

The aerospace and defense companies have started reporting their earnings for fiscal 2011 on an upbeat note. Majors like Boeing, Textron Inc. (TXT) and General Dynamics exceeded our earnings expectation. We eagerly wait to see whether this trend can be sustained by the other defense operators waiting to release their numbers in a few days.


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.

With all the major defense companies about to report their earnings within the next couple weeks, we maintain our Neutral stance on the U.S. Aerospace & Defense industry. This is reflected in our long-term ratings on U.S. based defense operators like Lockheed Martin Corp., The Boeing Company, Northrop Grumman, Textron Inc., Raytheon Co. (RTN), General Dynamics Corp, L-3 Communications Holdings and United Technologies (UTX).

BOEING CO (BA): Free Stock Analysis Report

GENL DYNAMICS (GD): Free Stock Analysis Report

L-3 COMM HLDGS (LLL): Free Stock Analysis Report

LOCKHEED MARTIN (LMT): Free Stock Analysis Report

NORTHROP GRUMMN (NOC): Free Stock Analysis Report

RAYTHEON CO (RTN): Free Stock Analysis Report

TEXTRON INC (TXT): Free Stock Analysis Report

UTD TECHS CORP (UTX): Free Stock Analysis Report

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