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Defense Spending Cuts Shift Industry's Balance

A few years ago, the U.S. was waging war on two fronts and demanded a sharp rise in federal defense spending. At that time, with the global economy largely on the fritz, military contracts drove the bulk of the growth in the aerospace industry.

But defense spending is now on the decline. Downsized U.S. military operations and proposed budget cuts tied to sequestration are raising questions about impact on aerospace contractors, and how well the industry is poised to handle such changes.

The trend will likely lead to a significant slowdown, according to analysts, particularly for companies on the lower end of the supply chain. Contractors specializing in parts for weapons systems and military aircraft will probably get hit hardest, experts say.

But even large contractors like Lockheed Martin (LMT), Raytheon (RTN) and Northrop Grumman (NOC) are feeling the pinch.

"There has already been an impact on the big, prime contractors," said Richard Whittington, aerospace analyst at Drexel Hamilton. "Their revenues have stopped going up, they have reduced head counts and internalized some manufacturing that was previously outsourced.

A Commercial Break

On the positive side, companies that get a large part of their revenue from the commercial aircraft sector are seeing increasing benefits as airlines boost spending and race to buy newer, more fuel-efficient planes.

These include top names like Boeing (BA), BE Aerospace (BEAV) and Embraer (ERJ).

"The companies with more diverse portfolios, who have significant investments in the commercial side, are doing well because that side of the industry is going gangbusters right now," said Dan Stohr, a spokesman at the Aerospace Industries Association. "Southwest Asia is a huge growth market for commercial airlines, and demand is still going quite strong there.

According to a report from PricewaterhouseCoopers, the aviation industry last year delivered a record 1,189 large commercial aircraft. That was up 18% from 2011, which was also a record year.

"In the long term, demand is projected to be about 1,700 aircraft annually, meaning that annual production rates may continue to increase by another 40%," the PwC report said.

There is much less certainty on the defense side of the industry. That's partly because lawmakers continue to quibble over when, how and even whether to implement federal budget cuts tied to sequestration.

About $37 billion in defense sequestration cuts are targeted for fiscal year 2013. But there is "still no detail" being provided by Congress or the Obama administration on what to reduce and how to implement the cuts, says Gregory Kiley, an associate at the Silverline Group, which provides strategic consulting and advisory services to the aerospace, defense and other industries.

"They are taking the typical approach with sequester that they do with everything in Washington, which is to delay making decisions and just kick the can down the road," Kiley said. "So the immediate impact on the defense industry is uncertain.

While Congressional Republicans have introduced legislation that would allocate more money to defense than is allowed under sequestration, the Obama administration has threatened to veto any such efforts.

Meanwhile, aerospace and defense companies are preparing for the worst.

"The defense companies have been hoarding cash, cutting their overhead back, and gotten themselves leaner in anticipation of a downturn," Kiley said. "They are very strong cashwise, but have held back on research and development. There is sort of an uncertainty regarding sequester.

Smaller firms that depend on military spending for their livelihoods might face an especially grim future over the next few years.

According to the PwC report, spending cuts will likely drive some small suppliers out of business. That in turn could leave larger companies with "a shortage of critical parts and long lead times to qualify new suppliers.

Department of Defense Comptroller Robert Hale voiced similar concerns in recent statements, saying that the $37 billion in sequestration cuts would likely result in a "sharp drop" in the number of contractors.

1. Business

Companies in the aerospace and defense sector range from commercial aircraft behemoths such as Boeing, which had more than $80 billion in revenue last year, to small niche players like Applied Energetics (AERG), a maker of laser-guided weapons with about $1 million in 2012 revenue.

BE Aerospace, which has a strong commercial sector focus, has run off 10 straight quarters of double-digit sales and earnings growth. Precision Castparts (PCP), which makes components for Boeing 737s and 787s, has grown the top and bottom lines in double digits in 10 of the last 11 quarters.

Large defense contractors have had a rougher go of it. Northrop Grumman, Lockheed Martin and General Dynamics (GD) are all having a hard time producing consistent revenue and profit gains.

Still, most of the 55 stocks in IBD's Aerospace/Defense group are trading near record highs and, as a group, are up about 19% since the beginning of the year. This is partly due to the fact that while there will almost certainly be a slowdown in defense spending, the cuts might not be as deep as people once feared.

"A few months ago I was much more negative about defense spending," analyst Whittington said. "But it turns out that the budget deficits are much less onerous than previously described, and the economy is much better than people anticipated.

2. Market/Climate

According to the PricewaterhouseCoopers report, the aerospace and defense industry reported its best year ever in 2012 in terms of revenue and profit as the surging commercial aviation market more than offset a soft defense performance.

For 2012, the top 100 A&D companies reported a record-setting $695 billion in revenue and $59.8 billion in operating profit. Revenue rose 4% from the prior year, while operating profit climbed 2%.

Strength in the market for large commercial aircraft was on display at last week's Paris Air Show, where Boeing and Airbus both announced large orders for long-haul planes.

Gecas, the aircraft leasing unit of General Electric (GE), said it would buy 10 Boeing 787-10X jets. The deal's list price is $2.4 billion. Qatar Airways ordered nine more Boeing 777-300ER planes with a face value of $2.8 billion. That deal includes a firm order for two planes with the option of seven more.

Airbus announced a potential order from Doric Lease for 20 of the A380 jumbo jets at a list price of $8 billion.

Meanwhile, the market for military goods is still pretty big, even in the face of U.S. budget cuts.

"A $600 billion-plus defense budget is nothing to sneeze at," Silverline's Kiley said. "I'm more bullish on defense than some of the industry people.

3. Outlook

While suppliers to the commercial aviation sector are gearing up for a rise in business in coming quarters, defense contractors are just hoping to hold serve.

According to Deloitte's 2013 Global Aerospace and Defense Industry Outlook report, only three of the top 13 defense contractors doing business with the Department of Defense posted revenue growth last year.

The outlook for the sector isn't any better this year.

"Continued global economic challenges, coupled with revenue gaps and cost pressures in 2013, might result in additional decreases in revenue, lower returns on invested capital, as well as margin contraction for many defense industry companies," the Deloitte report said.

The wild card is how sequestration will impact the industry. The AIA's Stohr says the effects of sequestration won't take effect until the period from September 2013 through September 2014.

"There is expected to be a slash of a little under 10% for both procurement and R&D," he said. "It's spreading down through the supply chain.

The impact of that slowdown will be softened by robust business elsewhere, at least for companies with diversified end markets.

Analysts at Deloitte expect growth in sales of commercial aircraft to reach record levels this year, based on increased production rates and the introduction of next-generation aircraft.

Backlogs should keep growing as airlines continue to update their fleets with new fuel-efficient aircraft in order to stay competitive.

And suppliers to aircraft manufacturers "are likely to be challenged to keep pace with production requirements and are expected to invest in skills development, tooling, and manufacturing capacity," the Deloitte report said.

And, for the first time in several years, there might even be an increase in demand for business aircraft.

On the defense side, the combination of less business from the Defense Department and tightening margins will put pressure on companies to consolidate "in order to squeeze out excess defense segment capacity," the Deloitte report said. "In response, the segment is likely to undergo more streamlining of its cost structure, divestiture of non-core assets, and additions of gap filling, as well as game-changing acquisitions."