Investor's Business Daily, April 27th, 2007
When the U.S. deployed its first Lockheed/Boeing F-22 stealth fighters at a Japanese air base in February, it was a veiled warning to North Korea: The newest warplanes in the U.S. arsenal are now in range of North Korean nuke facilities.
The move also dramatized another form of American muscle: its economic might.
Spurred by wars in Iraq and Afghanistan and nuclear standoffs with Iran and North Korea, U.S. defense and aerospace makers are riding an updraft of orders for new weapons. Demand is also soaring for civilian and executive jets.
"We happen to be in a strong cycle in aerospace and defense but they are separate industries," said Standard & Poor's equity analyst Richard Tortoriello. "Aerospace is driven by trends in the global economy, while defense is driven by the U.S. government and the political situation."
Because of this, Tortoriello doubts if both markets can keep growing at the same bullish clip.
The 10 companies that make up the S&P 500 Aerospace & Defense index -- including Boeing BA, Lockheed Martin LMT, Rockwell Collins COL and General Dynamics GD -- posted compound annual sales growth of 8.2% for the past five years through 2005. Their net income rose by 12.4% annually over the same five-year period.
Big names such as Boeing and General Dynamics make up the lion's share of big-ticket items for the Pentagon.
The sector also includes specialist firms such as Precision Castparts PCP, a maker of castings, fasteners and other parts for engines on civilian and military planes.
Another is Heico Corp. HEIA, a maker of jet engine components, replacement parts and electronic products.
Yet another is Orbital Sciences, ORB a supplier of rockets, launch vehicles and satellites.
"We see very robust markets in civilian, military and commercial satellites and rockets," said Orbital Sciences spokesman Barron Beneski.
1. Business
The aerospace and defense industry is a mature one focused on making commercial planes, military weapons and space equipment.
The sector follows a traditional manufacturing model that relies on the sale of finished products -- in this case to major clients such as the Pentagon, airlines and other big businesses. It also depends heavily on research and development, supply chains and state-of-the-art technology.
But each component in the sector has its own unique business cycles, opportunities and challenges.
On the defense end, demand for weapons is fueled by the U.S. military's long-term needs, demands stirred by individual conflicts and a complex defense budgeting process with annual and extended procurements.
The defense business also operates in a highly regulated environment, with everything from weapons demand to cost matters decided by the U.S. government.
For commercial aircraft makers, airline profits and long-term fleet planning are the key factors.
Two companies control that segment in an evenly split duopoly: Boeing and Europe's Airbus.
Airbus has struggled with delays in delivering its new superjumbo A380 wide body passenger jet. Boeing is getting more traction selling its new 787 Dreamliner to clients.
That has helped companies such as Precision Castparts, which supplies engine parts for prototypes of the Boeing jet.
"We're participating in the upsurge for commercial aerospace products," said Precision spokesman Dwight Weber.
The firm expects a bigger sales lift when full-scale production of the 787 begins this summer.
Precision, which also supplies parts for the military's F-22 Raptor, says it's performing well in defense, too, which makes up about 14%-18% of its annual sales.
Another growing segment is maintenance, repair and overhaul services, or MRO, for commercial planes.
Goodrich Corp. GR, one of the biggest MRO providers, added hundreds of thousands of square feet last year to its facilities in Scotland and Singapore.
S&P's Tortoriello says Heico has a strong presence in the so-called parts-manufacture authority business. This involves replacement parts churned out by firms other than original equipment makers. These parts are generally cheaper than those made by OEMs.
Makers of smaller business jets are also enjoying a boom.
S&P said in a November 2006 report that new orders for executive jets continue to exceed deliveries.
The global business of developing and making satellites generated sales of $20.8 billion in 2005, up 10.6% from 2004, according to the International Space Business Council, a trade group.
Name Of The Game: It's about cutting-edge technology. Airlines want more comfortable, fuel efficient aircraft. The U.S. military wants weapons and other equipment that's ahead of the curve in lethality, ruggedness and features.
2. Market
For military aircraft, the Pentagon is the chief client of U.S. aerospace and defense makers, accounting for 40% of all global weapons sales.
Congress approved a 7% boost last year in new Defense Department spending as part of the fiscal 2007 defense budget that began Oct. 1. It totals $436.6 billion.
The approved 2007 budget includes $84.2 billion for new weapons, up 10.5% from the year before.
The commercial jetliner market, meanwhile, is spread more widely, with about 500 buyers worldwide.
U.S. airlines used to account for the lion's share of new purchases. But U.S. carriers are still regaining their grip from steep losses in the aftermath of 9/11, and demand for new passenger jets remains weak.
Airlines in China and India are picking up the slack.
S&P says Chinese orders for new Boeing commercial jets jumped to 143 planes in 2005 and 144 for the nine months through September 2006. This compares with of 112 orders from China over the preceding five years.
India, meanwhile, ordered 98 Boeing jets in 2005 and at least 20 in 2006, after buying just one in the preceding five-year period.
Demand for avionics in both commercial and military aircraft should remain strong through 2007, said Rockwell CEO Clay Jones in an e-mail interview.
He predicts Rockwell's aviation electronics, network and other government business will benefit from President Bush's fiscal 2008 core Pentagon budget, which calls for a 10% spending increase over fiscal 2007. Bush is also pushing for more supplemental bridge funds to back operations in Iraq and Afghanistan.
"This puts off, for at least another year, the belief that we will see the rate of growth of the base defense budget decline to something more in line with inflation," Jones said.
3. Climate
Spending for new planes, helicopters, ships and armored vehicles are the result of demands triggered by fighting in Iraq and Afghanistan and the need to counter a Chinese military buildup.
But the days of pouring billions of dollars into unproven defense programs are over.
The Pentagon has grown more budget-conscious and is under growing pressure to get a bigger bang for its buck.
Orbital Sciences' Beneski says the U.S. military favors the smaller satellites the company specializes in, partly because they're cheaper to build and launch. He sees the same trend occurring among commercial clients.
Most analysts expect military spending to jump in the near term. But the fate of some weapons programs are less clear now that Democrats control Congress.
At the same time, demand for passenger jets is fueled by China and India, whose burgeoning economies are sparking a rapid expansion of air travel in both countries.
Demand for smaller business jets remains strong, though plane orders from the troubled U.S. airline industry are still weak. Demand for civilian and military satellites, meanwhile, is surging.
4. Technology
The defense sector is focused on developing so-called "leap-ahead" technology that offers vast superiority against foes.
Stealth technology that lets planes and ships evade enemy radar will shape future weapons systems. Nanotechnology that makes computer and electronic systems ever smaller are another priority. The military is also looking at new laser- and space-based systems.
The F-35 Joint Strike Fighter being developed by Lockheed will signal a new generation of warplanes. They'll have super capabilities -- with a price tag to match. Individual planes will cost hundreds of millions of dollars.
The Pentagon's also developing new artillery that uses magnetic pressure to fire projectiles over enormous distances and to destroy targets without explosives.
On the civilian side, jet makers are developing fuel-efficient airliners that carry more than a thousand passengers, letting airlines cut costs and boost capacity.
5. Outlook
Both the commercial and military sides of aerospace and defense are seeing accelerated growth. But some worry that stepped-up spending on arms and security will dampen civilian aviation and other nondefense areas.
Upside: In commercial aerospace, demand is much greater than supply. Orders for planes and parts are backlogged.
In defense, the U.S. military's replacing aging equipment. Spending on new weapons systems and R&D is surging as a result.
Risks: Terrorism and escalating conflicts around the world could reduce demand for commercial aircraft. It's possible that defense budgets will be cut by a Democratic-controlled Congress or a new president in 2008.
