The western countries increase military efforts against ISIS in the Middle East, and the coalition deals with new diplomatic and geo political challenges that cause new tensions, Turkey and Russia comes to mind. It seems that the constant feeling of global instability which has been hovering over our heads like an annoying mosquito is not going away any time soon. Just like in any situation, there are winners and there are losers. When it comes to global political instability, the winners are in the aerospace and defense (A&D) industry, and the losers are everyone else.
The A&D sector has always been an important innovative force for technology and for the global economy. Life changing innovations came out of this sector, including commercial aircrafts, space flight, the internet, GPS navigation and satellites, and more.
Historically A&D companies relied heavily on the U.S Department of Defense for major contracts and to fund innovations. In recent years however, due to military budget cuts, the government’s support has been diminishing. According to a recent research from Deloitte, “spending on aerospace innovation has declined sharply since 2009, both on independent research and development (IRAD) spending, down by 26.5%, and DoD innovation spending, down by 21.1% in the sector.”
Deloitte is in no way negative regarding the future prospects of the A&D sector in their report, on the contrary. There was a slow shift in the way businesses finance their operations and innovations in this sector. Partnerships with companies from similar and other industries that will result in strategic diversification of core operations has become a more common practice.
One of the most famous deals recently is Lockheed Martin’s (NYSE:LMT) acquisition of the Sikorsky helicopter unit from United Technologies (NYSE:UTX) for $9 billion. When the deal was announced it was the largest transaction in the A&D sector since 2011.
Shortly after, Berkshire Hathaway (NYSE:BRK.B) announced the behemoth acquisition of Precision Castparts (NYSE:PCP) valued at $37.2 billion, breaking all previous records for a single transactions in the sector.
Another famous deal, showing how companies are focusing on diversification, is Raytheon’s (NYSE:RTN) $1.6 billion investment in commercial cyber-security company Websens, which was announced on April 20, 2015. As a result, Raytheon now owns about 80% of the new company, and from the words of Raytheon’s CEO Thomas A. Kennedy himself, "The creation of this new commercial cybersecurity company allows us to leverage deep domain expertise to offer our customers unique capabilities that will help defend against the vast, advanced scope threats that exist today... We are excited to bring these advanced, defense-grade cyber solutions to our existing and new customers." In other words, Raytheon now has a business that is already highly operational, with an innovative new product that fits nicely with the company’s core operations and that is already developed and ready to be offered to customers without the need in additional R&D funding. Impressive.
Three examples prove nothing of course, so to prove the point here are some conclusions from a research report published by PricewaterhouseCoopers (PWC):
- Two thousand and fifteen will be a record year for A&D M&A — by far.
- With $52 billion in announced deal value, the third quarter of 2015 alone exceeds the deal-making value for any full YEAR on record for the sector.
- Notable transactions have been announced in both the commercial aerospace and defense segments of the sector with participation from both strategic and financial investors.
- 2016 will continue to be very active and likely above the rolling ten-year average, which will be around $25 billion after 2015.
No doubt that as the federal defense budget dropped companies in the aerospace and defense sector had to come up with new ways to prosper, but after a steady 4 year decline in U.S military defense spending, next year the government is very likely to break that streak. Earlier in October President Obama announced that he will not sign another continuing resolution, stating that a firm budget is necessary as U.S national security becomes an absolute priority. The fragile situation in the Middle East once again forces our government to pour more of tax dollars on the military, and as a result the contracting agreements with the A&D sector are expected to accelerate once again.
Large government contracts will have more impact next year, and the beneficiaries will be the companies in the A&D sector that are performing well when global political problems are not getting fixed. Lockheed Martin’s acquisition of Sikorsky helicopter unit from United Technologies, which we have mentioned above, has already proved itself as a wise investment. On November 30th several U.S Army contracts were announced, among them two deals with a total value of about $930 million with Sikorsky Aircraft. Lockheed Martin by itself has also received some extra money, with its Missiles and Fire Control department receiving $41.4 million modification to a foreign military sales contract.
Another big winner when it comes to governmental deals is, of course, Boeing (NYSE:BA), which landed five contracts from the Department of Defense, valued at almost 200 mill.
Aside from governmental contracts, as the fight against terrorism accelerates, other buyers desire weapons and technology that is manufactured by U.S companies. Recently Saudi Arabia has decided that they need 13,000 smart bombs and spare parts made by Boeing and Raytheon. The U.S government, for reasons beyond our understanding, approved the deal. As minor investors with no power of influence the best we can do after slapping our foreheads with amazement at how easily our government agrees to sell smart bombs to the country from where 15 of the 19 9/11 hijackers came from, is to at least have some profits out it.
For those who don’t have the time to follow and research all the companies listed in this article, there are a couple of popular exchange traded funds focusing on the aerospace and defense sector – iShares Dow Jones US Aerospace & Def (NYSEARCA:ITA) which has net assets of more than $645 million, and PowerShares Aerospace & Defense (NYSEARCA:PPA) with net assets of about $290 million under management.
Both graphs, as expected, look very identical -
The funds show tremendous growth in 2013, slowing down and eventually stabilizing since then. The combination of factors discussed throughout this article show great potential for growth to resume. Companies in the A&D sector showed an ability to maintain profitable operations and invest in innovations relying less on government contracts and more on investors and M&A activity which reached new high in transactions in 2015. In addition, the growing efforts to fight terrorism and global political tensions around the world resulted in the U.S military and defense budget to increase in 2016 for the first time in 4 years, as well as in a higher demand for modern defense and weapons technology from around the world.