The military and aerospace industry suffers from a big case of “it depends.”
The military and aerospace industry suffers from a big case of “it depends.” In an annual report titled Industry Top Trends 2019: Aerospace and Defense from S&P Global, analysts predict that the coming year will be fairly stable but will offer some potential challenges as well.
Defense spending will likely increase in the United States and Europe which will help encourage growth. In addition, increasing aircraft production rates support higher earnings and cash flow. “There is debate over the defense budget, in general, and uncertainty, especially with what Fiscal 2020 will be,” Christopher DeNicolo, senior director at S&P Global told EETimes.
This week, President Donald Trump sent Congress a proposed Fiscal Year (FY) 2020 Budget request of $750 billion for national security over the next five years, $718.3 billion of which is for the Department of Defense (DoD). “This will evolve for defense contractors for the next several years because it takes time for the money to get into the stream,” DeNicolo said.
The proposal, which has not been adopted by Congress yet, seeks sustained funding increases, including a 3.1% military pay raise. “Six months ago, I would have said that budgets would go up materially, but we’ve seen some pullback on that,” said DeNicolo. “Direction from the top is very inconsistent. The budget isn’t being determined by looking at potential threats to the United States but instead the administration is throwing numbers out and trying to fit the military into that.”
Stated goals for the budget include:
At the same time, commercial aerospace suppliers may struggle to increase production rates at the level demanded by aircraft makers. “Likely high levels of merger and acquisition (M&A) activity in both sectors could also lead to increasing ratings volatility,” the report said.
Image courtesy: S&P Global
Looking forward, credit ratios on moderate revenue growth and higher margins will likely improve as the year goes on, said DeNicolo. At the same time, supplier struggles to build operation to fulfill demand on the commercial side. “After peaking at a record of over 3,300 in 2014, the number of orders declined to the 1,800 to 2,300 range in 2015 to 2017 and will likely decline further in 2018,” the S&P Global report said. “We expect this decline to occur because near-term demand will have been met, the manufacturers' large backlogs are leading to long wait times for popular aircraft, and there are few new models to drive increased sales.”
Air traffic is growing at faster than the historical average of 5.5% and there is demand to replace older aircraft such as Boeing 777s and Airbus A330s with new and more fuel efficient planes. At the same time, orders for widebody planes are especially weak. Orders for cargo aircraft have also risen but represent only a small part of the market.
Both Boeing and Airbus have long wait times and backlogs in production on popular aircraft, which can be traced in part to supply chain issues. “Demand puts a huge strain on entire supply chain such that even though a supplier may get business, they have to make capital expenditures as well as spend working capital to meet those goals and higher production rates,” DeNicolo added. “Suppliers, especially smaller ones that don’t have resources, may have problems doing it.”
This constraint on the commercial side may have the potential to bleed into the military and defense sectors as they try to get product from the same pool of suppliers. “If a supplier is straining on the commercial side, it might cause them to pay less attention to their military business,” DeNicolo said.
Potential M&A activity may constrain growth as well. Aircraft manufacturers, for example, are looking at doing certain activities themselves and will look to strategic acquisition to gain those capabilities.
On the defense side, mergers have been common. In October 2018, L3 Technologies and Harris Corp. announced a merger that was an all-stock deal that will result in a $33.5 billion military technology company. The result, which will be dubbed L3 Harris Technologies and will be based in Melbourne, Fla., is expected to close this year.