Cuts leave defence industry up in arms

Prospects for tighter military spending in the West have the global aerospace giants taking a very defensive posture. While commercial sales have kept some solidly in the black, others are looking towards new markets or new ventures, such as green energy.

The RG41 Wheeled Armoured Combat Vehicle by BAE Systems on display at the Armed Forces Officers Club in Abu Dhabi. Ravindranath K / The National

Tighter military budgets in the United States and Europe are hitting the world's top arms makers hard and the prospects for the industry are even grimmer.

Only the most diverse companies are prospering, buoyed up by their major airline divisions. Everyone else is watching their revenues and margins flatline or dive.

Those are the conclusions of a survey of the top 20 global aerospace and defence companies (A&D) published this month by the international accountancy firm Deloitte.

Based on mid-year financial results, Deloitte figures show the top weapons makers have "experienced a decline in their global revenues of US$1.3 billion [Dh4.77bn], or a 1 per cent decrease, after a 3.3 per cent decline in 2011".

The top 20 companies, including Boeing, BAE and Lockheed Martin, represent about 71 per cent of total global industry revenue. Overall, the industry posted increased operating earnings of 8.8 per cent to $20bn in the first half this year.

"But [that was] largely due to the beneficial impact of higher deliveries of commercial aircraft, company cost cutting and efficiency initiatives in advance of expected continued declines in defence budgets," the Deloitte report notes.

It added that when taken separately, the defence divisions of the US giants showed flat growth in revenues and margins. And the European defence firms' performance was even worse, with revenue declining 4.5 per cent.

In July, Boeing's first-half results delivered a 3 per cent profit increase that handily beat forecasts from Wall Street analysts, who worried that sales in Boeing's defence division would post a loss. At the time, Boeing said it was reining in costs to prevent any revenue loss in the division that produced Chinook helicopters and F-18 fighter jets.

But the impact of the defence cuts could be seen in the revenue performance of the company's two main divisions, which are about the same size. Defence revenue rose by only 7 per cent, while revenue in the commercial aircraft division jumped 34 per cent.

"Boeing's defence unit is vulnerable to potentially severe military spending cuts in January," say analysts at FactSet Research Systems.

In its outlook to its first-half figures, published in August, BAE Systems said more declines loomed. "The risk of further reductions in US defence budgets remains, including sequestration if it comes into force in January 2013."

BAE's defence revenue had decreased 9.7 per cent due to lower volumes in the land and armaments business primarily reflecting the completed family of medium tactical vehicles programme.

"In the near term, the land and armaments business faces a challenging market environment," the Deloitte report warns. "The business continues to focus on capturing key new domestic programmes and export opportunities, while improving its competitive position through ongoing rationalisation and efficiency programmes."

The slowdown is already hitting share prices, according to Deloitte.

"Due to continued instability in defence spending forecasts for major global economies, share price performance was mostly down, with aggregate market capitalisation decreasing 0.6 per cent in the first six months of 2012," the report says.

"While companies associated with the boom in commercial aircraft production saw stock valuations rise in the first half of 2012, share prices of other companies fell - principally due to lower revenues and the expectations for cuts to various defence programmes.

"Only eight of the top 20 firms posted a gain during the first half of the year. This follows a decline in defence industry shares in 2011, where aggregate market capitalisation fell 6.3 per cent."

Hanging over the global industry is the future US defence budget. More than $50bn will definitely go from next year's budget and last year's US Budget Control Act would trigger in January about $487bn in additional cuts over the next 10 years should congress fail to find reductions elsewhere.

Already, leaders in the US defence industry are ringing alarm bells.

"In the absence of resources to modernise and refurbish fleets, the nation will witness a long-term decline in defence capability," says Lawrence Farrell, the president and chief executive of the National Defence Industrial Association.

"We need to recognise and account for the ageing of some of our major platforms."

The Deloitte report suggests that as US and European military budgets decline over the next several years, "there will be revenue growth pressure on major defence contractors as competition" over major programmes intensifies.

"Companies with heavier exposure to the defence sector will compete for a smaller share of total market and thus be challenged to fill the revenue gap," it says.

To try to beat the slowdown, five of the world's biggest arms and aerospace contractors are joining forces to enter the clean energy, environment and climate-change markets.

Finmeccanica, Lockheed Martin, Northrop Grumman, Raytheon and Saab have agreed to cooperate on "challenges that have proven too complex to be addressed by any individual government, sector, business or agency on an international level", they said in a joint statement.

In advance of next month's E3DS defence markets conference in London, they announced plans to muscle in on sectors from clean energy, environment, climate, transport and logistics, as well as the humanitarian and disaster-relief sectors.

"Our experience in providing innovative mission solutions uniquely positions us to support government and other industry sectors as they endeavour to tackle these complex challenges," the companies said.

The Deloitte report also offers a ray of hope for arms makers.

"Defence budgets in Asia and the Middle East are expected to grow, which represents an opportunity for defence companies to drive growth with foreign military sales," it said.

However, Tom Captain, the head of the aerospace and defence practice at Deloitte, is sceptical about whether the emerging nations would really ride to the rescue of the defence giants.

"US companies in particular are becoming more successful [at foreign military sales]", Mr Captain says. "Especially in those areas of the world where defence budgets are going up, like India, the UAE, Brazil, Singapore, South Korea and Japan. But there are plenty of other companies, western European, Russian and more, all going after that same small pool of customers."