Will U.S. Defense Contractors Miss Out on This $200 Billion Weapons-Buying Bonanza?

There's an arms race afoot in Southeast Asia, but what are the chances that America's defense companies will be able to profit from it?

May 11, 2014 at 10:30AM

China's first aircraft carrier, the Liaoning (PLAN CV-16). Source: Screen grab from Google Earth.

China has an aircraft carrier -- and it's making the neighbors nervous.

In fact, if news reports are to be believed, China may soon have two, three, or even four new aircraft carriers in its fleet as early as 2020. And if that's true, it's all the more reason for countries located in uncomfortable proximity to the Asian giant to begin building up naval forces of their own.

And fortunately for investors in some of the world's biggest defense contractors who sell to them, it seems China's neighbors are doing just that -- arming themselves to the teeth.

An arms race is afoot in Southeast Asia
As the foremost military power in the world, the United States is currently the biggest market for naval weaponry. That just stands to reason. But according to the naval analysts at AMI International, the Asian-Pacific region has become the No. 2 market for ocean-going arms sales. AMI estimates that Asian and Pacific nations are set to spend $200 billion on submarines and surface warships between now and 2032. At that level, they'll account for about 25% of the global naval arms market.

Unfortunately, U.S. defense contractors will be lucky to win even a sliver of this new business.

The good news
How is that possible? After all, the U.S. boasts both of the two largest privately owned defense contractors in the world -- Lockheed Martin (NYSE:LMT), with $44.9 billion in mostly military annual revenues, and Boeing (NYSE:BA), with a defense business of more than $33 billion annually (according to data from S&P Capital IQ). Both of these firms can expect to make at least some money off the Asian arms race, equipping local navies with weapons systems such as Lockheed's F-35B stealth fighter jet, optimized for use aboard "small carrier" platforms such as South Korea's Dokdo-class landing platform helicopter ships, and Boeing's P-8A Poseidon maritime surveillance aircraft.

South Korea's ROKS Dokdo (LPH 6111) in the foreground. Photo: Wikimedia Commons.

Smaller Raytheon (NYSE:RTN), meanwhile, already gets more than 10% of its annual revenues from the Asia-Pacific region, specializing in the sale of rockets and missiles that can be launched from land, air, and sea platforms. As the region invests in ever greater numbers of coastal defense works, warships, and aircraft, Raytheon can expect millions -- if not billions -- of dollars of additional business.

The bad news
But, at the same time, the two U.S. defense contractors that you'd think would be best-positioned to benefit from a boom in naval spending -- shipbuilders General Dynamics (NYSE:GD) and Huntington Ingalls (NYSE:HII) -- may largely miss out.

According to AMI, Asian and Pacific countries are likely to spend the bulk of their anticipated $200 billion investment buying warships -- perhaps as many as 1,000 surface combatants spread across several different countries, and more than 100 new submarines over the next 20 years. This implies an average purchase price of less than $200 million per warship -- probably much less, given the high cost of the submarines alone, and of the handful of new aircraft carriers to be included in the total, which will eat up far more than their fair share of the spending.

Now here's the problem in a nutshell: As a general rule, General Dynamics and Huntington Ingalls won't even get out of bed to bid on a warship contract of under $200 million. Your average GD-brand Littoral Combat Ship costs upwards of $350 million to build (some estimates put the unit cost closer to $500 million). General Dynamics' Oliver Hazard Perry-class frigate, which cost $194 million to build back in 1978, would be worth about $683 million today in inflation-adjusted terms. And Huntington Ingalls' DDG 51-class guided missile destroyers bear price tags that stretch into the billions.

And the ships these builders specialize in, those muscular, armed-to-the-teeth nuclear-powered fast-attack submarines and aircraft carriers? They all cost even more than conventionally powered craft, and are correspondingly less likely to appear on Asian-Pacific nations' shopping lists.

Foolish takeaway
America has taken a curious path in choosing how to "upgrade" its Navy over the past few decades. Eschewing the yeoman's (or, perhaps here, midshipman's) work of building small, cheap frigates and corvettes capable of maritime patrol and "showing the flag" missions, we've instead focused on building small, expensive warships like the Littoral Combat Ship, and larger, even more expensive warships such as the Zumwalt-class superdestroyer and, of course, our megabillion-dollar aircraft carriers.

This has resulted not only in a smaller Navy for us. It's also left our two best military shipbuilders woefully short of expertise in building the kinds of budget-priced small surface combatants that will be most in demand in the coming Asian-Pacific arms race. And unless we change course soon, this may cost America's defense contractors a $200 billion revenue opportunity in Asia.


America's new nuclear-powered aircraft carrier, the USS Gerald R. Ford (CVN-78). Photo: U.S. Navy.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, Lockheed Martin, and Raytheon Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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