Aerospace and Defense Products and Services Industry: Investing Essentials

Want to invest in aerospace and defense? Here's everything you need to know to do that.

Aug 10, 2014 at 6:02PM

Running the gamut from rocket ships to airplanes to nuclear submarines and main battle tanks, aerospace and defense are two industries that stock market analysts traditionally group into one.

Yet while it's true that rocket ships have some things in common with airplanes (both defy gravity, for instance)...

Spaceplane
It's a plane! It's a rocket! No, it's DARPA experimental space plane. Photo: DARPA.

...neither one seems to have a whole lot in common with a rumbling, 60-ton Abrams main battle tank (decidedly non-buoyant) or with a nuclear submarine (which actually boasts negative buoyancy).

File
Norwegian Ulla-class submarine on maneuvers with NATO. Photo: Wikimedia Commons.

Complicating matters, when dissecting the industry, analysts rarely break aerospace and defense into its most logical three parts -- air, space, and defense. Rather, they take the perverse approach of dividing the industry into the following three sectors:

  • aerospace and defense products and services
  • aerospace and defense major diversified
  • Simply "defense."

It's a procedure that defies logic and frustrates investors. But in the following few paragraphs (and companion articles), we'll try to unravel the mystery for you. Today, let's start with aerospace and defense products and services.

What is the aerospace and defense products and services industry?

All aerospace companies, and pretty much all defense companies, sell both products and services. As such, it seems logical that the aerospace and defense products and services industry should contain precisely as many companies as does the broader aerospace and defense industry. No more, no less.

But when analysts categorize a company as an aerospace and defense products and services company, what they really mean is that the company in question is a sort of niche aerospace company, or a niche defense company. Put plainly, they're saying that the company in question produces at least one major product, or performs one key service, that's identified with the aerospace and defense industry.

 A few examples may help to illustrate the point:

  • Truck maker Oshkosh Corporation makes a lot of products -- fire trucks, garbage trucks, ambulances, access equipment -- but it also makes heavy trucks and mine-resistant, ambush-protected vehicles, or MRAPs, for the U.S. military. MRAPs accounted for about 40% of Oshkosh's revenues in 2013, according to S&P Capital IQ. That's a big enough part of Oshkosh's business to win it a place (in analysts' opinion) as an aerospace and defense products and services company, even if Oshkosh doesn't just do defense.
  • Industrial conglomerate Honeywell makes a lot of products and performs a lot of services, too. Mostly, these are commercial, industrial products and services -- environmental control systems, performance chemicals, electrical components. The $12 billion in annual revenue that Honeywell gets from aerospace products and services is barely 30% of the company's revenues, so it's a less significant market to Honeywell than defense is to Oshkosh. But $12 billion is still a lot of money. Enough money, in fact, to put Honeywell in the aerospace and defense products and services box as well.
  • Tiny AeroVironment, in contrast, does the vast majority of its business with the U.S. military. Unmanned aerial vehicles, sold primarily to the U.S. Army and Marine Corps, account for more than 82% of the sales AeroVironment makes in a year. But this business still amounts to only about $209 million in total revenue. The small size of the revenue stream, plus the very specific nature of the product AeroVironment produces -- i.e., drones -- makes this one a niche aerospace and defense products and services player.

File
AeroVironment has produced more than 22,000 drones -- most for the U.S. military. Photo: Wikimedia Commons.

How big is the aerospace and defense products and services industry?

Globally, the market for defense products and services is estimated to be worth about $1.72 trillion annually. The nonprofit Space Foundation recently clocked the global space economy at $304 billion in annual sales. Commercial aircraft are estimated to be worth $5.2 trillion in sales over the next 20 years for aircraft sized for 100 passengers and up (according to a recent Boeing forecast), with a further $658 billion market opportunity for smaller commercial aircraft, and perhaps $617 billion for business jets (according to Canada's Bombardier).

There may be some overlap in the markets that these companies produce estimates for, of course. And none of this is counting potential sales of such "aerospace" products as helicopters, recreational small aircraft, crop dusters, and similar aircraft. But even so, estimates for the annual size of the aerospace and defense industry as a whole easily tops $2 trillion annually.

As a subsector of the global aerospace and defense industry, the aerospace and defense products and services industry would represent a not insignificant fraction of this sum.

How does the aerospace and defense products and services industry work?

Broadly speaking, spending on aerospace and defense comes from two sources: government, and private industry. Government spending is most important for the defense and space segments of the aerospace industry.

Space spending is most dependent on the state of federal government finances. For example, budget cuts in response to the financial crisis were directly tied to President Obama's 2010 decision to cancel NASA's Constellation program to return American astronauts to the moon by 2020. In contrast, China, where the economy is booming, recently sent a robot to the moon and plans to build a Chinese-only space station by 2020.

Defense spending, in contrast, depends far more on perceived military needs than on the ability to pay for them. A key example here: In that same budget year of 2010, with the U.S. economy stuck in the doldrums and spending on space exploration going under the ax, the U.S. increased overall defense spending by 4% and spending on the Iraq and Afghan wars by 11%.

Fy
Source: U.S. Department of Defense Fiscal Year 2014 Budget Request (link opens a PDF).

And of course in the "aero" part of aerospace, civilian passenger and transport aircraft are primarily bought by airlines or airplane leasing companies. (Such firms hold the planes on their balance sheets and lease them to the airlines and, in some cases, to individuals or to non-airline corporations, to operate.)

As for the specific role that aerospace and defense products and services companies play in this economy, as opposed to that of the aerospace and defense industry writ large, again, it's a niche role. Some of these companies (AeroVironment, Oshkosh) sell niche products to fill out specific needs that their customers have. Other companies (Honeywell, for example) provide specific parts that larger aerospace and defense companies incorporate into their aerospace and defense products.

What drives the aerospace and defense products and services industry?

Depending on which kind of niche aerospace and defense products and services company you're talking about, its business will be driven by different factors.

Producers of niche defense products, for example, will act much like pure-play defense-oriented companies. Their sales and profits will rise in times of perceived international threats to peace and subside in times of relative peace. Niche space companies will enjoy boom times as government coffers fill in good economic times, and they'll struggle in times of recession. Small plane makers will see business boom when their primary customers -- corporate CEOs, wealthy individuals wanting recreational aircraft -- are feeling flush. Sales will sag in a weak economy.

Where things get trickier is with aerospace and defense products and services companies that produce niche products, or perform niche services, for larger aerospace and defense companies. To cite just one famous example, you'll probably recall all the problems that Boeing had with getting its 787 Dreamliner program off the ground in the latter part of the last decade, right? And of course you remember the highly publicized fires aboard 787s in the early days of production? Well, delays in getting the 787 program going, and delays in shipments during the times when airlines grounded their 787s over safety concerns, tended to disrupt production of the plane -- and disrupted the supply chains of companies that produced parts for the 787 as well.

That's just one wrinkle -- probably underappreciated -- that makes investing in small aerospace and defense products and services just a little bit riskier than investing in its bigger doppelganger, the aerospace and defense major diversified industry.

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Rich Smith has no position in any stocks mentioned. The Motley Fool recommends and owns shares of AeroVironment and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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