Aerospace and Defense Major Diversified Industry: Investing Essentials

Want to invest in the world's biggest and best aerospace and defense companies? Here's everything you need to know to do that.

Aug 20, 2014 at 10:16AM

Aerospace and defense companies churn out everything from NASA rocketships and commercial jetliners to Air Force fighter jets, Navy nuclear submarines, and Army main battle tanks. Around the globe, they include "national champions" such as Airbus in Europe, Austal in Australia, and Yangzijiang Shipbuilding in China. Yet stock market analysts traditionally group these two industries into one: the "aerospace and defense industry."

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Globally, the aerospace and defense industry is a $2 trillion a year business. Photo: Wikimedia Commons.

Trying to lasso these disparate products into a single industry creates a marriage of inconvenience, however. So, for more detailed examination, analysts traditionally subdivide the aerospace and defense industry into three smaller groupings of companies:

  • Aerospace and defense products and services
  • Aerospace and defense major diversified
  • Simply "defense"

Today we'll focus on arguably the most important of these three groupings: the aerospace and defense major diversified industry.

What is the aerospace and defense major diversified industry?

The key word to focus on in defining the aerospace and defense major diversified industry is "major." As in "big."

Aerospace and defense major diversified includes such defense industry heavyweights as British warship builder BAE Systems (NASDAQOTH:BAESY) and its American analog Huntington Ingalls (NYSE:HII). Oftentimes, companies in this industry are so big that they have diversified into areas other than defense, complementing huge military products and services businesses with even larger commercial wings:

  • Boeing (NYSE:BA) earns billions of dollars a year building warplanes and guided munitions for the military, but billions more from launching satellites into space, and billions and billions more -- 60% of its business in 2013, in fact -- from the manufacture of commercial aircraft.
  • United Technologies (NYSE:UTX), whose Sikorsky division is one of the most prestigious producers of military helicopters on the planet, and whose Pratt & Whitney business builds the jet engines that power the F-35 Joint Strike Fighter, boasts an HVAC and building controls business that easily dwarfs either of its military products units in size.
  • General Dynamics (NYSE:GD), best known as the producer of Abrams main battle tanks and Stryker armored personnel carriers, makes more money from manufacturing Gulfstream business jets than from those armored vehicles.

The aerospace and defense major diversified industry includes several other heavyweights. The one thing they all have in common is great size. They're the acquirers of smaller defense and aerospace companies and the buyers of component parts manufactured by their smaller brethren. Think of them as the apex predators of the aerospace and defense industry.

How big is the aerospace and defense major diversified industry?

Globally, the market for defense products and services is estimated to be worth about $1.72 trillion annually. The nonprofit Space Foundation puts the size of the "global space economy" at $304 billion in yearly sales. And commercial aircraft are estimated to be worth $5.2 trillion in sales over the next 20 years for civilian planes sized for 100 or more passengers (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).

Naturally, some of these categories overlap. But when you add in the markets for "aerospace" products such as helicopters, recreational small aircraft, crop dusters, and similar aircraft, annual sales in the aerospace and defense industry as a whole easily top $2 trillion annually.

As the subsector of the global aerospace and defense industry boasting the companies with the biggest market caps and the biggest annual revenue streams, the aerospace and defense major diversified industry captures a large percentage of these sales for itself.

How does the aerospace and defense major diversified industry work?

Broadly speaking, spending on aerospace and defense comes from two sources: government and private industry. Of the two, government is by far the most important source of revenue for this industry.

According to Forbes, major diversified aerospace and defense contractors in the U.S. depend on the government for as much as 85% of their revenue streams. Bloomberg data suggests that the "vast majority" of revenues for these companies come from Pentagon contracts, with four of the five top government contractors depending on federal largesse for two-thirds of their revenue streams. The exception, Boeing, is less dependent on the government thanks to revenue from sales of commercial airplanes to airlines and airplane leasing companies around the world.

And speaking of "around the globe," dependence on government spending is not a solely American phenomenon. Europe's two biggest aerospace and defense companies, BAE and Airbus, depend on military and security contracts from the government for about half their income. And it works both ways: foreign governments often also have sizable stakes in the success of their national champion aerospace and defense entities. For example, the Italian government owns 30% of the country's premier aerospace company, Finmeccanica.

What drives the aerospace and defense major diversified industry?

This being the case, aerospace and defense major diversified industry companies often act as virtual arms of the government. It's a cyclical industry that rises or falls alongside the state of the economy.

This is true in part because of the role these companies often play in commercial aerospace -- selling aircraft to airlines and individuals, which buy more planes when the economy is good than when it's struggling. But it's also true because when the economy is down, tax revenue tends to fall, constricting the revenue streams that governments depend upon to pay for their military and space exploration programs.

Governments, though, have a bit more financial flexibility than other customers when it comes to spending in tight economic times. Sovereign debt markets, combined with the ability to literally "print money" when necessary, mean that government customers can often continue spending even when, technically speaking, they have no money to spend. During the recent wars in Iraq and Afghanistan, the U.S. government spent freely on defense products and services even as it cut taxes and took on more debt. This offered a prime example of how governments -- for a time at least -- are able to put off economic reality in order to keep spending on aerospace and defense when they perceive a need to do so.

Granted, the dark cloud within this silver lining is that the bills for such spending eventually come due. Recent quarters have seen modest declines in U.S. defense spending as a result, along with significant cuts to space programs. This means few analysts are predicting a return to strong growth in the industry in the near future.

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Lockheed Martin's F-22 Raptor is arguably the world's premier air superiority fighter -- but it simply cost too much to produce, and the U.S. government recently canceled the program. Photo: Wikimedia Commons.

 

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics. 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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