Cutbacks Spur Defensive Diversification

LONDON -- Britain's defense companies aren't exactly beating their swords into ploughshares, but diversification into civilian markets is just one response to cutbacks in defense spending that typifies current trends.

That augers well for the long-term future of companies in the sector, dominated by FTSE 100 (UKX) giant BAE Systems (LSE: BA.L  ) . With their technological strengths and diversifying geographic markets, defense companies are starting to resemble their successful engineering sector peers.

Strategy
There are three strands of strategy evident in the industry:

  • Greater emphasis on civilian markets, especially aerospace.
  • Diversification into non-NATO markets.
  • Cost-cutting drives.

Those three measures have provided a good degree of protection from defense cuts. And they position companies well to benefit from buoyant demand for airliners (driven by growth in emerging market economies), cyclical recovery in economic growth (whenever that may be), and eventual upturn in defense spending, which is as inevitable as human conflict.

It may be contrarian to consider buying into the sector when CEOs generally gave downbeat assessments of the outlook during the recent round of half-year results. But the resilience of the industry in the face of a triple whammy of cuts sets it in good stead for the future.

Russian roulette
It's not just that austerity measures have forced governments to rein in spending. The gradual withdrawal from Afghanistan is ending a period of heightened military spending that included the war in Iraq.

On top of that, a political impasse in Washington over how to implement spending cuts has left the U.S. playing a kind of budgetary Russian roulette. "Sequestration" essentially means that if budget cuts aren't agreed by next January then all programs will get an automatic 10% cut. With elections in November, it's starting to look like it could happen. That has helped to stall defense procurement.

But no Russian sales
It's only Western countries that are suffering from debt-induced austerity measures. The fast-growing economies of the East and South are increasing military spending.

Like their civilian counterparts, defense companies are following the money with increased sales to India, Brazil, the good guys in the Middle East, and those parts of South East Asia for which governments will provide export certificates. That rules out China, of course, and Russia. For defense companies, BRICs is spelt "BI."

Home advantage
With a 10 billion pound market cap, BAE Systems accounts for more than half the total capitalization of the U.K.'s defense companies -- not counting Rolls Royce, which has always been more biased toward commercial aerospace.

BAE's size and importance give it a home advantage in U.K. defense spending. Government policy recognizes the concept of national champions in defense, and the company is the lead contractor on major projects.

Nevertheless, its exposure to U.S. spending is significant. Apart from international sales, its diversification efforts are aimed at the aerospace sector and cybersecurity, where it has carved out an interesting niche.

Third leg
Meggit
(LSE: MGGT.L  ) is the only other FTSE 100 defense company. It is best known for its aircraft braking systems, which make up 30% of revenues. Alongside its significant commercial aerospace exposure, it is developing a third leg in energy markets. It recently won a $100 million order from Brazil's Petrobras with its technologically advanced design of a heat exchanger.

Cobham's (LSE: COB.L  ) market cap of 2.4 billion pounds puts it just outside the FTSE 100. The recent acquisition of Danish satellite communications company Thrane & Thrane has helped shift the business mix, which is heavily exposed to military sales.

Its core business is air-to-air refueling, a market in which it boasts a 75% global share. That's a strategic gem, and something that makes Cobham a perennial candidate for takeover speculation. It announced at the half-year that it would focus more on commercial aviation, which currently accounts for nearly a third of revenues.

All three companies are worth a close look, as are some of the smaller companies in the sector.

It often pays to look at trends across sectors, rather than just analyzing individual companies. For other industries with potential, read Top Sectors for 2012, a free Motley Fool report that examines three attractive industries. You can download it to your inbox by clicking here.

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Tony owns shares in Cobham but no other shares mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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