In the late 1980s, the United States, along with more than 30 countries, signed an agreement called the Missile Technology Control Regime, or MTCR. The goal of the agreement was to control the Cold War-era proliferation of weapons of mass destruction, or WMD.
However, the MTCR also stifled foreign sales of unmanned aircraft because of what's called "presumption of denial." Basically, that's when a company decides not to compete for a foreign arms contract because it knows it'll be denied under the terms of the MTCR. But if the Obama administration is successful with its Export Control Reform initiative, the rules that govern the sale of unmanned aircraft systems, or UASes, could be re-examined. That's potentially great news for Northrop Grumman (NYSE:NOC) and General Atomics.
Navigating the arms-race fallout
The MTCR was designed to limit WMD delivery system sales by creating two categories. Category 1 items, which include UASes capable of delivering a payload of 500 kg to a range of 300 km, are subject to "unconditional strong presumption of denial regardless of the purpose of the export and are licensed for export only on rare occasion." In other words, the U.S. government -- specifically the Department of Defense, Department of State, and Congress -- almost always deny exports of these types of systems. Clearly, this is bad news for Northrop's Global Hawk, and General Atomics' Predator and Reaper.
In fact, in 2011, James Pitts, then head of Northrop's Electronic Systems unit, told the Financial Times, "Countries have an insatiable appetite for drones ... and unless something changes in U.S. policy [UASes] will be another area where in five years we will look back and say, 'Gee, we missed the boat, the U.S. missed the boat.'"
Why this matters
According to the Teal Group, from 2012 to 2021, there will be an estimated $28.5 billion spent on UAS R&D, with the U.S. market accounting for 62% of that figure. The U.S. market is willing to spend so much on UAS R&D because there's an estimated $60.6 billion UAS procurement market over that same period. Also, according to the Teal Group, the U.S. has a clear competitive advantage over exporting rivals such as China, Israel, and Europe.
However, because of the MTCR, the U.S. advantages haven't translated to sales. The MTCR affectively limits foreign UAS sales to smaller, lower-cost systems such as Boeing's (NYSE:BA) ScanEagle.
At last year's Washington Aero Club meeting, Wes Bush, Northrop's CEO, stated, "Today, the U.S. is struggling to sell unmanned aircraft to our allies while other nations prepare to jump into the marketplace with both feet."
The sky's the limit
Clearly, the MTCR is putting a kink in defense companies' UAV sales. However, in 2009, President Obama announced his desire to overhaul current controls on weapons exports in what is known as the Export Control Reform initiative. This initiative doesn't specifically address MTCR controls, but P.J. Hart, director of international affairs for the Aerospace Industries Association, said that "through the export reform efforts the United States is looking at all the items it has regulatory control over." By extension, that includes UAS regulations.
More pointedly, in regard to foreign UAS sales, the Export Control Reform is expected to spark an internal dialog that could make it easier for companies to overcome the "presumption of denial" by easing the resistance of such sales from the DOD, State, and finally, Congress. That, in turn, could increase U.S. companies' competition for foreign UAS sales.
What to watch
The talk to reform UAS exports could go either way, but if it does turn in favor of eased foreign UAS sales, it would be welcome news for UAS manufacturers, and in particular Northrop Grumman and General Atomics. After all, $60.6 billion in potential sales isn't exactly chump change. And considering Northrop sells the RQ-4 Global Hawk for an estimated $30 million apiece, this will probably help its bottom line. Moreover, an increase in Global Hawk sales would also benefit subcontractors Raytheon (NYSE:RTN), which supplies the sensors; Boeing, which supplies the carbon fiber wing; and L3 Communications Holdings (NYSE:LLL), which supplies the communications system. Consequently, the Obama administration's Export Control Reform initiative is good news for defense contractors, and something investors should continue to monitor.