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Aerospace and Defense Industry: Investing Essentials

By Rich Smith – Aug 12, 2014 at 1:45PM

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

Born with Wilbur and Orville Wright's first flight in Kill Devil Hills, N.C., tested in the fields of France in World War I, and brought into mass production during World War II, the global aerospace and defense industry is still relatively young at a sprightly age of just 111. But already, few industries are more important to the modern economy than aerospace and defense.

The aerospace and defense industry produces the airplanes that carry travelers, and shuttle packages for billions of e-commerce customers, back and forth daily. It makes the constellations of satellites that guide the GPS chips in our cars, deliver television to our satellite dishes, and keep track of global warming. And yes, this industry also produces the military hardware that nation-states need to maintain peace and security around the globe.

Widely believed to be the world's most capable fifth-generation, air-superiority-fighter jet, the F-22 Raptor helps to protect America from "the bad guys." Photo: Wikimedia Commons.

No wonder so many investors are drawn to the idea of investing in aerospace and defense. But what do you need to know about the industry to invest in it successfully?

Let's start with the basics.

What is the aerospace and defense industry?

With products ranging from deep-sea-diving nuclear submarines to high-flying GPS satellites -- and everything in between -- the aerospace and defense industry is big enough that it's sometimes hard to grasp precisely which pieces fit within it. We can give you a few illustrative examples, though:

  • Commercial aircraft and general aviation (examples: passenger jets, cargo jets, prop-driven cropdusters, helicopters)
  • Military aircraft (everything from F-16 fighter jets to B-2 stealth bombers to combat helicopters to new-fangled unmanned aerial vehicles)
  • Warships (submarines, destroyers, aircraft carriers)
  • Ground defense (tanks, APCs, rockets, and guns both big and small)
  • Satellites (for communications, GPS, weather monitoring, and other scientific missions)
  • And the rockets that put those satellites in orbit, and the engines that power those rockets

And that's before you even consider the multiplicity of electronics and software products that go into making all of the above work the way they're supposed to, and the growing market for "cybersecurity" as well.

How big is the aerospace and defense industry?

Considering the staggering number of components that make up the broad aerospace and defense industry, you won't be surprised to learn that it's a very big market. Precisely how big is hard to estimate, especially since many parts of the market are off-limits to investors, controlled by sovereign states which classify their aerospace and defense industries as "strategic" to national defense.

A recent Deloitte report, however, estimates the size of the global market for defense products alone tops $1.72 trillion annually. Meanwhile, on the civilian side of things, Boeing recently forecast that the market for 100-passenger-plus, commercial airliners alone will amount to some 36,770 new planes -- and $5.2 trillion in new revenues -- over the next 20 years.

And as for "space," the non-profit Space Foundation recently clocked the "global space economy" at $304 billion in annual sales, and growing briskly at close to 7% annualized. That's five times the cost to build the International Space Station -- and it's being spent every year.

Construction of the International Space Station began in 1985. Photo: Wikimedia Commons.

How does the aerospace and defense industry work?

Broadly speaking, spending on aerospace and defense comes from two sources: government and private industry. As a general rule, defense spending comes from the tax revenues levied by nation-states. In the U.S., for example, annual defense spending accounts for about 41% of global expenditures, and takes the form of a "base" defense budget, plus supplemental funding for "overseas contingency operations" -- basically, war funding. The wars in Iraq and Afghanistan have featured heavily in such OCO funding in recent years.

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

Globally, the next four biggest markets for defense products are China, Russia, the United Kingdom, and France. Japan, currently sixth in global defense spending, is another hot market for weapons systems, and customers in the Middle East have been spending freely as well, most notably, Saudi Arabia.

Similar to the defense sector, space also depends heavily on government resources. It took nearly $60 billion to build the International Space Station, for example -- a sum that's beyond the ability of most private actors to raise. But private industry is rapidly ramping up spending on space, sending new satellites into orbit every day, and for the most part, private companies are the ones launching those satellites into space as well.

Civilian passenger and transport aircraft are primarily bought by airlines -- either state-owned, or private -- and more and more commonly, by private 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.

What drives the aerospace and defense industry?

As with many things in life, the aerospace and defense industry is driven by risk -- and opportunity. Purchases of defense products -- warplanes, warships, tanks, and so on -- largely depend on perceived threat levels in the world. Recent examples of this dynamic include the decline in U.S. and allied defense budgets after the end of the Cold War, and the rapid ramp-up in OCO spending, and defense acquisitions generally, after 9/11. Budget constraints can also be a factor. While it's true that borrowing can fund military purchases for a time, eventually the bills all come due.

Artist's rendering of a 100,000-ton Gerald R. Ford-class nuclear aircraft carrier. Source: U.S. Navy.

In space, new technologies (GPS, satellite communication) have spurred a reach for the stars among the globe's private rocket launch companies, helping to grow the industry.

Finally, commercial spending on civilian passenger and transport aircraft depends largely on two factors. The first is airlines' anticipation of demand for air transport. Mankind's growing population around the globe, and the growth of disposable income in the developing world, have both been significant drivers behind airlines' demand for new aircraft, for example. (Conversely, aircraft manufacturers can suffer severe contractions in demand in times of recession).

The second factor is new product introductions. Historically, the introduction of a new aircraft model such as the Boeing 787 Dreamliner or Airbus A380 super-jumbo jet -- or even just the offering of fuel-efficient engines on existing aircraft models, as with Airbus's line of "neo" models, and Boeing's "MAX" 737s -- has tended to spark explosions of demand among airlines eager to present their customers with the "latest and greatest" airplane models, and to cut their fuel costs in the process. When spending comes in waves like this, however, it inevitably results in demand for new aircraft falling into a lull between new product introductions. Thus, the commercial aircraft sector of the aerospace and defense industry exhibits signs of cyclicality in its business.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, Lockheed Martin, and Northrop Grumman. 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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