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Is Lockheed Martin Crazy to Ignore the Asian Arms Market?

By Rich Smith - Jun 13, 2015 at 11:07AM

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Should investors perhaps be looking to buy shares of European defense contractors instead?

Nuclear fast-attack submarine USS Virginia (SSN 774) at sea. Photo: U.S Navy.

It's official now. The Asian arms market is hot, hot, hot!

As we reported last year, naval analysts at AMI International predict that Southeast Asian and Pacific nations will spend $200 billion on submarines and surface warships over the next couple decades. If they're right, this will turn the region into the world's No. 2 arms market, accounting for about 25% of all naval weapons systems sold worldwide.

And as it turns out, AMI is right. (Or at least, so far).

Spying an opportunity
Last week, The Wall Street Journal tallied the numbers and confirmed that arms buyers in "Asia and Oceania" did in fact spend 25% of all international military dollars last year. The total came to $423 billion, or about 85% of America's base defense budget for 2015. China accounted for about half of this spending, while its neighbors, working to counterbalance China's military expansion, spent the other half. 

Spending is expected to ramp even higher, with defense analysts at IHS Jane's predicting a 30% jump among China's ASEAN neighbors through 2020. But while you might expect the U.S. to support their efforts, American defense contractors will be lucky to win even a sliver of this business.

Opportunity ... missed?
The reason: The Journal says that American defense firms are "abandoning the low end" of the defense market.

"Once-reliable U.S. customers, such as Thailand, Indonesia and the Philippines, are" buying more affordable weapons elsewhere, warns The Wall Street Journal. "In sticking to their high-end strategy, the U.S. companies might be missing an opportunity to help secure their futures."

Take Lockheed Martin's (LMT 0.04%) F-35 stealth fighter jet, for example. Lockheed says the fighter costs as little as $98 million a copy, but other estimates suggest it costs several times that. Whichever figure is correct, the plane certainly costs more than its predecessor, Lockheed's F-16, and several times more than Russia's most popular export, the Sukhoi Su-27 Flanker.

Pricey Lockheed Martin F-35s may have a hard time competing with cheaper Russian fighter jets. Photo source: Wikimedia Commons.

Or consider the submariners' market. Here in the United States, defense contractors General Dynamics (GD 1.11%) and Huntington Ingalls (HII 1.12%) are top of the atomic pile in building nuclear-powered attack and missile submarines. Problem is, these nuke boats are incredibly expensive. According to the Congressional Budget Office, America's newest class of guided missile-carrying submarines, dubbed "SSBN(X)," will cost as much as $7.7 billion per boat.

Meanwhile, Japan is hard at work negotiating a deal to sell advanced diesel-electric attack submarines to Australia at prices topping out at just $540 million.

The USS Barbel (SS-580) was among the last diesel-electric submarines built in America... in 1958 . Photo: U.S. Navy.

Indeed, in a recent piece in the National Interest magazine, France, Germany, and Japan were the only three countries named as bidding on the Australian submarine contract -- a deal that could net its winner as much as $33 billion in revenue. A deal that U.S. defense contractors ... aren't even trying to win.

How crazy is this?
According to The Wall Street Journal, recent years have seen European, South Korean and Russian submarine makers snag "multibillion-dollar contracts" to build submarines all across Southeast Asia and the Pacific, all while U.S. defense contractors have sat on their ... hands.

So why aren't large U.S. defense contractors making more of an effort to capture market share in Southeast Asia?

Well, the obvious answer is that "they can't" -- or at least, cannot right now. You see, it's not just General Dynamics and Huntington Ingalls avoiding building diesel submarines. Across the industry, very few of the "marquee" defense contractors manufacture small warships of the size, capability -- and cheapness -- that are in demand among Southeast Asian and Pacific buyers today.

Smaller U.S. companies, such as Maritime Security Strategies, LLC, of Tampa, Fl., do fill this niche. For example, in 2011, Maritime Security sold a 138-foot patrol boat to Lebanon for $29 million. And Juliet Marine Systems has developed a 38-foot stealthy "Ghost" fast-attack boat that costs even less -- but the U.S. Navy isn't interested in buying it.

Introducing Juliet Marine's Ghost -- half patrol boat, half fighter jet, and all very affordable at just $10 million a copy. Photo: Juliet Marine.

As for first-string defense firms, the ones that are (1) capturing market share globally; (2) doing so with the sale of small warships; and (3) publicly traded so that you can invest in them -- are primarily European. Also ... you probably don't want to own them.

Sales are one thing -- profits are another thing entirely
Britain's BAE Systems, and France's Thales SA (a 35% owner of French DCNS), both specialize in large, powerful warships suitable for modern First World navies. But they also build smaller patrol vessels of the type popular among second-tier navies around the world -- sub-300-foot warships such as BAE's River-class patrol vessel and the DCNS Skjold-class corvette, both of which have landed sales internationally.

Germany's ThyssenKrupp, meanwhile, just announced a half-billion-dollar sale of four Saar-class corvettes to the Israeli navy -- at a not insignificant price tag of $120 million apiece. Yet despite winning sales, none of BAE, Thales, or ThyssenKrupp come anywhere close to approaching America's defense contractors in terms of profitability.

According to Yahoo! Finance data, America's biggest contractor, Lockheed Martin, earns about a 12% operating profit margin -- on par with the rest of the U.S. defense industry. More detailed information about the profitability of BAE, Thales, and ThyssenKrupp, however (provided by S&P Capital IQ), shows that these downmarket European builders top out at:

  • 7.9% operating profit margins (for BAE), followed by ...
  • 7% for Thales, and precisely ...
  • 1% at ThyssenKrupp.

The upshot for investors
The fact that America's defense contractors earn fine profit margins while eschewing the market for smaller warships, while the Europeans make lousy profits despite winning international sales ... makes for a very strong argument for buying the Americans, and avoiding the Europeans. That said, I can't help wondering what would happen if U.S. defense contractors such as Lockheed, General Dynamics, and Huntington Ingalls made more of an effort to sell the kinds of products that smaller navies want to buy?

The combination of rapidly expanding sales, with industry-leading profit margins, could yield some very attractive profits for shareholders, indeed.

German Saar-class corvettes have been a mainstay of Israel's navy for decades -- they haven't done as much good for ThyssenKrupp's income statement. Photo: Wikimedia Commons.

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