According to the Stockholm International Peace Research Institute, global spending on defense shrank by 0.4% in 2014, the third straight year of such declines. Despite Russian aggression in Ukraine, ISIS' explosion across the Middle East, and a burgeoning arms race in Southeast Asia, countries with weak economies around the world continue to cut back on their defense spending.
This would seem to bode poorly for defense contractors trying to sell military equipment, except for one thing: As defense spending gets cut seemingly everywhere else, the business of drone-building is booming.
The wonderful world of drones
That's the upshot of a new report out of IHS Jane's, the gold standard for reporting on all things military. According to Jane's, militaries around the world spent about $6.4 billion on unmanned aerial vehicles in 2014. The drones market is expected to grow at 5.5% annualized over the next nine years and will hit $10 billion by 2024.
Why? According to Jane's principal unmanned systems analyst Derrick Maple, drones are "well established, combat proven and are an essential and expanding element of future operations across the globe." And because they keep high-value human pilots out of harm's way, they even have the potential to save money, in addition to reducing the risk of political fallout at home when a pilot gets shot down.
Result: With overall defense spending shrinking, but drones spending growing, drones will capture an ever-expanding proportion of defense revenues over the coming decade. This makes knowing which defense contractors are building drones, and winning drone contracts, absolutely essential if you hope to invest in the defense industry.
What you don't know about drones could hurt your portfolio
So which companies should a defense investor buy to catch the leading edge of the coming drone wave? You might be surprised to hear this, but according to Jane's, the world's biggest exporter of drones is Israel, and companies such as Israel Aerospace Industries and Elbit Systems do big business selling abroad.
That said, Jane's sees the U.S. catching up to and overtaking Israel in international drone sales in very short order. Just this week, in fact, we learned that Spain has placed an order for five of U.S.-based General Atomics' MQ-9 Reaper drone aircraft, at a cost of $243 million. This order follows a big French buy of 16 such Reapers from GA -- a $1.5 billion contract announced in 2013. Powered by Honeywell turboprop engines, and equipped with Raytheon's AN/DAS-1 Multi-Spectral Targeting Systems, Reaper drones are one of GA's hottest-selling products.
A second U.S. contractor making headway in the drones market is Northrop Grumman (NYSE:NOC). Whereas General Atomics' Predator and Reaper drones dominate the market for medium-altitude, long-endurance drones, Northrop Grumman is king of the stratosphere with its high-altitude, long-endurance Global Hawk. What's more, Northrop is in the running to sell Australia (among other buyers) an even more advanced maritime high-altitude, long-endurance aircraft, the MQ-4 Triton, currently in development.
At an estimated cost of $123 million when the drone begins shipping next year, Triton will be one of the most capable -- and most expensive -- drones on the planet, capable of staying aloft as long as 24 hours without refueling, and surveying wide swaths of maritime real estate for enemy submarines and surface warships.
The future of drones
And that's just to start with. The real "X" factor in the drones market -- the thing no one knows quite how to put a price on -- is the potential for development of air-to-air combat drones -- unmanned combat air vehicles, or UCAVs. Several U.S. companies have products in development, including both of Israel's big drone builders, Airbus and BAE Systems in Europe, and General Atomics and Northrop Grumman here in the United States.
That's some formidable competition. But if I were a betting man, I'd still be putting my money on Northrop Grumman to take the lead in this sector as well -- based on the success of its X-47B aircraft carrier-capable UCLASS drone, "UCLASS" standing for Unmanned Carrier-Launched Airborne Surveillance and Strike. Best of all for investors is that, unlike General Atomics and its rival Avenger combat drone, Northrop Grumman is a publicly traded company.
So unlike with GA, if Northrop does win a UCAV contract, you can own a piece of it.