Industry Market Trends

Aerospace and Defense Braces for Budget Cuts

Feb 11, 2009

Aerospace and defense industry observers and insiders are concerned about possible downward pressure on defense budgets, with more than half thinking the U.S. will spend less in 2009.

As Congress and the White House hammer out the details of the proposed stimulus bill, the aerospace and defense (A&D) industry is bracing itself for the bill's outcome and potential impact.

There has been plenty of speculation recently about potential defense cuts and competing priorities brought on by the financial bailout and developing economic stimulus package, notes a California business journal.

A recent Deloitte & Touche study echoes the industry's sentiments, saying the economic stimulus spending and declining military action in Iraq are likely to slow growth for United States aerospace and defense in the coming years. While defense spending climbed more than 60 percent during the Bush administration, to total at least $612.5 billion in fiscal 2009, Deloitte predicts Department of Defense budgets will flatten or decrease by 2010.

"We think it is inconceivable that the $700 billion (now around $800 billion) bailout plan will not put downward pressure" on defense spending, Merrill Lynch analyst Ron Epstein said in a Sept. 29 research note (via Defense News). More than half (53 percent) of industry observers and insiders polled by the Aerospace Industries Association (AIA), a trade group covering commercial and defense aerospace, agreed with Epstein, saying they think the U.S. will spend less on defense and weapons programs in 2009, Defense News noted in December.

"Declining tax revenue and potential tax cuts to stimulate the economy could strain the Pentagon's budget," the Orange County Business Journal (OCBJ) reports observers as having said.

Even before President Barack Obama took office, the AIA began campaigning for the A&D industry to be excluded from budget cuts, Defense Daily reports (subscription required).

The aerospace and defense industry supports more than 2 million middle-class jobs with more than 30,000 suppliers from all 50 states, the AIA explains.

"The biggest mistake would be to cut defense and space investments, making our industry a bill payer for other industries that are asking the government to bail them out," Marion Blakey, president and CEO of AIA, said in a statement last month. "This would diminish our strength and momentum in the recovery and cost thousands of high-paying jobs. And that, I'm sure we all agree, would be a very bad move right about now."

Others have been more positive. Though the Obama administration could make changes, observers cite the $612.5 billion defense budget for 2009 having already been passed and the 2010 budget being largely laid out, Defense News says. "Some also say flat or growing budgets are more likely in the near term because of plans to add troops and the costs of winding down the Iraq war, plus the possibility that operating in Afghanistan will be more expensive than in Iraq."

Hector Cuellar, president of investment bank McGladrey Capital Markets LLC, tells the OCBJ that "the government won't likely cut spending, as equipment used in Iraq likely will be replenished for Afghanistan. No administration would approve a significant drop."

Even if it does, A&D companies and contractors are more equipped to deal with the fallout because of its six-year run of improving performance and strong balance sheets, Deloitte says. Its financial performance is also expected to do better than that of its European counterparts due to foreign exchange differentials, program delivery challenges and European job protection policies.

Moreover, A&D companies had about $20 billion in free cash flow in 2008 and a low net debt of approximately $5 billion that should buffer them from potential budget cuts, Phil Finnegan, director of corporate analysis for industry research firm Teal Group, tells Defense News.

Still, some A&D companies are rethinking their business strategies, as they are no longer expecting many contracts for big-ticket items and, instead, believe the federal budget will swing from aircraft to research and development, the OCBJ notes. "Programs for intelligence, security and information gathering, such as unmanned planes, radar and satellite systems, stand a better chance of getting funding," Cuellar adds.

Although potential federal budget cuts deserve strong consideration, Deloitte suggests A&D companies also focus on product innovation, process improvements and new revenue opportunities, as the industry faces a number of other key challenges. These include technology complexities, skilled worker shortages, cost overruns due to poor management and manufacturing delays because of increased supplier outsourcing.


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