The U.S. is the worlds largest aerospace and defense market, and also home to the worlds largest military budget. The industry largely depends on U.S. government contracts. As such, the outlook for the industry is closely tied to the outlook for defense spending by the government. The spending component of the ongoing budget debate and the Fiscal Cliff is heavily weighted towards the defense budget.

Defense spending is the major source of revenue for the top nine global aerospace and defense companies, with the US accounting for more than 40% of total global defense spending. Given the uncertain macroeconomic environment, not just in the U.S. but also globally, the industry faces the risk of fewer new orders as customers are more likely to postpone or cancel contractual orders and/or payments.

In December this year, the U.S. Senate unanimously approved the fiscal 2013 budget worth $633.3 billion. Of this, $527.5 billion was allotted to fund basic national defense and the Energy Department, $17.4 billion was for nuclear weapons projects and $88.5 billion more for overseas operations.

Currently, the U.S. defense spending is negatively impacted by the Budget Control Act of 2011. The Budget Control Act of 2011 has two main parts that would affect future defense spending. The first part dictates a $487.0 billion reduction to previously-planned defense spending over the next decade. The second part is a sequester mechanism that would impose an additional $500.0 billion of cuts on defense spending if Congress is not able to reduce the U.S. deficit by $1.2 trillion by January 2, 2013.

With just days to go before the deadline hits, the issue is as uncertain now as it was immediately after the November elections. While a grand bargain doesnt appear to be on the table anymore, a non-resolution of the Cliff issue would be a major blow to the aerospace industry. In fact, the Congressional Budget Office expects the economy to slide into a recession if the automatic spending cuts and tax increases associated with the Fiscal Cliff are not averted.

Since the September 2001 WTC and Pentagon attacks, the U.S. government has spent significant amounts on military campaigns overseas. The country has already decided to gradually move out of Afghanistan, and the war in Iraq has already ended, which is expected to lower its expenditure on foreign campaigns. In addition to budgetary constraints, including the Budget Control Act, defense spending will come down with the draw-down of U.S. force levels tied to current major overseas deployments.

OPPORTUNITIES

Acquisition, Merger, Spin-offs and Strategic Alliances

The big defense operators armed with strong balance sheets are expanding their operations inorganically through acquisitions. The U.S. Defense department also endorses mergers among U.S. defense companies, provided they dont involve the top five or six suppliers acquiring each other. For that matter, the industry encourages acquisitions as the highest-priority investment area for a company with a sizeable cash balance looking for growth amid significant defense budget cuts.

In fact, the four main strategies to stimulate that growth are joint ventures, foreign military sales, international expansion and mergers and alliances.

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Aerospace & Defense Stock Outlook - Dec 2012