Edison Investment Research

China to attempt entry into the widebody market

China & Russia collaborate on rival to the A330 & Boeing 787

On May 22, United Aircraft Corp (UAC) of Russia and Comac from China launched a full scale development project for a commercial widebody aircraft, with the aim of entry into service in 2027. This represents China’s first foray into the widebody market. It is particularly notable because this time China has chosen to collaborate with the Russians, unlike on the C919 narrowbody which it is developing autonomously (albeit with Western technologies). The Russians have more commercial aerospace experience, which when combined by the financial backing of the Chinese government makes a potentially powerful cocktail.

The new company is called China-Russia Commercial Aircraft International Corp (CRAIC) and has been registered in Shanghai. Guo Bozhi, head of Comac’s widebody programm is the general manager and his UAC counterpart Macim Litinov is his CRAIC deputy.  Engineers from both companies have been working on a widebody concept since 2013 but this announcement signals the start of the formal design phase.

CRAIC will face the same challenges that COMAC has encountered with the C919 narrowbody, a project that is now more three years late (see my previous blog). However, in addition, there is the added complexity that Russia and China have to work out how to co-operate together and initial indications are that relations are tense. The two countries reportedly cannot agree on a name for the aircraft. For the moment its working name is the C929 which was what Comac planned to call a widebody aircraft of its own design before the countries decided to collaborate. The Chinese want C929 to become its permanent name, but as this would mark the aircraft as a Comac product so the Russian’s unsurprisingly disagree. A new joint engineering centre will be built in Moscow next year where engineers from both countries will be based. However, the Chinese are insisting on it having a branch in Shanghai, where the final aircraft will also be assembled.

Global demand for widebody aircraft over the next decade is expected to be led by China. Airbus Global Market Forecast 2016 predicted that 8060 new widebody aircraft will enter service between 2016 – 2035. Whilst this only represents 24% of all new aircraft by number, it is 43% of the market value. It is therefore a logical step for Comac to want to try and take a share of this market and Russia wants to replace its aging Ilyushin Il-96 which first entered service in 1992. Whilst the new aircraft is unlikely to compete well technologically with Airbus and Boeing’s offerings, it will have a guaranteed market in the Chinese and Russian airlines. If it then proves itself in the air, its lower price tag may well in time attract low cost airlines from other countries. For example, following the C919’s successful inaugural flight last month, Ryanair has reiterated that it remains keen on following the prospects of the aircraft.

The C929 project has a long road ahead. No exact target date has been set for delivery, but CRAIC has said development and certification could take up to ten years. Airbus, Boeing and the world’s airlines will of course watch with interest.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

FY18 US Defense Budget

Not as radical a departure from Obama as the headlines suggest

President Trump released his first full US Defense Budget yesterday. It requests a base budget of $574bn for FY18, and $65bn in Overseas Contingency Operations funding (OCO), making a total request of $639bn (as shown in the chart below). This would be a 3% increase year on year, and it is 3% higher than Obama requested for FY18. Whilst I acknowledge that the market environment looks better for the defence industry under the Republicans compared to the Democrats, I think the headlines this morning are focusing on the bullish rhetoric rather than understanding the nuances of the numbers. This budget is positive for the overall trajectory of defence spending and there is clearly going to be a focus on providing good equipment for troops, However, most of the uplift is consumed by higher troop costs and the Budget Control Act means there is uncertainty over whether this budget will ever come to fruition. In today’s blog I examine what I consider to be the three key questions; what has changed in this budget from Obama’s plans? Where will the extra money be spent? And how likely is it that the proposed budget is enacted by Congress?

US base defence budget and Overseas Contingency Operations funding ($m) FY01 – FY22 (Source: FY17 DoD Green Book & FY18 Budget materials)

How does President Trump’s budget compare to Obama’s?

To understand how the Trump budget compares to Mr Obama’s plans, the most relevant comparison is to the projection for FY18 in the last budget submitted by the Obama administration. The net increase in Trump’s base budget is $17.8bn, or 3%. There can be no comparison for the OCO spending because Obama had not made a projection for FY18. However, Trump’s requested $65bn would be the highest amount spent on OCO since FY14 when the Afghanistan campaign was coming to an end. Both Obama and Trump’s budget plans were above the $549bn base budget cap set by the 2011 Budget Control Act.

Where will the extra money be spent?

FY18 Defense Budget request by line compared to Obama’s (Source: FY17 DoD Green Book & FY18 Budget materials)

Of the additional $17.8bn dollars, 45% is consumer by higher military personnel costs and Operation & Maintenance (O&M) costs. Much of this is due to decisions made on force levels in the FY17 budget enacted by Congress last April. It was agreed to increase the Army’s end strength by 3.5% to 476,000, compared to Mr Obama’s plan of 460,000. Mr Obama then wanted Army end strength to fall to 450,000 but this budget suggests troop number may rise again in the future. Increased wages and accommodation costs are accounted for in the Military Personnel line, but these forces also require training and support which increases demand on the O&M budget. The largest percentage increase is in Research Development Testing and Evaluation, up 10% or by $7.6bn. Procurement is slightly down, by -0.2%, however this is a 12% increase on FY17 outlays so the increase there has already happened as illustrated by the graph below showing DoD outlays on procurement month on month.

DoD outlays on Procurement month on month ($m) (Source: Bloomberg)

Will this proposed budget be enacted by Congress?

The chart below shows that over the past five years, expectations for US defence spending have got lower almost every year due to Congress enacting a budget lower than that requested by the President. Putting aside the complication of the budget caps for a moment, Congress rarely enacts a budget at the level requested by the President, so it is likely that the overall spending number will be slightly lower. However, this outcome requires a resolution to the Sequester set in place by the 2011 Budget Control Act (BCA). Opinion in Washington is currently much divided on whether or not this will happen.  Modifying the BCA requires 60 votes in the Senate so Republicans needs some Democratic votes to enact change.

Presidential 5 year budget requests F12 – FY17 (covering FY12 – FY21) (US Budget materials)

The three previous deals to modify the caps have required every increased in the defence budget (including OCO) to be matched by an increased in non-defence spending. Given the size of President Trump’s requested increase for FY18 though, currently offset by cuts to non-defence spending, this does not look financially viable. Therefore we could see a compromise similar to that for FY17 where a smaller increase in the defence budget is allowed in return for flat non-defence spending. President Trump has firmly set out his stall though, saying in the budget introduction that it “fully reverses the defense sequester”. Whether Congress is in the mood to compromise though remains to be seen.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Global Xpress has lift off

4th and final satellite launched

Inmarsat’s high profile but somewhat beleaguered Global Express (GX) programme is now almost fully operational. The fourth and final satellite, I-5 F4, was successfully sent into orbit on 15 May. This is significant for the Aerospace and Defence industry because the Global Xpress network provides new bandwidth capacity for secure mobile communications from ships, aircraft and vehicles.

The GX constellation is made up of four Ka-band, high speed mobile broadband communications satellites, each with an anticipated life of 15 years. It is expected to be fully operational in late 2017 although the first three satellites are already up and running. The satellites themselves have been built by Boeing. The first three provide coverage of the entire globe, and the fourth is intended to be a spare as well as provide additional capacity and in-orbit back up.

The aim of GX is to allow customers from the aviation, maritime and government sectors to have secure and reliable connectivity. The US Government is reported to be the largest customer so far. Passenger connectivity in the aviation sector is still a nascent market, but demand for the service is growing.  Honeywell and Inmarsat have signed an exclusive agreement whereby Honeywell will produce the on board hardware that will enable airlines to connect to the GX network. Cobham’s wireless business is particularly dependent on GX because it provides the maritime communications equipment which speaks to the satellites. 

It seems to be that the reliance of Cobham, Honeywell and other A&D companies on GX is reflective of an ever more connected world where OEMs across all industries are interlinked with technology and communications companies who provide the infrastructure for the equipment to operate. Last week’s global Cyber attack is also a timely reminder of how this new form of warfare can impact every industry if connectivity is at the centre of everything.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

US strikes budget deal to end six month long Continuing Resolution

Trump secures 3% uplift for defence, half of what he requested

The Republicans and Democrats reached a compromise over the weekend to avoid a government shut down in the US. They have agreed at $1.6trn omnibus spending bill for 2017, with $593bn for defence. The US is currently in Continuing Resolution (CR) which as Ultra Electronics noted last week has led to lower levels of government spending in the first half of 2017. The House is expected to vote on the Consolidated Appropriations Act of 2017 today, followed by the Senate on Friday, putting it on track for enactment before Friday’s midnight budget deadline.

The agreement is significant for defence for two reasons. Firstly it signals that the defence budget is on a growth path again but that the Government is determined to keep President Trump in check. A total defence budget, base spending plus Overseas Contingency Operations (OCO) funding, of $593bn is 2.7% higher than the figure requested for 2017 by the Obama administration (as shown by red in graph below) and means there will be year on year growth of 3.1%. The Trump administration is due to publish its budget request for the next five years sometime this month so we do not yet know the exact trajectory he is planning for the defence, but it is safe to assume it will be one of steady growth. However, the Democrats and non Trump supporting Republican’s have used this omnibus bill to show that they can keep the President under control. The additional $15bn of defence funding is only half of what he requested last month, and $2.5bn of it is contingent on President Trump publishing a strategy to defeat ISIS. No money was provided for the US – Mexico border wall. The Senate Democratic leader Chuck Schumer said “Democrats and Republicans in the House and Senate were closer to one another than we were to the President on so many different issues.”

US defence budget 2001 - 2021E (current US$m)

Second, this omnibus bill is the first time in the past eight years that an increase in US defence spending has not had to be matched by a commensurate rises in social spending in order to placate the Democrats. This suggests that the Congressional stalemate of the Obama administration has come to an end which is positive.

Whilst optically this agreement looks positive, it is worth noting that any benefit the defence industry may have felt from the 3% uplift in spending this year has already been offset by the six month long Continuing Resolution. In addition, the 2011 Budget Control Act mandating Sequestration has not yet been repealed and so theoretically any future Trump budgets will still be at the mercy of spending caps. However, the level of compromise in this omnibus suggests the House and Senate may be in the mind set which could see them finally reach an agreement to end Sequestration.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

China launches its first indigenous aircraft carrier

A show of force which will force the West to take notice

China celebrated the launch of its first domestically built aircraft carrier yesterday (Wednesday 26th April). Known as Type 001A, the ship is as yet unnamed and is the largest ever warship to be built by China. The televised launch comes at a time when tensions are running high in the region’s waters after the US deployed warships and a submarine to the Korean peninsula.

Type 001A will not be operational until 2020, but aircraft carriers are acknowledged to be the best demonstration of hard power and military might. They are imposing, mobile and enable rapid projection of force through fast jets, helicopters, or even self-propelled missiles. This launch symbolises a new and very significant indigenous capability for the Chinese military, and one that will undoubtedly cause concern in the West. The carrier’s full capabilities are unknown by western analysts and the race will now be on establish the threat Type 001A could pose.

The growth rate of Chinese defence spending has slowed in recent years. Last month the Chinese government announced the military budget would increase by about 7% next year, the second year in a row the increases has been less than 10% after a decade of double digit growth. However, the West ignores China at its peril. China not only poses a threat in terms of its own indigenous weapon’s and equipment building capability, but as I noted in my blog last month, Chinese defence companies are now competing with their Western peers to win export orders in the Middle East.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Is stability returning to aerospace in Dorset?

Cobham and Meggitt Q1 FY17

Meggitt and Cobham both provided in line trading statements this morning, although the current position of both companies is somewhat diverged.

Cobham is in the middle of its underwritten rights issue and the new management team’s review of group structures, process and positioning. Whilst the Q1 trading is in line with expectations, with management noting the small weighting of the quarter to full year profitability, at least there were no more warnings. The rights issue should do the heavy lifting on the financial position, but the new management team has some way to go to restore the credentials of the company, which at its core retains high quality engineering assets. Management should outline the next steps with the interim results in the summer, which could be a catalyst for improving optimism.

Meggitt shares are up 14% over the last year and 3% since the start of 2017. Whilst a top line organic contraction of 1% is hardly likely to be popping corks, the fact that both civil aerospace original equipment and aftermarket sales rose 3% is a positive. Although offset by military aircraft revenue declines and the continued oil market depression slowing Heatric compact heat exchanger sales further, guidance for FY organic growth has been maintained at 2-4% implying an acceleration through the second half of the year. The small acquisition of Elite Aerospace during the quarter also indicates Meggitt retains the ability to augment its growth with appropriate, value creating opportunities.

As Huey Lewis once sang “It’s hip to be square”, that is of course provided the hole is not round.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The MOD is open for business again

‘Accelerator’ project intended to encourage innovation but may also encourage acquisitions

Historically, defence technologies used to lead development of civilian technologies. However, military research and development (R&D) budgets have been constrained over the past five years so we have seen civilian technologies leading the way, particularly in the communications sphere. I was therefore encouraged to read about the UK MOD’s new ‘Accelerator’ programme, which funds novel, high-risk and high-potential benefit research to develop new capabilities for UK defence and security.

There are two parts for the scheme. The Enduring Challenge is intended to provide a route into defence and security for any supplier who thinks they have a good idea. It has a budget of up to £6m in the financial year 2017/18 and typically funds proposals for proof-of-concept research in the range of £50,000-£90,000 for work of up to nine months duration. Whilst these figures may seem insignificant against an annual UK defence budget of ~£35bn, they are music to the ears of defence manufacturers who have been increasing their self-funded R&D spend to compensate for falling levels of customer funded R&D.

The second part of the scheme is themed challenges. Every month the MOD explains one of its research problems and invites submissions from companies who believe they have a technology that can help solve the issue. For example, this month the MOD is looking for ways to automate front line resupply in order to not put soldier’s lives at risk. Previous competitions have included how to detect and treat hearing loss, how to see through clouds and the future of aviation security.

Interestingly, the MOD publishes the successful recipients of awards so we can analyse how this money is flowing into industry. Approximately 50% of the awards are going to universities. 10% are going to the established defence primes (BAE Systems, QinetiQ, Airbus and Thales have all benefitted) and the remaining 30% are going to small unlisted companies. This lends further credence to my theory that with the ever changing nature of threat and the ability to borrow money cheaply, we may be about to see another round of M&A in the sector. The Accelerator scheme will not only make the MOD aware of new technologies, but will alert the primes to any ripe targets.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Airbus CEO says “he is not close to retirement”

Succession planning is proof that Airbus is a changed company

In a Reuters interview after the Airbus AGM yesterday CEO Tom Enders said he has no intention of retiring when his current term ends in 2019 and that “it is up to the board and shareholders to decide” if they want him to stay. Mr Enders’ comments yesterday are the first insight to what is likely to be fascinating succession planning at Airbus. It is interesting for two reasons; firstly the company’s history of the management team being chosen by the French and German governments and secondly what the future holds for Fabrice Bregier who currently runs Airbus Commercial Aircraft and has recently been appointed Chief Operating Officer of the newly integrated Airbus SE.

Airbus was previously known as EADS (European Aeronautic Defence and Space Company) and as the name suggests it was a company created by the French, German and Spanish governments. Up until 2012, the European Governments were the majority shareholders, with their share interest reducing progressively throughout the years down to 45% from an initial 70%. As of December 2011, Daimler held most of Germany’s 22.4% share, and French media giant Lagardère shared the French 22.4% with the French Government. Spain then owned a 5.5% stake with approximately 50% of shares in free float. This intricate balance of shareholdings was mirrored by EADS’ unorthodox French-German management structure, which demanded French and German co-chairmen and co-CEOs.

Mr Enders’ appointment as CEO heralded the end of this unusual arrangement. Instead the power sharing was brokered unofficially. With a German at the helm, who brought with him his German CFO, the French were placated by the appointment of Fabrice Bregier as Head of Airbus Commercial and by a French Chairman, Denis Ranque. Mr Enders then began the process of restructuring EADS’ shareholder register so that today 74% of the company is in free float, and shortly after the company was named Airbus.

Today, Airbus’ French-German parentage feels as if it is part of its heritage, rather than its driving philosophy. It undoubtedly remains a European company at its core, but is a truly global and market leading aerospace company, and its current management team is first class. So what will the board decide when faced whether to renew Mr Enders’ contract in 2019. My instinct is that they will make the decision that is in the best interests of the company, and in the middle of its largest ever production ramp up it seems to me that continuity would be the correct answer.

If Mr Enders stays though it raises the interesting question of where that leaves Fabrice Bregier. His recent promotion was seen by many in the media as confirmation that he is the ‘heir apparent’ to Mr Enders, with the assumption that he would take over in 2019, at the age of 57. However, if Mr Enders serves a further term (which would be three years since the implementation of the staggering principle in 2016) then Mr Bregier would be 61 by the time the CEO role is vacant. This is clearly not too late for him to take over, but the question is whether by 2022 an alternative successor may have emerged from the within business.

On balance though, the Airbus board and shareholders are faced with a wealth of talent when deciding who should run the company from 2019, so this is a nice problem to have. This situation is a far cry from the bureaucratic practices the EADS of old was renowned for, and I have every confidence that Airbus can flourish led by Mr Enders, Mr Bregier or even a yet to emerge contender.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The evolution of in-flight entertainment

Will the new restrictions on electronic devices change IFE trends?

Recently I have been reading with interest about how avionic manufacturers are rethinking in-flight entertainment (IFE) given that almost every passenger now has their own electronic device, pre-loaded with their choice of films, television programmes and music. In a culture of ‘on demand’ entertainment, a small screen with poor sound quality, showing a fuzzy version of a relatively recent film understandably lacks the allure it used to hold. There is one school of thought that personal devices could soon remove the need for dedicated IFE systems altogether and I can see the logic in that. Well at least I could until the ban on electronic devices on certain routes from the Middle East was introduced. This unexpected change to the status quo has caused consternation amongst travellers with children and business passengers alike, and will no doubt have the avionics industry reassessing about what future IFE systems should look like.

It is logical to assume that when looking from an economic perspective, airlines would fully support the long term idea of removing IFE systems. It would significantly reduce aircraft weight which leads to lower fuel burn, and therefore lower operating costs and higher profitability. From a customer perspective, it would lead to a more comfortable flight as the space around the seats would increase. This explains why you rarely see seat back screens on narrowbody aircraft nowadays which are generally used for short haul flights.

However, historically the quality of an airline’s IFE systems has been seen one of the few areas carriers could use to woo customers from rival airlines, and also to differentiate the classes of its cabins. Fundamentally, most passengers do not care about the technical developments in aircraft handling, reliability, fuel burn and aerodynamics, they judge their flying experience by how impressive the kit in their seat back is, how much space they have and the quality of the food.

This therefore explains why the current trend on wide body aircraft is towards finding ways for personal devices to interact with and augment seat back screens. Jon Norris, senior director of integrated solutions at Panasonics Aviation Corp explains that “it is not about having a personal device or seatback screen, it is about having both. In your home how often do you watch TV with a second screen on your lap?” I can firmly admit to this being the case in my household so I understand what Norris is suggesting. In our ever connected world we want to email, instant message and surf social media whilst watching our favourite box set or the latest film release.

It seems to be that whether or not IFE systems are required comes down to the issues of screen resolution, sound quality and connectivity. For a passenger to choose the IFE system over his own device, it must offer a better quality viewing experience with a wider choice of media. In the world of iPads, offline content from providers such as Amazon Prime and noise cancelling head phones, IFE systems face stiff competition.  Logically it therefore seems that airlines and the avionics industry must be facing a very fundamental decision; either scrap IFEs altogether, or invest heavily in new technologies to ensure that IFE remains a differentiating factor.

The new regulations last week are therefore likely to have challenged current thinking. Anyone considering IFE as superfluous to demand is probably reconsidering their position. In our day to day lives we are increasingly used to having whatever we want, whenever we want it thanks to the Internet. However, controls over what can be taken on aircraft are becoming more and more restrictive. It is all too easy to forget that in the 1990s smoking was still allowed on board, whereas nowadays the thought of lighting up a cigarette whilst airborne is inconceivable to most people. A world here we cannot fly with electronic devices in the cabin seems similarly incomprehensible, but it is not beyond the realms of possibility as terrorist’s use of technology becomes ever more sophisticated.

Therefore it seems likely that IFE systems are set to stay, and will require heavy investment in order to develop technology which keeps pace with customer expectations. The screen and sound quality, level of connectivity and personalisation could be the defining factors between airlines, and between classes on an aircraft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

China to build UAVs in Saudi Arabia

UK’s biggest defence export market looks east

Saudi Arabia has signed a strategic partnership with the China Aerospace Science and Technology Corporation (CASC) in order to establish the manufacturing of Chinese Unmanned Aerial Vehicles (UAVs) in Saudi Arabia. This announcement is significant for two reasons; first it shows that Chinese defence companies are now competing with their western peers, and second it will challenge the UK Government to become comfortable with Chinese made military hardware operating alongside UK built military aircraft.

This announcement illustrates that the dynamics within the defence industry are subtly changing. Historically, western defence companies have been the market leaders. Their technologically advanced products were designed for the own militaries and then slightly lower spec options were sold to countries in the Middle East on lucrative export contracts. Western companies were (and still are) prohibited from exporting to Russia and China, and therefore these countries developed their own defence industries and sold products between themselves.

However, in the past five years, Western defence budgets have been under pressure and so Western defence companies have been targeting more export sales to the Middle East where demand has been high due to conflict and terrorism. Middle Eastern governments have in turn become more exacting customers, wanting higher quality equipment and better value for money so exports from the West are now at the same margin as domestic sales. At the same time, China and Russia’s defence technologies have improved and so they have been touting their wares in the Middle East. Coincidentally, the US has been reluctant to allow export sales of its market leader Predator and Reaper UAVs.

This leads us to the fascinating juxtaposition we are now seeing in Saudi Arabia. US made F-15s and UK made Typhoons are sharing the same air bases and flying the same missions as Chinese made CH UAVs. As a result of the new agreement, soon Saudi engineers, some of whom may have previously worked in country for BAE on Typhoon, will be working on the CH UAVs. This situation is likely to make people in Washington and Westminster slightly nervous.

The CH family of UAVs look very similar to Predator and Reaper, and whilst a genuine comparison of their capabilities is challenging, on paper their performance is said to be similar. The CEO of Taqnia Aeronautics, the Saudi Arabian company that will manufacturer the UAVs has said that they will be used for both military and civilian purposes and will be marketed to other countries in the region. It seems the Middle Eastern defence market is no longer just a battle ground for Western defence companies, the Chinese have now joined the party and with a footprint on the ground in Saudi Arabia, China looks set to stay.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Comac C919 aircraft to fly next month, three years late

Challenges remain though to establish a Chinese aerospace manufacturing industry

The first Chinese narrowbody aircraft, the Comac C919 looks set to make its first flight next month. This is a significant milestone which will attract the attention of the aerospace industry across the globe and the event will no doubt be lauded by the Chinese government. However, this maiden flight will be nearly three years late. When the programme was launched in 2008 the target for first flight was June 2014, with the first delivery due in 2016.

This protracted development phase is testimony to the enormous challenge China faces to compete with the duopoly of Airbus and Boeing.  Building an aircraft is a notoriously tricky business, and almost all new aircraft programmes suffer from some setbacks. However, by comparison Airbus took the A320 aircraft from inception to delivery in four years during the 1980s and the A320neo also entered service in 2014 after four years of development.

There are two main areas where aircraft development programmes tend to come unstuck; integrating systems and managing suppliers. For example, the A380 faltered when Airbus encountered difficulties integrating the complex wiring system needed to operate the aircraft with the metal airframe through which the wiring needed to thread. The engineers discovered the wires were too short, a problems which was later attributed to designers using different versions of Computer Aided Design (CAD) software to create the engineering drawings.

The Boeing 787 entered service three year late after Boeing made the decision to act as a systems integrator rather than the manufacturer. It outsourced production of the 787’s major subsystems and components, but then encountered quality and communication problems with the supply chain, which led to delays and cost over runs.

The reason for this background is contextualise the scale of the challenge facing Comac. Boeing made its first jet aircraft sixty years ago, giving it an almost two decade head start on Airbus who has been producing jet aircraft for just over forty years. Both manufacturers are therefore a long way along the learning curve of how to develop and produce safe and fuel efficient aircraft. Comac is currently playing catch up, but inevitably its competitors are not standing still. Since the C919 was launched, Airbus and Boeing have both launched updated narrowbodies; Airbus’ has entered service and Boeing’s is due to do so next month. Meanwhile Comac is still battling to build an aircraft that was designed nearly a decade ago, so you have to question how relevant its technologies still are.  In addition, the first flight heralds the start of the notoriously tricky flight test phase, and with the required second, third and fourth aircraft yet to be assembled, experience suggests Comac could yet encounter further delays. 

So whilst next month’s hoped for first flight of the C919 will inevitably generate discussion about the risk to the Airbus / Boeing duopoly, getting a plane to fly is very different to having a successful aerospace manufacturing industry. It took Airbus nearly thirty years to get to its 50% market share of the narrowbody market when it had the benefit of previous aircraft manufacturing experience, whereas Comac is coming from a standing start.

The C919 is likely to be technologically behind Airbus and Boeing aircraft, but the big unknown is what price Comac will try to sell the aircraft into the market. There is of course the possibility that the discount to Airbus and Boeing aircraft is so big, that some airlines will be enticed by the economics of a Chinese plane. The presence of western engines and numerous components on the C919 also suggests the Chinese will receive support in their sales campaigns from established western aerospace manufacturers. However, I think that initially it is unlikely Western airlines will risk purchasing an aircraft without a proven safety record, even if it is offered at a generous discount. Therefore the aircraft will need to prove its worth with Chinese customers before sales take off internationally.

The financial backing of the Chinese government and the guaranteed purchases by Chinese Airlines ensure that the programme will optically be a success, but I am yet to be convinced that next month will mark the start of a fundamental shift in the competitive dynamics of aerospace manufacturing.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

US budget battles

End of 2017 Continuing Resolution looks likely as focus turns to Trump’s first budget

We are firmly in budget season. On this side of the pond Mr Hammond had his moment in the spotlight, but I was watching the news from the US because a few hours later the US House of Representatives approved the $584bn 2017 Defense Spending bill. This sets in motion the process to end the current Continuing Resolution (CR) that is only established until 28 April. The previous day, President Trump outlined his intent to spend $54bn (+3%) more than the Obama administration had planned to on defence in 2018. So what do we know so far and what can we expect?

Well there were no surprises in the 2017 Defense Spending bill. It requested $516.1bn for the base budget and $61.8bn for the war fund known as the Overseas Contingency Operations (OCO) account, which is in line with the National Defense Authorisation Act agreed last December. The original budget requested by Mr Obama was $524bn in the base and $59bn of OCO making a total of $583bn (as per the graph below), which means that for the first time in five years the US Department of Defense (DoD) will not have to make do with a budget far below that which is requested.

US defence budget (base and OCO) 2001 – 2021 as per the FY17 President’s Budget Request ($bn) (Source: US DoD Green Book 2017)

Unfortunately however, this small positive is offset by the fact that this year the DoD is enduring a six month Continuing Resolution. CR is a very frustrating mechanism for the defence chiefs and the defence industry. It means funding is held at the same level at last year and all existing programmes are funded at the same rate, but no new programmes can be paid for. So whilst the dollars are theoretically there, it is an inefficient way of doing business, which ironically forces money to be spent in places it sometimes doesn’t need to be. CR occurs when the House and Senate do not agree to pass the President’s budget request, and cannot reach a compromise. For the past two years the CR has ended in January, but this year’s CR is twice as long and a number of defence companies have noted recently that their short cycle businesses are seeing a significant impact.

President Trump’s first defence budget should be a positive catalyst for the defence stocks though. He outlined his headline number of $603bn during his speech to Congress last week. This means he would be requesting a 3.2% increase on President Obama’s existing plans. However, the Republican chairman of the House Armed Services Committee Mac Thornberry, and his Senate counterpart John McCain think a budget of $640bn is required. Their concern is that a lower budget would “unintentionally lock in a slow fix to readiness, consistent with the Obama Administration’s previous position, from which we would not be able to dig out.” At the moment it seems President Trump will win the initial battle, but for the first time in the last five years could 2018 be the year where we see the committee process revise the defence budget up rather than down?

We must not forget that in order for any of this to happen the US Government first needs to repeal the 2011 Budget Control Act (BCA) which sets caps for the defence budget through a process known as Sequestration. Confidence seems to be increasing that that BCA and its Sequester will be overturned, but I have learnt over the past few years that anything can happen in US politics, so it is best not to take anything for granted.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Is it a car or is it a plane?

Airbus looks to appoint car expert to its board

It seems my prophecy that 2017 could be the year of the flying car may not have been as implausible as it initially seemed. Last week Airbus proposed Lord Drayson, a self-confessed “car-nut” as an independent non-executive director.

Lord Drayson was formerly the Minister of Science in the Department for Business, Innovation and Skills, and he made his fortune in biotech, by developing the Powderjet device, a needle free injection system. He also has a PhD in robotics. Therefore his proposal is concordant with Airbus’ stated desire to use exploit advances in digital technology in order to improve efficiency.

However, it is unlikely to be coincidental that a man with such a passion for high end cars has been admitted to Airbus’ board, a few months after the company established a division called ‘Urban Air Mobility’ through which it is testing prototype self –flying cars. Lord Drayson owns Drayson Racing Technology, his own motor racing team that has competed at Le Mans. Its technology development sister company, Drayson Technologies, has been developing hardware for the electric racing series, FIA Formula E Championship.

Airbus is in the middle of his biggest ever production ramp up today with the A350 and the A320Neo now fully in service. Its focus is undoubtedly on successfully delivering its record order book of aircraft. However, the emergence of Lord Drayson as a non-executive director exemplifies the fact that Airbus is no longer the staid European aircraft manufacturer it was once perceived to be.  It is an innovative technology company that has one eye on the future in order to stay ahead of the market place.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Boeing comes to Sheffield

The US aerospace giant is spreading its wings into Europe

Last week, Boeing announced it would be opening its first ever manufacturing facility in Europe. Where will it be I hear you ask? Sheffield. I imagine that isn’t what you were expecting. I certainly wasn’t. The decision is significant for two reasons; what it says about Boeing’s relationship with Europe, and what it says about UK industrial capability.

Boeing’s first foray into Europe will only produce actuators, so it isn’t quite as significant an incursion onto enemy territory as when Airbus opened a final assembly line (FAL) in Mobile, Alabama. Any decision by Boeing to move some production to Europe would be very significant indeed, but we are not there yet. What it shows is how keen Boeing is to keep its European governments on side. This is likely the result of a quid pro quo arrangement following recent defence sales. The UK MOD has signed contracts totaling £5bn for P-8 surveillance aircraft and Apache helicopters, but in a blow to the UK defence industry assembly of the helicopters will be in the US rather than the UK as was the case with previous orders. Boeing has therefore committed to building a £100m facility to service the Royal Air Force’s (RAF) P-8s at RAF Lossiemouth in Scotland, as well as making Britain a centre for training and maintenance of military aircraft, with Boscombe Down considered the front-runner.

Sir Michael Arthur, President of Boeing UK said that the move was part of Boeing “becoming a more global company”. Currently Boeing employs 2,300 staff in the UK on civil and military programmes. The new 25,000 sq ft factory will have an initial staff of 30, though this could well be expanded. Boeing maintains that the decision is not linked to lower manufacturing costs in UK, however with Airbus enjoying such a strong currency tailwind following the devaluation of sterling against the dollar, it must be a small factor. It is intriguing though that with Brexit looming, Boeing has not chosen a location with the future EU for its first European plant. Sheffield’s choice must surely be a boost to Theresa May and her Government, following the launch of the new UK Industrial Strategy at the end of January which champions technological development as the core of a Great Britain after we leave the EU.

The North of England, our traditional industrial heartland will certainly see it as a vote of confidence, and so it should. In this automated era, where more and more manufacturing plants are closing, it is all too easy to bemoan the loss of our industrial capability. However, it seems that brilliant things are happening in the North. Sheffield University’s Advanced Manufacturing Research Centre has been at the forefront of combining academic research with industry. It specializes in metals, materials and virtual reality prototyping and design. 500 engineers work alongside 5000 industry sponsored apprentices. It has developed designs for Rolls-Royce composite turbine blades, McLaren superstars and the Boeing Dreamliner. Boeing’s new facility will be 30 miles down the road.

Boeing aircraft are unlikely to lose their “made in the USA” stamp anytime soon, but this decision is a reminder why the two sides of the Aerospace and Defence sector will always be inexplicably linked, because often concessions on one side to sales in the other. In addition, it reminds Airbus that the dynamics of the US vs Europe aircraft duopoly are always shifting and is a small but well-timed boost to the UK industrial capability.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

All eyes on the Geared Turbofan

2017 is a make or break year for Pratt & Whitney’s beleaguered engine programme

The Geared Turbofan (GTF) engine is proof that innovating in aerospace is never an easy task. When Airbus and Boeing first introduced the concept of their new re-engined narrowbodies (A320neo and 737MAX) they were quick to reassure airlines and investors that this was a simple development proposition - a design modification rather than a clean sheet aircraft. I remember noting at the time that Airbus and Boeing were cleverly transferring the majority of engineering risk to the engine original equipment manufacturers (OEMs), and it has proved to be ever thus.

Unfortunately, Pratt & Whitney’s bid to get back into the narrowbody market, which has been dominated for a decade by CFM International (a JV between GE and Safran), has proved more complicated than the company envisaged. The aircraft OEMs have made it abundantly clear on their recent conference calls that it is GTF engines causing aircraft deliveries to be delayed. In 2016 Airbus had to substitute 20 A320neos for A320 classics and Bombardier only delivered half of its planned C-series aircraft. Airbus made clear on its FY16 results call yesterday that the main factor limiting the narrowbody ramp up is the speed at which Pratt & Whitney can deliver functioning GTF engines.

Last year the GTF struggled with its engine cooling cycling, requiring pilots to wait three minutes after powering the aircraft off before starting the engine again. Three minutes may not sound like much, but time really is money to low cost carriers whose business model depends on short turnaround times at the gate. Recently it has emerged that the engine’s aluminum-titanium fan blades are taking 60 days to manufacture, rather than the planned 30. All engines have a learning curve, but it seems Pratt & Whitney is taking rather a long time to make progress along the curve with the GTF.

In contrast, GE’s new engine, the Leap, has entered service almost without hiccup. Ascend Flightglobal estimates that GE has 54% market share on the A320neo where customers have chosen their engine. However, one third of customers are yet to choose an engine so there are lots of sales up for grabs. Modern airlines are much better businesses than their ancestors, and therefore are not afraid of changing from their established supplier on grounds of performance or price.  Last October Qatar Airways, one of the launch customers for the GTF powered A320Neo, followed through on its threat of ordering 100 Boeing 737Max aircraft in order to mitigate risk on its A320neos which have been delayed.

Pratt & Whitney must now prove it can get the engine working reliably and efficiently, whilst ramping up production. It delivered 150 engines in 2016 but is targeting 350-400 in 2017. There is then of course the risk that the GTF will require higher than expected levels of maintenance during its lifecycle. The new gearbox technology means that Pratt & Whitney is not able to depend on its wealth of existing engine data.

If airlines do not see progress in 2017 then there is a real risk that the LEAP engine will become the engine of choice on the A320neo and Pratt & Whitney’s bid to end the narrowbody monopoly will effectively have failed.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Trump soldiers on

General H.R McMaster is appointed as US National Security Advisor

There is a certain irony that the US host of the Apprentice was left scrabbling around for someone to fill the post of US National Security Advisor (NSA). However, after what appears to have been a fraught week of negotiating, President Trump has appointed General H.R.McMaster, a current Army Officer, who gained notoriety for his criticism of military leadership during the Vietnam War.

General McMaster’s appointment continues President Trump’s predilection for having high ranking military officers as his key advisors on defence. Gen McMaster has been warmly welcomed by many Republicans because he is not from President Trump’s ‘inner circle’ (in fact prior to last week the two men had never met) and has a reputation in the military for being outspoken against conventional military leadership. Notably, US Senator John McCain (Chair of the Senate Armed Services Committee), who has been openly critical of President Trump praised the appointment saying “I could not imagine a better, more capable national security team than the one we have right now.”

It is widely acknowledged however that Gen McMaster was not the first choice for the role. Vice Admiral (Rtd.) Robert Harward reportedly turned down the job because he wouldn’t be able to make his own personnel selections and General David Petraeus felt snubbed at originally losing out to General Flynn so was not willing to take on the position now.

So what can we expect from General McMaster? The man known amongst friends as HR has a PhD in US military history and in 1997 wrote ‘Deriliction of Duty’ which criticised the US Joint Chiefs of Staff for not standing up to President Lyndon B Johnson during the Vietnam War. That alone gives me some confidence that this is a man who will not be afraid to stand up to his new Commander-in-Chief. He is another of the so called ‘thinking generals’; his leadership of the Third Armoured Cavalry regiment during the battle of Tal Afar during the second Iraq War was cited as a textbook example in General Petraeus’ counterinsurgency manual written some years later. His most recent post has been Director of the Army Capabilities Integration Centre so he is likely to have some interesting ideas on what equipment the military needs (although this is not technically in his remit as NSA).

General McMaster will need to call on every ounce of his West Point military academy leadership training because his biggest challenge initially will be to unite a National Security Council which has reportedly fractured since General Flynn’s departure. The US media has derisively referred to General Flynn’s associates who remain in the NSC as ‘Flynnstones’. A united front is crucial to restoring national and international confidence in US Foreign Policy.

I am encouraged that President Trump has made another military appointment to lead his national security team. I stand by my assertion in December’s blog that having Generals at the helm means the US will be less willing to use military force when diplomacy would be the more appropriate weapon, even if this idea is counter-intuitive. My main concern is that this fiasco has caused fissures in the fragile architecture of Washington politics and General McMaster has no background in the processes of Capitol Hill. The big question over the next few months will be whether he can lead civil servants as well as soldiers in tanks?

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Court room dramas

Embraer & Brazil vs. Bombardier & Canada – round 2

Embraer and the Brazilian Government vs. Bombardier and the Canadian Government looks set to be the next aerospace courtroom drama. This follows hot on the heels of the aerospace giants Airbus and Boeing slogging it out in the courts over government’s providing financial support for new aircraft programmes, known commonly as ‘Launchaid’ (see Andy’s December blog). 2017 will see the aerospace minnow’s take to the stand in a replay of their previous drama, as Embraer has again complained to the World Trade Organisation about Canada’s support of Bombardier.

Last week the Canadian government announced US$282m in repayable but interest free funding for Bombardier’s C-series aircraft and Global 7000 jet, with the money coming from Canada’s Strategic Aerospace and Defence Initiative (SADI).  This announcement triggered the Brazilian government, whose own aircraft manufacturer Embraer is a direct competitor of Bombardier, to claim Bombardier has received government support to the tune of $2.5bn over the past decade. It is alleged this has come through research incentives and reductions in local taxes, as well as injections of capital.

This government support is what, according to Brazilians, helped Bombardier get an order for 75 CSeries jets, worth an estimated US$5.6bn, from Delta Airlines, beating the competition from Embraer’s E-Jets. Brazil believes Bombardier offered a discount to below break-even price in order to close the deal – something it couldn’t have done without the alleged subsidies. Both parties now have sixty days to reach a settlement, after which the WTO will set up a dispute panel with the final decision likely to take more than a year.

Government’s subsidies have been an intrinsic part of the aerospace industry over a number of decades because commercial aircraft sales generate high levels of trade and jobs, and therefore economic growth. With so few players in the industry, and no more than one aircraft manufacturer in any one country, it seems ludicrous to suggest that governments will remove their support and therefore the status quo or the established Boeing and Airbus duopoly, with a few smaller manufacturers such as Embraer and Bombardier fighting over the spoils.

However, we easily forget that only four decades ago the market was much more fractured and centred on the West, with three US manufacturers, three Europeans, no Russian or Asian players. These trade disputes, which are over long standing issues and are notoriously lengthy to resolve, risk distracting attention from subtle evolutions of the competitive environment. If the WTO chooses to crack down on government support, then the status quo in the west will suddenly look vulnerable. The Chinese C919 aircraft manufactured by the state owned COMAC is due to enter service at the end of 2018, and the Chinese government is more than willing to financially support its flagship aircraft, even if it is technically and commercially uncompetitive. In addition we have the added dynamic of President Trump promising to ‘make America great again’, thus leaving us in no doubt that Boeing’s governmental support will continue.

We in the west are walking a tightrope between upholding scrupulous business practice and doing what is best for our own economic and business interests. We should be wary of becoming too comfortable squabbling over whether the current competitive environment is fair, because that affords new entrants an opportunity.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Russian Roulette

General Flynn resigns as US National Security Advisor over links to Russia

In my blog last December I described President Trump’s new security team of General Flynn and General Mattis as a ‘fiery and intriguing cocktail’. After less than a month in office, Gen Flynn has indeed set the sparks flying over his liaisons with Russian officials, and on Monday evening handed in his resignation. So what happened and where does this leave President Trump’s foreign policy now?

General Flynn had a reputation for disregarding conventional norms when he was a serving Army officer, and his links to Russia were well known. Unfortunately it is these two aspects that have proved to be his undoing. He is alleged to have discussed lifting US sanctions against Russia with Russia’s ambassador to Washington, prior to President Trump’s inauguration and therefore prior to Gen Flynn’s formal appointment. It is against precedent, and possibly US federal law for a private citizen to discuss matters of national security with state officials. Gen Flynn’s real crime though was not the conversation, but obfuscating details of it when asked by Vice-President Pence.

What I think is most interesting about this situation though is the conflict it reveals in President Trump’s administration about how to deal with Russia. General Flynn was known to subscribe to the theory “keep your friends close but your enemy’s closer” and therefore wanted the US to work more closely with Russia. He is likely to be the driving force behind Russia’s omission from President Trump’s defence priorities, signalling that this US administration sees Russia as a diplomatic problem rather than a military one. General Flynn has President Trump’s full support, and was also particularly close to Steve Bannon, the President’s top strategist.

It seems though that Flynn’s fan club ended there. It is reported that Russia-phobia permeates the White House and the US Intelligence Agencies. As a result General Flynn was said to be disliked by President Trump’s more establishment aides. When rumours of General Flynn’s wrongdoing started to swirl, advisors told President Trump to fire him. Ironically, the President famed for appearing on the Apprentice and barking “you’re fired”, dithered over this dismissal due to his loyalty to his National Security Advisor, and so Flynn’s resignation reached him first.

Keith Kellogg, General Flynn’s Chief of Staff has taken over in his absence whilst a decision is made about a permanent replacement. The main name in the frame seems to be General David Petraeus, former CIA Director and who was also known as a ‘thinking general’ during his time in the military. He co-authored the US Army Counter-Insurgency doctrine with Gen Mattis (US Defense Secretary), although he was sacked a director of the CIA for a security breach. Appointing Petraeus would send a signal that Trump’s foreign policy strategy remains intact because Petraeus and Flynn are cut from the same cloth. Whoever is appointed though would do well to clarify the US approach to Russia before this issue becomes more of a problem.

One other issue this scandal raises is whether the personnel in President Trump’s government have the skills to negotiate the minefield that is the US Constitution and Capitol Hill processes. Whilst many have applauded his desire to make appointments from outside the political establishment, there is a real risk that their lack of knowledge about political process could be their undoing. 

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

“You like me and I like you”

Trump promises to “load up” the US military

With Valentine’s Day next week, it seems fitting that President Trump has made public his love affair with the US military. He opened his first speech to service personnel on Monday with the words “you like me and I like you”, referencing the support he received from military voters during the election. He then promised to “load them up with beautiful new planes and beautiful new equipment.” Words which sent US defence stocks soaring. So is this really music to the defence industry’s ears?

Thus far President Trump’s commentary on defence has matched his election rhetoric. He is vowing to look after veterans, buy new equipment for serving personnel, increase troop numbers and get tough on inefficiencies in defence procurement. To me this sounds like a worrying combination from the perspective of the defence companies. 

The reason the Investment lines (Procurement and RDT&E) of the US defence budget have been so squeezed over the past decade is that personnel costs have been rising higher than inflation. As a military veteran myself I am a firm believer in providing for ex-service personnel, however the current US veteran’s pension and medical arrangements have been proved unaffordable. If President Trump wants to maintain, or even improve the current offering, then personnel costs will consume an even higher percentage of the overall defence budget in the future.

Higher troop numbers and more equipment are undoubtedly positive for top line growth at US defence companies. However, President Trump has already showed with his F-35 price negotiations, that margins are going to come under pressure. He wants to buy more for less which will either impact quality or lower margins, or possibly even both.

The important area that President Trump has not yet spoken publicly about is how his ‘made in America’ strategy will impact defence exports. It is likely that defence exports from the US will decline under Trump’s administration for two reasons. Firstly President Trump is likely to be more selective over who he will allow to buy US equipment, and secondly other nations will be less likely to buy from such an overtly protectionist and insular government. This is concerning for the defence industry because exports tend to be higher margin.

So it seems that after Monday’s speech at CENTCOM President Trump is the military’s darling, but he is not likely to be inundated with Valentine’s cards from defence industry executives.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Uber in the sky

Could flight sharing apps rejuvenate the ailing bizjet market?

I recently read an interview with Embraer’s CEO where he discussed the ‘Uberization of business jets’. As an uber devotee, I started to investigate what this actually means and discovered that we may be on the brink of a structural change in the bizjet industry.

Flying on a bizjet has traditionally been the preserve of the rich and famous; royals, politicians, celebrities, sports stars and CEOs. The very wealthiest own their own jet, whilst others charter aircraft through a broker who sources availability for a particular date, and then negotiates a price with the owner on their client’s behalf. This modus operandi leads to an extremely underutilised asset. It is estimated that approximately a third of hours spent flying were done without passengers on board, and that the average private jet was airborne for 300 hours per year, far below the optimal 1,100 to 1,200 hours.

The 2009 financial crisis caused the second hand bizjet market to be flooded. Currently 10-12% of used aircraft are for sale, where in 2008 it was 4-6%. As a result, demand for new aircraft (which depreciate rapidly) has been subdued. Flight Global Consultancy is forecasting the number of turboprop deliveries to fall in 2016 (the final data are yet to be received).

Enter stage left the disruptors; JetSmarter, Skyuber and Blackjet. Companies that are exploiting technology in order to connect passengers with empty seats on bizjets. Passengers can book seats on shared flights or charter their own aircraft all using an app on their smartphone in return for a one off joining fee and then either an annual subscription allowing unlimited travel, or on a pay per flight basis. Flights can be booked months in advance, or on the day of travel, giving incredible flexibility. The CEO of JetSmarter estimates that opening up bizjet travel to the next tier of passengers – those who would normally travel first and business class – could widen the market from tens of thousands to 2.5-3 million people in the US alone.

The precursor to JetSmarter and its competitors is NetJets, which works through fractional jet ownership. Customers purchase only a portion of the aircraft, a bit like a timeshare. NetJets has undoubtedly opened up the business jet market but the upfront costs involved mean that its customers are mainly large corporates who purchase ownership to be used by a group of executives. JetSmarter, Skyuber and Blackjet are opening up business jets to individuals in an unprecedented way.

This way of flying is still in its infancy and is not yet prolific enough to impact demand for new aircraft. However, if this proves to be a profitable and sustainable business model for what are effectively technology companies, then it stands to reason that we could see a return to pre 2008 demand levels for smaller aircraft. The next question though is who will own the assets. Will high net worth individuals see business jets as an asset they can get yield from through ‘uberising’ it, or will the technology companies acting as the modern age brokers look to lease aircraft in the way that airlines do now? Either way it looks as though the way to rejuvenate the bizjet industry could be through an app.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

2017…the year of the rooster, Trump and flying cars

What does the year have in store for Aerospace & Defence stocks?

The Aerospace & Defence sector has two distinct sides to it, with civil aerospace and defence often proffering very different investment narratives. Historically, terrorism and political instability have tended to cause the two sides of the sector to diverge, with defence valuations surging and civil valuations falling. This happened most notably after 9/11 in 2001. At the end of 2016 though, a year defined by terror attacks and political turmoil, the situation was quite different. Defence stocks were the stand out performers during last year, driven initially by the fact global defence spending is now growing, having been in decline from 2011 – 2015, and more latterly by Donald Trump’s US election victory. However, civil stocks have also performed well. Although there have been a high number of terror attacks during 2016, improved airport security measures have forced terrorists to seek new targets and so aerospace stocks have been largely unaffected, and in fact have continued to benefit from the structural growth of passengers numbers which continues to drive output growth. So what does 2017 have in store for aerospace and defence?

Absolute % change in price for Aerospace & Defence stocks in 2016 and 2017 YTD (Source: Bloomberg)

There have been two themes dominating the January headlines; record production levels at Airbus and Boeing and what impact Donald Trump as President will have on the defence industry. I expect these topics to remain major talking points throughout the year.

Airbus and Boeing both recently held their New Year press conferences which were customarily upbeat. Boeing delivered an industry record of 748 aircraft in 2016, and Airbus set its own company record delivering 688 aircraft. This means we have now had six successive years of production growth as shown in the chart below.

Airbus & Boeing deliveries 2001 – 2020E (Source: Airbus & Edison)

It is almost inevitable therefore that industry and the financial markets are starting to get twitchy about whether the civil cycle is about to enter a downturn. Historically a book-to-bill ratio of below one has been a warning sign. As the chart below shows, book-to-bill in 2016 was 1.0x and this is likely to be lower in 2017 as deliveries should increase again but orders are expected to decline. However, I do not believe there is currently any cause for concern. The main reason fewer orders are being placed is that the wave of demand for new fuel-saving models has run its course. The order backlog is at a record level with 6874 aircraft on order from Airbus and 5715 from Boeing, which equates to roughly nine years of production for each manufacturer. This level of order visibility is the stuff of dreams for manufacturing companies.

Since the start of the century, management mindsets and methodologies have changed due to the adoption of shareholder value creation as a key metric. This has fundamentally changed the way companies deal with customers and operate manufacturing systems. Output no longer varies in response to customers’ lumpy order placement demand. Instead, airframers seek to achieve sustainable output rates and make customers wait for deliveries if necessary. This is a very different approach to the boom-bust, produce to order regime of the last century (the customer was always right). The change has directly induced the record backlogs, overbooking practices and stability in output that we have seen despite substantial air traffic disruptions. It makes the book to bill ratio argument for driving company performances and share prices largely redundant.

My one concern about the backlog is that it is scheduled for delivery over a longer period than previously. Only 70% of the aircraft on order are due to customers in the next five years, so if there is demand weakness, outer year slots can be brought forward. This can be easily monitored though by tracking cancellation and deferral data. The other major talking point this year is likely to be whether the planned single aisle production rates are both achievable and sustainable? Ascend, one of the leading Aviation consultancies believes they are too high even though they look sensible based on current accelerated demand for single aisle fuel efficient and extra capacity in China.

Airbus and Boeing combined orders and deliveries (LHS) compared to the book-to-bill ratio 1970 – present (Source: Airbus, Boeing & Edison)

Civil Aerospace continues to be an attractive industry for investors seeking exposure to growing end markets. However, 2017 will be a capital intensive year for the aircraft and engine manufacturers as they focus on ramping up production of new aircraft. As the rivalry between Airbus and Boeing intensifies, we may see a decision from Boeing about whether it intends to build a mid-range aircraft to compete with Airbus’ A321. In addition, aerospace engineers perennially have one eye on the future and as we hurtle towards the next decade I expect we will start to hear more about what the aircraft of the future might look like. Just this week it was reported that Airbus has established a division called ‘Urban Air Mobility’, through which it is testing prototype self-piloted flying cars.  I also expect that we will see some changes in how deals are made in the industry, following Rolls-Royce’s prosecution by the SFO (see my blog ‘SFO shows its metal with £497m fine for Rolls-Royce’), with company’s having to prove their technology more, rather than rely on relationships and goodwill.

M&A activity kicked off yesterday, with Safran’s tender for Zodiac in France. UK companies are suddenly much more attractive to overseas investors due to weaker sterling so I expect a raft of bids, deals and rumours during the year.

Defence stocks have performed strongly during 2016, driven initially by a higher global defence spending (as a result of a more unstable geopolitical situation), and in the closing months of the year by Donald Trump’s election as Presidents. His intent to defeat ISIS and his commitment to increase US troop numbers sent stocks with US defence exposure up 15% after the election. They have pulled back a little now as there is quite mixed messaging coming out of the US, so his first defence budget (due in February but likely to be delayed until March) will be crucial for sentiment.  Early reports suggest the Armed Services Committee has recommended a base budget of $640bn for FY18 in order to fulfil Mr Trump’s plans. This would be a 17% uplift from Obama’s current request of $557bn (as per the chart below).

US defence budget 2001 - 2021(E) split by base budget and overseas contingency operation (OCO) funding ($bn) (Source: US DoD Green Book 2016)

Although the budgetary environment may be more positive for the industry, margins which are currently at record highs may start to come under pressure. Throughout his election campaign, Mr Trump vowed to get tough on inflated costs and poor procurement processes in the defence industry. Shares in Lockheed Martin and BAE Systems’ fell yesterday morning on the news that Mr Trump has demanded that the cost of the programme be slashed by at least 10%.

I expect 2017 will continue to see government’s outsourcing more work traditionally done by uniformed personnel into the private sector as has already happened in the UK with recruitment (Serco), aircraft maintenance (Babcock, Rolls-Royce) and running ranges (Qinetiq) to name but a few. There will continue to be a focus on unmanned technology, although unusually civilian technology is leading the defence sector on this. We are also likely to see a step up in the focus on cybersecurity technologies, and if legislation is brought in we may see consolidation of what is currently a very fragmented market.

The Aerospace & Defence sector can often be a paradox; it is one of the sectors with the best long term visibility due to government defence budget cycles and long lead times on aircraft, however it is one of the most impacted by global shocks. The long term indicators suggest the sector should continue to prosper in 2017 but we continue to be cognisant of the risks posed by terrorism and by any economic slowdowns which could affect airline passenger traffic numbers.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

SFO shows its metal with £497m fine for Rolls-Royce

Black cloud over engine manufacturer should now start to lift

The Serious Fraud Office’s (SFO) five year investigation of Rolls-Royce has finally come to a conclusion, with a verdict that shows the SFO is getting tough on corruption, but one which should hopefully allow the dark cloud over Rolls-Royce to start lifting.

The company announced on Monday that it has reached a Deferred Prosecution Agreement (DPA) with the SFO, agreeing to pay £497m with interest over five years, plus an undisclosed payment for the SFO’s costs.  It also has to pay the US Department of Justice (DoJ) $170m and Brazil’s Ministério Público Federal (MPF) $26m, creating a total fine of approximately £671m. These agreements relate to bribery and corruption involving intermediaries in a number of overseas markets. The conduct covered by the UK DPA took place across seven jurisdictions: Indonesia, Thailand, India, Russia, Nigeria, China and Malaysia.

I last wrote about this issue in our blog last November ‘One man’s gift is another man’s bribe’ and I noted that the US DoJ’s prosecution of Siemen’s in 2008 was probably the most comparable case. It paid a total of $800m to the DoJ ($350m in costs and $450m fine), as well as $854 to the Office of the Prosecutor General in Munich. In contrast, when BAE was investigated by the SFO in 2010 it was fined £30m, which at the time was a record monetary punishment for a corporate.

The SFO’s prosecution of Rolls-Royce is the most high profile bribery case since the new 2010 Bribery Act which made organisations liable for failing to prevent any member of staff or associated person from bribing an individual or Foreign Public Official on its behalf. It is therefore unsurprising that it has chosen to flex its muscles and impose a material fine. Historically the SFO has been seen as more lenient than the DoJ, but this ruling ensures this will no longer be the case.

The international nature of Rolls-Royce’s business means that this ruling may not be the end of this issue for Rolls-Royce. There may be some outstanding smaller issues in other jurisdictions. However, the company is likely to have reported everything they could find in this tranche, and this is the ruling the market has been hotly anticipating for five years now. The impact on Rolls-Royce’s cash flow will be material, with a £293m payment required in 2017, however, the fact that the negative impact can now be quantified goes some way to explaining the 7% jump in the share price today. Rolls-Royce’s cash flow is already under pressure with a high number of new engine deliveries, so this is another headache for the new management team to contend with.

The question now moves onto whether any other companies in the Aerospace & Defence sector are in the SFO’s crosshairs? Rolls-Royce cannot have been the only engine manufacturer to try and win business using intermediaries. In addition it will be interesting to see whether the competitive environment changes. Will this mean that there will be a greater requirement to prove technology over a competitor’s? And might deals potentially become more difficult and time consuming to sign? We shall be watching with interest.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Airbus does it again

Record breaking 2016 for Airbus as it exceeds delivery target

At yesterday’s annual New Year press conference, Fabrice Bregier (Airbus Commercial CEO) triumphantly announced that Airbus delivered 688 aircraft last year, exceeding its target of 670. 

Regular readers of this blog will know that throughout 2016 I debated with myself whether or not Airbus would be able to make its delivery targets, consistently concluding that I was not predisposed to bet against Airbus under its current management team. My faith has proved correct although the company took it right to the wire.

Airbus always has a Q4 weighted delivery schedule. Since 2008 it has shipped 10-12% of its total annual deliveries in December. However in December 2016 it shipped 16% (111 aircraft). In my piece ‘Airbus is cutting it fine’ I noted there were three likely reasons why Airbus left itself so much to do in December:

1. Customers dragging their heels over accepting aircraft due to issues with performance, finish quality or customer financing.
2. The supply chain struggling to keep pace with the ramp up.
3. Airbus employing an element of bravado in order to keep the industry and market guessing.

Yesterday, Mr Bregier attributed most of this extreme back ended delivery profile to cabin delays on the A350 and problems with engine maturity on the A320 neo. He was also quick to point out the he would like the 2017 delivery profile to be much smoother over the year so perhaps he wasn’t trying to make a show of bravado after all. Whether or not point one was an issue will only become apparent at Airbus’ FY16 results on 22 February when we will be able see whether 2016’s aircraft have been shipped at a favourable price.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Cyber wars

Will Russia’s attempt to influence the US election change global cybersecurity policy?

The news this week that Russia tried to influence the outcome of the US election is likely to have elevated cybersecurity up Mr Trump’s ‘to do’ list for when he takes office next week. The report from the Intelligence Agencies stated that “Russia’s effort the influence the election represented a significant escalation in directness, level of activity and scope of effort compare to previous operations.” Cyber is not a new topic, and has been a buzz word in the defence industry over the past five years as companies sought exposure to what has been seen as a growth market. However, cyber is still a very small percentage of revenues for the defence primes and the market has been very fragmented. In today’s blog, I ponder what impact Russia’s meddling in the election will have on cybersecurity.

Donald Trump takes office in a world where the cybersecurity environment looks very different to that which President Obama inherited eight years ago. In 2008, espionage was a serious problem and the level of cyber crime seemed too high. However, it was not front page news. Now the public has caught up so there is no hiding, and every one of us has become a target in what is increasingly an information war, rather than a pure cyber war.

There are three categories of offensive cyber action; attack, espionage and crime. Cyber crime and espionage are commonplace and cost the global economy billions of dollars every year. However, the most dangerous are attacks, where the action is equivalent to the use of force. The most likely targets are critical infrastructures, for example energy, telecommunications, finance, government services and transportation. The current assessment is that the only actors capable of such an attack are nation states. Unfortunately, nation states make uncomfortable and difficult enemies.

Interestingly, experts increasingly believe that deterrence rarely works in cyber space. The global information network we are creating thanks to the internet is so insecure that cyber criminals intent on causing harm are able to circumvent almost any form of protection. What does work however is imposing economic consequences for malicious cyber action – for example sanctions of indictments, not necessarily a counter attack or military action.

Therefore in order to punish rogue nation states who cause harm, Governments must take a more formal approach to cyber security and define the acceptable norms. Historically there has been a reluctance to do this because it has been easier to deny attacks and therefore avoid punishing another nation. However, Russia’s bold actions during the election campaign, and the subsequent media storm, have forced the US into action. 35 Russian diplomats have been expelled from the US, and two Russian compounds on US soil have been closed. President Obama also said there will be more actions, “some of which will not be publicised.”

So if the solution to cybersecurity is diplomatic, where does that leave all the defence and technology companies who see cyber technology as a growth market? Well I believe there are two key points. Firstly technology to try and deter attacks will still be required as the first line of defence. However, the current haphazard approach which allows companies to purchase any solution they see fit may well be about to end. We could be on the verge of having government mandated sector specific standards and policies to ensure continued delivery of critical services, which would lead to industry consolidation. Secondly, more investment will be made in technologies which can retrospectively identify attackers in order to hold people to account.

Increasingly, modern cyber warfare looks less like a scene from a futuristic film, and more akin to the propaganda war waged by Goebbels in the 1930s. In the information war of 2017 it will take a combination of high tech solutions and good old fashioned diplomacy in order to prevent a serious attack.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Do we need another Strategic Defence and Security Review?

UK Armed Forces have secretly begun preparing for another round of defence cuts

In last July’s blog ‘Can aerospace & defence weather Brexit?’  I wrote that the economic and political impact of the UK’s decision to leave the UK would require a new Strategic Defence and Security Review (SDSR). This has proved wrong thus far; Theresa May has maintained that the strategy remains intact and therefore the 2015 SDSR is extant and fit for purpose. However, press reports over Christmas that the UK Armed Forces have secretly begun preparing for another round of defence cuts suggest that my prediction may yet come true.

In July, my reasoning for needing a new SDSR was that if UK GDP is lower after Brexit then priorities will have to be reassessed, with cuts from the procurement budget likely. Six months on from the vote, the lasting effect on our GDP is unclear, however the impact on our currency is indisputable. The 17% fall in the value of sterling against the dollar over the past six months means that planned purchases of US made equipment (for example the P-8 Poseidon aircraft, AH-64 Apache helicopters and the F-35 Joint Strike Fighter) are now significantly more expensive. This is a major problem for the MOD as the budget was always reported to be tight for 2017 and 2018 and planned acquisitions from the US are estimated to total billions of pounds a year every year for the next decade.

The easy option for the Government would be to just make cuts to the procurement plan without reassessing the bigger picture through an SDSR. However, I believe this would be a flawed approach and one which would take us back to the incoherent approach to equipment buying seen during the Afghanistan and Iraq campaigns. Troop numbers are in crisis; the number of trained soldiers in the Army is at its lowest since 1750 and there is currently a personnel deficit of 4.1% across all three services compared to the SDSR targets. Therefore with low troop numbers, an under pressure procurement budget and a volatile global security situation, it feels to me that the time is ripe for an explicit re-evaluation and restatement of our defence priorities.

So how would a new SDSR impact the defence industry? Most companies are planning on 1% real growth in procurement spending over the next five years, and a new SDSR would probably rein in these expectations, with the outlook likely to be flat. Major programmes such as the costly acquisitions from the US are likely to be protected at the expense of smaller ones which would impact the smaller tier two suppliers the most. We may also see some reduction in customer funded R&D.

The Prime Minister’s number one priority in early 2017 is to trigger Britain’s departure from the EU, and therefore it feels likely that the government will take the easy option of making procurement cuts behind the scenes. This is the more challenging outcome for the defence industry because it leaves companies trying to second guess where the Government’s priorities actually lie in the balance between procuring according to the current SDSR and balancing the books.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Trump wants to defeat ISIS and eliminate budget caps

Leaked memo outlines the President Elect’s defence priorities

A leaked Pentagon memo has given us a fascinating insight into President Elect Trump’s approach to US Foreign Policy. It suggests that Mr Trump is going to take a very different approach to handling Russia compared the current administration. His top four priorities are reported to be; defeating ISIS, eliminating budget caps, developing a new cyber strategy and finding greater efficiencies in the US Department of Defense (DoD). You will note that controversially Russia does not feature in this list. In today’s blog we examine what this new approach could mean for the defence industry.

Firstly it is important to note that the memo’s provenance seems credible. It was discovered by the US website ‘Foreign Policy’ and is dated 1 December 2016. It was purportedly written by acting Undersecretary of Defense for Policy, Brian McKeon, to employees in his office, and McKeon said the four-point list was given to him by Mira Ricardel, the co-leader of Trump’s transition team. It has not been that widely reported in the press yet, with only a few US websites catching onto the story.

I have compared Trump’s priorities to those published by the DoD in its FY17 Oversight Plan. The notable omission is that Trump fails to mention Russia at all whereas the DoD puts it as its number one threat with terrorism second, effective acquisition and contract management third and developing cyber capabilities fourth.

So how should we interpret Trump’s lack of focus on Russia? I would argue Russia probably is still Mr Trump’s number one priority, but that this signals it is seen as a diplomatic problem rather than a military one. His National Security Advisor, General (Rtf) Michael Flynn is known to believe that the USA should work more closely with Moscow and he has made a number of appearances on Russian state television. It seems Mr Trump may well agree with this approach and therefore is going to adopt the approach of “keeping your friends close but your enemies closer” with Mr Putin. It is important to note though that a soft solution to Russian posturing in Eastern Europe would not remove the imperative for the US defence industry to ensure it continues to have technological superiority. In fact quite the opposite. When trying to exert soft power, it is all the more important that the threat of using hard power is meaningful. It means that NATO must be a credible stick, while Mr Trump tries to tempt President Putin with diplomatic carrots.

Trump’s explicit statement about developing a strategy to defeat / destroy ISIS suggest that he does not believe in the Obama administration’s strategy which has been a ‘hands off’ approach to warfare. It has seen the US working with allies and partners to establish control over ungoverned territories through mentoring or training, and directly striking the most dangerous groups and individuals when necessary. It therefore seems likely that we will see more prolific deployments of US troops in the Middle East which would push the levels of Overseas Contingency Operations (OCO) funding up again which would be beneficial for the defence industry. For context, in FY17 the US will spend $57bn on OCO compared to the peak of $174bn in FY12 during operations in Afghanistan and Iraq. His commitment to eradicate the budget caps imposed by Sequestration is also heartening and implies we could see a higher base budget than is currently projected in the chart below.

US Base and OCO defence spending FY01 – FY21E (US $m) (Source: DoD Green Book)

The other deduction from Trump’s priorities is that he will stand by his campaign rhetoric about getting tough on the defence industry. He wants tighter contract terms, contractor liability for cost over runs, genuinely competitive bid processes which should all result in cost savings for the DoD.

On balance I think the operating environment for the defence industry under Trump looks to be a favourable one in terms of a growing addressable market. However, it is not going to be an easy ride and we are likely to see pressure on margins which have been maintained, and in some cases improved whilst the defence budget has been shrinking.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Airbus is cutting it fine

Record breaking December needed to meet guidance

I highlighted last month that Airbus had its work cut out to meet its 2016 delivery target of 670 aircraft, needing to deliver 154 in two months. Well the latest statistics show 61 aircraft were delivered in November, leaving 94 to be delivered in December. I previously said that “I am not generally predisposed to bet against Airbus when it comes to them achieving delivery targets” and I think I still feel the same as their track record is strong, but it feels as though the risk is increasing of Airbus not meeting FY16 guidance.

December is always Airbus’ busiest month for deliveries. Since 2008 it has shipped between 10-12% of its total annual deliveries in December. In order to meet guidance for 2016 it will have to deliver 14%. Given that there are 21 working days in the month, Airbus needs to be pushing 4.5 aircraft out the hangar door every day. The company has said that the delivery schedule remains feasible and that they have a large number of aircraft in the Final Assembly Line (FAL) and on the Flightline ready for delivery. If Airbus pulls this off then December 2016 will be record breaking for the company.

The extreme back-end loading of 2016 deliveries raises the question of why does this continue to happen year after year? And why is 2016 more extreme than previous years? It seems to me there are three theories. Firstly customers could be dragging their heels accepting aircraft, due to issues with the performance, finish quality or customer financing. Secondly Airbus’ supply chain is possibly struggling to keep up with the ramp up and so certain parts are delaying what are otherwise finished aircraft.  Thirdly, perhaps the company is employing an element of bravado to keep the industry and market guessing. In truth it is likely that a combination of all three factors is at play here. None of these in isolation is particularly sinister, although customer financing issues would carry financial risk for Airbus. We expect the company to be questioned about these issues during the New Year Press conference in January.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Trump’s new security team

Gen Flynn and Gen Mattis make a fiery and intriguing cocktail

I have resisted commenting on Mr Trump’s election victory until now, because I wanted to let the dust settle and see whom he appointed as National Security Advisor and Defense Secretary. With General (Rtd) Michael Flynn and General (Rtd) James Mattis now confirmed respectively (pending Congressional approval for Mattis), today I take a look at what these appointments signal for foreign policy, and therefore the defence industry, during Mr Trump’s tenure as President of the United States.

The market reaction to Mr Trump’s victory has been unilaterally positive for defence stocks. Lockheed Martin is up 12% since polling day, BAE Systems 9%, and their peers have performed similarly. This positivity seems to stem from his hardline stance on foreign policy during his election campaign. The media reaction to the appointments of Flynn and Mattis, two straight talking military veterans of Iraq and Afghanistan, seems to have deepened public belief that the Trump administration will take an aggressive stance on terrorism in order to protect the USA.

I concur that Mattis and Flynn’s appointments suggest President Elect Trump is going to pursue a pugnacious foreign policy. However, I challenge the consensual view that the new approach will lack cultural sensitivity and turn to military might before diplomacy. The careers of Mattis and Flynn thus far suggest this will be far from the case.

Both were known as ‘thinking generals’ and both authored seminal works during the Counter-Insurgency (COIN) campaigns of Iraq and Afghanistan. Gen Mattis co-authored the now famous 2007 COIN manual with Gen Petraeus which cautioned restraint and discrimination in lethal force. The manual was the ‘go to’ text for every military officer of my generation. Its basic precepts of COIN give some interesting insight into how Gen Mattis may approach his task as Secretary of Defense:

1. Some of the best weapons do not shoot
2. Sometimes the more you protect your force, the less secure you may be
3. The hosts doing something tolerably is often better than foreigners doing it well
4. Sometimes the more force is used, the less effective it is
5. Sometimes doing nothing is the best reaction

In 2010 Gen Flynn authored the paper ‘Fixing Intel’ when he was Head of Intelligence in Afghanistan. It was responsible for a huge shake up in the way military intelligence operated, urging a population centric approach to gathering information and targeting. He described the Afghan population (which is overwhelmingly Muslim) as “the people we are trying to protect and persuade”. I was serving as an Intelligence Officer in Afghanistan at the time and Flynn’s message came through loud and clear. We were to stop using remote force as the default setting, and instead get out amongst the people to find out what needed to be done and how it could be achieved. If Trump’s administration truly applies this tenet to its foreign policy, the results could be fascinating.

Both men have clashed with the Obama administration over its strategy on the Middle East. Gen Mattis retired five months early when leading US Central Command (CENTCOM), reportedly because President Obama did not agree with his assertion that the Syrian civil war provided the US with an opportunity to depose the Syrian President and Iranian ally, Bashar al-Assad, thus dealing Iran its biggest strategic setback in twenty five years. Gen Flynn was dismissed as Director of the Defense Intelligence Agency in 2014. He has maintained he was forced out of the role for refusing to tow the Obama administration’s line that Al-Qaeda was in retreat.

Change is therefore inevitably afoot on a strategic and practical level for the military and the defence industry. Both men cite Islamic terrorism as the number one threat against the US. Flynn has called for the US military to be more aggressive, however Gen Mattis has advocated a softer approach. He wants to place regional Muslim countries into a leading role, which puts him slightly at odds with Mr Trump’s tendency to denounce all of Islam as synonymous with terrorism. Gen Mattis also favors arming Syrian rebels to fight against Assad, something Trump has signaled he considers a distraction from fighting Isis.

Gen Flynn thinks the Iranian nuclear deal should be renegotiated. Gen Mattis has not been that explicit but describes Iran as a “special case that must be dealt with as a threat to regional stability.”

Where they differ most is over Russia. Gen Mattis has criticised the “unfortunate and dangerous mode the Russian leadership has slipped into”. He has also warned other NATO allies against accommodating “Russian violations of international law”. Gen Flynn however thinks the USA should work more closely with Moscow. He regularly appears on RT, the Russian owned state television channel, and once attended an RT gala, sitting two seats away from President Putin. He claims to see no difference between RT and US news organisations such as CNN.

I am excited that the appointment of Gen Flynn and Gen Mattis may bring some much needed clarity to what or who is the ‘enemy’ when fighting Islamic terrorism. It is a notoriously complicated issue and one that successive US administrations (and UK Governments for that matter) have shied away from discussing with the public. In Gen Flynn’s recent book he wrote:

“This administration has forbidden us to describe our enemies properly and clearly; they are Radical Islamists. They are not alone, and are allied with countries and groups who, though not religious fanatics, share their hatred of the West, particularly the United States and Israel.”

Interestingly Gen Mattis was Supreme Allied Commander of transformation for NATO 2007 – 2010. He job was to focus on improving military effectiveness of allies. Therefore whilst Mr Trump has previously been scathing of NATO and critical of smaller nations for not spending enough, Gen Mattis is likely to be a supporter of the organization and is already well versed about what is realistic to expect in terms of contributions from the other nations.

On a practical level I expect them to adopt a no nonsense approach which will not be to the liking of everyone, particularly those used to a more civilian style of working. It is likely they will get tough on the defence industry, ensuring that equipment is fit for purpose and delivered on time. This will be set against a backdrop of what is expected to be more a more certain budgetary environment. The House and Senate are both under Republican control, ending the impasse of the last administration and making a repeal of the Sequester legislation highly likely.

The personalities of President Elect Trump, Gen Mattis and Gen Flynn make for an intriguing cocktail. The hope is that Mattis, who is known as an exceptional leader can bureaucratically moderate Trump and neutralize some of Gen Flynn’s more controversial ideas (particularly on Russia). For example, Mattis is known to be against torture, and reports suggest he has already convinced Mr Trump round to his way of thinking, claiming to be able to get better results with “a packet of cigarettes and a couple of beers”.

The general public seems disbelieving that putting military men in charge of national security and defense policy will lead to anything but a more active military, however Gen Mattis and Gen Flynn’s scholarly work suggests this may be the case. I believe that one of the main reasons the military conflicts Iraq and Afghanistan escalated and went so badly wrong is because the civilian politicians were faced with a problem they did not know how to solve and so they asked their military commanders to come up with a solution. The Generals, in true military fashion, tried to oblige and did the best it could without any real mission. By putting Generals in charge of the entire outfit, they will know its limitations and hopefully adhere to Clausewitz’ principle that “war is a continuation of policy with other means.”

The final ingredient to the cocktail will be revealed when Mr Trump announced his Secretary of State. The front runners currently seem to be Rudy Giuliani, former Mayor of New York, and Gen (Rtd) David Petraeus, Gen Mattis’ co-author of the COIN manual and former Head of the CIA. Either man would be a fiery and strong addition to the mix.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Who’s the daddy?

Airbus, Boeing, the WTO or the lawyers

As the latest round of chest beating by Boeing and Airbus dies away until the next round of appeals, I really start to wonder why the finger pointing and name calling persists. It seems to me that only one group of people are directly benefiting from the “discussion”, and I do not mean Joe public.

We all know that Airbus was an intergovernmental creation in the 1970s that has now evolved into a real world, highly capable aerospace and defence engineering megalith, uncannily akin to Boeing. The use of “loans” to facilitate new aircraft development programmes was a standard practice for years. However, we also know that various US administrations have encouraged Boeing’s civil aircraft operations with a number of fiscal and policy measures stretching back decades.

One man’s loan, tax break or R&D agreement, is undoubtedly another man’s subsidy. Is it important, yes, but is it relevant? I would argue probably not any more. Most of the issues being processed have been consigned to history, and most had been accepted as terms of trade by both sides for 12 years until the US chose to rip up the 1992 US/European civil aircraft agreement on subsidies in 2004, launching the dispute that 12 years later still drags on.

The duopoly that had formed in the large commercial aircraft market bestrode the narrow world like a colossus. Both companies remained fiercely competitive, and still do. Both led the world in technological innovation in the production of civil aircraft, leveraging highly developed and technologically advanced supply chains, governmental agencies and academia. Both still do. Whilst new entrants threatened to disrupt the market, the duopoly has effectively taken the market with them, not so much controlling the ball, but more the pitch everyone is playing on.

The trouble is that for the first time in my career a credible new entrant exists. China.

The companies are giants in the economies of the US and Europe, commercial aircraft sales are excluded from most measures of core capital goods development as they can be so large and distorting to monthly and even quarterly trade figures. The companies provide hundreds of thousands of highly skilled jobs in their own businesses and throughout the supply chain hinterland.

Whilst like many others I dismiss the immediacy of China’s ability to disrupt, I do not believe that the status quo will last forever. Over the next forty years, it would be more surprising if China did not become an effective competitor in export markets.

Whether the administrations on either side of the Atlantic can prove as adept at building bridges as well as walls remains a matter to be resolved. In my view, the imposition of penal tariffs and trade restrictions would likely leave only one set of participants with smiles on their faces, trade lawyers. It would be nice to think that in the interests of the economies of both regions, that this damaging, and in our view avoidable and potentially unsolvable dispute could be amicably consigned back to the history from where it was unfortunately unleashed.

If you think this is unrealistic, my wish for Christmas is world peace.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

F-35 funding in chaos

DoD and Lockheed Martin still struggling to agree contract terms

Earlier in the year I highlighted that there were serious problems with F-35 contract negotiations (Lockheed Martin names and shames the US DoD). Last week’s announcement that Lockheed is to receive $1.3bn of ‘stop gap’ funding to continue production of LRIP 10 whilst negotiations drag on, together with the unexpected and unilateral contract announcement for LRIP 9 earlier in November, indicate that the situation has got worse not better in the past four months. So what does the future hold for the programme, particularly under Donald Trump as President?

In Lockheed Martin’s 3Q earnings statement (25 Oct) the company emphasized again that it is effectively building aircraft without any idea how much it is going to be paid for them. This is a farcical situation for the largest ever military procurement programme, but sadly is indicative of the chaotic procurement processes within the US DoD.

“In 2014 and 2015, the Corporation received customer authorization and initial funding to begin producing F-35 aircraft to be acquired under low-rate initial production (LRIP) 9 and 10 contracts, respectively. The Corporation continues to negotiate these contracts with its customer. Throughout the negotiation process, the Corporation has incurred costs in excess of funds obligated and has provided multiple notifications to its customer that current funding is insufficient to cover the production process. Despite not yet receiving funding sufficient to cover its costs, the Corporation continued work in an effort to meet the customer’s desired aircraft delivery dates. Currently, the Corporation has approximately $950 million of potential cash exposure and $2.3 billion in termination liability exposure related to the F-35 LRIP 9 and 10 contracts.”

On 2 November the US DoD then issued the $6.1bn LRIP 9 contract on for 57 F-35s unilaterally, without finalising the agreement with Lockheed Martin. Negotiations to combine LRIP 9 and 10 into one big contract for 150 aircraft worth around $14bn reportedly fell apart, leading to the DoD issuing the LRIP 9 contract unexpectedly. Lockheed Martin issued another statement saying:

“The contract for LRIP 9 announced today was not a mutually agreed upon contract. We are disappointed with the decision by the government to issue a unilateral contract and we will evaluate our options and path forward.”

The $1.3bn undefinitised contract action (UCA) announced last week will cover costs incurred for long-lead work on the LRIP 10 batch of aircraft. This is the first UCA for LRIP 10 but the pentagon used the same mechanism a number of times to cover costs on LRIP 9 before awarding the full contract.The full LRIP 10 contract remains under negotiation.

The F-35 programme is too mature now to risk cancellation, the value of the export orders alone ensures that the US will pursue the aircraft. However, it is Lockheed Martin’s main driver of top line growth over the next decade, so questions must surely be asked about what margin the company is going to make on the programme?

The F-35 is likely to be high on Donald Trumps agenda when he takes office. He criticized the aircraft during his election campaign:

“I hear that it is not very good. I hear that our existing planes are better. Test pilots are saying it doesn’t perform as well as our existing equipment which is much less expensive. So when I hear that, immediately I say we have to do something because they are spending billions.”

Lockheed Martin is probably pinning its hopes on the fact that Trump and his new Defence Secretary (whoever that may be) decide the best way to improve the programme is to spend more money on it.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Is the last bastion of the UK Defence Industry at risk?

Urgent decisions are needed about UK shipbuilding

Naval Ships and Submarines are forecast to consume 40% of total UK defence equipment spending over the next decade, so you would think it is a safe assumption that shipbuilding is an excellent market for the likes of BAE Systems, Babcock and Rolls-Royce?  Last week’s report by the House of Commons Defence Committee suggests otherwise. MPs highlighted that decisions made over the next year about the Type 26 and Type 31 are critical in establishing whether skills can be maintained, budgets can be met and ships can be delivered on time.

The report concludes that:

“At 19 ships, compared with 35 in 1997, the Royal Navy’s frigate and destroyer fleet is way below the critical mass required for the many tasks which could confront it. If the National Shipbuilding Strategy can deliver the Type 26 and Type 31 GPFF to time, the MoD can start to grow the Fleet and return it to an appropriate size. The 2015 SDSR set out the Government’s ambition for a modern, capable Royal Navy. Now is the time for the MoD to deliver on its promises.”

At Sandhurst it was drilled into me the important difference between a strategy and a plan. The Defence Committee report ‘Restoring the fleet’ seems to suggest the MOD has an overarching strategy, but does not yet have a plan of how to deliver it. It is the plan that is crucial to the defence industry because it will establish when the ships will be built and under what contract terms.

Currently the MOD is dragging its heels over the Type 26 frigate contract and the report highlights that this causes three main issues:

1. There is a risk that the Type 26 will not be in service in time to replace the Type 23 and therefore fleet numbers will fall below our current historic low.

The MOD announced on 4 Nov 2016 that work is due to start on the ships in the summer of 2017, however that date remains dependent upon a successful conclusion to negotiations on both the design of the ship and the contract.  The Type 26 frigates are intended to replace the Type 23 frigates, which will start to come out of service in 2023 at twelve-monthly intervals.
“If the new frigates are not delivered to that decommissioning timetable, ship numbers will be reduced further from what is already an historic low (see chart below). The current total of 19 frigates and destroyers—only 17 of which are usable—is already insufficient: to go below that number, even for a transitional period, would be completely unacceptable.”

UK Royal Naval Fleet 1975 – 2016 (Source: UK MOD statistics)

Strict timelines are clearly required, but past experience with the Aircraft Carriers and Type 45 Destroyers does not fill me with confidence that the MOD and industry can deliver to such a strict schedule. At Defence Questions on 7 Nov 2016m the Secretary of State for Defence was asked whether the first Type 26 would be ready to enter service in 2023. His response was uninformative:

“Yes, I can confirm that it is our intention to replace the anti-submarine frigates within the Type 23 force with eight new Type 26 anti-submarine frigates”

2. Contract delays lead to cost inflation which jeopardises the number of ships the MOD will be able to purchase.

The MOD has already admitted that there is a £750m shortfall in the funding for the Type 26 programme in the current year. If work does not start in the summer of 2017 then the overall cost of the programme will increase because BAE is currently paying to maintain capabilities in an underutilised workforce. The Royal Navy budget is already being squeezed (most notably because of the costs to fix the Type 45 engine) and if the unit price increases then consideration will have to be given to purchasing fewer than the planned eight ships. The report warns that the Government must not try and mask the problem by imposing artificial delays to the programme thus stretching the cost over more years (as was done with the aircraft carriers), as this will only increase the problems further down the line for another parliament.

3. There is currently a lack of work for the shipbuilding workforce which risks undermining a national capability.

The 2009 Terms of Business Agreement (TOBA) between BAE Systems and the UK Government was the closest we have ever had to a coherent defence industrial strategy. The National Shipbuilding Strategy is intended to supersede the TOBA and give industry the long-term certainty necessary to generate a secure and skilled workforce. The current delays to Type 26 mean there is insufficient work in Scotland for the existing workforce and has resulted in BAE Systems retaining staff at Rosyth on the carrier programme for “longer than anticipated”.  In addition, BAE has reduced its number of apprentices from 100 per year, to 20 per year.

The MOD has announced that the construction of two Offshore Patrol Vessels (OPVs) will start shortly for delivery in 2019 which it hopes will protect jobs before the Type 26 programme gets underway. However, Duncan McPhee from the Unite Union has warned that further delays would be “catastrophic for the industry.” Timelines for the Type 31 General Purpose Frigate must also be made explicit in order to secure jobs through to 2035.

In Conclusion, we are entering a critical period if industry is to benefit from the promised and much anticipated increase in spending on UK Naval ships. Shipbuilding is the last bastion of the UK Defence Industry so it is vital the Government gets this right, otherwise the industrial landscape of the UK could change irrevocably.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

One man’s gift is another man’s bribe

How has the 2010 Bribery Act impacted Aerospace & Defence?

The recent BBC Panorama entitled ‘How Rolls-Royce bribed its way around the world” prompted me to revisit the 2010 Bribery Act. Crucially I wanted to understand whether Rolls-Royce’s business activities prior to the Act becoming law in July 2011 could be looked at retrospectively? And what punishments does the SFO have in its arsenal? In answering these questions, it is interesting to look at how the Aerospace & Defence industry is adapting in order to operate within the law. 

The practice of gifting has been in operation since the earliest days of man with the Book of Proverbs stating that “a man’s gift makes room for him and brings him before the great”. However, the difference between gifting and bribery has historically been a very grey area. In any discussion of corporate bribery or corruption, the Aerospace & Defence sector invariably steps into the spotlight. In fact the new law came about as a direct result of the Serious Fraud Office (SFO) terminating its investigation into BAE Systems in 2006 due to issues of national security.

The rights and wrongs of the BBC documentary about Rolls-Royce are beyond the scope of this blog, with Rolls-Royce’s fate ultimately lying with the SFO. However, the programme served as a reminder that if Rolls-Royce was operating in a slightly murky world, then many of its peers and competitors inevitably were as well. So what has had to change?

The 2010 Bribery Act attempts to make the ‘grey area’ more black and white. Since 2011, an organisation can be held liable for failing to prevent any member of staff or associated person from bribing an individual or Foreign Public Official on its behalf.  The Bribery Act extends extraterritorially so it does not allow for any cultural expectations or local customs when business occurs outside of the UK. The law applies to any company that is incorporated or formed in the UK, or conducts business or part of a business in the UK.

Legal experts have highlighted however, that the wording of the act leaves a number of ambiguities and it strikes me that two of these are very important. Firstly, an associated person is defined as ‘a person who performs services for, or on behalf of a company’. This is clearly a very wide definition and could potentially include any other contractual counterparties such as joint venture partners, distributors, consultants and professionals advising the relevant company.  This is clearly a significant area of vulnerability for companies. Secondly, the SFO fails to specify the degree of control that must be exercised by the state representatives over a company’s affairs to qualify those individuals as ‘foreign public officials’. There is therefore a grey area as to who counts as a ‘foreign pubic official’, with a concern that any member of a management team with some link to government could be considered to be.  Therefore some legal advisors have suggested UK businesses should err on the side of caution when dealing with foreign companies and regard them as state owned enterprises employing foreign public officials.

The global nature of the Aerospace & Defence industry means that companies have historically been reliant on a network of contacts around the globe to tout for, and subsequently win business. Often this network was kept at arm’s length by management. The new law dictates that such practices can no longer occur. As a result management teams are establishing in-country foreign sales teams and ensuring stringent controls are in place to hold them accountable.

Facilitation payments, which are payments to induce officials to perform routine functions, are illegal, as they were under previous law. Many businesses claim this is too stringent an approach though, as historically such payments have been customary and transacted on a daily basis. It feels as though we are in a fascinating period of transition as both corporates and governments are forced to address deeply embedded cultural practices which are now viewed as wrong by the UK, as well as most other western regimes.

Crucially, the Act is not retrospective and therefore the previous anti-bribery regime will continue to apply to bribery offences committed or attempted prior to 1 July 2011. This means that much of what the BBC highlighted in its Panorama programme falls under the old laws.

Ironically, the Act seems to have created another grey area when it comes to punishing those found guilty of bribery. The punishments available to the SFO are extremely subjective leaving significant room for interpretation. Companies are encouraged to self-report, but there is no guarantee that self-reporting affords any benefits. Fines must reflect the seriousness of the offence and have no upper limit. They must take into account the financial circumstances of the offender and be substantial enough to have a real economic impact, thus reminding management and shareholders of the need to operate within the law. However, it must be considered whether the fine would put the company out of business and whether this is an acceptable consequence.

As a context, it seems the US Department of Justice’s (DOJ) prosecution of Siemens in 2008 is probably the most comparable case. Siemens was found to have paid bribes on multiple transactions across a number of territories, earning more than $1.1bn of profit.  It paid a total of $800m to the DOJ ($350m in costs and $450m fine), as well as $854m to the Office of the Prosecutor General in Munich.

The bribery act states there is a full defence if a company can prove it had adequate procedures in place to prevent bribery. This has therefore given rise the most obvious change in the Aerospace & Defence industry. Almost all the major companies now have specialist anti-bribery teams and they all dedicate a significant portion of the annual report to ethics.

Whilst the industry is changing its working practices, it feels as though it is going to remain under scrutiny because an investigation into one company inevitably triggers an investigation into another because they all work with and compete against each other. Perhaps the only limiting factor will be the SFO’s capacity. The Rolls-Royce investigation has reportedly occupied 30 investigators for three years this far, without reaching a conclusion.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Busy festive season at Airbus

154 aircraft due for delivery in 2 months

In my blog ‘August deliveries at Airbus’ I noted that during September and October we would be looking for demonstrable progress towards the 2016 annual delivery target of more than 670, given that at the end of August only 400 aircraft had been delivered.

Progress has been slow in coming, with only 516 aircraft delivered as of the end of October, leaving Airbus to make 154 deliveries in two months in order to reach the target. The main laggards are the A320 programme where we understand problems with the engine have all but halted deliveries of the new engine option (neo), and the A350 due to issues with the ramp up and the supply chain.

I am not generally predisposed to bet against Airbus when it comes to them achieving delivery targets. In 2014 it looked highly unlikely Airbus would deliver its planned 30 A380 aircraft but against all odds they delivered five in the month of December, with CFO Harold Wilhelm admitting that the workforce was brought back between Christmas and New Year and told they would not be leaving until the last A380 left the hangar.

It feels as though he may have to issue a similar message this year, because at the Q3 results on 26 October Mr Wilhelm seemed extremely confident Airbus would not only meet, but exceed its delivery guidance for 2016. At the beginning of the year the company said it was targeting ‘more than 650 deliveries, but during the Q3 presentation Mr Wilhelm said he was targeting 670.

This leaves Airbus needing to ship 154 aircraft in the next two months. The delivery schedule is notoriously weighted towards the fourth quarter. In 2014 it delivered 30% of its annual total in Q4, and 30%, so the required 31% in 2016 looks realistic but it looks like this one will go right down to the wire. I hope the Airbus engineers have a good New Year’s Eve party!

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

China shows its air power

Stealth fighters take to the skies at Zhuhai air show

On Tuesday, China showcased its long awaited J-20 stealth fighter jet for the first time in public at the Zhuhai air show. Yet again an impeccably timed show of force with the US Presidential Election next week. The first test flight of the aircraft in 2011 coincided with the then US Defense Secretary Robert Gates’ visit to Beijing. With other new military aircraft expected to be unveiled throughout the week we look at the changing shape of China’s military arsenal, and question how does Chinese defence spending affect Western budgets.

China’s Air Force used to be the poor relation to the Army, relying on cast off soviet aircraft. However, over the past decade, double-digit growth in China’s defence budget has allowed for modernization of the fleet, on a par with the development of land vehicles and the US Pentagon’s 2016 report on China’s military stated that the People’s Liberation Army Air Force (PLAAF) is “rapidly closing the gap with western air forces across a broad spectrum of capabilities. Although it still operates a large number of older second and third generation fighters, it will probably become a majority fourth-generation force within the next several years.” 

It has however been pursuing fifth generation fighter technology since 2009, and is the only country other than the US to have two concurrent stealth fighter programs; the J-20 and the FC-31. The J-20 has drawn comparisons with the Lockheed Martin’s F-22 Raptor which remains in service with the US Air Force (USAF) but is no longer in production. The J-20’s capabilities are expected to be someway behind the new Join Strike Fighter (JSF) F-35, but it represents a step change in capability for the PLAAF. China wants to use the aircraft to project its regional power and to strengthen its ability to strike regional airbases and facilities.  The PLAAF sees the use of stealth aircraft as a core capability in its transformation from a predominantly territorial air forces to one capable of conducting offensive and defensive operations. The FC-31 has not yet flown publically but is being marketed as a fifth generation multi-role fighter that will be able to compete with the F-35 for export sales. Interestingly, in 2009 it was reported by the Pentagon that unknown cyber attackers, appearing to originate from China, had compromised information about the F-35.

The Y-20, China’s first heavy transporter aircraft was unveiled yesterday. Also set to be showcased this week are the AG-600 seaplane for search and rescue missions, a Zian H-6K bomber and the new Changhe Z-10K attack helicopter. Away from the airshow the People’s Liberation Army (PLA) is focusing on its ability to operate as a modern, networked force, with a focus on Electronic warfare, Information operations and Cyber capability. The People’s Liberation Army Navy (PLAN) is modernizing its submarine fleet and is currently building is first domestic aircraft carrier, with more expected in the future.

The modernisation and development of China’s military over the last decade means that the PLA is increasingly able to project power during peacetime and to contest US military superiority in the event of a regional conflict. Therefore the Chinese defence budget is effectively a driver of the US defence budget. Whilst China still only spends a quarter of what the US spends per year (as shown by the graph below), the Chinese defence budget is estimated to have a compound annual growth rate of 31% between 2000 – 2015, compared to the equivalent US rate of 9%.

US and Chinese defence spending 2000 – 2015 (constant 2014 US$ millions) (source: SIPRI military expenditure database)

Whilst China’s defence budget growth is expected to slow to between 7-8% this year due to lower overall economic growth, the Chinese are still spending enough for Obama to justify the ‘pivot to Asia’. Whoever becomes the next US President should find it hard to refute the importance of countering Chinese defence capabilities, especially as there is a strong belief amongst analysts that China’s actual military spending is significantly higher than is officially published.

The Western defence companies are under tight controls about what they can export to China. Even Russia has had an informal ban on selling advanced military systems to China since 2004. Interestingly though, the announcement at the Air Show that Russia will deliver four Su-35 fighter jets to Beijing later this year, along with an agreement to sell the S-400 surface-to-air missile (SAM) represents a lifting of the ban. The US is likely to be highly concerned by Russia providing technological support to China as it boosts China’s air defence capability in the western Pacific. Russia is also taking another step in complicating its relationship with the West.

The Stockholm International Peace Research Institute (SIPRI) ranks China as the fifth largest arms exporter after the US, Russia, Germany and France (the UK is seventh). International sales are primarily conducted to support broader foreign policy goals such as securing access to natural resources or promoting its political influence. China’s defence products are less expensive than those offered by Western arms suppliers, and also lack the same guarantee of security and through life support. Therefore China’s customers are mostly developing countries, predominantly in Africa and the Middle East.

The export situation with the J-20 and other military aircraft is likely to look similar to the market for the civil C919 aircraft. It will remain the preserve of the domestic market, for at least the next decade until its technology is proven. Whilst price is undoubtedly a factor for customers, it only comes into play once certain safety and performance standards can be guaranteed. The Chinese government is unlikely to be worried by this though; all it wants is for the PLAAF to have its own stealth fighter jet.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

It pays to be civil in the long run

Backlog execution should enable improved investor returns

By the end of September, Boeing and Airbus had surpassed an aggregate of 1,000 aircraft deliveries as previously announced product introductions and rate increases continue to drive up demand across the aerospace supply chain. By the year end the two companies are expected to deliver an aggregate of around 1425 aircraft, slightly higher than in 2015.

Whilst output of the ultra large widebody segment (B747 and A380) is set to decline, output across the rest of the widebody (twin aisle) and narrowbody (single aisle) large commercial aircraft markets (>150 seats) is set to continue to grow healthily with A320neo family, A330neo, A350, B737 MAX, and Boeing 787 all increasing through the end of the decade. Although the B777 transition to the new B777X model still requires order cover, overall Boing production is rising with yesterday’s modest increase in expected deliveries for the current year providing further encouragement. Whilst many commentators forecast a decline in output from 2020, we continue to believe the long term growth of the segment as likely to continue. This is due to increasing passenger demand, the growth trend in fleet replacement due to the historic progressive rise in aircraft deliveries, and the continued requirement for technologically driven fuel efficiency step gains where we are just seeing the entry into service of the newest generation.

Airbus quarterly deliveries 2010 - 2016 (Source: Airbus, Edison Investment Research estimates)

It is apparent from Senior’s trading statement on 21 October 2016 that the ramp up in the A320neo programme for Airbus continues to be dogged by issues with regard to the engine supply. Despite maintaining overall A320 family production numbers, Airbus have flexed up the number of A320ceo (classic engine option) aircraft that will be delivered in the current year. A320neo deliveries are now expected to total 45 this year and account for just under 15% of A320 deliveries compared to just under 20% previously. When combined with Bombardier’s comments in early September when it reduced its expected C-Series deliveries to just 7 from 15 previously, it is a reminder that new aircraft programmes seldom experience perfect introductions.

I would argue that Airbus has indeed managed the industrial impact extremely well, by ensuring enough ceo volumes in the order book to allow the type switch. In its Q3 call it indicated that customer requests for earlier production slots continue to outweigh deferrals, largely facilitated by its policy of overbooking in the narrowbody market. It is also aided by the variety of A320 family models, with FACC, the Austrian composite structures supplier owned by AVIC of China, noting increasing demand for A321 shipsets. As a result Airbus appears to have avoided the worst impacts on its production line that the engine delays could have caused. Whilst the mix shift may be less favourable financially for Airbus, given the purported premium of A320neo’s versus ceo’s, this may be mitigated by launch customer discounts at this early stage.

The good news appears to be on the A350 ramp up which is expected to meet delivery targets of over 50 this year according to Fabrice Bregier, with both Senior and FACC noting progress. Indeed FACC have been preloading interior work for the aircraft, incurring extra cost in Q2 to ensure interiors can be fitted earlier than previously scheduled in Toulouse. This would appear to be to try and ensure that cabin interior issues that have delayed final deliveries to date, largely attributed to performance by Zodiac, do not recur as output increases further in 2017.

At Boeing the B787 rate increases to come and the higher rates as the B737MAX is launched also point to growing volumes for suppliers. Add in China’s Comac and Embraer’s second generation regional jets and continued growth in civil output looks well set for the next few years despite the current softness in bizjet markets.

Boeing and Airbus deliveries and forecast 2000 - 2020E (Source: Boeing, Airbus and Edison Investment Research estimates)

All of this continues to drive volume growth into the large commercial aircraft suppliers, who should see revenues rise sharply and enable both learning curve and efficiency benefits to be realised across the supply chain. As it is the high value segment of the civil aerospace sector, suppliers who execute successfully into this environment should see returns improve significantly.

My view remains that civil aerospace is an attractive segment for long term growth and investment. Indeed FACC sees an additional €250m of revenues from organic development alone over the next five years. Not too bad on a base of €588m reported last year, especially considering other incremental programmes yet to commence.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Consolidation in the Cyber market

Who will benefit from the super nomal levels of forecast growth?

The global Cyber attack last Friday is the latest stark reminder of how the defence and security market is changing. Attacks do not have to be physical in order to cause harm. Cyber attacks have the potential to be fatal or economically disastrous in just the same way as conventional warfare. As President Obama said on Monday “One of the biggest challenges for the next President, and the President after that is going to be how do we continue to get all the benefits of cyberspace but protect our finances, protect our privacy”. In a world where growth is hard to come by, new forecasts see the Cyber Security market growing 12-15% year on year until 2021. But is it clear what the products of the future will look like? And can we discern which protagonists will win market share?

Last week’s internet outage was caused by an attack on under-protected Internet of Things (IoT) devices, for example smart televisions, digital video recorders, security cameras, baby monitors and web connected home devices such as coffee makers and fridges. The vulnerability of the rapidly growing IoT has led to the leading researcher into Cybercrime, CyberSecurity Ventures, to say that previous growth forecasts of 8-10% year on year for the Cyber market now look too low.

Putting numbers on current Cyber Security spending is incredibly challenging because businesses and governments categorise security spending in many different ways. Most put security into another budget line; whether IT, General Operations or Compliance. Traditional IT security is rooted in servers, networks, data centres and IT infrastructure. However, we now have to consider non-computer devices and non-IT centric platforms, which gives rise to whole sub-markets, for example aviation security and automotive security. CyberSecurity Ventures estimate that worldwide spending on Cyber Security products and services will total $1 trillion over the period 2017 – 2021. Other experts argue that if you encompass data collection, storage, analysis, threat intelligence, operations and dissemination then the figures involved could be much higher.

So where will all this money be going?  For the past decade, niche security providers have taken market share from larger more traditional IT companies. However, there is a growing belief that the market is reaching a point of maturity that is going to see industry consolidation and the largest providers regaining traction.

The most common approach to safeguarding digital assets is defence in depth – the layering of more and more layers of protection, often from a number of different providers because small companies have developed specific protections or fixes to one-off problems. However, this strategy is difficult to maintain and relies on human judgment to assess the threats at any one time. Increasingly Management teams want consolidation of systems in order to streamline their processes.

IBM and Cisco have two of the largest Cyber businesses ($2bn and $1.75bn respectively). Both have been steadily growing and making strategic acquisitions in the space. They are competing fiercely with more pure play cyber companies and there is one school of thought that sees the biggest players taking significant market share from smaller competitors over the next five years.

However, it is important to remember that Cyber products are by their nature very short cycle and must constantly evolve. The risk to the growth at the big players is that they are unable to be agile enough to compete with the technological developments at their smaller competitors.

It is the ever-changing nature of the threat that means whilst there is now legislation in place in the US and EU mandating cyber protection for anyone that provides ‘essential services’, Governments are reluctant to legislate the level of protection required, or endorse specific providers, for fear of the legislation rapidly becoming obsolete. It is however noteworthy that in the UK, Hewlett Packard (HP) is now the seventh largest supplier to the UK MOD which indicates HP is the UK Government’s preferred provider of Cyber products.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Innovation in the defence industry

Is it industry or the the MOD that is too old to innovate?

There is uproar in the upper echelons of the defence industry. Last month Tony Douglas, CEO of the government’s Defence Equipment and Support group (DE&S) reportedly berated senior defence industry executives for all being over forty-five, implying that they are too old to be innovative. Ironically, in my previous blog ‘Brave new world for defence industry’ I highlighted that it is the Government’s cost cutting that is jeopardising long term innovation. So is Mr Douglas’ criticism fair? 

There are three fundamental flaws with the suggestion that defence industry executives are too old to innovate. Firstly, his assembled audience was senior managers – a demographic that is likely to be older. I am firm believer in the importance of strong leadership and management and therefore ascribe a premium to companies with talented teams at the helm. Whilst age is not a precursor to management ability, the two are generally coincidental by virtue of experience. The attendees are likely to manage the inventors of new technology rather than invent it themselves. It is also worth noting that often engineers and scientists have no desire to ‘give up the day job’ and enter the world of corporate management. BAE Systems has its own scientific career stream to afford such individuals career progression without them following the conventional path upwards into management.

Secondly, innovation is generally driven by the culture within a company or industry, rather than by individuals. Age is therefore no barrier to this. Even if older senior executives lack the technological know-how to develop new products they can still set the conditions for those that they manage to do so. Conversely management can stifle innovation if it is too prescriptive and does not allow time and space for employees to pursue that which is ‘interesting’.

Thirdly and most importantly, the biannual Defence and Security Event International (DSEI) held in London’s Excel centre is demonstrable proof that the defence industry remains innovative. When I visited last year there was no shortage of pioneering, futuristic and occasionally times curious products. Whether or not there is a market for these products though is a different matter entirely. With an already constrained defence budget, suffering further from the devaluation of our currency, the MOD’s appetite to purchase new equipment seems limited (see my blog ‘Do tanks have a future?’). It therefore strikes me that the defence industry would be within its rights to turn Mr Douglas’ comments back onto himself and challenge whether the people managing procurement in the MOD are agile and innovative enough to supply the new solutions the military might need in future warfare?

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Brave new world for defence manufacturing

Hundreds of jobs at risk at GKN Yeovil

Last Friday GKN announced that it may have to “close or significantly downsize” its Yeovil site which employs 227 people. A statement from the company blamed the decision by Leonardo Helicopters to relocate all future A159 Wild Cat helicopter assembly away from the GKN Yeovil site to one of their own facilities. However, the story is more complicated than that and it raises the emotive debate of how much the Government is willing to invest in order to preserve the UK defence industry?

In my 9 Aug blog ‘Common sense in UK Defence’, I highlighted that in July the UK MOD announced it would be purchasing 50 Apache AH64E helicopters directly from Boeing for £2bn, rather than buying them from Augusta Westland (now Leonardo) on license from Boeing as was done for the original fleet of Apaches. I noted that from my external perspective it was heartening to see the MOD making a rational decision based on procuring the best equipment at the best possible cost.

Lord Paddy Ashdown, formerly the MP for Yeovil, has been quick to point out that it is the Government’s decision to buy Apache’s from Boeing, rather than the latest decision about Wild Cat production which has sounded the death knell for the Yeovil site. He is probably right, but should the Government have made an uncompetitive decision in order to preserve jobs?

It is a controversial and complex debate. At its heart lies the fundamental question of whether the Government is willing to afford protection to the UK defence industry in order to maintain skills and technological capabilities? Ten years ago this was thought to be the case, but since then protections have gradually been eroded and we are seeing the MOD conducting more and more ‘off the shelf’ purchasing. This undoubtedly leads to cost savings but risks losing long term British innovation, and with it an entire generation of engineers. The only remaining bastions seem to be nuclear submarines and missiles where the Government remains determined to ‘buy British’.

This is forcing defence companies at every level of the supply chain to rethink how they do business; with many focusing on export markets and cutting production costs wherever possible in order to be competitive on price. Historically in defence a company has only been able to export a product once it is in service with its own nation’s military, but again this may start to change as the MOD continues to operate under a constrained budget. From the government’s perspective, it should also be concerned as the UK is currently the second largest defence exporter in the world. However, there are plenty of countries plying their wares to the UK’s traditional export markets, who are only too willing to fill any voids.

Defence manufacturing is entering a brave new world.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Heathrow vs. Gatwick?

The airport expansion debate rages on

Are we finally about to get an answer to the Heathrow vs. Gatwick airport expansion question? MPs are scheduled to debate the question of UK airport capacity next Tuesday (18 October) as the Prime Minister has indicated a desire to finally make a decision on an issue the Conservative Government has thus far managed to sweep under the carpet. Interestingly, the debate will be set against the backdrop of new research which shows that it is the road traffic in and around the airport that is the main contributor to emissions, not the aircraft themselves.

The air quality around Heathrow airport is often in breach of European standards. Emissions are therefore at the heart of the argument against expanding the airport with a third runway. To counter these arguments, previous studies have used estimates to suggest the air quality will improve in the future as technology improves for both aircraft and road vehicle engines. However this new study by the University of Cambridge is the first to be based on real-world data, collected from 40 Nitrogen Dioxide (NO2) sensors at the airport. It stated that:

“If there is the development of a third runway, we expect there to be a marginal increase in NO2 coming from the airport itself, but that would be against the background of reduced NO2 from other traffic, because of Euro 6 engines and electrification of the traffic fleet.” (Professor Rod Jones, University of Cambridge)

Therefore road vehicles, rather than aircraft are set to take centre stage during the debate next week. Campaigners against airport expansion claim that the assumptions made about greener vehicles are falsely optimistic. The Deputy Director of the Aviation Environment Federation (AEF) said “the assumption would have to be that over the next decade, we’d move from having 57% of London’s vehicles fleet being diesel vehicles to instead having ultra-clear electric vehicles throughout the capital. There just isn’t evidence to suggest that is going to happen.”

As an aerospace analyst though, I think the most interesting point from the study is that despite modelling over a third more aircraft take-off and landing cycles there is only expected to be a ‘marginal increase in the NO2 coming from the airport itself.’ This illustrates the significant improvements in aero engine technologies that have already occurred and which will continue. The International Air Transport Association (IATA) reports that new aircraft are 70% more fuel efficient than 40 years ago and about 10% better than ten years ago. The A350 and 787 MAX are targeting three litres of fuel per 100 passenger kilometres, which is better than an average small car.

MPs have three options on the table; a third runway at Heathrow, a second at Gatwick, or doubling the length of one of Heathrow’s existing runways. Theresa May is expected to give MPs free vote. Whilst her constituency (Maidenhead) would be impacted by expansion at Heathrow, she has said very little openly about the debate so her stance is unknown. The Foreign Secretary Boris Johnson and the Environment Minister Justine Greening are both openly against expanding Heathrow. Whichever scheme is chosen is expected to be operational by the middle of the next decade. 

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Are airlines weathering the impact of Brexit and terrorism?

Passenger traffic growth analysis

In my 27 July blog ‘The Summer of Hate’ I espoused that summer 2016 could be a defining moment for the aerospace industry. I questioned whether the new wave of terrorism on mainland Europe would lower our propensity to travel by air and therefore encourage more people to holiday closer to home. The IATA passenger data is now in for July so what does it show?

So far the outlook is positive. In July 2016, growth in industry-wide revenue passenger kilometers (RPKs) rose 5.9% year-on-year in July – its fastest pace in five months. Therefore RPKs have grown 5.5% year-on-year so far this year. Whilst this is lower compared to 6.3% in the same period of 2015, passenger traffic has still grown broadly in line with the average pace seen over the past decade or so. Most importantly the July data show demand was resilient at the start of the peak summer period.

Air travel has faced two major headwinds in 2016 – terrorism and economic uncertainty. As I discussed in my summer of hate blog the impact of terror attacks is normally temporary, however the frequency of attacks this year has led many in the industry to suggest the impact may last longer than normal. Air passenger volume growth usually goes hand in hand with global business confidence as the chart below shows. September’s PMI data was better than expected which bodes well for passenger growth, but the uncertainty around Britain’s exit from the European Union (EU) continues to be a risk. These headwinds have been offset though by lower fares, which are a function of lower oil prices as well as competition between airlines over the summer season.

Air passenger volume growth and global business confidence (IATA Economics)

So thus far summer 2016 does not look to be the moment when terrorism altered our propensity to fly, although it is worth nothing that many people already had their travels plans made when the attacks in France and Belgium occurred. Confirmation of the theory though will come next summer when we see if passenger growth is at its usual levels during July and August.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Do tanks have a future?

A look at how armour is evolving

Last month the British Army caused traffic chaos in London by driving a replica First World War tank and a modern Challenger tank around Trafalgar Square. This impressive, yet slightly anti-social display was to commemorate one hundred years of tank service. Seeing these two goliaths of warfare side by side, it struck me that whilst major technological advances have been made over the past century, a modern tank still looks remarkably similar to its predecessor. It made me question whether tanks one hundred years on will still look so similar? Or whether in fact modern warfare no longer needs tanks? These are questions that are likely to be preoccupying the military vehicle manufacturers such as General Dynamics, BAE Systems and Nexter.

The last decade of counter-insurgency (COIN) warfare has led many soldiers of my generation to question the utility of the tank. In Afghanistan tanks were a hindrance rather than a help. They were too big to manoeuvre, their imposing presence terrified the local population and they were not appropriate firepower for taking on an enemy equipped mainly with small arms and improvised explosive devices (IEDs). COIN warfare demanded a new type of vehicle. The infantry needed to move at speed with protection from roadside bombs and so the new generation of Protected Mobility Vehicles (PMVs) such as the Jackal (SC Group)  and Mastiff (General Dynamics)  were born.  Currently the British Army has 428 tanks compared to 1945 PMVs.

It is easy to forget however that COIN is not the only type of warfare and as General Sir Richard Barrons recently warned, we must remain prepared for other types of conflict.

“There is a sense that modern conflict is ordained to be only as small and as short term as we want to afford – and that is absurd. The failure to come to terms with this will not matter at all if we are lucky in the way the world happens to turn out but it could matter a very great deal if even a few of the risks now at large conspire against the UK. Counter-terrorism is the limit of up-to-date plans.”

RUSI estimates that there are approximately 108,000 main battle tanks in service globally, of which only ~18,000 belong to NATO. That leaves more than 90,000 that could be mobilized against us. The unstable geopolitical situation is such that there are any number of scenarios that could occur leading to warfare involving tanks, for example North Korea invading South Korea, China invading Taiwan and Middle Eastern war involving several Arab states and Israel or Pakistan attacking India to name but a few.

It is important to remember that tanks were not initially designed to counter tanks; they were intended to defeat the machine gun and penetrate layered defences in difficult terrain in order to restore mobility to the infantry. Therefore whilst you do not necessarily need tanks if your enemy has them (as the Taliban proved in Afghanistan), you do generally need them against an enemy with heavy weapons or fortified defences. In addition, anti-tank missiles have reached a level of sophistication such that tanks are vulnerable against any enemy with air power, as was the case for the Iraqis.

These issues are forcing militaries and the defence industry to rethink the requirements for tanks and there are a number of nascent technologies which could find their way onto the battlefield:

- Stealth: This is already used widely in warship and military aircraft, but it has yet to be used operationally with ground assets. BAE Systems caused amusement in 2012 when it showcased technology that could cause a tank to emit the heat signature of a cow, but anti-radar materials and coatings along with stealth based design could improve the tank’s survivability.

- Electronic Countermeasures (ECM): Again these are widely used by military aircraft and by soldiers on the ground, but the tank has yet to be used as an ECM platform in order to detect and jam enemy systems.

- Active countermeasures: During the Iraq and Afghanistan conflicts static technology was developed which detected sniper or mortar rounds and rocket-propelled grenades (RPGs) as they are fired by means of radar and acoustic signatures enabling counter-strikes to be launched. Such technology could be developed for mobile use on tanks and integrated with an automatic defence system which could autonomously intercept and destroy hostile rounds.

- Unmanned tanks: Drone technology is at the forefront of thinking about future warfare, but it has not yet been applied to armour. The US Defence Advanced Research Projects Agency (DARPA) has stated it wants to develop tanks capable of going anywhere meaning they need to be lighter. It is therefore testing unmanned prototypes, as well as those which only need a two man crew (like an Apache helicopter) rather than the current standard four man crew.

So my reluctant conclusion, as COIN generation soldier who likes to dismiss tanks as a relic of the Cold War, is that tanks do have a future. However, in another hundred years I think they will be unrecognisable from those of today. They could well be smaller than Armoured Personnel Carriers and most likely without any soldiers inside. Crucially these innovations will only occur if the major defence superpowers of the US, UK and China as well as all NATO members, are forward thinking enough to acknowledge that armour still has a place in modern warfare and therefore invest in developing new technologies. The UK Ministry of Defence (MOD) decided earlier this year to give the Challenger 2 a £700m upgrade to extend its life to 2035 rather than the more expensive option of purchasing a new tank. The US will be the real bellwether though when it reaches a decision point about its Abrams main battle tank.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The debate about the A380 rages on

Singapore Airlines will not extend lease on first A380

The A380 programme has taken another blow with the news that Singapore Airlines (SIA) – the aircraft’s first buyer and currently its second largest customer - will not renew the lease for its first A380. My 19 July blog ‘The end of the road for the A380’ highlighted that the future of the aircraft looks uncertain, with one of the issues being the unknown shape of the market for second hand A380s. The end of this first lease marks a new chapter for the aircraft and so far the outlook does not look that positive. 

Singapore Airlines’ first five A380s, delivered in 2007 – 2008, are on ten-year leases. The decision not to keep the first has just been made and the future for the others should be decided by April 2017. The A380 in question was the first one ever delivered to an airline and it will be returned to its owner, German investment fund Dr Peters Group, in October 2017.

Opinion is divided over what this means for the A380 programme as a whole. SIA’s airlines decision may well be based on some very specific factors and may not set a trend. Early model aircraft are significantly less mature than those built later on in production. They are notoriously high maintenance and more unpredictable. Therefore it is fair to assume that this first A380 SIA has chosen to get rid of is the most unattractive aircraft in the fleet. Notably the airline has another five A380s on order that are due for delivery from September 2017, so it clearly believes in the programme and may just want a more modern and reliable fleet.

The other side of the argument though is that if other airlines follow suit in not renewing leases then there will be a glut of second A380s which will have limited value because only a small number of airlines who fly routes which are viable for such a large aircraft. Qantas, the fourth largest A380 customer, currently has twelve aircraft in service which are on twelve year leases, the first of which is due to end in 2020. However, Airbus has always said it is confident in the second hand market believing that the aircraft will be leased or acquired at attractive rates. Interestingly IAG CEO Willie Walsh has previously said British Airways would be “interested in leasing second-hand A380s” (Jan 2016). The lower initial capital cost of second hand aircraft could also make the aircraft’s economics more attractive to operators currently put off by the huge capital cost of new A380s, meaning that we see new airlines operating the aircraft on new routes.

The outcome of this debate won’t really be known until the next decade when more and more A380s come to the end of their first lease. However, in the mean time we will be watching SIA’s decision about its other four aircraft which come to the end of their leases in 2017 and 2018. If they too are not renewed then it will be interesting to see which airline ends up flying them.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The ‘special’ relationship?

Carter and Trump's speeches raise big questions about US and UK defence

Events of the past week have raised some fascinating questions about the ‘special relationship’ between the United States and the United Kingdom. Firstly we saw Ash Carter (US Secretary of Defense) hold Theresa May and Michael Fallon’s feet to the fire to ensure the UK supports the US in its role as global policeman, and continues to spend 2% of GDP on defence. Subsequently Donald Trump set out his plans to increase the size of the US military without any explanation of how he would fund it. So what do these two acts of showmanship actually mean for the defence landscape?

Ash Carter’s speech last Wednesday was a somewhat surprisingly effusive ode to the ‘special relationship’ between the US and UK. The exact nature of the relationship has been under question since the UK Parliament voted not to send troops to support US military action in Syria, and Brexit has then lead to uncertainty as to how the US is intending to treat its long standing ally.

Mr Carter was full of platitudes – “the US has no closer ally, no stronger ally than the United Kingdom.” However, he firmly set out his stall to our new Prime Minister. He spoke of the two countries needing to “re-commit” to standing together and implored the UK to spend at least 2% of GDP on defence.

“President Obama and all Americans are heartened to know that we can continue to count on our allies and alliances, and especially on the United Kingdom, to join us in meeting these challenges and defending the principled world order.  That’s because – even with all the change in the world – the inherent logic of our countries’ special relationship still stands.”

Michael Fallon, the UK Defence Minister, responded, saying “as the world gets more dangerous, we continue to stand shoulder-to-shoulder with the United States.” Interestingly, he highlighted how the UK is focusing on interoperable equipment, for example the new fleet of Apache helicopters and the deployment of US F-35s on the UK Aircraft Carrier. During the height of the Afghanistan campaign, there was a reticence to become reliant on US equipment, because of the desire for the UK military to be able to act alone if required. Perhaps Fallon’s latest comments indicate an acknowledgement that this is unlikely to happen? In my 9 Aug blog, ‘Common sense in UK defence?’ I questioned whether the decision to buy Apaches from Boeing ‘off the shelf’ heralded a new dawn in defence procurement, where capability and price trumped national allegiances. It sounds as if the MOD is willing to make more such decisions.

Ash Carter’s measured comments last week were in sharp contrast with Donald Trump’s speech outlining his plans for the US military. He pledged to scrap the budget caps imposed by the 2011 Budget Control Agreement which would allow him to increase the number of active duty US solders from 500,000 to 540,000. He also promised to increase the Navy’s surface ships from 276 to 350 and to boost the number of fighter jets from 1,113 to 1,200.  An equipment uplift of this scale would be music to the defence industry’s ears, although his plans remain theoretical because he has not outlined how he would pay for the additional equipment, nor has he detailed how he would use the additional assets. However, he has said that if he becomes President, he will give his Generals thirty days to develop a plan to destroy Isis.

Events of the past week will undoubtedly have given those at the top of the defence industry cause to reflect and question. The nature of the ‘special relationship’ between the US and UK will be defined by who wins the US Presidential Election, not by anything Ash Carter can convince Theresa May and Michael Fallon to do at the moment.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

August deliveries at Airbus

Slow progress on A320neo

In my blog on 4 September I said I would be watching Airbus’ August delivery numbers with interest. Well they were released last week and despite Airbus CEO Fabrice Bregier saying that staff on the A320neo programme have been working overtime to catch up on deliveries, not much progress appears to have been made so far.

5 A320neos were delivered in August, bringing the total for 2016 to 16 thus far. Airbus clearly flagged in January that deliveries would be back loaded into the second half of the year, but with a target of 56 aircraft, it definitely has its work cut out.

The problems have been caused by issues with the new Geared Turbofan (GTF) PW1100G (see my blog ‘Geared turbofan too hot to handle’). Airbus is reported to have 25 A320neos without engines parked at Toulouse. We will be looking to see evidence of these aircraft being delivered to airlines in the next few months, in order to provide reassurance that Airbus can reach its 2016 delivery target.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Safran and Zodiac - do opposites attract?

A look at two very different French Aerospace companies

Safran and Zodiac are both French, both exposed to the structural growth of the civil aerospace industry, and both have world class products. But it is there the similarities end. Over the past five years, Safran has proved itself to be a well-run company with strong project execution. Zodiac’s management and execution has been found sorely wanting as it struggles to keep pace with the production ramp ups at Airbus and Boeing. Last week saw Zodiac’s ninth profit warning in two years, but interestingly over the past couple of months there has been a resurgence in market rumours that Safran is potentially interested in acquiring the company. Why are the two companies such a different investment proposition, and do they really have a future together?

It is all too easy to think of the French Aerospace & Defence sector as a homogeneous group of companies, notoriously subject to state control and unable to be competitive internationally due to high wage costs. Frequently there are calls for consolidation amongst the numerous players in order to create a state champion rather than a number of smaller companies who compete for a share of the global market. The names of Airbus, Safran, Thales, DCNS, Zodiac Aerospace and Dassault Aviation all get mixed in together.

It is widely acknowledged that Airbus is now in a league of its own, comparable only to its US rival Boeing. Safran is arguably also now a member of the aerospace elite. Its joint venture with GE, CFM International, produces the world’s best selling jet engine – the CFM56 – which is used on Boeing 737 and the Airbus A320. This year CFM started producing the new LEAP engine which will be used on the 737MAX and A320Neo. The development of the engine has gone well so far and managing the production ramp up is the main challenge for Safran’s relatively new CEO, Philippe Petitcolin, who was previously the programme manager.

Zodiac Aerospace, which supplies aircraft interiors, is currently languishing at the other end of the spectrum, despite being exposed to the same end market as Safran. It should be reaping the rewards of increased production at Airbus and Boeing, but instead the family run company has issued a string of profit warnings over the past two years. It has repeatedly pledged, yet failed to fix recurring problems of seat production for the A350 at plants in the United States. Airbus has publicly accused Zodiac of being “in denial” about the severity of the problems and has refused to work with the company on future projects.

So why are these two companies, who are seemingly poles apart, being talked about in the same breath? Safran’s CEO has said he wants to focus the company on civil aerospace, and is on the look out for growth in the aircraft equipment market to augment Safran’s landing gear and nacelles businesses. If Safran were to buy Zodiac, it would make a company resembling two divisions of United Technologies; Pratt & Whitney (engines) and UTC Aerospace Systems (aircraft equipment).

Safran and Zodiac have history together. In 2010 Safran proposed an offer which Zodiac’s board unanimously rejected with the CEO Olivier Zarrouti saying “Zodiac isn’t looking for a partner and has a good outlook as a stand alone company. The outlook for Safran is modest and the industrial synergies are weak.”

Six years on, Safran is in a position of strength compared to Zodiac, so negotiations could look quite different. However, Zodiac maintains it is not for sale and Petitcolin is acutely aware that Safran’s management has been criticised for its acquisition track record. His disposal of the Morpho security business suggests that Safran is now focusing on what it does best. It seems to me that distributing any surplus cash to shareholders is a far better idea than paying a premium for a struggling business with few industrial synergies.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Does a smaller military present an opportunity for industry?

MOD statistics show significant troop shortfall

Last month’s UK Ministry of Defence (MOD) personnel statistics show the UK Armed Forces have a personnel deficit of 4.1%, and strikingly the number of trained soldiers in the Army is at its lowest since 1750. The doomsayers note that this recruitment crisis means the UK would struggle to respond to a major crisis. However, could this not provide an interesting opportunity for the defence industry to show how the right equipment means you do not need as many troops?

The 2015 Strategic Defence and Security Review (SDSR) stated that by 2020 the full-time trained strength (FTTS) of the Armed Forces should be 144,200. Today’s Armed Forces are well short of that number, at 139,910. The Army, Navy and RAF are all below their manning targets, but it is the Army number that stands out the most. There are only 79,390 trained soldiers. By comparison, at the peak of the Afghanistan and Iraq conflicts there were 109,000, and at the end of the Second World War there were 364,000 (see graph below).

Number of UK full-time trained Regular Service Personnel 1750-present (‘000s)

The problem is twofold. Firstly, the 2011 redundancy programme saw many high quality individuals take voluntary redundancy. Soldier’s morale plummeted as those that were left behind had to pick up the pieces. This triggered a wave of unforeseen resignations, which meant in 2013 there was an unexpected manning deficit.  Secondly, the Armed Forces have been struggling to recruit. Low unemployment for the past few years means the military is not seen as a ‘last resort’ job . The outsourcing of recruitment to Capita has meant people are not lured into the services by charismatic serving personnel and shiny uniforms. Also, perhaps counter-intuitively to most members of the public, it is generally easier to recruit into the military when we are at war because soldiers want action.

Whilst low troop numbers are probably not a positive thing for the defence industry in the long term, in the short term there are two positives that could come out of this situation. The 4% manning deficit means personnel costs should be lower than budgeted and this money could be spent elsewhere, possible on procurement. In addition, the defence industry has an opportunity to show how the correct equipment can mean fewer personnel are needed.

In the civilian world more and more tasks are being outsourced to machines; one look inside an Amazon fulfillment centre confirms this. Whilst the military has made some technological progress, most notably with Unmanned Aerial Vehicles (UAVs) and bomb diffusing robots, there is an antiquated reliance on humans. I acknowledge that there are ethical issues with using autonomous decision making machines on the battlefield, where ultimately someone must be responsible for adhering to the Law of Armed Conflict (LOAC). However, there has never been a better time for the defence industry to fund research into products that allow the military to “do more with less”.

For example, yesterday the Royal Navy unveiled a drone speedboat which theoretically could lead to a fleet of unmanned high speed reconnaissance and surveillance vessels. The Maritime Autonomy Surface Testbed (MAST) will be tested along with forty other prototypes in a major robot war game off the coast of Scotland next month.

Modern warfare is not necessarily about having the most soldiers or tanks. It is about outwitting your enemy and using your resources cleverly. Whilst the full-time trained strength of the military will remain an indicator of the Service’s ability to execute military tasks, there could conceivably be a day when it is a far less relevant measure of effectiveness because robots and machines are shouldering the majority of the burden.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Busy summer at Airbus

Record breaking number of deliveries in August

In last week’s blog I highlighted that Boeing and Lockheed Martin had been busy over the traditionally quiet month of August. A recent Reuters interview with Airbus CEO Fabrice Bregier suggest that engineers in Toulouse have also been unusually industrious this summer. Airbus has not yet published official orders and deliveries data for August, but Bregier said “I can already tell you is that it will be the best month of August in Airbus’s history, in terms of the numbers of planes delivered”.

Importantly and encouragingly, Airbus has met its target of delivering six A350s in August. In the first half of the year the supply chain was struggling to provide the cabin equipment on time. By the end of July only fifteen finished aircraft had been handed to customers, making the annual target of “at least 50” aircraft look ambitious. Bregier said “It doesn’t mean the 50 are in the bag, but if we keep up that rhythm of six to seven aircraft a month over the next four months, then we shouldn’t be too, too far off”. Notably though he has toned down his language and now appears to be targeting 50 rather than at least 50.

Bregier reported that Airbus staff have responded to requests to stagger holidays and work extra hours of the summer. This is indicative of how well management has managed to implement cultural change at the European aircraft manufacturer. However, there is still a significant amount of catching up required on the A350 programme.

Bregier did not specify how many A320neos have been delivered in August where deliveries have also been slow this year due to the engine troubles I wrote about recently. However, he said that staff have also been working overtime on the A320neo in order to catch up so we await the official delivery figures with interest. The fourth quarter of the year is traditionally Airbus’ busiest for deliveries; it is targeting at least 650 aircraft for the full year 2016 and had delivered 339 at the end of July.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

New tanker and fighter jet ready for take off

F-35 declared combat ready and KC-46 ready to enter production

August may traditionally be the month of days spent by the beach and long summer evenings, but it seems life has been somewhat busier at Lockheed Martin and Boeing in August 2016. Last month saw the companies achieve major milestones for the F-35A and KC-46 tanker respectively.  The F-35A has now reached Initial Operating Capability (IOC) and the KC-46 has been approved to enter production. These are significant achievements because the products have both had eventful development phases and both aircraft should be important drivers of profitability going forward, at not only the prime manufacturers but for suppliers as well, notably BAE Systems with its significant programme share.

On 2 August, the US Air Force (USAF) declared IOC for the F-35A. It now has twelve aircraft capable of providing basic close air support (CAS) and air interdiction, as well as limited suppression or destruction of enemy air defences. It also has sufficient pilots, mechanics and equipment to support the aircraft. The USAF can now theoretically send its first operational F-35 unit into combat operations if required. The F-35B reached IOC with the US Marine Corps (USMC) last year and the US Navy is expected to reach IOC with the C variant in 2019.

The F-35 is the largest ever defence procurement programme. It has been in development for fifteen years and has been blighted by cost overruns and delays. However, the B variant and now the A variant have met their IOC deadlines which were set in 2013. In fact they have not only met them, but met the earliest planned date (i.e. for the F-35A IOC was targeted for August 2016 but the latest threshold was December 2016). Does this mean that the F-35 is now over the worst? It looks as though this may be the case, and bodes well as Lockheed Martin looks to ramp up production. The cynics in the industry though will be quick to point out that the services set their own standards for IOC so the benchmarks are largely arbitrary and do not necessarily indicate that the aircraft will be used in combat any time soon.

The US DoD declared the KC-46 Pegasus tanker fit for production on 12 August 2016. It passed its milestone C requirements which saw it refuel five different aircraft in using its hose and drogue system and its boom; it also had to receive fuel from another tanker. Air to Air refueling (AAR) is technologically complex and challenging, and Cobham is to all intents and purposes the supplier of AAR equipment due to its long history as the pioneer of the equipment.

However, developing and then integrating the AAR equipment for the KC-46 has been problematic for both Boeing and Cobham, so successfully reaching milestone C is an important achievement. In July 2016 Boeing stated it would miss the August 2017 contractual delivery deadline, and that the first 18 tankers will be delivered in January 2018. The US tanker fleet is aging and as a result the KC-46 was given the highest priority in the US 2014 Quadrennial Defence Review. 179 aircraft are due to be in service by 2028.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Boeing struggling to meet 2016 orders target

Is the 777 going the way of the A330?

Aviation Week last week published data that suggest Boeing will struggle to meet its widebody order target in 2016. It appears the American aircraft manufacture is suffering from the same phenomenon as its European rival Airbus where sales of the legacy A330 dropped sharply once the newer and more fuel efficient A330neo was an option. Boeing has only booked 8 orders for the classic 777 in 2016, due in part to the re-engined 777X which is due to enter service in December 2019. So what is happening and is this cause for concern?

Aircraft order numbers for Airbus and Boeing create striking headlines but are not generally seen as material for the stock because they fluctuate month to month. However, in 2016, the data clearly show that Boeing has only booked 18% of its targeted widebody sales for 2016 (38 out of 211). Aviation Week reports that Boeing is expecting 88 orders each for the 777 and 787, but so far they have secure only 8 and 19 respectively.

We know there are three specific issues which have negatively impacted orders this year. Firstly the completion of an expected Emirates order has been slow in coming to fruition. Secondly Turkish airlines, who it was hoped would place a Boeing order this year has been affected by the attempted military coup in Turkey. Thirdly, the large order which would recapitalize Iran Air’s fleet, provisionally including 34 Boeing widebody aircraft is facing barriers in receiving US Government approval. In addition, the low oil price is driving some airlines to keep older aircraft in service for longer. It must also be acknowledged that the current order backlog – 6815 aircraft at Airbus and 5693 at Boeing(c. 11 years of production for both) – reflects that airlines who require a new widebody in the next decade are likely to have already placed their order.

However, the lack of 777 orders is still notable. Boeing has openly admitted that it needs 40-50 orders per year in order to bridge the production gap to the 777X at the end of 2019. It therefore looks likely that Boeing’s legacy 777 programme will suffer in the same was as Airbus’ A330, where the production rate was cute from 10/month to 6/month in the space only three months, and pricing suffered in an attempt to win new orders. Both of these issues have negatively impacted Airbus’s margin. Whilst Boeing’s contract accounting obfuscates the picture on this, the impact will be seen in the cash number. As at Airbus where these issues occurred during the highly cash consumptive phase of developing the A350, Boeing will be trying to weather this storm whilst developing the 777X.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

What does the future hold for NATO?

Trump and Corbyn refuse to support Article 5

9/11 was the first time that NATO’s article five – an attack on one member state is an attack all – had been invoked. It sent a powerful message about the strength of the alliance. Every member of NATO, no matter how small, provided assistance to the United States during the campaign in Afghanistan.  Fifteen years on and the alliance is arguably in its weakest position since its formation in 1949. Politicians in six major member nations have questioned the point of NATO and only five of the twenty-eight states spent the guideline 2% of GDP on defence. Could this be ‘make or break’ for NATO? And if so what could this mean for the defence industry?

The last few months have seen the political criticism of NATO crescendo. At last week’s Labour leadership debate, Jeremy Corbyn said “he would want to avoid us getting involved militarily” if another NATO country were attacked.  His comments follow Donald Trump saying last month that the US could refuse to help a NATO country that had not spent 2% of its GDP on defence. In addition, Marine Le Pen (President of French National Front) and Beppe Grillo (founder of Italian Five Star Movement) have called for withdrawal from NATO and the Alternative for Germany (AfD) party has said German troops should not be expected to act outside the country’s borders. The Spanish populist party has wanted Spain to leave NATO since the party’s inception in 2014 and wants Spain to hold a referendum on the issue. 

This uprising against NATO is set against the backdrop of Russia seizing Crimea from the Ukraine in 2014, annexing the territory of a European country for the first time since 1945. In addition, NATO’s latest data released last month (see chart below), which shows that in 2016 only five member states; US, Greece, UK, Estonia and Poland, are projected to spend the guideline 2% of GDP on defence. Critics also highlight that some nations, including the UK, inflate their overall defence spending number by including different budget lines.

Defence Expenditure as a share (%) of Gross Domestic Product based on 2010 prices and exchange rates (source: NATO)

However, the figure of 2% is only a guideline – no sanctions are imposed against those that do not meet it. At the 2014 summit in Wales all the members reaffirmed their commitment to work towards reaching the benchmark figure because for the five years prior spending levels had been declining year on year. Since then the NATO total defence expenditure for Canada and European NATO countries has gone up $3bn, a 1.5% real increase, and in 2015 19 members halted their defence cuts. NATO members also commit to spending 20% of their defence budget on equipment and research, development, test and evaluation (RDT&E).  10 countries are expected to meet this benchmark in 2016 (see chart below), but there has been a lack of European investment in equipment for the past five years which will take time to recover from.

Equipment as share (%) of Defence Budget based on 2010 prices and exchange rates (source: NATO)

So what are the options? The CEO of Saab, Håkan Buskhe, put forward one at company’s first half results in July:

“If NATO is to remain, everyone has to spend 2% of GDP on defence. This would lead to huge demand for equipment in those countries.” (Saab 1H2016 conference call)

I agree with his logic that NATO would be stronger, and better able to rebut its critics if all members met the spending benchmark. Clearly this would be hugely beneficial for the defence industry. Mr Buskhe even noted that the industry would probably have a shortage of capacity in the short term which would take us back to the heady early days of the conflict in Afghanistan when the DoD and MOD needed large amounts of equipment, and quickly. However, in the current economic climate it feels unlikely we will see a sudden surge in spending.

The number of significant security threats, most notably terrorism, Russian expansionism and insecurity along NATO’s southern border from Syria to North Africa give to my mind, a genuine purpose to the collective security provided by NATO. Reports from the 2016 NATO summit which took place last month suggest that NATO may be entering a new era. One in which Europe’s collective security and territorial defence are once again NATO’s core mission, and with new resources to fulful it. President Putin has been provocative in exercising his troops in Crimea, but NATO has answered with a show of strength by exercising troops in Eastern Europe. If NATO does push forward with new found vigour, the upward trend in European defence spending is likely to continue and questions are likely to emerge about interoperable equipment for NATO nations. Common equipment is less important for conventional military hardware such as vehicles and ships, however, it is vital when it comes to software which enables communications and equipment sharing. A lack of a common intelligence database was one of the biggest problems during the Afghanistan campaign. The US and the UK particularly will be keen to ensure this does not happen again.

The third option of course is the disbandment of NATO. Any suggestion of which is likely to embolden President Putin and send the defence industry into a tailspin. It is notable though that the politicians criticising NATO are not actually in power, and therefore not charged with protecting their national security. If they were I cannot help thinking they might have more interest in protecting the alliance.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

A New Year’s resolution for Cobham?

CEO and CFO to move on from the struggling Aerospace & Defence company

Three years ago I, and many others, expected Cobham to be given a fresh lease of life by its new CEO Bob Murphy and CFO Simon Nicholls who joined the company in 2012 and 2013 respectively. Mr Murphy was the first American to take the helm of a business whose largest customer is the US Department of Defence (DoD), and Mr Nicholls was the highly respected CFO of Senior, where he had a reputation for cost cutting and attention to detail. Whilst Cobham has made some progress under their stewardship, the past three years have also been turbulent for the company. Here we stand in 2016; a year which has seen the company profit warn, require a £500m rights issue and the CFO resign. To cap it off, it was announced last Wednesday that Mr Murphy is to leave the company in order to ‘pursue other opportunities’, ending months of speculation over whether he would remain as CEO. So what has gone wrong and what does this change in management mean for the company?

From my external perspective, it looks as though there have been two problems at Cobham in the past few years. Firstly its acquisition of Aeroflex seems with the benefit of hindsight to have been a poor deal. Whilst I accept it may still deliver growth in the future, the £900m price paid looks expensive for a business which has subsequently underperformed. Together with adverse FX movements this led to Cobham approaching its debt covenants and forced the company into the £500m rights issue earlier this year. Secondly, Mr Murphy does not appear to have had the correct leadership and management skills to unify and control Cobham’s disparate businesses. He tried to instill common working practices, however, it is not a ‘one size fits all’ business. Culturally and technically I suspect his aim was unachievable and instead frustrated a number of business units. In addition, two senior executives were dismissed from the Wireless business earlier this year after “mistakes” with revenues from contracts - an error that forced Cobham to take a £9m charge.

Cobham is a complicated company which some in the stock market shy away from. It largely deals in high end aerospace and defence communications technology. Its positioning as primarily a Tier Two/Three/Four supplier rather than a prime contractor makes it challenging to understand the range of products and markets it is exposed to – which are mainly small subsystems and components. Also, management has been highly acquisitive in the past so it has a diverse business portfolio. However, in 2015 the company said it was on the verge of returning to organic growth for the first time since 2009 and with the market chasing exposure to good value A&D stocks, Cobham started to feature on many investor’s radars.

Unfortunately sustained organic growth has not yet materialized and margins have been under pressure due to a number of products being in the development and initial delivery phases. The potential for success is there though. Cobham has a number of businesses with market leading positions, most notably air-to-air refueling (AAR) and Satellite Communications (SATCOM). It is exposed to the structural growth story of civil aerospace, and defence markets are now returning to growth after a lean period. However, the task facing the new CEO David Lockwood and CFO David Mellors should not be underestimated. A number of challenging programmes are due for delivery, including AAR equipment on the A400M, KC-46 and KC390 tankers and SATCOM equipment for Inmarsat’s new Global Express network.

Mr Lockwood is an accountant by profession but has an Aerospace & Defence background having worked at BAE Systems, Thales and GPT (Marconi). His two most recent roles; BT and Laird, have been in the sphere of connectivity which should provide some useful overlap to Cobham. Mr Mellors is currently CFO of Qinetiq which is known for having strengthened the balance sheet and re-focusing the portfolio, both areas that Cobham needs to address. 

Mr Lockwood and Mr Mellors are both due to be in post no later than Jan 2017. It is not normally ideal to change CEO and CFO at the same time as there is no continuity but given Cobham’s torrid 2016, the incoming management team may relish the opportunity to make some New Year’s resolutions for Cobham. Let’s hope they manage to stick to them.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The rise of the activists

A look at the impact of activist investors on the Aerospace and Defence sector

Last week it emerged that the activist investor, Elliott Capital Advisors, now holds a 5% stake in Meggitt. This makes Meggitt the third European Aerospace & Defence company to have such an investor on its shareholder register and it led me to ponder what is driving these activists? Why the interest in Aerospace and Defence? And what are they trying to achieve?

Activism has been rife in the US for the past decades, but in the UK and Europe it has been far less common. In 2014 Bill Ackman the US activist founder of Pershing Square Capital said that pressure to meet pension obligations in Europe would “make shareholders inherently more active”. He has been right to an extent. European investors have started pushing companies harder to improve governance and returns. However, confrontational activism of the style seen in the US though still remains rare.

Against this background then, it is intriguing that Safran, Rolls-Royce, and now Meggitt all have vocal activist investors on their registers. The Children’s Investment Fund (TCI) took a stake in Safran in 2012 before then openly criticizing its acquisition track record. TCI outlined a list of demands of management, including an audit of all recent acquisitions, holding managers to account for any poorly performing deals, a ban on deals outside of civil aerospace and raising the dividend to 50 per cent of profits.

The San Franciso based hedge fund ValueAct became a shareholder in Rolls-Royce last year. ValueAct is known for working behind the scenes with companies when it believes strategic change or management shake-up is needed. The Chief Operating Officer (COO) Bradley Singer was granted a seat on Rolls-Royce’s board earlier this year, and it is reported that he has pushed the company to accelerate its cost-cutting plans. It has been reported that ValueAct also wants Rolls-Royce divest its non-aerospace businesses.

Elliott Capital Advisors now has control of a 5% stake in Meggitt. Elliott is the UK operation of American Hedge Fund Elliott Management, which has a long history of agitating for change at companies, and is particularly known for spotting potential takeover targets. Meggitt profit warned last year, primarily because the company’s energy business has been struggling with the lower price of oil.

TCI, ValueAct and Elliott Capital Advisors seem to have different objectives with their investments, however at the most fundamental level they are aiming to maximize value for shareholders. That explains why Safran, Rolls-Royce and Meggitt all saw their share price rise when it became public knowledge that they had an activist investor on their register. The market generally sees activism as a good thing because it forces companies to listen to shareholders and be open to their ideas. Activists can make companies more accountable and responsive to the market and their influence often prompts management to think about a wide spectrum of initiatives; including strategy reviews, leadership succession plans and portfolio management. 

That three aerospace and defence companies have come under the activist’s spotlight is likely to have occurred because the companies are exposed to the attractive end market of civil aerospace which is in the middle of a significant period of structural growth. However, Safran, Rolls-Royce and Meggitt are not as profitable as their US peers, seemingly because of struggling to cut costs and structural management issues within large businesses. Activists it seems think they are underperforming their potential, although it is important to note that many of the challenges these businesses are facing are due to the large investment required on new programmes during this growth period.

In order to work with an activist investor, company management requires a high level of detail and knowledge about what is going on in its business which can only be a good thing. Notably this is where Rolls-Royce has particularly struggled, highlighting that one of the causes for its recent string of profit warnings was poor management information systems.

There are a number of long only shareholders who worry that activists with short-term agendas, particularly that of achieving a company break-up, will undermine the independent non-executives who represent all shareholders. This is understandable, and for every activist campaign that succeeds in the UK, another one fails. However, long-only fund managers and increasingly thought to be using activist investors to do their bidding to management in order to effect change. TCI’s criticism of Safran’s acquisitions is a prime example of this; TCI only said what most of the market was thinking.

Activism does not look likely to become as prevalent in the UK as in the US, however it is becoming an increasingly important item on the boardroom agenda. Safran, Rolls-Royce and Meggitt will feel its influence first hand in the coming weeks and months, but their peers will also have to challenge themselves to ensure that they are equipped to handle any potential activists questions. It seems to me to be a force for good in a sector that is famed for its lack of transparency.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Geared Turbofan engine too hot to handle?

Teething problems for Pratt & Whitney's new narrowbody engine

Pratt & Whitney’s struggles to deliver correctly functioning Geared Turbofan engines for Airbus A320neo aircraft is a reminder that aircraft development is always fraught with risks. Airbus clearly signposted in January that 2016 neo deliveries would be back loaded into the second half of the year. It is targeting 56 aircraft this year but as of the end of July has only delivered 11, so it has its work cut out in Toulouse. Where has it gone wrong?

The first airlines to fly the A320neo complained to Pratt & Whitney that the Geared Turbofan (GTF) PW1100G engine has a much longer delay before it can be restarted than the industry standard of less than one minute. All engines need a cooling cycle between uses, however the GTF is requiring a three minute delay which is increasing the aircraft’s time at the gate, which in turn negatively impacts the airline’s punctuality and profitability.

After the engines are shut down, rising heat causes a temperature differential between the top and bottom of the engine, which causes a slight bowing in the rotor as the metal expands at different rates. If the engine is started when the bowing is at its worst, a harmonic vibration can develop. Matthew Bromberg, President Pratt & Whitney’s aftermarket division said that “the engine will bounce a little, to the point where it can eat into the seals that are surrounding the blades.”

Pratt & Whitney has developed a three-phase fix.  Firstly it has installed software onto all engines currently flying which measures how long the engine has been cooling for, and if needed causes it to spin slowly when started, hence forcing the three-minute start up. This is not an acceptable long term solution though so two technological alterations are being made. A coating is being applied to the engine blades which will strengthen the engine’s third and fourth shaft bearings, thus preventing the harmonic vibration and a coating will be put on some of the blades that will improve the sealing function on the compressor. The first new engines with the fix should be fitted onto aircraft this month. Airbus is reported to have 25 engine-less A320neos parked at Toulouse so this fix cannot come soon enough. Pratt & Whitney will upgrade the engines currently in service over the summer at a time convenient to the airlines.

When the idea of a re-engined narrowbody was espoused, Airbus was quick to highlight that it was a low risk programme because the only significant development required was on a new engine. However, the engine is arguably the most technologically complex, and safety critical part of an aircraft. The geared turbofan is pushing technological boundaries for Pratt & Whitney. It is therefore unsurprising that it has encountered some stumbling blocks. The company is quick to point out though that the engines have a 99% dispatch reliability rate and are meeting thrust, fuel burn and noise expectations.

Whilst the responsibility for fixing the issues lies with Pratt & Whitney, it is Airbus that customer’s hold responsible. Qatar Airways was the planned launch customer but refused to take delivery of the aircraft and has already said it will be seeking compensation. Lufthansa and Indigo may well follow suit. How this will be borne by Airbus and Pratt & Whitney remains to be seen. The engine problems also highlight how aircraft programmes are on a learning curve which is why airlines are often want deliveries slots some way in the future in order to ensure the aircraft is mature. For Airbus of course the fix is also necessary part of achieving FY16 guidance.

These teething problems with the engine are also likely to raise concerns about how the Geared Turbofan will perform through its life cycle. The new gearbox technology means that Pratt & Whitney is not able to depend on its wealth of its existing engine data in order to manage the aftermarket cycle. It was also one of the risk areas that drove Rolls-Royce’s decision not to participate in the programme. However, lower maintenance costs was one of the selling points of the engine.

The A320neo is also offered to customers with the LEAP engine from CFM (GE and Safran) which has more conventional two shaft architecture. The first of these aircraft was delivered to Turkey’s Pegasus Airlines in late July CFM has now accelerated the LEAP development which will power some of the A320neos and all of the competing new B737MAX aircraft. The LEAP engine is said to have a start up time of 50 seconds so is unaffected by this issue.

Pratt & Whitney developed the PW1100G with the aim of re-entering the narrowbody engine market which has been dominated by GE. Whilst the engine has achieved this aim, its problems entering service mean that GE seems set to maintain its leading position and reputation for consistency in the narrowbody market. 

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Common sense in UK defence?

The UK MOD is to buy its new fleet of Apaches directly from Boeing

In my blog last week I highlighted the calamitous processes, and often illogical decisions that characterise defence procurement. However, the announcement during the Farnborough Air Show that the MOD will buy 50 AH-64E Apache Guardian helicopters from Boeing may well be turn out to be one of the Ministry of Defence’s (MOD) most sensible decisions yet.

The current UK Apache AH-1 (AH-64D equivalent) has been an outstanding asset to the British Army in both Afghanistan and Iraq. However it was bought at unnecessary cost. The original fleet of 66 Apache helicopters was produced by Westland in Yeovil under license from Boeing. In 1995 it started assembling US built components and added UK modifications that more than doubled the price to about £44m per helicopter. Spare parts were then bought from Westland at a mark up from Boeing’s original price.

The new AH-64E will be bought through the Foreign Military Sales (FMS) network directly from Boeing in the US. The UK helicopters will be almost identical to those flown by the US Army and other international customers. The UK will be able to draw on a global supply chain for its new Apache fleet, and will therefore benefit from economies of scale for spare parts.

Whilst UK Apache pilots adore their helicopter, they have become frustrated over the past decade that their Apache has not developed technologically in the same way as the US versions because the UK variant has not been able to incorporate upgrades. The new fleet will be able to benefit from any new software, modifications and weapons that are incorporated into the US fleet. This will not only help keep the aircraft more capable for longer, but it will allow greater inter-operability between the UK, US and other allies who fly the Apache. This benefit will not only be felt by pilots, but by ground troops as well, who will no longer need to worry about whether it is a US or UK Apache overhead as they will be able to network into both in exactly the same way.

Press reports during Farnborough focused on the fact that this probably sounds the death knell for Britain’s ability to build combat helicopters. However, from my external perspective, this looks to be the MOD making a rational decision based on procuring the best equipment at the best possible cost, which is extremely heartening. One further crucial question remains though - who will be awarded the lucrative support and maintenance contracts for the helicopters? Leonardo (formerly Augusta Westland) is the incumbent but Boeing is undoubtedly an option. Political forces will undoubtedly be at play here because jobs at Leonardo’s site in Yeovil are at risk and it will be fascinating to see who wins out. Twenty years on from the so-called Westland Affair when Prime Minister Margaret Thatcher and Defence Secretary Michael Heseltine clashed over the future of Westland (as Leonado was then known), history may well be repeating itself.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Have you heard of GKN?

Making things work for more than a quarter of a millennium

Watching a BBC documentary of a behind the scenes look at the opening ceremony of the 2012 Olympic games reminded me of how the industrial revolution was a centre piece of the performance, creating the illusion of the Olympic rings being forged from steel. Had it happened back in the latter part of the 18th century as new processes changed Britain for ever, those rings may well have been forged in iron by one of the UK’s greatest global brands. GKN’s forebears have been making things happen for over 250 years and the company Guest, Keen & Nettlefolds was formed via merger in 1902. The company is one of our leading global manufacturers, and yet it is hardly a household name.

Every time you get on a plane, or into your car you will likely be transported courtesy of vital components manufactured by a GKN subsidiary (“Engineering That Moves the World” is its current mantra). It has been a pioneer of technologies since it started making iron at the Dowlais works in Wales in 1759. In 1856 it became the first British company to acquire a licence to produce steel using the Bessemer process, taking a decade to fully develop the process to commercial production. By 1936 when Dowlais was shut the company had moved amongst other things into production of automotive components. In WWII it produced Spitfires, and in the 1960s provided the constant velocity joints (CVJs) that enabled front wheel revolution that fundamentally changed the car industry, supplying the legendary Mini. Today it produces the first composite material wing spars for Airbus on both military transport (A400M) and civil aircraft (A350XWB). The future in additive manufacturing (3D printing) stems directly from the company’ strengths in manufacturing and Powder Metallurgy. GKN remains at the forefront of technology development.

GKN Aerospace supplies all of the primary wing structures for Airbus aircraft

I have looked at GKN for only a small period of its history. However, even over those thirty years GKN has had to evolve to survive, in common with most other UK based industrial companies of the 1980’s. The steel businesses are gone, with the constant velocity joint based Driveline business still the core of the group today with a greater than 40% global market share. It has also built leading positions in AWD (all wheel drive) and eDrive (electric and hybrid driveline products).

GKN Driveline potential vehicle content

Over the last 20 years the company has developed an aerospace business that now ranks second in the world for aerostructures and engine systems, and as part of the recent Fokker acquisition has bought the number 3 wire harness manufacturer in the industry. Its Powder Metallurgy division is one of the world’s largest metal powder producers and a clear leader in ever more intricate sintered components with more than 15% of the market.

GKN was one of the initial constituents of the FT30 Index in 1935, and only one of two of the original companies (with Tate & Lyle) that survive today (exit being by failure or takeover). Given its history, a £5bn market cap establishing it firmly in the FTSE100 and its significance in our lives, one might think it would be a household name.

However, ask most people outside of financial markets if they have ever heard of GKN, I suspect that sadly the answer is probably no. Maybe it is time for a brand awareness campaign on TV. However, maybe the answer is that nobody needs to know. GKN has survived longer than most companies to date, and perhaps another 100 years may be on the cards. I just feel a greater appreciation of its brand may rub off on its rating, which retains a cyclical discount despite the growth of the aerospace contribution, and the clear adherence to a value creation philosophy.

As Churchill once said “The future is unknowable, but the past should give us hope.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Lockheed Martin names and shames the US DoD

Funding for the F-35 is "insufficient"

Lockheed Martin depends on the US Department of Defense (DoD) for c.80% of its revenues. Therefore for Lockheed Martin’s CEO Marillyn Hewson to name and shame the DoD as having overdue bills at Q2 results last week is not a decision she would have taken lightly. It caused me to wonder, what was Hewson trying to achieve?

Low-rate initial production (LRIP) contracts 9 and 10 are still in negotiation between the Pentagon and Lockheed and are not expected to be concluded before the end of the year, despite the fact that Lockheed is now well into production of these aircraft. The company claims that the US Government is withholding appropriated funds and so Lockheed has made the decision to temporarily fund the program from its own balance sheet in order not to disrupt production. However, with the F-35 ramp up requiring $400-500m cash every month this is not a sustainable solution and Lockheed continues to ask the DoD for recovery funding. CFO Bruce Tanner said “the Pentagon clearly knows the situation and I am optimistic we are going to get the cash soon.” However, in the presentation slides, Lockheed stated explicitly it has $3bn of termination liability exposure.

The F-35 is the largest ever single military procurement programme and the next generation fighter is due to reach initial operating capacity (IOC) with the US Air Force (USAF) later this year. So far 180 aircraft have been delivered to numerous customers and the jet has clocked up 65,000 flying hours. The programme is therefore relatively mature, but has a very troubled history due to its cost overruns and lengthy delays. In 2010 the then Secretary of Defense Robert Gates withheld $614m in fees as a penalty and none of the 36 aircraft delivered in 2014 had war-fighting capabilities.

Relations between the DoD and Lockheed Martin are well known to be tense. The publication of the termination costs the company would incur raises the question of whether Lockheed is suggesting to the DoD that it is willing to walk away if negotiations do not go its way? Some press reports say this is Lockheed making a statement of intent. However, I find it incredulous that Lockheed Martin (and its industrial partners) could walk away from the largest ever procurement programme, particularly at this late stage. It would be the end of the company as its reputation would be damaged beyond repair, and thousands of jobs would be lost, which in the months before a US Election would be untenable for the politicians.

I believe that this public naming and shaming is a reflection of Hewson’s despair with the calamitous budget and procurement processes in the DoD, and is her attempt to shock officials into action.

It is well known that the defence industry operates in a way that seems perverse to outsiders. Usual laws of economics and competition often seem irrelevant, with politics, national pride and job preservation playing a far more important role. The question is how long can it remain this way? Successive US Defense Secretaries have pushed to make the DoD audit ready, but none have succeeded. The UK has just appointed a new Defence Procurement Minister, Harriett Baldwin. It is hoped that her private sector experience at JP Morgan will help bring some business sense to decisions made by the Ministry of Defence (MOD). Hewson’s comments last week imply that industry is reaching the end of its tether with the DoD and that real change may well be forced upon it. The problem is though, the industry is totally reliant on the DoD as its number one customer by some way, and therefore the DoD will always have the upper hand in negotiations.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

What do amazon drones and BMX bikes have in common?

How civilian technologies are leading the defence industry

What do Amazon drones and BMX bikes have in common? The answer – the use of cutting edge ‘sense and avoidance’ technology, developed by the civil aerospace industry. Traditionally in the A&D sector, pioneering technologies were developed by the defence industry (funded at least in part by Government customers) and then used in the civil aerospace industry. However, as Governments looks to rein their spending, companies are developing new technologies for civil applications, which will then in time be used in the military sphere. The use of ‘sense and avoid’ technology by Amazon to step up its drone tests, and by British BMX cyclists in preparation for next week’s Olympics are timely examples of this.

Unmanned Aerial Vehicles (UAVs) have been flown regularly by the military during the Iraq and Afghanistan campaigns. However, the military had air supremacy (complete control of the air space) during both these conflicts, with no civilian aircraft in the area and UAV pilots had constant contact with their aircraft. Therefore the military never had to push for the development of a UAV that could autonomously sense and avoid obstacles.

This limitation is what is currently hindering widespread integration of UAVs into civilian airspace. Honeywell and General Atomic have been working with NASA to develop the required technology which is now undergoing testing.

This week Amazon announced that it will step up its drone tests in UK airspace after the Civil Aviation Authority (CAA) granted it permission to test aerial vehicles without several of the rules that typically bind UAV pilots. Amazon’s drones will operate without a pilot having direct line of sight and pilots will be able operate more than one vehicle at once, in order to test the ‘sense and avoid’ technology. This takes Amazon another step closer to realizing its dream of having a fleet of drones that can deliver small packages to customers within thirty minutes of them ordering.

Next week, Great Britain’s BMX cyclists will be haring around the muddy tracks of Rio di Janeiro in pursuit of Olympic glory.  BAE Systems is UK Sport’s official research and innovation partner. It has worked in conjunction with British Cycling to adapt UAV ‘sense and avoid’ technology to help the BMX cyclists understand their optimal trajectory both on the ground and in the air. Cutting edge optical sensor technology interacts with miniature LEDS affixed to the bikes. The information is then relayed to a specifically designed app, giving riders and coaches a real time read out of performance, enabling them to identify where they can make British Cycling’s much talked about ‘marginal gains’.

Military UAVs will undoubtedly benefit from this technology in the future, but only once it has become more cost effective. Defence technology having to sometimes take the lead from civil industries is an inevitable consequence of the world becoming more technologically advanced. This should not be seen as a negative for the defence industry though. It can reap the rewards of pioneers like Amazon whilst focusing on developing defence technologies that will never be used in the civilian environment, for example weapons systems.

As you watch the Olympics next week, give a thought to the A&D engineers.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The summer of hate

The impact of terrorism on the Aerospace & Defence sector

An article in the press today described the summer of 2016 as the “summer of hate”.  The relentless pace of the attacks has invoked terror into the minds of ordinary people and politicians have been forced to make frequent declarations of their determination to protect their citizens.  It therefore seems logical to me that the summer of 2016 will be one which shapes the near term future for Aerospace and Defence companies.

At times of global instability, the two sides of the sector often diverge. Wars and terrorism are generally bad for civil aerospace, but good for defence. The starkest divergence in recent memory was after 9/11. Whilst this was very specifically a terrorist attack using aeroplanes, and therefore the impact on aerospace was magnified, the premise holds true.

A politician’s appetite to spend on defence is driven at the most fundamental level by how threatened they feel.  It is then influenced by the health of the national economy and the nature of the threat. Events of the past few months are likely to have left politicians feeling under siege. Not just from the terrorists themselves, but from social media and the press. The Internet has opened up a new front in the war on terror; one which sadly aids the terrorists by giving them publicity, and is likely to force politicians to take action

In 2015, defence spending in North America and Western Europe fell again, but at a slower pace that in previous years according to SIPRI data. The three biggest spenders in Europe – the UK, France and Germany – have all signalled a growth in spending in coming years. Public support for increased defence spending has been very low though since the Afghanistan and Iraq wars. However, recent events are likely to change this and make the public more supportive, which therefore make the spending more likely to come to come to fruition.

Changes in military expenditure by region 2014-15 (SIPRI)

We are also likely to see a shift in where the money is being spent. Whilst the rhetoric from the defence companies and Governments has been an increasing focus on surveillance, intelligence, cyber warfare etc. the budgets in the UK and US continue to tell a different story, with the bulk of the budget being spend on conventional military equipment as shown by the chart below. Intelligence, Surveillance, Target acquisition and Reconnaissance (ISTAR) is currently forecast to decrease (see chart below). This feels wrong in the current climate.  The forecast should shift to new technologies that can help to pre-empt terror attacks and enable better intelligence sharing. This should see companies such as Qinetiq, Ultra Electronics, Cobham and BAE Systems. However, smaller companies are also likely to become more important to Governments, and they will be attractive acquisitions for the major listed players.

2015 UK Defence Equipment Plan by Operating Centre (UK MOD)

In aerospace, global instability and the threat of terror attacks are likely to have a negative impact on passenger traffic volumes. IATA data shows that annual revenue passenger kilometres (RPKs) growth remained unchanged at 4.6% in May – their slowest pace since January 2015. 

Air passenger volume growth and global business confidence (IATA May 2016)

IATA’s report attributed this slowdown partly to the “Brussels terrorist attacks, which affected the large international European market in April and May”. The report written in early June said it expected the “impact to be only transitory in nature”. We await June and July’s data with interest. Admittedly monthly passenger numbers are unlikely to impact the aircraft and equipment manufacturers in the short term as airlines make capacity decisions based on long term projections. However, there is a genuine possibility that this new generation of terrorism may lower our propensity to travel by air and therefore encourage more people to holiday closer to home. If this turns out to be the case, then the summer of 2016 may well be a defining moment for the aerospace industry.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Inside the White House

A guide to the US budgetary process

Last week I wrote about what Donald Trump as President of the United States might mean for the US Defence Budget and I noted that in an election year, the President’s ability to alter the budget is quite limited. Today I look at why that is the case by unpicking the rather confusing and protracted US budget process.

The process, which takes nearly a year from start to finish, is nicely summarised by the graphic below from the National Priorities Project (NPP) – an organisation that attempts to make the federal budget process transparent to the US taxpayers. 

There are six main stages:

1. Federal Agencies submit budget requests to the President – these outline which programs need more funding, which could be cut and any new priorities the agency would like to fund.
2. The President submits his / her budget request – this is a compilation of all the agency’s budgets and is usually submitted on the first Monday in February, although it is frequently delayed.
3. The House and Senate pass budget resolutions – these set annual spending limits for the federal agencies, but do not set specific amounts for individual programs. The documents are not legally binding. A conference committee then attempts to iron out the differences between the two resolutions and each chamber then votes on the reconciled version.
4. House and Senate subcommittees write ‘Appropriations’ bills – there is a specific defence subcommittee, responsible for deciding the level of allowed spending by the Department of Defence (DoD). The subcommittee holds hearings in which they pose questions to the leaders of all three services about their requests. An Appropriations Bill is then written, amended and voted on. Once passed it goes to the full Appropriations committee and who then sends it the House or Senate.
5. House & Senate vote on each Appropriations Bill – A conference committee then meets to reconcile the House and Senate’s Bills. This reconciled Appropriations Bill is then voted on by both Chambers, and once passed it goes to the President.
6. The President signs each Appropriations Bill and the Budget is law – this is due to occur by 1 Oct, in time for the new fiscal year, but the deadline has rarely been met in recent years. 

Stage One is already well under way for the FY18 President’s Budget Request , which is due next year. The new President will take office on 20 January 2017 and whilst the President’s Budget Request (PBR) will be delayed until April / May, Obama’s successor will have very limited time to put his stamp on the DoD’s submission. The President’s involvement at the end, signing the bills into law, is very much a formality.

The real horse-trading takes place when the defence subcommittee thrashes out its Appropriations Bills, and then between the House and Senate as they attempt to pass a mutually agreeable bill. This is when the new administration can attempt to stamp its authority on the defence budget, although achieving anything is very much reliant on having a majority in the House and Senate (the lack of which has caused a stalemate in recent years).

The delayed submission next year makes it almost certain that the US will enter a period of Continuing Resolution (CR). This happens when the budget process has not been completed by 1 October. A CR provides temporary funding to all the agencies at the same level as the previous year.

There are a few other nuances to the US budgetary process that are worth understanding:

Mandatory vs. Discretionary spending: About 1/3rd of federal spending is discretionary, 2/3rd is mandatory. Mandatory spending includes the three largest entitlement programs (Medicare, Medicaid and Social Security) as well budgets such federal civilian and military retirement benefits, disability benefits, interest on national debt etc. The PBR does not need to include budgets for mandatory spending as it is automatically granted, however the President can include proposals to alter mandatory programs (hence Obama’s Medicare reforms). The process I have outlined above is therefore only applicable to discretionary spending, and crucially almost the DoD’s entire budget is discretionary.

Budget Control Act and Sequestration:  The 2011 Budget Control Act imposed limits (known as caps) on the level of discretionary appropriations until 2021. If the budget submission is above these caps then theoretically the Sequestration mechanism (equal cuts across all budget lines) is triggered, unless Congress passes a bill to modify the requirements of the BCA. However, it has so far passed a deal in every year as per the chart below from the Centre for Strategic and International Studies.

Base Discretionary National Defence Budget compared to amended BCA budget caps (CSIS – Todd Harrison)

Appropriations vs. outlays – The budgetary process is focused on agreeing ‘appropriations’ i.e what can be spent in future years but the money flowing down to the defence contractors is known as ‘outlays’. This is the actual in year defence spending and normally reflects the budgetary trends developed one to two years previously. Therefore the Fiscal Years Defence Programme (FYDP) that we see requested in the PBR is normally a lagging indicator of the budget’s trajectory, particularly during drawdowns, as the chart below shows.

FYDP budget projections versus enacted budget (CSIS – Todd Harrison)

The next US defence budget is undoubtedly an important one. It will set the tone for the new President’s tenure and give an insight into whether US strategic priorities are likely to change. However, the complicated budgetary process means that it will be the President’s rhetoric that the defence industry and financial markets are most interested in. Those close to Washington know that way to influence the numbers is through the members of the House and Senate Appropriations Committees.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The end of the road for the A380?

A look at why the business case for the A380 has gone wrong

Airbus launched the A3XX aircraft (which would become the A380) in 1997 based on winning 650 orders over the next twenty years. It claimed to be in consultation with 20 leading airlines about their requirements for a new double-decker aircraft. Nineteen years on, the A380 has won just 319 orders from 18 airlines. So where has it all gone so wrong for what is Airbus’ flagship aircraft? In addition, with the announcement last week at the Farnborough Air Show that the production rate has been cut to twelve per year, what does the future hold for the programme?

In 1993, Boeing and Airbus did a joint feasibility study of a Very Large Aircraft (VLA), aiming to form a partnership to share the limited market. Two years later the study was abandoned, because Boeing did not believe that it could recoup the projected development cost. Airbus and Boeing had opposing views on how air travel would evolve. Boeing believed in the ‘point to point’ method of flying – where lots of smaller aircraft fly passengers directly between their destinations. Airbus however thought that capacity constraints at larger airports would lead to a ‘hub and spoke’ system, which consolidated traffic into larger planes between a few major airports, with connecting flights then taking passengers to their final destination. Airbus’ Global Market Forecast from 2000 predicted that 1235 VLAs would be delivered between 2000 – 2019 (see chart below). In reality much of that capacity has been provided by more fuel efficient twin aisle aircraft, particularly with the introduction of the Boeing 787 and the A350XWB.

Airbus Global Market Forecast 2000

The key idea behind the business case for the A380 was that air traffic was doubling every fifteen year and key airports were getting overcrowded. Numerous hub airports, including London Heathrow, New York JFK, Chicago and Frankfurt, are at or near their capacity limits. Logic therefore dictates that if these hubs cannot accommodate any more additional flights then airlines would need bigger planes to meet rising demand.

There have been two major flaws in the business case. Firstly, capacity has not become constrained quickly enough in the aviation mega cities. As a result, there are currently only a few routes where the A380 makes real sense – British Airways’ Los Angeles to London Heathrow flight is one example. The flying time of eleven hours constrains take off and departure slots, so frequency of flight is not valued in the way that it is for New York JFK to London Heathrow. The larger aircraft therefore equates to a higher yield for the airline.  With IATA forecasting passenger traffic to grow at an average rate of ~4% for the next two decades, capacity at hubs will inevitably become more constrained, but the A380 may be just too far ahead of its time.

Secondly, whilst passengers undoubtedly love the A380 (hence Airbus’ new website which enables you to search for flights on the A380) and will pay a small premium to fly on it, as a general rule, passengers are not willing to pay a premium for space. Airlines have discovered that whilst passengers prefer to have more space, adding more seats to their airplanes to increase yield has not induced any long term drop in passenger numbers. This means the A380 struggles to compete with smaller aircraft. Whilst airlines could copy Emirates who has recently fitted some of its A380s in a denser two-class cabin configuration with more than 600 hundred seats (Airbus markets the A380 with a standard configuration holding 525 passengers in three classes), there are limited routes that can handle that much capacity. 

So where does this leave the programme now and in the future? Airbus reached break even in 2015 at a production rate of 27 aircraft per year, but the rate has now been lowered to twelve per year from 2018. Management now claims it can achieve break even at 20 A380 deliveries a year in 2017, and will continue to work hard to reduce costs further. Nevertheless, the programme is likely to continue to be a drag on profitability for Airbus into the next decade. Airbus management has presented a fairly confused picture about the programme. At the 2015 Global Investor Forum,  Airbus Group CFO Harold Wilhelm raised the prospect of discontinuing the A380 but then the next day Fabrice Bregier, Airbus CEO said there would almost certainly be a stretch A380 and possibly an A380neo (new engine option). The market seemed to think the neo was a question of when rather than if. At Farnborough last week the tone of Bregier’s commentary had changed.  He told Flight Global the A380 “will find its way”.

An A380 stretch or neo now looks increasingly unlikely, although with Airbus one can never say never, and a neo would likely be a far easier business case, theoretically requiring little development cost except the engine manufacturers R&D. With an extremely limited market for second hand A380s, the next chapter in the aircraft’s story may well be the challenge that airlines have in getting rid of them despite the attractions of a significantly lower capital cost.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

The rain fell mainly on the planes

Farnborough Airshow 2016 rant, sorry round up

When considering my view on the Farnborough International Airshow 2016 it is tempting to focus on the chaos of the first couple of days at the show. Monday’s washout was spectacular, and when we were eventually cleared from the site at around 5.30pm there was hardly anybody left. Even the ice cream van had gone home!

At least the weather was not the fault of the organisers. However, the queues on Tuesday morning, despite years of practice, appeared to suggest that Farnborough might have already unilaterally removed the right of free movement for people within the EU. However, we believe it was a lack of organisation that ended up with the queue snaking back over the entrance bridge before the entrance security process was “accelerated”. In addition it is all very well selling overpriced goods to the captives for lunch, but please could you ensure the detritus created by the feeding frenzy is subjected to a waste management system of some sort. Piles of rubbish are worse than unseemly.   

Rant over, so what of the show itself.

Well the highlight of any show for me is seeing new aircraft fly, so Tuesday afternoon was undoubtedly that point. The F-35B appeared around 4pm in the flying display, and with good grace came into its hover phase right in front of us. Not as noisy as the Harrier, or am I going deaf, but powerful enough to stir the memories. Very stable and a partial view of the future for both BAE Systems and the UK military as volumes continue to build and the new aircraft carriers progress towards launch.

F-35B hovering at Farnborough Airshow 2016

What happened on the business front, allowing for the usual distortions of previous announcements being confirmed etc.? Well Airbus booked $35bn of new aircraft orders (197 firm orders worth $26.3bn) and commitments (82 aircraft worth $8.7bn).  Whilst not as much as at recent shows in Paris and Farnborough it did beat its order intake in 2012 largely due to continued strong demand for the A320 family. So maybe it was not as quiet as we expected. Although John Leahy was quoted as saying he thought a book to bill of 1x was unlikely this year, Fabrice Bregier still expects him to deliver the 250-300 orders in the second half that will be required to achieve that feat. The major news for the markets though was the A380 production rate reduction from 2018 to just 12 a year, with Airbus convinced this is the best option and having to run hard to reduce the break even still further.  Nevertheless earnings growth still looks set to accelerate from next year.

At Boeing the 100th birthday party today is supported by orders and commitments for 182 civil aircraft worth $26.8bn. The icing on the cake from a UK perspective may well be the $2.3bn UK MOD order for 50 Apaches, although this had been foreshadowed, and the commitment to create 2,000 Boeing UK jobs. Boeing also committed to build a new £100m facility at RAF Lossiemouth to support the 9 P-8A Poseidon aircraft that are to be purchased and to open more bidding opportunities to UK suppliers on Boeing programmes, all nice positives.

Boeing and Airbus values of orders and commitments at Farnborough and Paris Air Shows

What we did not get was either manufacturer progressing new aircraft plans. Indeed the A350-“2000” stretch seems unlikely to be this year and the business case for Boeing’s midmarket B757 replacement still looks debatable.
 
Despite the much anticipated and long awaited slowdown in order intake for both Boeing and Airbus, the main challenge for the two main commercial aircraft manufacturers and their suppliers remains the execution of the ramp up and the progressive reduction in the length of the backlog. This should provide solid volume growth through the end of the decade as the newer programmes increase production to new heights.

Civil aerospace remains a growth industry, as more passengers around the world fly more often and more aircraft come up for retirement every decade. Even after the impetus of fuel efficiency from the new models starts to wane, I expect that global trend to continue.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Full speed ahead for Successor

UK's nuclear deterrent looks assured with May as PM

On Wednesday evening, Theresa May was asked to write her orders for how the military should react in the event of nuclear war. Not exactly the easiest first few hours in a new job and probably cause for a sleepless night. However, the executives at the top of the UK defence industry will probably have slept a little more soundly as the future of Trident finally looks secure under her leadership.

Mrs May is a known supporter of a ‘Continuous at Sea Deterrence’ (CASD), saying previously it would be ‘sheer madness for Britain to give it up’. Michael Fallon, who has escaped the merry go-round that is the cabinet reshuffle and remained in post as Defence Secretary, supports her view. Earlier this year he laid out his case, saying, “Our nuclear deterrent has helped keep the peace between the major powers for decades. Abandoning it would undermine our security and that of our allies, it would not make us safer.” Therefore as we enter our next political chapter with a new Prime Minister leading us out of the European Union, it feels as though the debate about whether or not the UK should purchase the new Successor submarines to carry the Trident nuclear missiles is coming to an end.

A Successor submarine (BAE Systems)

Successor is the single biggest UK military procurement programme over the next decade at a total projected cost of £31bn, although it looks likely the £10bn of contingency will also be spent due to significant cost overruns. This will see it consume approximately 25% of the UK Defence Equipment budget over the next ten years, as per the chart below. The programme is also a long-term component of earnings for not only the main industrial partners ; BAE Systems, Babcock and Rolls-Royce, but also for the supply chain including Ultra electronics, Cohort and TP Group.

UK Defence Equipment Budget by type 2015 - 2025 (MOD)

The 2015 Strategic Defence and Security Review (SDSR) took away the requirement for Successor to go through a ‘main gate’ decision. This was to have been the point of no return and there was to have been a parliamentary vote to approve the main gate decision, although this was not a legal requirement. The SDSR did however promise a debate on the principle of a CASD and plans for Successor. This is scheduled for next Monday (18th July) and the House of Commons will no doubt be the scene of heated discussions. Labour is split over the purchase of the new submarines; many of its MPs support it but Jeremy Corbyn does not. The SNP and Liberal Democrats are staunchly opposed to all nuclear weapons and the SNP want the submarines, which are based at HM Naval Base Clyde (commonly known as Faslane), to be moved from Scotland. However, given that the programme now operates on ‘staged investment’ system, much of which has already been approved, and with a Prime Minister and Defence Secretary in support, Successor looks inevitable.

The UK’s Defence Nuclear programme supports over 30,000 jobs, making it a significant contributor to the UK economy, and particularly that of Scotland. HM Naval Base Clyde is one of the largest employment sites in Scotland, with around 6,800 military and civilian jobs, which is set to increase to 8,200 by 2022. Therefore perhaps the debate will shift to what will happen to the Successor submarines if there is a second referendum in which Scotland votes for independence.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

Trumping Clinton on defence spending

A look at the potential impact of Donald Trump as President on US defence spending

“I’m gonna build a military that’s gonna be much stronger than it is right now. It’s gonna be so strong, nobody’s gonna mess with us. But you know what? We can do it for a lot less.” (Donald Trump)

Donald Trump is somewhat of an enigma when it comes to his military strategy. On the one hand he seems to have the US defence primes in his crosshairs. He frequently criticises politicians and defence contractors for colluding to build costly and unnecessary weapons systems, and he is determined to reduce the procurement budget. On the other hand he has spoken of wanting to increase troop numbers, buy new equipment and bolster the US military presence around the globe, particularly in the Middle East and China.

Putting aside my big picture concerns about the potential for President Trump to take office next year, to my mind the impending US presidential election looks to be a positive thing for the defence industry, no matter who wins. While many Democrats would like to see a lower defence budget, Clinton is likely to maintain the current budget trajectory as outlined by Obama – a status quo that the industry is able to manage. The Republicans are generally more pro defence spending and Trump seems to have big ambitions on the global stage. While he seems to want to try and spend less, he is unlikely to meet his strategic aims with a shrinking defence budget.

Trump’s controversial attitude to foreign policy makes the deployment of US troops look more likely than under the current, more pacifist Democratic regime. He is strongly against the Iran deal made last year and his criticism of Chinese trade deals and encouragement of Japan gaining nuclear weapons capabilities increases the chance of a conflict in Asia. His determination to build a border wall with Mexico will surely require increased military involvement.

The inefficiencies of Pentagon procurement processes are widely acknowledged, and so his determination to improve the system is to be applauded. While it might put uncomfortable pressure on the defence industry in the short term, making the system more commercial, competitive and transparent should be a good thing in the long term. If such improvements are made against the backdrop of a larger and more active US military, then it is hard to see how the US defence spending can decrease.

By nearly every metric of size – number of brigades, aircraft, ships, submarine battalions and end-strength – the US military in 2017 is smaller than when the build-up in the Middle East began in the early 2000s. Yet the budget is more than 50% larger (in real terms) than before 9/11 (as per the chart below from the Centre for Strategic and International Studies). The military and the US government assert that the capabilities of the force are improving. This is a hard claim to test, although logically the more technology-centred warfare makes spending on equipment rather than people seem logical. People cost money though, in training, housing and equipping. Therefore any increase in troop numbers by Trump will see a commensurate increase in spending.

DoD Budget authority and active strength troop numbers, FY1948 – 2017 (CSIS)

There are two major defence budget challenges that await the new President, irrespective of who it is:

1. The Budgetary Control Act (BCA) caps still remain in place for their original level FY18-21. The defence budget submitted this year for the next five years requests $113bn of funding, which is above the budget caps. The new administration must either broker a deal to remove the caps, or devise a defence strategy that can work within the caps.

2. The use of the Overseas Contingency Operations (OCO) budget to fund activities that should be in the base budget is coming under increasing scrutiny. Roughly half ($30bn) of the FY17 OCO budget is funding activities that were previously in the base budget. Many in Washington believe there should be no OCO budget when the US is not at war but currently the DoD is relying on it.

In conclusion, a victory for Trump is likely to be a small positive for the defence industry as the US defence budget should increase. The new President, whether Trump or Clinton, will only have a short period of time in which to influence the FY18 budget request because the budget development process takes more than a year, so is already well underway. However, they should have four months to insert any major strategy changes or alterations to high-profile equipment programmes, which will give us a flavour of the operating environment for the defence industry over the next four years.
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