Opportunities in Orbital Warfare

The launch of the U.S. Space Force last year created brand new revenue opportunities for leading U.S.-based aerospace and defence suppliers. These arms manufacturers are the direct beneficiaries of large and growing sums of budget allocations being carved out for Space Force, the sixth branch of the military.

Aimed at beefing up U.S. dominance in space and counter growing space ambitions and activities of rivals Russia and China, the launch of U.S. Space Force is a sign of acknowledgement that space is the next frontier for war. The Department of Defence plans to allocate more than US$15 billion to the U.S. Space Force as early as 2021, to fund a slew of security satellite launches, GPS projects, and to develop critical technologies. Dominant defence contractors with lucrative, long-term agreements to supply their products and technology are well-positioned to benefit from additional government spending to buttress its defence capabilities against space-borne threats.

Apart from receiving large tranches of military funding, the following companies also boast multiple revenue streams sustained by partnerships for a wide spectrum of non-military space programs including commercial missions, exploratory endeavours and scientific research expeditions.

Lockheed Martin (LMT) is Earth’s largest defensive contractor. The firm’s largest segment is Aeronautics, dominated by the massive F-35 program. Lockheed’s other segments are rotary & mission systems (mainly the Sikorsky helicopter business); missiles and fire control; and space systems (satellites and the United Launch Alliance joint venture).

Lockheed is developing and installing cutting-edge GPS satellites for the U.S. Space Force that would provide more-secure, harder-to-jam GPS signals. The company was recently awarded a US$15 billion contract by the U.S. Air Force for C-130J aircraft, and another US$240 million contract for developing advanced space systems. But it’s not easy money.

The defence budget and its allocation are steeped in politics, which is inherently difficult to predict. “Therefore, we favour companies with tangible growth profiles through a steady stream of contract wins, ideally to contracts that are fulfilled over decades,” says a Morningstar equity report.

For instance, the F-35, which accounts for about 30% of the firm’s revenue, will run through 2070. “Regulated margins, mature markets, customer-paid research and development, and long-term revenue visibility allow the defence primes [prime contractors] to deliver a lot of cash to shareholders,” says Morningstar equity analyst, Burkett Huey, who sees multiple growth opportunities for Lockheed.

The defence contactor’s wide moat is underpinned by product complexity that thwarts new entrants, contract structures that reduce its risks, decades-long product cycles, a lack of alternative suppliers, and the switching costs of a risk-averse customer,” says Huey, who recently upped the stock’s fair value from US$429 to US$433, prompted by a strong second-quarter performance despite the COVID-19 impact.

Another aerospace and defence manufacturing major, Northrop Grumman (NOC) is diversified across short-cycle and long-cycle businesses that include aeronautics, mission systems, defence services, and space systems.

The defence contractor is expected to work closely with the U.S. Space Force as the latter looks to boost its network of secret reconnaissance satellites. Northrop Grumman was recently awarded a US$2.37 billion contract by the U.S. Space Force to develop missile-warning satellites.

“We view Northrop Grumman as a higher-tech defence prime contractor, with a greater focus on producing hardware for restricted programs,” says a Morningstar equity report, adding that the firm’s biggest growth opportunities are represented by “the Ground-Based Strategic Deterrent, the further militarization of space, and the development of the B-21 bomber.”

Defence programs and contracts are typically sustained over decades, which benefits leading manufacturers such as Northrop. “We believe that intangible assets in the defence industry ensure that incumbent firms are the only companies capable of servicing the military’s large need to purchase arms, which manifests as a material barrier to entry,” says Huey, who recently raised the stock’s fair value from US$331 to US$337, “due to an increased growth outlook in the company's space segment.”

Defence primes, he adds, are implicitly a play on the defence budget, which is ultimately “a function of both a nation’s wealth and perception of danger.” While defence spending could moderate over time, Huey argues that “prime contractors will still grow because of a shift in focus toward defending against great powers conflicts with the 2018 National Defense Strategy.”  

Raytheon Technologies (RTX) is a diversified aerospace and defence industrial company resulting from the merger of United Technologies and Raytheon. The company operates four businesses: Pratt & Whitney (engine manufacturing); Collins Aerospace (a diversified aerospace supplier); integrated defense and missile systems; and intelligence, space and airborne systems.

The Space and Missile Systems Center -- the U.S. Space Force's centre of excellence for acquiring and developing military space systems-- recently awarded Raytheon a contract valued at US$500 million. More recently, the company snagged another US$378 million contract to shift the future ground systems for global positioning satellites from IBM hardware to Hewlett Packard Enterprise gear.

“Within defence, Raytheon is exposed to missiles, missile defence systems, space militarization, and IT services for the government,” says a Morningstar equity report, pointing out that “the military’s increased focus on defending against great powers conflict will drive material investment in each of these exposures.”

The firm’s intelligence, space and airborne segment has an overall narrow moat, but boasts a wide-moat component in sensors and secure communications business (about 60% to 65% of operating income), Huey notes.

On the commercial aerospace side, Raytheon’s jet engine manufacturer, Pratt and Whitney, is in the midst of a large ramp up for the Geared Turbofan engine to support its placement on the popular A320neo family of aircraft. “Engines are a razor-and-blade business, with the razor being the original component sale and the blade being servicing,” says Huey, who recently lowered the stock’s fair value from US79$ to US$78, prompted by weakness in the commercial aerospace segment due to pandemic-imposed air travel restrictions.