An Analysis of the

Aerospace and Defense

Industry

Parker Troutman and Drew Bridges

April 29, 2015

Finance 414 – Section 001

Dr. David Cicero

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Table of Contents

Aerospace and Defense Industry

Overview…………………………………………………………………………………. 2

History …………………………………………………………………………………… 3

Current Assessment ……………………………………………………………………… 4

Future Projections ………………………………………………………………………. 5

The Boeing Company

Overview…………………………………………………………………………………. 6

History …………………………………………………………………………………... 6

Qualitative Analysis ……………………………………………………………………... 6

Quantitative Analysis ……………………………………………………………………. 7

Intrinsic Value …………………………………………………………………………… 8

Lockheed Martin Corporation

Overview…………………………………………………………………………………. 9

History ………………………………………………………………………………….... 9

Qualitative Analysis ……………………………………………………………………... 9

Quantitative Analysis ………………………………………………………………...… 10

Intrinsic Value …..……………………………………………………………………… 11

Works Cited….………………………………………………………………………………… 12

Appendix……….………………………………………………………………………………. 13

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The following is an industry analysis of the Aerospace and Defense industry along with an

analysis of two stocks in the industry: Lockheed Martin Corporation and The Boeing Company.

The analysis is complete with our valuation of the intrinsic value of the stock based off of

assumptions explained in the analysis. Each analysis is concluded with our recommendation to

buy, sell, or hold based on our intrinsic valuation and the current market price of the stock.

Aerospace and Defense Industry

Overview

The aerospace and defense industry is a large, robust and very volatile part of the industrial

sector. While typically referred to simultaneously, they are different markets with distinctly

different economics at work and require a totally separate approach in their analysis. According

to the Deloitte 2015 Global Aerospace and Defense Industry Outlook, the global industry is

likely to grow around three percent overall this year. The Commercial Aerospace sector is

expected to grow with increased revenue and earnings. This is expected to be a driving force

behind creating positive global aerospace and defense industry performance in 2015. On the

other hand, the global defense sector is expected to continue to decline as budget cuts of major

industry contributors decrease total revenue in the industry. Over the last two years, budget cuts

in defense have been the leading cause for the overall industry slow down. Although budget cuts

are being implemented, recent conflicts, primarily in the Middle East and Asia, have prompted

increased defense spending to prepare their countries for combat. Listed below are some

important values to understand the industry:

Aerospace and Defense Industry Structure

Life Cycle Stage Mature Technology Change High

Regulation Heavy Barriers to Entry Very High

Revenue Volatility Medium-High Concentration Level Medium

Capital Intensity Medium Industry Globalization High

Industry Assistance Medium Competition Level Medium

Price/Book 3.61 PEG Ratio 1.65

Price/ Earnings 29.78 Net Profit Margin 7.64%

ROE 24.54% Dividend Yield 1.69%

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In order to properly analyze this group, we must divide the industry into two major segments:

Commercial Aerospace and Defense.

According to the Deloitte Touche Tohmatsu Limited (Deloitte Global) Manufacturing Industry

group, the Commercial Aerospace sector is expected to achieve an 8% growth rate this year.

Historically, the industry has had good delivery results throughout the 2009-2011 downturn in

the economy even as orders fell. This was a unique phenomenon in the industry unlike that

experienced in the prior recessions of 1995, 1997, 2002 and 2004. This is most likely attributable

to continued demand from emerging market participants. Additionally, airlines were quick to

address excess capacity issues as travel declined, which therefore, created higher load factors as

aircraft were retired and seating increased in the remaining fleet—stabilizing cash flows during

the decline.

The defense component of the industry is expected to continue to decline at an estimated 1.3

percent as global defense expenditures slow. No one can predict what military upheavals may

occur to change this outlook, but, at the moment, the trend for the major players in the defense

industry is for less defense spending on traditionally large systems, like aircraft carriers and new

bombers. Additionally, with the greater emphasis being placed on relatively low-cost defensive

and offensive systems like drones and lasers, the outlook continues soft for overall expenditures.

Companies proficient in cyber warfare and the aforementioned drone and laser technologies will

benefit from the modernization. The Defense industry is directly aligned with global politics.

The U.S. government continues to lead the world in defense spending with 39% of total global

military spending. Yet, recent United States budget cuts will cause U.S. defense expenditures to

decline dramatically. For the future, the declining defense industry must break the cycle by

cutting costs, expanding their markets, and investing in research and development of next-

generation technology.

History

The aerospace and defense industry has been a cyclical industrial industry that has always been

strongly tied to the nation state’s spending. Today, the size of the industry is significantly smaller

than it was during the Cold War, now dominated by a few larger companies. The fall of

Communism in 1989 caused Defense spending to decrease and the economy to fall. Many

companies chose to leave the industry and pursue other interests using their existing

technological expertise. Some companies merged with others, forming powerhouse companies

(Boeing - McDonnell Douglas and Lockheed - Martin Marietta) to compete with mounting

foreign pressure in the industry. As recession struck the US economy in the 1990s, increased

globalization boosted international sales of US aerospace and defense companies’ products.

Towards the end of the decade, the Asian economic crisis of 1998 caused a widespread

cancellation of defense and aircraft purchases from the US companies. In response, the industry

was forced to lay off many workers. The US industry was most recently hit hard by the crash in

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the subprime mortgage market and the recession that followed. Commercial airlines saw a

significant reduction in demand for air transportation, reducing their need to produce additional

planes. Defense companies started to see a consistent decline in Federal funding for defense until

the beginning of 2013.

Current Assessment

The Aerospace and Defense Industry is several years removed from its lowest operating margin

percentage as of late and is continuing a downturn in profits. This downturn is driven by the

reduced conflicts in Afghanistan and Iraq. Several areas across the world have seen increases in

spending including UAE, Saudi Arabia, India, and China. The largest driver of this downtick is

The United States. With the US accounting for 39% of the total global defense spending, a

decrease in military action by the US means a reduction in the industry revenues. With the

Budget Control Act of 2013, defense spending was cut by $37 billion that year, followed by

anticipated cuts in the following years of $52 billion annually for the next nine years. With the

decline in revenues, defense companies have been reducing staff and making lean decisions to

stay ahead of the anticipated DOD budget cuts.

There are a few factors to take a look at when analyzing the current state of the commercial

airlines sector. First, there is a growing demand for passenger airline travel, especially in the

Asia-Pacific region, Middle East, and Latin America. This increased demand has caused an

upward shift in plane manufacturing. Older planes are also being decommissioned or being

revamped with state-of-the art, fuel efficient technology. Second, according to Deloitte’s

industry report, “Fuel costs, as a percentage of total operating costs for airlines have risen from

an average of 13.6% in 2001 to 28.6% in 2014.” The recent decline in oil prices will have a

positive effect on decreasing a major portion of total operating costs. This high growth sector

will continue support the overall A&D industry results in the future.

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Future Projections The global aerospace and defense industry is expected to continue the growth experienced in

2014, with an expected growth rate of 3% in 2015. This growth rate is propelled primarily by

the accelerated production rate due to new technology and fuel efficiency. There is also a

continued growth in demand in passenger air travel demand. This is very true in all areas but

especially in the Middle East and Asia region. Passenger travel demand is expected to increase

by 5% each year for the next 20 years, contributing to airline revenues and an increase in aircraft

production.

Despite the upside on commercial air travel, downsides are forecasted. With many of the

defense and aerospace firms revenues tied closely to the United States defense budget, any

decrease in defense spending can spell disaster for these firms. Going forward, forecasters will

be very interested in how continued conflict in the Middle East affects the budgets of the United

States and countries directly involved. According to Deloitte, The United Arab Emirates, Saudi

Arabia, India, and several other countries will continue to increase their purchases of next

generation defense equipment.

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The Boeing Company

Overview

The Boeing Company (NYSE: BA) is the world’s largest Aerospace and Defense company

headquartered in Chicago, IL but operates in 90 countries. The company is split into three

divisions: commercial airplanes, defense and space, and the Boeing Capital Corporation. In their

most prominent division, commercial aircraft, Boeing’s primary competitor is the European

Aeronautic Defense and Space Company and their Airbus plane line. Currently, Boeing’s

commercial airplanes comprise 48 percent of the world’s fleet. In defense operations, Boeing

competes with Lockheed Martin, Northrop Grumman, and General Dynamics. Boeing Defense,

Space, and Security is a 33 billion business that has approximately 56,000 employees worldwide.

History

The Boeing Company was founded in 1916 in Seattle, Washington, where they produced

aircrafts for the United States Military. As the 1950s approached, airplane producers merged or

went bankrupt, Boeing emerged as the premier U.S. aircraft manufacturer. By the end of the

1950s, Boeing began producing jet airplanes and by 1966, it had produced the biggest

commercial airliner in the world, the well renowned 747. Boeing went public in 1972. After

going public, the accomplishments of the company became shadowed in 1973 and 1993 by

economic recessions and strong competition from Airbus Industries. This caused Boeing to

dismiss about 60% and 25% of its staff, respectively. Boeing bounced back in 1997 when Boeing

bought it’s U.S. rival McDonnell Douglas, forming the largest merger in aviation history. In

2008, the recession caused the global demand for air travel to decline. Despite the challenging

environment, Boeing was able to ride out the recession and position themselves in a positive

direction for the future.

Qualitative Analysis

When analyzing Boeing, we have to look at both the commercial airlines and the space and

defense divisions of the company.

There are a few factors to take a look at when analyzing the future of Boeing’s Commercial

Aircraft division. First, there is a growing demand for passenger airline travel, especially in the

Asia-Pacific region, Middle East, and Latin America. This increased demand has caused an

upward shift in plane manufacturing. Older planes are being decommissioned or being revamped

with state-of-the art, fuel efficient technology. Second, the recent decline in oil prices will

decrease a major portion of total operating costs for Boeing. Another positive outlook for Boeing

is the decreasing Trade-Weighted Index (TWI). Boeing will benefit from a decreasing TWI

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because U.S. imports will become more expensive and exports cheaper. The trade weighted

index is expected to increase throughout 2015. In recent years, there have been qualms with

Boeing’s reliability, as supply chain issues and new systems delayed the production of their

planes. Making up 66.1% of their overall revenue, Boeing’s commercial airlines division is

expected to have a positive future even with the issues they are having with production.

The recent U.S. defense budget cutback will have an adverse effect on revenues in Boeing’s

Space and Defense business. This sector has had decreasing revenues for years now, but is

counterweighted by the increase in the commercial aircraft sector. At the end of 2014, Congress

approved $1.46 billion to go to Boeing to build 15 attack jets. Also, Congress granted the

company money to upgrade existing Apache helicopters. Boeing’s defense division is expected

to do well internationally, as non-NATO countries (specifically in the Middle East) begin to

engage in military action, requiring defense products. Boeing’s should expect to see a smaller

decline in revenue from the Space and Defense business this upcoming year.

Quantitative Analysis

Boeing has been growing and is expected to continue doing so. Since 4/20/2005, Boeing Co. has

grown at an average annualized return of 14.83%, increasing stock value by $94.58. According

to IBIS World, Boeing’s commercial and military aircraft revenue is expected to grow at an

annualized rate of 11.3% to an estimated $77.0 billion in the next five years. The expected

growth is partially stemming from the introduction of Boeing’s new 777x, 737-MAX, and 787-

10 planes. A $440.1 billion dollar backlog of orders for the newest additions to the Boeing fleet

allow for strong revenue visibility moving forward. This backlog represents a 72% increase from

2010 levels. According to Morningstar, the fair value estimate is $138 per share, caused by a

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lower cost to equity which, in turn, reduces the total cost to capital to 9.3%. Key valuation

information is charted below:

Market Price $147.80 Price/Earnings 16.1

Market Capitalization $102.2 billion Dividend Yield 2.1%

Price/Sales 1.2 Price/Cash Flow 13.7

Price/Book 12.9 Price/Fair Value 1.07

*All stats are from market close 4/27/2015

Below shows comparison between stock prices of Boeing and the Dow Jones Industrial Average

over the past ten years:

Intrinsic Value

To complete our intrinsic valuation of Boeing, we used the discounted cash flow method. To

derive this valuation we took the free cash flows and multiplied them by the expected growth

rate. Next we found the NPV of these cash flows by dividing by the discount rate. Following

this, we projected out the cash flows for 10 years using the same method. Next we added up all

the NPVs of the free cash flows and multiplied the 10th year with a free cash flow multiple of 12

to get the sell off value. After adding up the total NPVs and the result of the 10th year and the

12 cash flow multiple and the cash and cash equivalents, we arrived at the intrinsic value for the

entire company of $132,505.27 (in millions). After dividing by the total number of shares, the

intrinsic value per share was concluded to be $191.

Based on the current market price of $147.80 (4/27/2015), we recommend to BUY because

Intrinsic Value > Market Price.

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Lockheed Martin

Overview

Lockheed Martin is a Bethesda, Maryland-based global security and aerospace firm that

employees roughly 112,000 people worldwide. Lockheed Martin has current operations in

aeronautics, information systems and global solutions, missiles and fire control, mission systems

and training, and space systems. Lockheed Martin’s biggest contract is with the Department of

Defense.

History

Lockheed Martin was formed by the merger of Lockheed Corporation and Martin Marietta.

Each of the companies share a long, deep-rooted history in the United States aerospace

development. Lockheed Corporation traces its beginning back to December 19, 1912 and Martin

Marietta traces its history back to August 16, 1912. Throughout the great developments of

United States aviation, Lockheed and Martin have been at the forefront of innovation. The

current President and CEO of Lockheed Martin is Marillyn Hewson, a former University of

Alabama graduate. Lockheed Martin generated $45.6 billion in sales in 2014 and $3.9 billion in

cash flow from operations. Lockheed Martin’s stock ticker on the New York Stock Exchange is

LMT.

Qualitative Assessment

Lockheed Martin is the world’s largest defense contractor, with 61% of its sales coming from the

Department of Defense, 21% from other U.S. government agencies, and 18% from international

clients. They operate 572 facilities in 500 different cities and all 50 states throughout the United

States. Lockheed Martin also has an international presence with locations in 70 nations and

territories. Lockheed Martin has current operations in aeronautics ($14.9 billion), information

systems and global solutions ($7.8 billion), missiles and fire control ($7.7 billion), mission

systems and training ($7.1 billion), and space systems ($8.1 billion). The Aeronautics aspect

brings in the most revenue because of the defense contract awarded to them by the DOD for their

F-35 stealth bomber. This projects to bring $400 billion in revenues through 2035. One

qualitative concern for Lockheed Martin going forward is a cut in the defense spending of the US

Government. Given that Lockheed Martin derives upwards of 80% of its revenue from US

Government contracts, the realization that budget cuts could derail the company are a real

concern for shareholders. This, however, is a shortsighted view given that recent projections

have an uptick in the estimated defense spending for the following years. The sharp budget cuts

were a reactionary effort by the government following the financial crisis of 2008. With the

American people adamantly opposing troops on the ground in foreign conflicts, Lockheed

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Martin’s unmanned systems show great promise. Below, are projections for the Federal Funding

and Demand for Air Transportation:

With the anticipated growing uptick in percentage increase in federal funding coming sometime

in late 2015 or 2016, Lockheed Martin will be able to continue to grow at around 3% according

to analysts from Morningstar.

Quantitative Assessment

Lockheed Martin generated $45.6 billion in 2014 revenue through its main operational

components. Overall, investing in Lockheed Martin has generated huge returns for those who

have stuck with the company. An investment of $10,000 in 2000 generated a return of

$87,086.37 in 2013 or a 17% annualized return. The current annualized return lies at 17.98%.

This is in stark contrast to the 2.9% return of the S&P 500 index. There is consensus among

analysts that Lockheed Martin will continue to grow at a 3.6% rate for the coming 2015 year

according to IBIS World. The fair value estimate should be at $161 per share from $144 per

share according to Morningstar.com. This change is due to a lower cost of capital. Margins

should increase continually because of steps Lockheed Martin has taken to consolidate its

company. A graph displaying growth of LMT compared to the A&D industry and key valuation

information is charted below:

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Market Price $196.80 Price/Earnings 17.4

Market Capitalization $60.852 billion Dividend Yield 2.9%

Price/Sales 1.4 Price/Cash Flow 16.2

Price/Book 18.1 Price/Fair Value 1.2

*All stats are from market close 4/20/2015

Intrinsic Value

To complete our intrinsic valuation of Lockheed Martin, we used the discounted cash flow

method. To derive this valuation we took the free cash flows and multiplied them by the

expected growth rate. Next we found the NPV of these cash flows by dividing by the discount

rate. Following this, we projected out the cash flows for 10 years using the same method. Next

we added up all the NPVs of the free cash flows and multiplied the 10th year with a free cash

flow multiple of 12 to get the sell-off value. After adding up the total NPVs and the result of the

10th year and the 12 cash flow multiple and the cash and cash equivalents, we arrived at the

intrinsic value for the entire company of $46,609.40 (in millions). After dividing by the total

number of shares, the intrinsic value per share was concluded to be $148.

Based on the current market price of $196.80 (4/20/2015), we recommend to SELL because

Intrinsic Value < Market Price.

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Works Cited:

Aircraft, Engine & Parts Manufacturing in the US Industry Report, IBISWorld, n.d., 20 Apr. 2015.

Captain, Tom. 2015 Global Aerospace and Defense Industry Outlook. Rep. Deloitte Touche Tohmatsu

Limited, 2015. Web. 19 Apr. 2015.

Carnevale, Chuck. "Lockheed Martin: Concerns Abound, But Still A Powerful Company."

Forbes. Forbes Magazine. Web. 29 Apr. 2015.

Damodaran, Aswath. "Current Data." Damodaran Online. New York University, n.d. Web. 23 Apr. 2015.

Dehora, Neil. "The Boeing Co. Analyst Report." Morningstar Investment Research Center. N.p., 22 Apr.

2015. Web. 28 Apr. 2015.

Dehora, Neil. "Lockheed's $79.6 Billion Backlog Provides Near-term Visibility." Morningstar. 21 Apr.

2015. Web. 22 Apr. 2015.

Frederick, Paul. "The Boeing Company." History of the Boeing Company. View America, n.d. Web. 20

Apr. 2015.

Gates, Dominic. "Boeing Says It Can Ride out Global Recession." The Seattle Times. N.p., 28 Jan. 2010.

Web. 21 Apr. 2015.

"Industry Overview: Aerospace and Defense." Wetfeet. Ed. The Editors. N.p., 3 Dec. 2012. Web. 28 Apr.

2015.

Schmidt, Ally. "The Boeing Company: Filing a New Flight Plan for 2015." Boeing's Fleet of Wide-Body

Aircraft. Market Realist, 8 Apr. 2015. Web. 22 Apr. 2015.

"Sustainability." Who We Are · Lockheed Martin. Web. 29 Apr. 2015.

Yahoo Finance. Yahoo, 22 Apr. 2015. Web. 22 Apr. 2015.

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Appendix:

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