Defense in Times of Economic DistressSeptember 26, 2008

 

The unfolding crisis on Wall Street and the ensuing tightening of the credit markets is sending shock waves through most industries. The defense and aerospace sector remains far healthier than other domestic industries, but it is still going to feel some repercussions — both positive and negative — because of the crumbling banking sector.

"Defense companies are very healthy at the moment, and they have lots of cash due to intense Defense spending [during] the last few years," said Wharton professor of operations and information management Serguei Netessine.

What could possibly be a positive result for the defense and aerospace industry from the financial crisis? For one thing, as private equity funds have difficulty raising money, fewer of them will bid for smaller defense and aerospace manufacturers and suppliers. The larger, healthier companies in the industry — with their sizeable cash holdings — will be better positioned to snap up the smaller players as their prices drop. This will help them plug any supply-chain or manufacturing gaps.

"Certainly, we can expect that there will be fewer outside players in the M&A arena since many companies will have trouble raising money. This will drive prices down and make acquisitions potentially attractive to cash-rich defense companies," said Netessine. "The bigger question is: Will there be a need to buy? At the moment, the answer is not clear."

The trouble may weigh more heavily on companies that have both Defense and Commercial arms, according to Netessine.

Take the striking case of American International Group (AIG), which is likely to have a detrimental effect on the aerospace sector. Despite the U.S. government's $85 billion bailout of the massive insurer, one of AIG's subsidiaries, International Lease Finance Corp (ILFC), may find it harder to get credit to purchase aircrafts. The company is one of the largest buyers of aircrafts that it then leases out to the airline industry, which cannot afford to purchase planes outright because carriers’ scarred balance sheets. If that is the case, it will have to reduce its order for aircrafts from Boeing and Airbus.

"ILFC is both Boeing's and Airbus's largest clients, so any troubles at ILFC would have a direct impact on those companies," said Geoff Seiler, the editor of BullMarket.com, a newsletter published by Indie Research, an independent investment research company. "ILFC has been one of AIG's few bright spots over the past year, but it needs to be part of a well-financed firm awash in liquidity. ILFC has borrowed $6.5 billion against its three credit lines to get through the next six months, and we'd suspect it gets sold before then."

Seiler also said that Boeing has a backlog of 3,696 planes, and 102 of the orders are from ILFC. "In the unlikely scenario IFLC can't get financing or goes under, it won't break Boeing," said Seiler.

Netessine noted that Boeing announced its intention to finance planes for some commercial customers, adding that he expects that Airbus will have to do the same. "This is a risky endeavor, but it might be a necessary step."

YOUR THOUGHTS: If you are in the defense and aerospace industry, what impact is the credit crisis having on your company's long term plans? What steps do you plan to take during this period of tight credit? Send us a note and, pending editorial approval, we’ll publish some of your comments (anonymously, if you’d prefer) in an upcoming post.