4 Critical Trends in Aerospace, Defense & Security for 2014 and Beyond

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1 IHS AEROSPACE, DEFENSE & SECURITY 4 Critical Trends in Aerospace, Defense & Security for 2014 and Beyond 4430_0214TS

2 As 2014 starts to take shape, the Aerospace, Defense & Security (AD&S) sector continues to move beyond the Cold War paradigm that shaped the patterns of defense spending for most of the second half of the 20th century. New types of threats are emerging from new parts of the globe that require governments to shift the focus of their military expenditures. How these threats will be countered, and which players will be involved in equipping states to help protect against these emerging perils, is an evolving and complex process. Though still by far the world s dominant purchaser and exporter of military equipment and systems, the U.S. is embarking on what looks to be a protracted period of reduced defense budgets. Emerging from wars in Iraq and Afghanistan, as well as from the worst economic recession in 60 years, the country faces the burdens of massive debt, growing entitlements and rising interest on the debt. As a result, U.S. lawmakers have already cut the Department of Defense budget by USD487 billion over a nine-year period ending in FY2021. Additionally, sequester action will have removed another USD67 billion between FY13 and FY14, with the threat of additional sequester cuts looming. Such drastic cuts in overall defense spending, combined with those of other Western states, have had predictably negative business impacts on private companies in the defense industry that traditionally have developed and manufactured equipment and systems. As such, defense companies will need to consider expanding their operations into new and emerging markets around the world, as well as into adjacent industries. Trend: Declining Western Defense Budgets Will Force Defense Firms to Expand Business with Emerging Markets With U.S. defense spending declining continuously from FY10 through FY15 in constant dollars and then flattening out thereafter combined with only anemic growth in Western Europe many defense firms are being compelled to look to emerging markets for new business opportunities. IHS forecasts that addressable North American defense spending including procurement, research, development, test, and evaluation budgets will advance only slightly at a 4-year compound annual growth rate of 0.75 per cent between 2013 and 2017, rising from USD174.6 billion to USD179.9 billion over the period. On a percent of world spending, however, this is a contraction of 2.06 percent. (See chart below.) Addressable Global Defense Procurement & RDT&E Spending (in % of World Market) Latin America 2.67% MENA 7.43% Oceania 1.21% Sub Saharan Africa 0.41% Latin America 2.64% MENA 6.26% Oceania 1.75% Sub Saharan Africa 0.51% East Europe 8.02% East Europe 10.40% West Europe 13.25% North America 45.30% West Europe 12.63% North America 43.24% Asia 21.71% Asia 22.56% Global Addressable Defence Expenditure 2013 (USD billion) Global Addressable Defence Expenditure 2017 (USD billion) Source: IHS Jane s Defense Budgets 2

3 Southeast Asian markets, in particular, will be targets of opportunity for Western defense contractors as countries such as Singapore, Indonesia, Malaysia, Thailand, Vietnam, and the Philippines look to shore up their security in the face of the growing influence of China in the region. The Obama administration has facilitated this development, softening its stance toward exports to the Asia-Pacific region by beginning the transfer of thousands of restricted items on the State Department s U.S. Munitions List to lower-risk categories under the jurisdiction of the Department of Commerce. While defense firms will be buoyed by these developments for which they lobbied many sensitive technologies will remain under tight control and off limits for export. Greater U.S. strategic emphasis on the Asia-Pacific region (the pivot to the Pacific that is emphasized in the National Military Strategy, issued by the President, Secretary of Defense and the Chairman of the Joint Chiefs of Staff) will be accompanied by expanded opportunity in India, identified in the Department of Defense s 2012 U.S. defense strategy as a longterm strategic partner. Of growing strategic and economic importance, India is part of the South Asia region whose addressable defense spending IHS forecasts to increase at a CAGR of 5.1 percent over the next four years. Indeed, with spending on defense procurement already higher than that of France and the UK, IHS analysts forecast total Indian defense spend to reach USD63.7 billion by 2020, making it the world s fifth largest defense market overall (fourth if counting just procurement and RDT&E). Risk: Economic Fragility in Many Emerging Markets Makes These Opportunities Less Than a Sure Bet While economic growth and diversification efforts in Southeast Asia and other emerging regions are fueling procurement growth, definitive slowing of these economies is underway. Malaysian procurement plans were hit hard in 2011 by lower-than-expected growth. Flooding in Thailand that same year saw government funding diverted from military equipment procurement programs. In India, there are decades-old restrictions on foreign businesses that wish to do business in the country. And India s economic expansion to support government spending growth is no longer assured, as inflation and currency depreciation pose near-term challenges. India has also failed to spend its entire procurement allocation at least once in recent years and has canceled procurement contracts amid charges of bribery and corruption. South America, where renewed economic vigor has led to the resurrection of procurement ambitions, represents another risk-fraught opportunity. Renewed economic growth owes as much to auspicious circumstances i.e., currency collapse and demand for low-valueadded goods as sound fiscal management. These economies remain highly vulnerable to economic shocks. Compounding the risk that western defense firms face in entering these markets is the potential competition they face from others operating in these regions. China, Russia, and Israel are already in many of these markets and soon may be joined by emerging producers such as South Korea, Singapore, Japan and Turkey. Trend: Procurement Relations Are Broadening as Fewer Countries Can Be Viewed as Captive Defense Markets The buyer-seller relationships of the past are giving way to partnerships of equals. Increasingly, emerging-market countries are looking to reset relationships with developed countries that play the role of benefactor, by demanding a greater return and involvement in their procurement contracts, in areas such as work share and technology transfer. In part, this is motivated by developing states desire not to be beholden to one supplier that could choke off their military ambitions with an arms embargo. Also, there is the realization that narrow procurement reliance is not the optimal method for gaining the best value. 3

4 The Gulf states, which have traditionally traded with U.S. and European suppliers, are increasingly establishing ties with Southeast Asian countries for their procurement needs, as well as China, Russia, and India. India, which formerly procured substantially all of its materiel from Russia, made a conscious decision to diversify its supplier base. These changes reflect a strategic rebalancing of the world procurement market but one that nonetheless offers new business opportunities for defense companies willing to look beyond their traditional clients. Risk: Greater Competition Among Defense Contractors; International Procurement Procedures Increasingly Codified Chasing new international opportunities in an era of slow growth in defense spending IHS forecasts a 0.10 percent CAGR in defense spending globally through 2017, excluding the largely closed markets of Russia and China defense firms will be vying for procurement dollars against tough competition. With countries less beholden to their traditional suppliers, more deals can be expected that resemble Turkey s purchase of an air-defense system from China, which was announced in September Further, emerging markets are increasingly looking to ring-fence procurement funding where possible to keep funds within their national borders. Western defense firms competing for business in emerging markets could conceivably find themselves priced out of certain contracts. Comparatively high prices for advanced systems demanded by the U.S. defense contractors or the U.S. military may be beyond the needs, and budget constraints of emerging countries. In such instances, less-expensive alternatives from, say, Russia or China may be the more fiscally responsible purchase. To complicate matters further for firms playing in the international arena, foreign procurement policies including offset obligations are becoming increasingly sophisticated and, in some cases, codified. As an example, European Union (EU) defense procurement directives that came into force in 2012 provide member countries with the formal right to exclude non-eu market entrants. (It should be noted, however, that EU countries can still open procurement competitions to companies from the U.S. and may well continue to do so to obtain high-quality, off-the-shelf equipment at a reasonable price.) Trend: Conventional Defense and Commercial Security Domains Are Converging/Blurring Over the past two decades, the aerospace, defense, security, and commercial markets have overlapped to some extent. But the trend toward a blurring of the lines among these sectors is more pronounced now than ever providing new business opportunities for defense firms that wish to diversify their operations in adjacent areas. Firms that traditionally have sold military products and systems will increasingly contemplate moving into adjacent areas such as national infrastructure protection, commercial security, IT and healthcare. Emerging threats such as cyber warfare will provide defense companies with the opportunity to compete with core information technology companies both in the marketplace and in competition for acquisition of cutting-edge technology companies. The global security market is forecast to grow substantially over the next five years. The U.S. and Europe remain the primary markets for homeland security and surveillance systems but the Asia-Pacific region, in particular, as well as the Middle East, Latin American, and African regions also offer defense firms potential opportunities for diversifying their operations. Risk: Defense Contractors Face Competition from Commercial Firms for Procurement Dollars Just as the blurring of the defense and security markets has created opportunities for defense firms to move into the commercial sector, so too has it created the opportunity for commercial firms to move into traditional military markets. In this emerging 4

5 environment, manufacturers are providing adequate commercial off-the-shelf solutions to meet military requirements a reflection of cost pressures in mature markets and lowerlevel performance requirements in emerging markets. Examples of this tendency include the use of heavy commercial trucks as tactical logistics vehicles and, potentially, the purchase of turbo-prop commercial aircraft for counterinsurgency operations. Similarly, commercial hardware manufacturers such as Apple Inc. and Dell Computers are supplying an increasing proportion of hardware products and services to the Pentagon. Trend: East Asian Industrial Giants Increasing Their Involvement in Defense and Technology Exports China, South Korea, and Japan, all to varying degrees in recent years, have increased their involvement in exporting military equipment and related technologies a trend that can be expected to increase in the future. According to IHS Jane s May 2013 report into global defence imports/exports, Balance of Trade, Chinese exports increased from USD1.16 billion in 2008 to USD2.22 billion in 2012, making it the eighth largest exporter in the world. South Korea, long an electronics giant, has seen an enormous expansion in its exports from , moving from the 27th to the 11th largest global exporter, according to IHS Jane s data. Japan, like South Korea, a long-time electronics manufacturer, has taken its first steps toward developing its defense export business through the revision of its long-standing Three Principles policy, which had effectively banned Japanese manufacturers from joint development and export of military technology. Risk: Defense Trade Could Raise Regional Tensions The fragile security landscape in Southeast Asia ensures that defense equipment exports can be viewed as regionally destabilizing. Border disputes, the threat of internal security challenges, and maritime demarcation all drive procurement efforts, with concerns over China s growing regional influence acting as an ever-present force. Although domestic capabilities range from fledgling (Thailand / Vietnam) to developing (Indonesia / Malaysia) and highly developed (Singapore), requirements are invariably becoming more sophisticated as increasing funds are allocated to defence procurement. Information contained in this article was sourced from interviews with Guy Anderson, Senior Principal Analyst, aerospace & defense research for IHS. For more information 5