TheStreet.com Ratings provides exclusive stock, ETF and mutual fund ratings and commentary based on award-winning, proprietary tools. Its "safety first" approach to investing aims to reduce risk while seeking solid outperformance on a total return basis.WASHINGTON ( TheStreet) -- The Senate vote to end production of the F-22 jet fighter has led to a sharp drop in the stock price for defense company Lockheed Martin ( LMT) and rattled the industry as a whole. While the defense budget is on track to exceed half a trillion dollars in 2010, the axing of $1.7 billion in aircraft has investors in the military industrial complex spooked. With the budget deficit growing ever larger and new agenda items such as health care threatening to rack up a tab of more than a trillion dollars in the next 10 years, something has to give. The question is, if defense spending, currently about 21% of the entire budget, is reduced, what will happen to the profitability for companies like Lockheed, Raytheon ( RTN), Boeing ( BA), General Dynamics ( GD) and Northrop Grumman ( NOC)? A review of the competitive forces affecting the defense industry helps shake out the real threats. Degree of Rivalry: Rivalry is high among defense contractors. With every new order comes a highly reliable source of income that has the potential to pay dividends for years. The F-22 led to billions of dollars in revenue for Lockheed Martin after the initial development as 187 of the $137.5 million jets were ultimately ordered. Most of the major players have niches that give them a bit of an advantage over competitors. Raytheon, for example, is highly focused on missiles and radar systems, while General Dynamics focuses on ground transportation, such as the Abrams tank, and submarines. Any overlap has been more than satisfied in recent years by the intense increase in spending because of the war in Iraq and a general push for defense spending, whether through homeland security or otherwise, by the Bush administration.
In addition to the public firms listed above, several private companies, such as General Atomics, also compete for a share of the defense budget. Should spending begin to soften, the high degree of rivalry may push out smaller firms that can't compete with the big names. Bargaining Power of Customers: With a single buyer making up a massive portion of these companies' sales, success depends on consistent governmental defense spending. While other countries also purchase defense products from these companies, the U.S. government outspends them all, effectively making America the only customer of consequence. Due to few switching costs and a plethora of similar products to choose from, defense contractors have little assured security in ongoing sales of a particular product. Luckily, defense contracts typically have many zeros in them, leading to fat profit margins. Governmental price sensitivity seems to be low, ensuring that when business is won, the contractors will be compensated for the variability in sales. Still, millions of dollars are sometimes spent to deliver a prototype that is ultimately rejected in favor of a competitor's product. Bargaining Power of Suppliers: Suppliers include subcontractors such as Pratt & Whitney, a subsidiary of United Technologies ( UTX), which produce key components for the main contractor. In the case of Pratt & Whitney, this includes the jet engines for the F-22 and F-35, among others. The actual power of suppliers is relatively low because of the number of competitors all vying for a piece of the defense dollar. General Electric ( GE), Honeywell ( HON), Rolls-Royce, and BAE Systems also produce jet engines and other defense products.
Subcontractors' products can be replaced easily by other suppliers should a relationship sour. As a result of this interchangeability, prices from subcontractors are kept low, allowing for higher margins for the primary contractor. Threat of New Entrants: Producing a jet, nuclear submarine or tank isn't something that can be done by a start-up company out of a suburban office park. Until software programs are the weapon of choice, it appears that all viable entrants are already established. Beyond the physical needs and expertise required to build advanced battle systems, a key component to winning business is connections to the decision makers, which doesn't come cheap. Politicians are currently dealing with a severe recession, an unpopular war and health care, all of which will probably reduce the perceived need to fund national defense. As a result, new competition would find it difficult to gain traction at this time. Unfortunately, this reason for a low threat of new entrants also means lean times may lie ahead for existing contractors. Threat of Substitutes: Traditional battle systems have been undergoing a sea change toward unmanned devices. In Afghanistan, most air missions are carried out by Predator and Reaper drone aircraft, which are safer and cost only a fraction of what traditional aircraft do. As warfare has moved away from direct confrontation with an equally armed aggressor to a more guerilla-type battle, drone vehicles make more sense. The Predator and Reaper are both produced by General Atomics. Other major contractors will need to start incorporating this technology into offerings to stay competitive. The competitive forces affecting the defense industry are great and the current economic landscape makes funding of vast military projects seem ridiculous. While there is still plenty of cash sloshing around in the industry in the near term to keep investors happy, it wouldn't be outlandish to suggest that the glory days of huge defense contracts may be over. -- Reported by David MacDougall in Boston. Feedback can be sent to firstname.lastname@example.org.