Feb 18 - Fitch Ratings believes that the threat of sequestration in the US looms over the defence sector once again, but that it’s unlikely that large European defence contractors will face an immediate significant deterioration in their operating performance or negative rating pressure in the event that it comes into effect.
This assessment applies to all European-based aerospace and defence (A&D) corporates regardless of the scale of their operations in the US, and is based on three key factors: relatively small exposure to the US defence spending, likely limited immediate cut to procurement spending and A&D companies’ solid track-record in preserving cash flows in the face of changing demand dynamics.
Firstly, European A&D companies’ overall exposure to US defence spending is relatively small in the context of their total respective activities. In the event of sequestration, we believe that defence spending could decline by as much as USD45bn in 2013, or around 7% of the Department of Defence’s (DoD) total operating budget on an annualised basis. However, most of the six largest European defence contractors rated by Fitch derive around 10% or less of their revenue from the US DoD, and sequestration would likely lead to a 2013 revenue loss of less than 1%. Even for BAE Systems, which derives around 30% of its revenue from the US DoD, sequestration would reduce 2013 revenue by no more than 2%.
All large European A&D companies rated by Fitch possess relatively well geographically diversified businesses. The portion of revenue derived from emerging markets among the six ranges from high-teens (Finmeccanica ) to low 40’s (EADS), and Fitch expects these to grow as emerging countries, not facing the same fiscal pressures as developed markets, continue to modernise and expand their defence capabilities.
Secondly, whilst it remains highly uncertain which accounts will be cut in the event of sequestration (other than military personnel, for example, which will be unaffected), Fitch believes that procurement spending, that part of the defence budget most affecting contractors, is unlikely to be significantly reduced in 2013. Long lead times on defence programmes mean that in many cases spending must be committed up to three years in advance in order for companies to make the necessary investment in development and tooling. While certain programme production could be curtailed beyond 2013, Fitch believes it is non-essential service work which is likely to bear the larger brunt of immediate cuts made. In this respect, most European defence contractors do not face significant exposures.
Thirdly, European A&D companies have historically shown a capability to preserve their cash flow margins in the face of shifting demand dynamics through timely and sufficient restructuring measures. The sector is characterised by cash flow margins whose broad stability is chiefly threatened by programme cost overruns or delays, not changes in spending patterns of key customers.
This, coupled with buoyant commercial markets, from which most companies derive a significant portion of their revenue, and rating profiles which are, for the most part, within the expected ranges of the current ratings, means that any revenue and margin pressure resulting from sequestration over the coming 12 - 18 months is likely to be relatively mild for European A&D companies and unlikely to have a negative rating impact in itself.
The six largest western European companies rated by Fitch in the A&D sector mentioned above are:
Rolls-Royce Holdings plc (‘A’/Stable)
European Aeronautic Defence and Space Company N.V. (‘BBB+'/Positive)
BAE Systems plc (‘BBB+'/Stable)
Thales SA (‘BBB+'/Negative)
MTU Aero Engines AG (‘BBB-'/Stable)
Finmeccanica SpA (‘BBB-'/Rating Watch Negative)