Opportunities for Aerospace Defense Investing in 2021
Aerospace investors rightly focused on opportunities in the hard-hit civil aviation sector in 2020. But for a number of reasons, 2021 will likely bring significant opportunities on the defense side of the industry, despite the ongoing pandemic-related distress impacting commercial aerospace. The shift in US defense planning to addressing high-end threats in the Pacific Rim is a well-documented story by this point. Within that larger story, two less-visible opportunities relating to outsourcing in-air refueling and dissimilar air combat training are examples of how to gain exposure to the macro-trend, without overpaying in the better-known manufacturing segment of the market. With fewer eyes on these subsectors of the market, comes increased opportunity for outsized value.
The pivot to the Pacific highlights two capital-intensive areas where service outsourcing could grow in popularity: private air-refueling and adversary training services.
The Pacific pivot
After two decades of focusing on counter-insurgency operations in the Near East, the United States and its Pacific-Rim allies are in the midst of a major shift in doctrine, force structure, and equipment to address the so-called near-peer threat posed by Russia and China. Most investment analyses tend to focus on the new hardware this will require: hypersonic weapons, high-end drone capabilities, and shipbuilding initiatives. But this Pacific pivot poses two particular problems to the US Air Force (USAF) and the naval aviation arms of the Navy and Marine Corp that present an investment opportunity on the services, rather than manufacturing, side of the market.
Both opportunities are, ironically enough, a reflection of the US military’s adoption of corporate best practices—namely, the outsourcing of non-core services to lean out the balance sheet. The most mature implementations of this outsourcing practice can be found in the maintenance and sustainment organizations of the military, where private contractor vehicle/equipment maintenance and logistics contracts to resupply bases are now ordinary course. The pivot to the Pacific highlights two capital-intensive areas where service outsourcing could grow in popularity: private air-refueling and adversary training services.
Prepared: In-Air Refueling
To bridge the distance between the continental US and remote Pacific locations, military forces draw upon limited air-refueling assets. Private solutions can contribute in lower-stakes, non-combat scenarios.
Profile: Contractors in Demand
Private contractors pair retired airframes with new avionics and accurate tactics to help US Aviators train against the threats they may face in battle.
NKAWTG (Nobody Kicks ___ Without Tanker Gas)
While any specialist community puffs its chest with pride at its particular contributions, this motto is as close to a truism in modern air warfare as any other. In any Far East conflict, a steady stream of tanker aircraft will be necessary to establish a “bridge,” upon which American combat aircraft will transit from the continental United States to reinforce forward-based assets in Japan, Korea, and Guam. Should peace prevail, regular deployments to the region are still necessary for training exercises, to improve relationships with allied forces, and to familiarize aircrew with the local geography and conditions. In either scenario, the “tyranny of distance” in the Pacific exacerbates the need for aerial refueling assets. Private aerial refueling services will likely never be used in the near term to support actual combat operations; the risks from both enemy action and private contractor failure on a critical mission are too great. But services like Omega Aerial Refueling Services have already been providing the US Navy with private tanker support, utilizing its own fleet of aircraft in support of training and testing flights in non-combat scenarios. The relevant command within the USAF—traditionally more resistant to the idea of outsourcing the same services—has recently investigated the idea as well, plugging a capability gap driven by teething problems in the new KC-46 tanker fleet.
While there are still issues to overcome in terms of FAA approval for domestic operations and cultural resistance within the services to increased outsourcing of a core capability, the concurrent deterioration of the civil aviation market has helped to lower costs for any new entrants to the space or existing players looking to expand. Widebody passenger airframes suitable for conversion to tanking operations are available at healthy discounts as airlines and lessors look to shed capacity. The reduction in near-term demand outlook for passenger airlines will also result in downward pressure on pilot and aircrew compensation.
Top Gun (minus the volleyball)
In a hypothetical conflict, once US aviators arrive in the region, they will be faced with a large, well-equipped foe in the Peoples’ Liberation Army Air Force. Ever since learning hard-won lessons from the early ineffectiveness of US air power in Vietnam, both the USAF and USN have maintained dedicated aggressor squadrons to provide a full-time, in-house sparring partner for their aviators to train against who can mimic the tactics and equipment of potential adversaries like the PLAAF. As with other high-end capabilities, however, these aggressor squadrons have faced tightening budget constraints, first from the peace dividend of the ‘90s, and then from the shift in focus to fighting threats in Iraq and Afghanistan that lacked meaningful air forces.
To supplement these aggressor squadrons and reemphasize training needed to confront near-peer air forces, the services are increasingly turning to contractors who maintain small private air forces that can realistically represent an enemy force in training exercises. Firms like Draken International, ATAC, and Tac Air maintain small fleets of upgraded third generation fighters (1970-1980s vintage), as well as a roster of pilots familiar with military tactics and operating procedures. The investment opportunities are both direct (to compete with an existing marketplace that has not consolidated to a meaningful degree), as well as indirect (exposure to the MRO niche for older military platforms). Customer demand for increasingly sophisticated threat representation (with modern radar and jamming systems) will raise the capital needs of both existing and new competitors, leading to increased investment opportunities as the market evolves.
The next opportunity
These two opportunities are a reflection of the front-line visible strength of the US military concealing a hollowed-out core of the unsung capabilities needed to prevail in a potential future conflict in the Pacific. Investors scanning the headlines for opportunities should keep in mind the long tail of support activities needed to train, sustain, position, and equip US and allied forces to do their jobs at decisive points of a conflict.
