Industry tensions and uncertainty in the current geopolitical setting,

Industry Overview

The global Aerospace and
Defense (A&D) industry generated $574,466.54 billion in industry revenue in
2017, up 2.23% from the previous year. As a highly concentrated industry, the
top five firms account for approximately 40% of market share, with the remainder
divided among 426 other firms. Harris is a large player primarily within
Electronic Aerospace & Defense Systems (EA&D), a sub-industry of
A&D, which consists of corporations focused on commercial
telecommunications, wireless and satellite communication equipment. The
EA&D sub-industry’s market capitalization totals $526.10 billion, of which
$92.10 billion is derived from Lockheed Martin, the current industry leader
(Figure 1).  It proves to be even more concentrated than the A
industry as the top five corporation (Lockheed Martin, General Dynamics,
Raytheon Co., Northrop Grumman, and Safran S.A.) hold 58% of market share.
Harris holds approximately 3% of all market share in this sub-industry, and its
competitive peer group consists of companies such as BAE Systems, Thales S.A.,
Rockwell Collins, L3 Technologies, and Ball Corp. (Figure 2). Key competencies
that firms must display to remain competitive in this industry are cutting edge
technology, strong operating leverage, high ROIC (see Appendix) and high free
cash flow yield. According to FactSet, revenue from the A industry has
grown by .8% in the past five years and the World Aerospace & Defense Total
Return Index is outperforming the World Total Return index by $12.86. Harris
Corp. is also outperforming the World Total Return index, with an even wider
spread of $16.97. This expansion can largely be attributed to economic growth,
increasing demand for Defense equipment internationally due to rising tensions
and uncertainty in the current geopolitical setting, and an optimistic outlook
for Department of Defense (DoD) budgets. With this, sales growth is projected
to spike to 5.1% by the end of 2018, pointing to an expected $604,706.42
billion in revenue.

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Industry Forces

Notable industry forces
are the power of suppliers, power of buyers and competitive rivalry (Figure 3).
Due to the limited industry participants and vendor concentration, suppliers
consist of a number of large corporations that have the ability to leverage
their proprietary technology and raise prices while preventing customers from
acquiring the same product from a competitor. The Defense industry’s principal
buyer is the U.S. Government’s Department of Defense, which also has the power
to regulate the industry in their favor by increasing competition in order to
lower prices and have a bigger selection of high-quality products and services.
The force of buyer power is evident considering the massive influence DoD
budgets have on revenues of companies operating in this industry (Figure 4).
Competitive rivalry is intense due to the highly concentrated nature of the
industry, of which over half is dominated by a few large corporations, and the
competitive bidding process involved in winning contracts. Though measures
taken by the DoD to increase competition such as prolonging the competitive
bidding process and requiring transparency in areas once considered a part of
proprietary technology may be beneficial for both the U.S. Government and
smaller companies, it may also hinder innovation by disincentivizing
collaboration between corporations in the long run.

Macroeconomic Drivers

drivers of the EA industry include economic growth and geopolitical
uncertainty. Thus, indicators such as GDP, the WTI Crude Oil Price, and
Consumer Confidence can be utilized to both gauge the current health of the
industry and forecast the direction in which it is headed, as they have shown a
significant correlation to industry performance in the past (Figure 5). The GDP
growth rate averaged approximately 3.6% in the past five years. Not only do
some components such as Government Spending and Private Investments directly
impact Defense, but Defense also influences GDP as it is the U.S.’s largest net
exporter. International demand for Defense equipment depends largely on the
current and expected strength or volatility in oil prices, which is tracked by
the WTI Crude Oil Price. A low price benefits the commercial aircraft sector
and also leads to higher demand from customers in the Middle East and Asia
Pacific. Though not directed towards consumers, the Defense industry
performance is highly correlated to Consumer Confidence because it is an
indicator of economic growth and reflects factors such as favorable employment
environment and consumer spending. Due to the nature of the business, rising
global tensions characterized by civil wars and terrorist attacks lead to
increased demand for defense equipment and spending internationally, frequency
of bids and contracts, and higher Defense budgets.



at Premium to Broader Market

& Defense stocks continuously and incrementally outperformed the market
over the past five years. The S&P 500 Aerospace & Defense Industry
Index reported a CAGR of 22% from FY 2012 to FY 2017 while the S&P 500
experienced a CAGR of only 14.64%. Harris stock experienced even more growth
throughout this period with a CAGR OF 24% (Figure 6).  Historically,
Defense stocks have proven to perform well both in anticipation of a budget
rise and during periods in which Defense budgets are increasing, which explains
why they still have room left to grow.


a business model focused on government-funded programs is common across the
EA&D industry, Harris maintains a competitive advantage over its global
peers by employing a commercial market-driven business model, which focuses on
speed and innovation. This distinction enables Harris to anticipate customer
needs by focusing on internal R&D and utilize the insight acquired to make
projections of future demand (Figure 7). As such, this accelerates the
innovation process by providing to the market readily available products that
can be purchased under government contract, designed to be implemented easily
into existing systems without the need for customization.

to Entry

EA&D industry has incredibly high barriers to entry. This is due to the
heavy investment in R&D required to keep up with advances in
technologically intensive products as well as the proprietary technology
already owned by big businesses (Figure 7). New entrants may also be obstructed
by the loyalty associated with established brand identities, including the
strong long-term relationships with suppliers, manufacturers, and customers.
These are facilitated via the use of vendor financing, long term sales
agreements, and the ability to allocate significant capital towards marketing
resources. Big players can also provide large contract manufacturers lower
labor costs and connection to raw materials and other manufacturers due to
economies of scale. These factors combined make it extremely difficult for
smaller new entrants to secure government contracts and compete with
established brands.


geopolitical events, ongoing instability, and conflicts in global markets have
caused economic and political uncertainties that hinder the ability to forecast
international growth in the A&D industry. The prospect of continued
terrorist attacks and unprecedented events such as Brexit could have a
significant unfavorable impact on the industry due to the political, economic
and social instability in geographic areas in which companies in this industry
operate, including the Americas, Africa, the Middle East, Asia Pacific, and
Europe (Figure 9). International demand for tactical communications or other
products from countries in Asia and the Middle East depend on the current and
expected strength or volatility in oil or natural gas prices. Players in this
industry such as Harris depend on a sizeable portion of international sales
(Figure 10). International customer demand and industry growth will ultimately
be determined by the future performance of the global economies.


EA&D industry is extremely competitive. Key competitive advantages in these
markets are linked mainly to reliable and innovative technological
capabilities, product quality and reliability, ability to meet delivery
schedules, and cost-effectiveness. One of the main competitive threats Harris
faces is their larger competitors’ abilities to allocate higher levels of
capital to R. Harris often partners with competitors as the U.S.
government frequently utilizes subcontracts between more than one company in
this market. Competitors vary by business segment, but principal competitors
include BAE Systems, Thales S.A., Rockwell Collins, L3 Technologies, and Ball
Corp (Figure 11).


in an environment of constant technological advancement, in order to remain
competitive relative to peers, companies in this space must consistently invest
in R to deliver new and innovative products, systems, services, and
technologies. Excluding significant acquisitions or divestitures, R expenditures
are highly correlated with company revenues (Figure__). Industry leaders
embrace emerging trends and anticipate customer needs by developing
cost-effective solutions that are delivered to the market quickly.

Contracts & Competitive Bidding Process

industry’s principal customers are agencies of, or prime contractors to the
U.S. Government’s Department of Defense. As such, government contracts are
common in this business and contain contract clauses that allow for
redetermination of profits and for termination or default based on performance.
Companies in the A industry are highly reliant on their relationship with
the U.S. Government, thus any disruption in this relationship would trigger a
sizeable decrease in the company’s revenue. Competitors are continuously
striving to strengthen their relationship with the industry’s principal
customer in order to increase their likelihood of winning government contracts
and/or subcontracts, which are awarded through competitive bidding. The U.S.
Government utilizes multi-award contracts such as the multivendor Indefinite
Delivery, Indefinite Quantity (IDIQ), Government-wide Acquisition (GWAC) and
the General Services Administration Schedule because they are subject to
several competitive bidding processes. By awarding multiple vendors who then
must compete among themselves, this increases the amount of competitive bidding
and allows the government to further push down costs while still contracting a
highly qualified company for the job. Though beneficial for the U.S.
Government, this leads to more competition and increased pricing pressure in
the industry. Further disadvantages of this process include costs involved in
preparing bids and proposals without the guarantee of securing a contract or
the risk of termination should the company miscalculate resources and costs
necessary to satisfy awarded contracts. Bid protests are common among
unsuccessful bidders, resulting in additional expenses, delays, modifications
or even annulments following contract awards.

Budgets & Sequestration

a result of buyer power, the uncertainty of economic conditions that determine
changes in U.S. Government’s spending priorities present a major risk and are
difficult to predict. President Donald J. Trump sent Congress a government
fiscal year 2018 budget request of $639.1 billion, of which $574.5 billion is
the base budget and $64.6 billion is the Overseas Contingency Operations (OCO)
budget. This budget request would fund the DoD with $52 billion over the
defense budget cap in the Budget and Control Act (BCA) of 2011, which
established limits on discretionary spending and enacted automatic spending
reductions called “sequestration.” Reduced U.S. Government funding or
sequestration can lead to a decrease in the A&D industry’s sales to the
DoD, which can have a substantial negative impact on current and future
revenues. Consequently, this results in lower R expenditures, which
further decrease revenues (Figure 12&13). The potential U.S. government
shutdown on Jan. 20th, 2018 could slow economic growth, which will
likely hurt GDP, a main macroeconomic driver of the A industry.


order to remain competitive, companies in the industry rely on an assortment of
proprietary technology including patents, trademarks, copyrights, trade secrets,
licensing, and confidentiality provisions to ensure the protection of
intellectual property rights. Nonetheless, these protections involve material
costs and resources to maintain and it is common for competition to challenge
the validity of such proprietary technology and/or design similar products and
services without infringing rights.