Air combat systems evolving beyond the dogfight

You could be forgiven for ascribing a slight plaintive quality to this assurance, particularly as the Joint Strike Fighter (JSF) program, from which the F-35 emerged, is seven years behind schedule, $164bn (£128bn) over-budget, and is generally considered to be the most expensive defence project in US history. Just as some banks are deemed ‘too big to fail’ so, too, some military projects are simply too big to can. It’s not difficult to understand why BAE’s new chief executive Charles Woodburn might be a little anxious to recoup more of BAE’s front-loaded costs.

F-35 program highlights the issue of military procurement

Eventually, the Pentagon will buy around 2,440 of the supersonic warplanes through to 2039. Orders are also in train from the eight partner countries that helped fund the jet's development, as well as Japan, South Korea and Israel. The Royal Air Force and Royal Navy, which have invested around £1.54bn to help develop the new warplane, plan to buy a total of 138 F-35, including the costlier vertical/short take-off ‘B variants’, at between £78m-£146m a pop (estimates differ on this). The ‘B variants’ will be deployed on HMS Queen Elizabeth, the first of the Royal Navy’s two new carriers, from 2020.

?Since the tailend of 2015 the FTSE Aerospace & Defence index has increased by 28 per cent

The F-35 was billed as a fighter jet that could fulfil multi-facetted roles for the military, but cost overruns, coupled with speculation over some technological shortcomings, have made it the most contentious procurement programme of recent times – and that’s saying something. According to a report from the Centre for Strategic and International Studies, since the turn of the millennium the Pentagon has spent over $48bn on 15 major projects “without any fielded systems to show for it”. The underlying problem – or ‘bull point’ where investors are concerned – is that 'sunk' costs (the pre-existing expenditure on any given project) will often prejudice future investment decisions. And even when projects are terminated, they're usually sold to taxpayers as ‘savings’. Governments routinely throw good money after bad where defence spending is concerned. This fiscal myopia is bound up with what industry analysts refer to as strategic hubris – when policymakers lose sight of the ends they’re seeking to achieve, in favour of an indiscriminate expansion of the means to achieve them. This is obviously a major issue given that defence spending usually accounts for the largest capital commitment on the part of government. 

A growing impact on the UK supply chain

But whatever the eventual verdict on the efficacy of the JSF program – and it does have its proponents – the UK’s key role in the development of the F-35, from the 8m lines of software code that keep it in the air to the high-performance rear fuselage, is about to start paying off. KPMG estimates that the project will generate upwards of £1bn in annual revenues domestically when the jet reaches peak production. And that’s saying nothing of the multiplier effect through an estimated 25,000 jobs supported across the UK supply chain. Aside from BAE, that includes the likes of Cobham (COB), Ultra Electronics (ULE) and Rolls-Royce (RR.). The program will also have a beneficial impact on the UK’s balance of trade figures as around 15 per cent of each jet sold globally will be manufactured in the UK. Not only that, but the UK will act as a global repair hub providing maintenance, repair, overhaul and upgrade services for F-35 avionic and aircraft components.

Source: Lockheed Martin

Costs and complexity engender a collaborative approach

The JSF program is one of a number of projects focused on so-called ‘fifth-generation’ fighter planes, including Lockheed’s F-22 Raptor, China’s Chengdu J-20 and the Russian Sukhoi Su-57. These fighters are characterised by their stealthy profile, advanced avionics, and integrated computer systems. However, defence analysts believe we're about to witness a profound change in the way in which air defences are organised, extending beyond the interception of enemy aircraft to methods of neutralising low-earth-orbit satellites and ballistic and hypersonic missiles. In a sense, the latest generation of manned combat aircraft could be the first of their kind – and the last.

Future air battle concepts and weaponry are being shaped by rapidly evolving threats. Digital attack and cyber threats are springing up around the world, increasing the dangers posed by asymmetrical warfare. (The increased reliance on digitalised avionics renders fifth-generation fighters vulnerable to cyber-attack.) To achieve air parity in the future it will take more than new aircraft types, but a range of complementary technologies, including new propulsion systems, directed energy beams and hypersonic projectiles. (To this end, BAE is already working on a futuristic concept that alters the Earth’s atmosphere into lens-like structures to magnify the path of light and radio signals.) UK planners have already put forward a possible scenario involving a stealthy manned fighter flying with a support squadron of drones to protect it and act as off-board sensors. It may sound a little like science fiction, but the implementation of such a system could become reality sooner than we might imagine. 

Last year, the UK and France publicly committed to develop a Future Combat Air System (FCAS) aimed at replacing the Eurofighter Typhoon in 2040. However, a recent Franco-German agreement to “jointly develop a future combat aircraft system” raises questions about the original deal between Paris and London, particularly in light of the pro-EU stance of new French President Emmanuel Macron. Both BAE Systems and Dassault Aviation (Fr:AM) continue to work separately as lead contractors on their respective Taranis and Neuron unmanned combat air vehicle (UCAV) demonstrators, which would provide critical technical data for any future collaboration. The technological advances made through Taranis will help the Ministry of Defence, which co-funded the project, make decisions on the future mix of manned and unmanned fast jet aircraft. Development partners include Rolls-Royce, the Systems division of GE Aviation (formerly Smiths Aerospace) and QinetiQ (QQ.). We should know whether or not the French will proceed with the FCAS program by the end of this year, but given the inherent fiscal demands and technological complexity of future aerospace systems, national governments will almost certainly be forced to take a collaborative approach. (It has also been mooted that Germany will sign a new post-Brexit bilateral defence deal in areas including maritime patrol and cyber-security.)

The investment case – thematic options

After a prolonged period of retrenchment, the outlook on the defence industry started to improve at the tail-end of 2015. Since then the FTSE 350 Aerospace & Defence index has increased by 28 per cent. But if you think that it’s a not a case of ‘if’ but ‘when’ we’ll witness a major stock market correction, it’s worth keeping in mind the counter-cyclical nature of the industry. External factors that can drag down the rest of the market can act as catalysts for defence stocks. From a thematic investment angle, you would be wise to consider contractors with established capabilities in the growth areas outlined above, although we needn't point out that valuations in the sector (as with so much else nowadays) are a bit rich for our liking.

We reiterated our buy call on BAE Systems in March, so the reasons why we back its long-term prospects are well known to readers. Raytheon (US:RTN) is a major US contractor whose range of technologies, including advanced cyber-security technology, have helped it to adapt to the evolving nature of air warfare. The shares aren't cheap at 21 times forecast earnings, but the rating is probably justified given the company is likely to be a major beneficiary of the $110bn arms deal the US signed in May with Saudi Arabia. Another interesting thematic play, albeit a relative minnow, is AeroVironment (US:AVAV), the Pentagon's top supplier of small drones. The company has strong commercial ties with Lockheed Martin, allying the latter’s expertise in systems integration with AeroVironment's drone technology – a pointer to future air defence strategies. It may even end up in the aerospace giant’s cross-hairs eventually. For now, however, the stock is certainly priced for growth, but as drones gain wider commercial acceptance, AeroVironment is poised to drive revenues from civil applications in addition to its military channels.

The analyst's view:

Decisions, decisions: optionally manned fighters

The current stable of fourth and fifth generation aircraft have been manned, whether F-35, Typhoon or Sukhoi Su-30, but the future question will be whether future sixth generation aircraft will need to be manned or unmanned? The effectiveness of unmanned vehicles in combat is seen daily on our screens, protecting crews from the vulnerability of contested air space, which is politically very attractive. The huge advance in sensor accuracy, communications, networks and stealth technologies is making this optionally-manned capability an increasingly attractive proposition. Key to these developments is much greater miniaturisation, lower weight and power consumption, enabling longer mission time and simultaneous combat and intelligence gathering roles.

The recent US Defense plan, released on 17 May, saw an expansion of the Reaper UAV procurement, growing to a total of 363 vehicles in the coming five years, while research in support of the MQ-4C Triton has increased by $480m in this period. Moreover, the US Army is developing an extended range version of the Gray-Eagle to provide a greater payload for weapons and fuel carriage. Other initiatives are looking at ‘penetrating mission’ UAVs, requiring greater use of these technologies on a larger scale, including the RQ-180, SR-72 and TR-X programmes developed by the major primes.

From an air-to-air combat perspective this is likely to remain the preserve of manned fighters, where we see an increasing ability of smaller aircraft such as the Swedish Gripen, Korean T-50 and Leonardo M-346 Master easily capable of acting in a training and air defence capacity. From an Industry perspective, the main areas of engagement are sensor technology, lighter and stealthier airframes (using carbon-composites), data fusion and dissemination, engine efficiency and smart weapon integration. Some Industry players already offer optionally-manned variants of manned platforms, such as the Piaggio P.1HH Hammerhead, Kaman K-Max helicopter, and in future Saab has already proposed an unmanned Gripen variant.       

John Sneller, Head of Aviation, Jane’s by IHS Markit