by Chris Mecray

The Bush Administration’s FY04 budget submission, sent to Congress in February, appears to provide for generous funding for ongoing space projects. Though it is more challenging to discern administration priorities in space programs versus, say, fighter aircraft, we see a generally robust level of support for key projects, as recommended in the Rumsfeld Space Commission that the secretary chaired immediately prior to joining the Bush team. Defense contractors increasingly relying on government work to offset the dearth of commercial opportunities are salivating, eager to gobble up new scraps from Uncle Sam’s table. It appears they will not be disappointed. It is instructive to examine the FY04 budget to see what lessons may be learned for the future of the space hardware markets, and implications for the contractors involved.

Although reported budget data fails to capture the large classified space budget and certain other programs imbedded in other categories, we can see that key space-related programs are seeing significant step-ups in overall funding. The total funding for nine key reported space programs has increased from $2.3 billion in FY02 to a projected $3.3 billion in FY04. Critical elements of this ramp-up include Advanced Extremely High Frequency satellites (up $320 million), Evolved Expendable Launch Vehicle (EELV) (up $295 million), and Mobile User Objective Satellite (up $282 million), Space Based Infared System-Hi (up $190 million) and Spaced Based Radar (up $251 million). We would need to consider solid upsides in ground systems spending, as well as elements of missile defense funding on top of the National Reconnaissance Office and other classified work to fully appreciate the increases seen in the last several budget cycles. Also of note is the stable projected funding with steady three to four percent growth in the NASA budget, which includes development funding for key follow-on technologies such as the Webb Telescope, recently awarded to Northrop-TRW.

What is the upshot of all this? Contractors are seeing a wealth of opportunity in government space funding, with a broad diversity of healthy programs receiving new funding. Indeed, it might not be a stretch to say we are entering a new golden era of space investment by the U.S. government. This is propelled by urgent needs to recapitalize older in- orbit assets (many key space programs are between 30-40+ years old), as well as to enhance intelligence, surveillance and reconnaissance capabilities and harden assets against new threats. Seemingly gone are the "herky-jerky" budgets of the late ’90s, when space programs seemed to cling to the budget by a thin thread, and missile defense related programs were threatened with extinction due to rampant cost overruns and weak mission support. Clearly, the cost overrun part may not be totally behind us, but any uncertainty over funding support seems to have waned.

In the context of the broader space market, this "new paradigm" of military space support seems to have eclipsed the heretofore "new paradigm" markets of broadband communications and mobile telephony, at least until mobile broadband demand grows some real peach fuzz. From another angle, contractors are bowing to the good graces of Uncle Sam for rescuing them from utter doom in space segments, with the government side clearly offering some positive offset to the evaporated commercial markets, which were, at one point (say, 1998), expected to dominate space sales with around 75 percent of the market by 2002, according to the International Space Business Council, but in reality, we estimate, may now comprise no more than about 25 percent of total market sales.

In practical terms, this trend relieves certain contractors from further scaling back on space-related infrastructure. Lockheed Martin’s January decision to remain in the market was one clear example. While commercial satellite plants remain beleaguered and desperate for new business, overall space capacity, ground systems business and new launch infrastructure appears more fully utilized than we might have projected several years ago. Seen from a backlog perspective, space business is also more stable than we feared a few years ago. TRW (now under Northrop Grumman) has added several billion to backlog with the wins on key satellites last year. Lockheed Martin’s year-end space backlog at $12.6 billion, meanwhile, is a far cry from the $16-$17 billion levels of a few years ago, but has been stable for the last year, with the added benefit of hope for continued stability. On top of this, government support (read: direct subsidies) for EELV continues, with offsets added to FY04 that help reduce exposure for Lockheed Martin and Boeing to the investments made in anticipation of nonexistent commercial demand.

Looking ahead, we believe the strategic nature of space, and the Defense Department’s position that it represents a key differentiator for U.S. and allied forces, seems to ensure that current funding levels may be fairly stable, with ongoing moderate growth likely. This has already helped offset downside business cases in space for defense contractors, and we see the overall returns for contractors in this area stabilizing (though still low to be sure) as a result of the positive growth experienced on the government side in the last several budgets–a clear unexpected surprise to forecasters as meaningful as the unexpected negative delta in commercial space since the late ’90s.

Christopher Mecray is a research analyst with Deutsche Bank Securities Inc. The following comments should not be considered a recommendation concerning the purchase or sale of any security mentioned herein.