How U.S. Defense Contractors Are Creating Their Own Competition

(MoneyWatch)  Large U.S. defense contractors like Boeing (BA), Lockheed Martin (LMT) and Raytheon (RTN) make money in two ways--first, by selling equipment and systems and then, by securing contracts to maintain them. The second part of that equation is looking distinctly tougher.

Recently, for example, the Saudi Arabian Ministry of Defense awarded a maintenance contract for the engines on their Lockheed Martin-produced C-130 transport aircraft to Hellenic Aerospace Industry (HAI) of Greece. The work had previously been done by a local Boeing subsidiary.

A state-owned company, HAI provides comprehensive aircraft and engine repair and maintenance for both military and commercial products. It is certified by Rolls-Royce (RR:L) and Pratt & Whitney (UTC) as engine parts provider and repair. The company is also one of the co-producers of the F-16 fighter aircraft used by many NATO member countries. In a sense, the U.S. helped to make HAI an competitor; when it sold the aircraft to Greece, the Greek government required some domestic production and offsets.

With the planned expansion of aircraft production and maintenance facilities in China--much of it through joint ventures with European and American companies--it is likely that that country will begin to get the type of contract HAI just won. Rockwell Collins (COL) has a maintenance facility in China that just signed a ten-year agreement with Air China (AIRC) for avionics repair and support.

U.S. laws on technical exports limit who is able to touch parts of an aircraft, but that leaves much lucrative grunt work up for grabs. Take the C-130. These aircraft, especially the older models, are not considered very advanced, and Lockheed and Rolls-Royce have licensed production and repair to many different companies.

In the past, the U.S. would often sell a system to a foreign customer with requirements of support contracts as well. Now, there is so much competition that it is the buyer who is setting the conditions.

Canada, for example, recently purchased several new C-130J aircraft. As part of the contract, Lockheed Martin is required to invest a substantial amount of money in the country. Since it would prove expensive and complicated to actually build the aircraft in Canada, this will take the form of parts and service. The first maintenance contract was signed in January. Eventually, then, Canadian companies will be able to do this work for anyone. Result: More competition for Lockheed. Brazil is doing something similar with its helicopter and fighter purchases.

U.S. military contractors rely on their technological superiority to help create overseas demand. The U.S. military also benefits as the more foreign sales of a system, the cheaper it tends to be for everyone. But the side-effects of this model are becoming clearer. It may be time to take a second look.