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First of all, congratulations to FLIR for being added to the S&P 500.

Secondly, although it was a brutal year for investors, hats off to the Defense Index’s Top 10 2008 performers, each of which ended the year in positive territory and the top six which were up more than 30%. Two have been acquired (DRS and SI International), four operate in the C4ISR/IT space (NCI (NASDAQ:NCIT), Mantech, SI International, Stanley (NYSE:SXE)), three in homeland security (Cogent (COGT), American Science & Engineering (NASDAQ:ASEI), Axsys (AXYS)) and one in UAVs (Aerovironment).

* * *

Although 2008 was the worst year the stock market has seen since the 1930s, companies involved with defense, homeland security, aerospace, and government space activities continue to outperform the broader markets, with our benchmark SPADE Defense Index beating the S&P500 for the ninth consecutive year.

An 8.21% surge in December saw the sector, which trailed the market most of the year, end on a positive note. Although the index finished 2008 down 38.03%, the worst it has recorded since launching in 1997, December’s gain enabled the Index to finish ahead of the S&P500 by 46 basis points and overcome a year that saw the Index trade downward due to pressure from the market, a strike at Boeing (NYSE:BA) which impacted a number of firms, and the uncertainty associated with a presidential election.

Three-, five-, and ten-year performance remains significantly ahead of the broader markets producing gains of [9.66%], 14.60%, and 86.69% respectively. With the market trading on momentum rather than fundamentals or technicals, the sector was hit harder than the underlying fundamentals would indicate.

Companies involved with defense, homeland security, aerospace, and government space activities generate nearly 5% of U.S. GDP. With the government as a primary customer, they are less likely to be directly affected long-term by economic factors associated with the banking crisis, recession, and inflation. Additionally, the sector remains a major source of manufacturing jobs in the United States and should benefit from the planned 2009 infrastructure initiatives. Healthy balance sheets and a number of trends suggest growth in 2009. Notably:

  1. The mission to protect and defend the U.S. and its citizens remains a critical goal of government.
  2. Support for defense and security initiatives inside the Obama administration is strong.
  3. A tremendous need to recapitalize equipment used in Iraq and modernize defense equipment and systems exists.
  4. Continued expansion in related business lines such as cybersecurity and the delivery of commercial aircraft.

What 2008 shows is that while the sector may move in sympathy with the overall market at times, the underlying factors driving the defense industry remain quite different. As investors return their focus to fundamentals, defense companies should benefit.

What to Look for in 2009

UAVs Expanding
The Army stated that it plans new missions in 2009 for its UAVs including counterterrorism and counterinsurgency efforts in Africa and testing surveillance situations in a jungle in Latin America.

TSA $2 Billion IT contract
The TSA issued a request for proposals on December 12th for an IT infrastructure contract. Contenders include Northrop Grumman (NYSE:NOC), Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Computer Sciences Corp. (NYSE:CSC), and Unisys (NYSE:UIS).

Revised Tanker Bids
Boeing and Northrop Grumman are lobbying behind the scenes to ensure bidding guidelines for the revised $40 billion tanker contract favor the product. Boeing is seeking the ‘lowest bidder’ whereas Northrop and EADS are seeking ‘best value’ equation. The Mobile Register (AL - 12/21) cited an analyst who believes Boeing will low-ball its bid in order to prevent EADS from gaining a foothold in the U.S. market

MRAP RFP
“Probable” order quantity of 2080 vehicles with a ceiling of 10,000. Army officials hope to buy M-ATVs as quickly as MRAPS, with delivery in less than two years. Written proposals and armor samples are due Jan 12. The request is for a vehicle weighing up to 12.5 tons not including payload, up from the 7-10 ton vehicle mentioned a few months ago. Potential bidders include: Lockheed Martin, Oshkosh (NYSE:OSK), Force Protection (NASDAQ:FRPT), BAE (OTCPK:BAESY), and Navistar (NYSE:NAV).

$40 Billion Needed for New Soldiers?
The U.S. Army stated in a November 2008 ‘pre-decision’ report that it would require an additional $40 billion annually in order to add the planned 74,200 troops. Independent analysis have the cost to recruit and train 10,000 soldiers at $1.2 billion per year. An independent CBO analysis stated that the cost would be $80 billion through 2013 (about $14 billion annually).

2009 Forecasts and Commentaries

Lockheed Martin - CEO Robert Stevens: The company is unconstrained by the credit crisis and the firm plans to make acquisitions in 2009, paying mostly in cash - focusing on companies they understand, that bring additional capabilities and core competencies to the business, that they can integrate without any disruption, and add to the diversity of offerings they can provide a customer.

Barclays Capital analyst Joe Campbell: The downturn in aerospace “will not be deep and prolonged”. The much delayed 787 program could be the key to Boeing’s performance through 2013 when its competitor, the Airbus 250, is scheduled to debut.

United Technologies (NYSE:UTX): Sees a ‘modest recovery’ in the second half of 2009 and profits in the aerospace division that should be up 8% to 10% subject to currency exchange rates...although overall revenues for 2009 could decline 3.3% to $57 billion.

AIA: The trade association for commercial aviation, defense, and space manufacturers, forecasted 2% growth for the industry in 2009. Military and space sales are expected to rise although the uncertainty of the financial markets could change things. AIA President, Marion Blakey says, “[Obama] understands the criticality of an adequate defense budget and the importance of strong defense.”

Northrop Grumman CEO Ron Sugar: “The world is not getting safer...it’s probably going to be even more uncertain as a result of the global economic turmoil” citing predictions of social unrest in China if the country’s growth rate falls below 8%. Even if the incoming administration slows development of new weapons systems, the need to replace equipment lost in Iraq and Afghanistan will help to prop up orders for years to come. Reuters Dec-19.

Northrop Grumman CEO Ron Sugar: “Defense spending will likely remain steady through the first few years of a new administration...though there could be significant deviations in Pentagon priorities for 2011 and 2012. You may see some rearrangement of what’s emphasized and what’s not emphasized, but the way this system works, the next several years are pretty well understood.... cybersecurity and UAVs are two areas that should see significant growth.” -- As cited in Reuters on 11/19.

Rockwell Collins (NYSE:COL) CEO, Clay Jones: “The basic, core defense budget will not be reduced because I don’t think it can afford to be reduced.”

Boeing - Jim Albaugh, head of Boeing’s Integrated Defense Systems unit told Reuters: Boeing is seeking to increase defense sales by up to 5% over the next 5 to 10 years and that the firm is focused on boosting foreign sales to 20% of its total.

Boeing: Cited in Bloomberg on Dec-11, girding for any forthcoming military budget cuts, Boeing said it will offer cheaper weapons systems based on existing technology that still provide “80% or 90% of the capability” of newer, higher priced systems. Cited as an example was the F/A-18 Super Hornet over the costlier F-35 Lightning II made by Lockheed Martin. The article said that it is not necessarily a win-win option for the firm citing that Boeing’s role on complex, new technologies for missile defense could lead to themselves being undercut by their rivals.

FTN Midwest Securities analyst, Mike Derchin, stated that U.S. airlines could earn $5.2 billion in 2009 due to the decline in oil prices, consolidation, reductions in capacity, and higher average fares. [Ed note: this bodes well for companies providing operations and maintenance services and aircraft manufacturers concerned that a recession might delay / cancel orders.]

Contract News

  • $27 Billion - Marine Corps began testing the $27 Billion amphibious Expeditionary Fighting Vehicle built by General Dynamics.
  • $14 Billion - From the Navy to General Dynamics Electric Boat and Northrop Grumman Shipbuilding for new eight additional Virginia class submarines
  • $3.5 Billion - NASA contract for space cargo to the International Space Station to Orbital Sciences (NYSE:ORB) and Space X (private).
  • $3.3 Billion - Raytheon (NYSE:RTN) for Patriot missiles from the UAE.
  • $900+ Million - The Pentagon is going to shift funds from the Boeing P-8 patrol aircraft toward a third Northrop Grumman / General Dynamics DDG-1000 destroyer. The move indicates that the Navy is willing to sacrifice aircraft programs to boost the fleet to 313 ships by 2020, up from the current 283.
  • $774 Million - Lockheed Martin from the US Army Aviation & Missile Command for new PAC-3 missiles for the UAE and others $136 Million - Boeing from the Navy for two C-40A Clipper aircraft bringing the fleet to 11. Work is to be completed by February 2011.
Source: 2009 Forecasts for Defense Spending