Five (Actually Three) Things Defense Sector Investors Are Thinking About

After starting the year off with strength as compared to the broader markets, the defense and security sector slid significantly in February posting one of its worst one-month returns. Whereas in January, when the SPADE Defense Index outperformed the markets by better than 5%, February saw the sector give it all back. The Top 10 laggards for the month included three of the sector’s largest firms with Boeing (BA), Lockheed Martin (LMT), and General Dynamics (GD) all losing more than 20% of their value.

Meanwhile, the sector’s price-to-earnings and price-to-book ratios are at a level usually seen after the sector has undergone a significant downturn in defense spending leading some to wonder if the sector has already priced in budget declines years in advance and hence, open up the possibility for upward action.

As we enter March, the broader market continues to drift lower as an understanding of the global economic situation becomes clearer. For defense sector investors, there are five things on their mind.

1. The Budget

Details and specifics won’t be released until mid- to late-April, but some are already beginning to react based on expectations that some individual programs will be cut or cancelled. There are three things to consider.

One, that the FY10 budget will add approximately $20 billion to the core DoD budget bringing it to $533.7 billion.

Two, that while this top level figure gets all the attention, ultimately, the important figure is the amount devoted to procurement and R&D (what is known as the investment accounts) and the percent of the operations budget that is outsourced to private companies. This is the money that is awarded in contracts to private and public firms. What is interesting to note is that although the investment account budgets have remained flat in recent years, companies have been increasing their revenues and earnings. While specific details won’t be known for at least another month, the investment account budget is expected to be similar to prior estimates.

And third, it is a given that a number of programs will be reworked or cancelled. Witness the recent flap over cost overruns to develop upgraded Marine One helicopters for the President and the reorganization of the TSAT satellite program, a $20 billion effort to revolutionize DoD communications whose contract has been postponed to allow additional development. Importantly, if the top line remains the same, other existing or new programs will see an increase. At the end of the day, the question for individual firms is, what is the net? Declines in a big program may be offset with gains in several smaller ones. Until the budget is released, this is an unknown and investors shouldn’t necessarily jump to conclusions.

2. Iraq

The White House has announced an August 2010 deadline for two-thirds of the troops in Iraq to return home and the remaining third by the end of 2011. The current force of 142,000 will be reduced to a level of 35,000 to 50,000 until the final pullout. Additionally, 17,000 troops will be sent to Afghanistan. Of the roughly $10 billion dollars a month being spent in Iraq (estimates vary), most of the resources do not end up with defense contractors and is instead allocated for fuel, healthcare, salaries, transportation, and other operational activities. A company like Raytheon (RTN), would be expected to benefit greatly from the the use of its products during a military action, yet, their CEO at the recent Cowen &Company investor meeting said that Iraq generates less than 5% of revenues. Though the war effort is costing the U.S. more than $100 billion/year, leaving Iraq will likely benefit the sector in the long-term and free up resources that could be allocated elsewhere and into areas that companies could compete for.

3. The Stimulus

The defense sector got much less than many expected. With products of need and a manufacturing force in place, from an economic standpoint the sector could have produced a turnkey option for employment while resetting the military.

Stimulus funding of interest to the sector’s companies include:

• $4.5B for renovation and modernization of posts, camps, and stations
• $1.7B for energy efficiency on military bases
• $3.75B for construction of military hospitals and medical facilities and care for service members and their families
• $1.6B for construction and modernizing troop housing and child care and development centers
• $350M for R&D and pilot projects to improve energy generation and transmission
• $4B to Justice Dept. grants to state and local law enforcement
• $2.7B to Homeland Security including:

• $1B for airport baggage screening equipment
• $420M to build border checkpoints
• $210M for fire stations
• $300M for port, transit and rail security
• $240M for the Coast Guard
• $200M for a new Department HQ

• $400M to NASA for Earth science climate research missions and to increase its super-computing abilities.

Other non-defense, but areas of interest:

• $4.7B grants to extend broadband + $2.5B to expand broadband into rural areas
• $20B to digitize medical records
• Investments, such as the $165M to Fish & Wildlife to manage natural resources, could benefit the sector when satellite imagery is acquired to assist in that management.

4. The Budget

Oh, did I mention this already? Well, it is that important. There are concerns about what will happen in 2011, 2012, and 2013 but a lot can change by then. Defense companies have already begun to conserve cash and apply their skills to related areas in order to capture business in other sectors and initiatives. Cyber-security and the the anticipated health care digitization revolution, are but two emerging markets that will utilize technologies and skill sets developed to keep military and intelligence systems secure.

5. The Budget

Yes, this is what the sector revolves around -- how much its primary customer plans to spend. The question that investors need to ask is, how much of a decline has already been priced in? As mentioned, many companies are trading at levels normally seen after a decline in defense spending has already taken place. Look at the list of companies in the SPADE Defense Index and see how many have a PEG (price to earnings growth) of less than 1 -- a level historically associated with undervalued firms. Ultimately though, the issue is not whether any contract cancellation or weakness in the budget will lead to a decline, but how far and how fast the company/sector will bounce back from these levels. Considering current market conditions, this is an unknown.

Ultimately, defense and security is as important today and the foreseeable future as it was ten years ago. Economic issues will only exacerbate instability around the world. [According to a recent Defense News article, the 70%+ drop in oil prices has not led to a decline in the acquisition of military hardware by countries in the Middle East.] And the Obama administration and their supporters need to remember that when history is finally written, all the good he can/will accomplish can be washed away in the aftermath of a single action.

Comments

[oldman:]

With the Gov't wanting to increase employment, the defense industry is cutting employment. How will this budget increase defense company employemt? Seems it is a oxymoron.

Mar 05 10:50 AM

[BertNo!:]

I agree with the comment above. Increasing speding in defense increases employment opportunities for Americans. You can't outsource very much of a classified project.

Mar 06 12:34 AM