Ten Keys for Investing in Defense Over the Next Six Months

Specifics of the FY2010 Defense Department budget were finally made available in early May and there were few surprises from the information that was leaked over the previous weeks. A number of large programs were cancelled or scaled back including major initiatives such as the Future Combat System, Transformational Satellite TSAT, and the presidential helicopter, but each were “replaced” with other programs that are designed to meet the ongoing needs of the agency. In fact, despite the cancellation of the multi-billion TSAT program, spending on new communications satellites in FY10 rose.

Analysts have now shifted their attention toward gathering information on the 2010 Quadrennial Defense Review (QDR) which will be the guide for the FY-2011 to FY-2015 budgets -- although final details are not due until next February. While a number of analysts think defense spending has peaked with the FY-10 budget, dramatic cuts in future budgets is meeting with resistance from a number of current and former members of the executive branch and Congress as well as military officials.

So with investors starting to look again toward the sector, it appears as if the recent decline in share prices over the past nine months went too far. Which brings us to the top 10 keys for the next six months.

Ten Keys for the Next Six Months (and Beyond)

1. The FY10 Budget is Released. The budget has always been the most important factor in determining the health of the sector and the companies that will benefit. With the base budget for FY 2010 showing a 5.6% growth ($5.7 billion) in procurement and another supplemental spending package to fund war efforts through the rest of 2009 coming, the issue has been put to rest for the time being.
2. Global Tension: North Korea and Iran. The launch of rockets by Iran and North Korea as well as their nuclear interests have raised the potential that something might happen. Fears that Israel may act in Iran before the U.S. are rising.
3. Rebound in Commercial Aerospace. The global recession and the collapse of the financial system had little impact on defense spending but commercial activities suffered. With roughly 20% of the defense sector maintaining commercial aerospace operations, an improving economy is showing benefits. The first test flights and delivery of the Boeing 787 will an additional provide a boost to the sector.
4. Positive Press Over the Next Month from the Paris Air Show. The improving commercial sector be showcased at the mid-June Paris Air Show, the largest and most important show of its kind. Over the next several weeks hundreds of press releases and articles will be issued highlighting new contracts and new products. More than $50 billion worth of contract announcements are anticipated. In addition, rumor is that the Boeing 787 may make its maiden flight.
5. Declining Dollar is Positive for Exports. The United States has become a net importer of products; but one sector in which the U.S. has a positive trade balance is aerospace. With companies around the world still operating in a recessionary mindset, a weakening dollar offers a competitive advantage against global competitors.
6. Valuations Still Well Below Recent Levels. The market decline wiped out years of gains that took the sector through the dotcom bubble, the 9-11 attacks, and the wars in Iraq and Afghanistan. Today, valuations in the industry are at levels typically seen after a major decline in the defense budget with P/E, P/S, PEG, etc all bottoming earlier this year. Advance comments from several companies indicate that 2Q09 reports should continue to show healthy balance sheets.
7. Strength in the Satellite and Space Business. Like the defense sector, spending on satellite services did not see major declines over the past year and many firms are reporting steady revenue gains. Going forward, U.S. satellite manufacturers (such as Orbital Sciences (ORB), Lockheed Martin (LMT), Boeing (BA), General Dynamics (GD)) and other hardware and software providers (Integral Systems (ISYS), Moog (MOG.A), etc.) could benefit if a provision in the 2010 State Department Authorization Act passes turning satellite export review over to the Department of Commerce. Prior to the law change in 1998, the AIA states that 78% of communications satellites were U.S. made, whereas today it is 27%.
8. Rebound in the Economy to Put Less Pressure on Obama. Beginning with the FY-11 budget, the Obama administration will seek to reduce a number of spending programs in order to pay for new programs (such as health care) and pay down the debt generated from the stimulus and overcoming the financial crisis. Defense, as the largest discretionary budget item, is likely to come under pressure. Defense Secretary Gates and a number of members of Congress have already begun efforts to hold back any dramatic cuts. A recent article in the NY Times highlighted that rocket launches by North Korea have started to sway some in Congress toward the need for continued defense spending.
9. Leaks about the 2010 QDR. Lastly, between now and February 2010, there will be a number of leaks as the agency determines its strategic direction and acquisition plans for the rest of Obama‘s first term. We can anticipate that not every trial balloon that is flirted with will make it to the final version. It is likely, however, that these comments will lead to temporary moves in the market for the companies that might be impacted.
10. New Initiatives / Diversification. Defense companies have seen the future and have already begun positioning their firms to adapt to changes inside the Pentagon as well as to leverage their skills and technologies to meet the needs of customers outside the core defense sector. In addition, the cancellation of large multi-billion programs is opening up new opportunities to compete for new business against the former incumbent and new initiatives, such as cybersecurity, will see billions spent not only by DoD but other government agencies.

Comments

[TinyTim:]

Thanks, good points.
No wonder these guys are still hiring.

Jun 08 02:03 PM

[Pew:]

Man. I'm really hoping the 737 flies this Monday at the show. The number of TOTALLY negative headlines regarding the Air France show has got me really discouraged. See for yourself: after reading these headlines you'd think the event was a funeral for the aviation industry. Geeeze!

Well, I think it was Warren Buffet that said something to the effect that it's when things don't look so good that the real money in stock investing is made. Boy, I hope Boeing blows the socks off of these negative reporters! Maybe a fly-by of the 737 over the grandstands just as the press dirge away on camera. And then maybe an unexpected order for more planes from ??? The truth is: even if Boeing announces an unexpected order for 50 planes and flys the 737 next week, the press will pine away how the order was short of 60 and how the 737 is still riddled with problems. Ya think?

Jun 13 02:18 AM