Five Trends with Upside for Defense Industry

by: Scott Sacknoff

The SPADE Defense Index (DXS) continues to trend upward in spite of the five largest defense companies contributing subpar performance year-to-date.

Since what is referred to as the “Haynes bottom,” after CNBC host Mark Haynes’ call of a market bottom in March 2009, the SPADE Defense Index is up more than 44%. For the market chartist, the SPADE Defense Index has broken out from its moving averages.

  • Index on August 4th: 1688.46
  • 200 day moving avg: 1620.34
  • 70 day moving avg: 1582.09
  • 40 day moving avg: 1606.69

Trends that Could Move the Sector Higher
The pivotal event that will move the sector will be clarity from the Obama Administration and the Pentagon regarding their spending/budget plan for the next several years. We are not likely to get the specifics on the ongoing QDR or future (FY2011-FY2015) budgets for some time but it is likely that we will see two things:

  1. FY2010 was the peak (unless a new world destabilizing event occurs, with Iran and its nuclear efforts being one of them); and
  2. That future budgets will be much more stable than the massive declines that started at the end of the Bush I administration and extended through the Clinton administration. Already signs are emerging that a flat budget is the direction we are headed.

The FY-11 Budget

The military service (Army, Navy, Air Force) budget recommendations for FY-2011 are due to the Secretary of Defense in late August (2009) for initial review. As part of this, an estimated $50 - $60 billion worth of changes in existing programs are expected with the savings going toward new programs and initiatives. DoD (namely David Ochmanek, Deputy Assistant Secretary of Defense for Force Transformation and Resources) has stated that they are operating under a zero-growth initiative. Reading into this, one can make the assumption that the DoD budget will be flat and those forecasting significant budget declines will have to wait to future years of 2012 or beyond. Winners according to a intratheater cargo planes, UAVs, and countermine warfare systems with suggested losers as amphibious craft, heavily armored vehicles, and air defense systems. The fear of large budget declines has already been priced into the share prices of many defense sector companies and knowledge of future budgets can provide a positive upside.

News Events

Other near-term events with upside potential include:

  1. A split award for the $40 billion Air Force tanker program. A DoD request for new proposals is expected to be released by late September.
  2. The first test flight and the subsequent first delivery of the Boeing (NYSE:BA) 787.
  3. An announcement from Congress that the now-cancelled F-22 fighter will be allowed to be exported to U.S. allies, and thus continuing the program without DoD funds.
  4. Anticipated multi-billion awards from India for defense systems. In addition, continuation of the trend which has seen deals for the U.S. export of defense equipment and supplies surpass $40 billion annually.
  5. Announcements of initiatives / contract awards that take place in the end-of-budget year / September timeframe. These can have a significant impact on firms. For example, the aware of MRAP (mine resistance armored) vehicles for Afghanistan to Oshkosh Truck has sent the stock soaring, more than tripling since its lows and that of Force Protection, a competitor in the field, down by more than 40% in July. Likewise, a new $10 billion classified imagery satellite program could benefit satellite imagery firms such as DigitalGlobe (NYSE:DGI) and GeoEye (NASDAQ:GEOY) as well as other firms active in this area such as Lockheed Martin (NYSE:LMT) , ITT, and Ball Aerospace.

Downside Issues

But like every sector there are concerns. Congress is always an unknown and budget issues may force the hand of the White House and Congress to reduce spending across-theboard. Rising pension expenses is an issue facing several large companies in the sector, with Lockheed Martin, for one, announcing it affected its second quarter earnings. [A revitalized stock market should ameliorate this issue going forward.] Lastly news events, such as delays in or cancellation of programs, can have a nearterm impact even when it doesn’t affect overall company sales or earnings. Congress’ failure to approve additional funds to continue the F-22 was offset by F-35 spending, both Lockheed Martin programs, yet the company was impacted.) Even considering these, valuations remain attractive and there appears to be plenty of upside for investors to consider.

Scott Sacknoff is the Index Manager for the SPADE Defense Index. The Powershares Aerospace & Defense ETF (NYSEARCA:PPA) is an exchange traded fund that is designed to track the performance of this index.