Defense Sector: 10th Year of Outperformance?

The following is the author's commentary that appears in the September 2009 issue of "The SPADE Investor".

The Chase for Ten

Historically, aerospace and defense cycles can run 12-15 years. And for nine years running, the SPADE Defense Index has outperformed the broader markets. Even after huge gains by financial stocks since the March market bottom, defense stocks trailed the S&P 500 by just 3.5%at the end of August but have been making up ground lately.

A number of end-of-year events could aid the sector -- namely the start of a new government budget year, Boeing’s (BA) plans for the first test flight of the 787, and news that the QDR will show that future budgets will be flat and without major declines. All are positives.

Year-to-date, the stock performance of the sector has been dampened as investors speculate on what changes will appear in the QDR and we hit an anticipated peak in defense spending. In addition, twice as the market was beginning to climb higher, the run stalled based on the timing of news -- Boeing’s announcement shifting the 787 first flight schedule and Congress canceling one jet fighter program in favor of another.

As the defense budget is restructured and several large initiatives are canceled / delayed in favor of newer ones there is PR impact but “the devil should be in the details.”

For example, canceling the F-22 was big news and impacted the share price of Lockheed Martin but with the Pentagon’s plan to allocate dollar-for-dollar the resources to Lockheed’s (LMT) F-35 fighter, the real impact was less than the media promoted. Initiatives related to unmanned vehicles, cybersecurity, persistent surveillance, etc. continue to provide opportunities for new business and increased competition.

Still after nine years of outperformance, the question for investors of course is, can the Index continue its run in what has been a negative news year. A third of the year remains and there are signs that the next few months could be a positive one for aerospace and defense companies.

All’s Quiet on the Analyst Front

As the sector awaits firm news from the QDR and future budget details, investment analysts covering the sector have been very quiet. A search for recent analyst forecasts or comments on the sector revealed little.

Here are two that we found:

Douglas Harned of Bernstein Research raised price targets on several aerospace firms stating that,

Rising demand could help establish a recovery more quickly than in previous downturns...unlike previous periods when airlines placed orders after one year of profitability, orders now are already in place and the market is grappling with less excess capacity. Backlogs are now double what they were at similar points in earlier cycle.

Ryan Fuhrmann, CFA, stated,

In today’s stock market, defense is one of the few industries where investors can find appealing valuations and solid underlying business fundamentals to move portfolios forward.

Market Drivers

While the U.S. budget will likely be in a holding pattern with outside pressures upon it, long-term stability (ie. flat budgets) are seen with growth coming from international markets, new opportunities, and non-core defense business.

• New opportunities in persistent surveillance, UAVs, C4ISR, cybersecurity, homeland security, bunker busters, new fighter and tanker program opportunities, armored vehicles, and lasers.
• Growth from international markets and increased forecast as export restrictions loosen.
• Growth in new and and non-traditional defense business lines.
• Shift into the manufacturing phase for new aircraft including the 787 and future derivatives; theF-35 fighter, Air Force tanker, etc.; and a reboundfrom the bottom for companies exposed to thesmall aircraft market (ie. GD, TXT) as the economy improves and homeland security needs expand.
• An increased focus on technology that keeps people and equipment further out of harm’s way and helps the military more rapidly deploy.

Technicals / Fundamentals Remain Strong

Technicals

At 1726.68 the SPADE Defense Index and the Powershares Aerospace & Defense ETF(PPA) at $15.42 remain above their 21-day moving average ($15.04), 40-day moving average ($14.74), and 200-day moving average ($14.41).

Fundamentals

• 70.87% of the Index has a P/S <1
• 33.46% of the Index has a P/E <10
• 88.92% of the Index has a P/E <14
• 61.05% of the Index has a PEG <1.25

YTD, only five are negative for the year -- Lockheed Martin, Raytheon (RTN), SAIC (SAI), Harris (HRS), and FLIR.

• 17 of the 20 largest companies in the Index have a P/E <14.
• 14/20 have a P/S <1.0
• 12/20 have a PEGs <1.2

The Upcoming News Cycle

Even the trade press has drifted into the summer doldrums. As we enter the final third of the year, we think there will be increased activity.

1. September: Less than past years, but we still anticipate a number of end-of-the-year contracts will be let. In addition, the re-launch of the $35 billion tanker contract should be announced.
2. October: The new fiscal budget year begins, expect a number of contract announcements.
3. 2010 QDR details and proposed spending: Word on the street is leaking that the quadrennial defense review will reveal that the budget will be flat for the next two years with no large declines, although what programs will receive money will change. Procurement is to remain greater than $100 billion annually.
4. The first test flight of the Boeing 787 (we believe this will really happen without any additional slips): Many defense companies have great exposure to commercial aerospace and this will affect a number of companies besides Boeing (eg. Precision Castparts (PCP), Goodrich (GR), Moog (MOG.A), etc.)