Don't Forget about Aerospace and Defense

Includes: BA, DCP, PPA, STST-OLD
by: Scott Sacknoff
  • More than 60% of companies have a price-to-sales ratio under 1.0.
  • More than 60% have a price-to-equity ratio well under 14 and many under 10.
  • Even in the worst recession in decades, the sector contributes a positive trade balance and produces billions in net exports.
  • The sector has declined from its April 2010 peak by 18.06% and is 33.48% from its all-time close (tracking the market's decline) --but this after a gain of 166.81% over the past decade
  • If you had invested $10,000 in 2000 in the A&D sector you’d still have $17,749 today vs. just $7,011 if you invested in a fund tracking the S&P 500 (ex dividends).
  • Customers around the globe continue to need and desire its product.
  • Considering the sector generates roughly 5% of U.S. GDP, investors are significantly underweight
If we weren’t talking about aerospace and defense and this was any other sector, CNBC’s analysts on Fast Money would be hyping the sector and Jim Cramer would be pushing the companies day after day. The reality, though, is that the sector continues to be largely ignored by the financial press.
When it is mentioned, the focus has been on the cost savings efforts by the Pentagon and potential budget cuts. However as most analysts will tell you, the impact of these is an unknown and the impact on any individual companies is even more unknown. It is why companies have spent the past several years planning for what is to come -- building cash reserves, making acquisitions, cutting internal costs, reorganizing operations, promoting foreign sales, and targeting adjacent markets -- all designed to make them healthier and positioned to grow regardless of any changes to the Pentagon’s plans. In spite of this environment and the global economic troubles, companies operating in the sector have thrived compared to the troubles faced by firms in other sectors. As Antonie Boessenkool said in the June 28, 2010 Defense News: “For years defense contractors girded for military spending cuts that largely failed to materialize.”
For the most part, companies in the sector continue to report robust revenues with stable profit margins, have paid their dividends without interruptions; and generally equalling or bettering the performance of the broader stock market for more than a decade. If you had invested $10,000 at the turn of the century in the defense sector you’d still have $17,749 today vs. just $7,011 if you invested in a fund tracking the S&P 500 (ex dividends).
After a cycle which saw the benchmark SPADE Defense Index (licensed for the Powershares Aerospace & Defense ETF - PPA) beat the S&P500 by more than 10% in 6 of 8 years, growth has slowed, but investors still remain significantly underweight in a sector that represents an estimated 5% of U.S. GDP. It is a sector whose “product” continues to see growth internationally -- both from commercial and government customers.
One of the hardest things to do as an investor, and I speak from personal experience, is separate the facts from the market reaction. Positive developments sometimes are met with market dips against all rational wisdom. In the short-term, sometimes the chart-action is more important than the underlying fundamentals. For investors, at the end of the day, it's performance that should matter and the noise (blogs, speculations, opinions) should be just noise and work itself out over time. Even after five years of what will happen “after we pull out of Iraq; when budgets get cut; when (fill in the blank with your own worries)”, the Aerospace & Defense sector has held-up remarkably well to the negative speculation. As the media focuses on the latest restructuring plans and potential cuts, the impact of which remains unknown but not necessarily a negative, here are some things to consider.
  • Turmoil around the globe continues to present an obstacle to world stability and presents opportunities for investors. Global defense spending continues to rise (as do U.S. exports) reaching $1.53 Trillion in 2009, up 6% in real terms and 49% higher than 2000, as 14 of the 15 largest buyers increasing spending in 2009 according to SIPRI. Overall, there were 17 major armed conflicts including Columbia, the Congo, Philippines, and Somalia. As the report indicated: “While some greater stability came to Iraq, conditions worsened in Afghanistan and violence in Pakistan’s Swat Valley region escalated.”
  • Increased M&A activity continued with the Boeing (NYSE:BA) acquisition of SPADE Defense Index constituent Argon ST (STST-OLD) on June 30th for approximately $775 million in cash. Boeing’s offer of $34.50 was a 41% premium to the previous closing price. The deal is expected to close in the third quarter and Argon will operate as a standalone subsidiary. In addition, investors in index constituent DynCorp (DCP) approved its acquisition by Cerberus Capital Management, a private equity firm, for $1.5 billion including debt. Closing is expected July 7th. A private equity investment is usually a sign that the firm and/or a sector is undervalued.
  • Acquisition reform by the Pentagon is being undertaken to save an estimated $100 billion over the next several years -- money the agency wants to appropriate toward investments in equipment and services INCREASING the total market available for organizations to bid on. Additional efforts by the Pentagon may eliminate programs and contracts to reduce the procurement waste that currently exists. A separate proposal for 10% declines in defense-related spending is likely to be fought furiously by Congressional members who for the most part support the sector, the jobs it brings to their states, and forget soccer moms, retired military is the largest voting demographic in the U.S.
  • Aerospace Expansion -- The Boeing 787 will make an appearance at the Farnborough Air Show and is on schedule for its first deliveries by year-end. Aerospace firms including Moog, Precision Castparts, and Honeywell among them will be ramping up to meet production quotas by year-end. Meanwhile, Boeing has also increased production of the 737, a second time since May to meet demand; its 747-8 freighter has been approved for test flights by the FAA; and its 747-8 Intercontinental, a new version of the jumbo jet began assembly of its fuselage, with Air China buying 20 of the planes for $1.4 billion.
  • The World Trade Organization rules that European governments were providing improper subsidies to Airbus, Boeing’s main competitor, in the form of government loans and below market interest rates. (Are any of us surprised that government’s intervene in this manner or that it got caught?) Anyway, although it is likely the EU will appeal this decision, it could provide the means to sway the Pentagon toward giving the $35B - $40B contract for refueling tankers to Boeing after a multi-year battle. (to be decided in November).
  • As European nations focus on resolving budget issues, declines in defense spending are likely to increased purchases from their U.S. allies instead of pursuing expensive development efforts.
  • Cybersecurity - The Chicago Tribune reported that the Pentagon faces as many as 250,000 efforts per hour to attack its systems... any wonder why this is such a hot topic at DoD?
  • The Farborough Air Show - Late in July, a number of press releases will hit the wires detailing contracts and agreements signed by companies at this major, bi-annual global event.
Valuations - Powershares Aerospace & Defense ETF (NYSEARCA:PPA) holdings
P/S: 35 companies less than 1.0 with 13 less than 0.5
P/E: 33 companies less than 13
P/B: 7 companies less than 1.0 and an additional 33 less than 2.0
PEG: 18 companies less than 1.0 with 38 less than 1.50
Disclosure: No positions.