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(As I get ready to post this, its just been announced that Defense Secretary Gates will announce later this week the results of his previously announced plans to find $100 billion in savings. Among the programs reported to be on the block are the Expeditionary Fighting Vehicle, a 40-ton amphibious landing craft being developed for the Marine Corps by General Dynamics (NYSE:GD); a medium air-to-air missile being developed by Raytheon Co (NYSE:RTN); and a further restructuring of the Lockheed Martin (NYSE:LMT) F-35 Joint Strike Fighter that could extend the program's development phase by up to two years. Republicans in the House of Representatives have reiterated their calls this morning for 20% cuts in most government agencies for 2011 -- except defense -- however Senate Republicans have not said they are on board with the plan. Neither of these news items impact our comments below).

Interesting Fact: Every constituent in the SPADE Defense Index was positive during the month of December 2010. This is the first time this has happened.

(Click to enlarge)

End of Year Summary

If the goal of an investor is to beat the benchmark, which for the aerospace and defense sector is the SPADE Defense Index (DXS), then in 2010 most investors failed. Investors who wanted to gain exposure to the defense sector by simply buying one of the large prime contractors – Lockheed Martin, General Dynamics, Raytheon, L-3 (NYSE:LLL), etc. were proven wrong as the mid- and small-caps dominated gains in 2010. The exception was Boeing (NYSE:BA) which had a year marked by ups and downs but finished substantially higher and Northrop Grumman (NYSE:NOC) whose announcement to sell its shipbuilding operation was met favorably. Overall, investors who purchased shares of a sector ETF, like the Powershares Aerospace & Defense ETF (NYSEARCA:PPA) which gained 9.6% during the year, benefited from the added diversification that it provides.

Overall, the sector trailed the Dow by 1.4% and the S&P 500 by 3.17%, the first notable underperformance since the index was launched in 1998. However, considering the negative news cycle on defense, in particular relating to an anticipated decline in the defense budget in the face of mounting federal deficits, and the fact that the defense sector still managed nearly double-digit gains, the gains likely surprised some financial analysts. With the exception of August, which saw the sector underperform by nearly 4% (on no specific news), the aerospace and defense sector would have outperformed the market.


Mergers & Acquisition

As companies seek to position themselves, nearly 20% of the SPADE Defense Index was acquired or is pending acquisition during 2010. Statistically, the sector saw several hundred deals although most were smaller sized. Multi-billion deals were few. Index constituents that were acquired: Argon ST (STST-OLD), Cogent (COGT), Dyncorp (DCP), ICX Technologies (ICXT), and Stanley (SXE). Companies whose acquisition were announced but are pending include: L1 Identity (NYSE:ID), Applied Signal (APSG), Ladish (NASDAQ:LDSH), and CPI International (CPII).

Forecast for 2011

The sector’s 9.62% gain in 2010 should not be a surprise to those that follow the sector considering the underlying fundamentals and technicals which have seen the index consistently above the 50-day and 200-day moving averages. Defense companies end the year with a record amount of cash on hand and have been making acquisitions to position themselves into higher growth areas of their business or into adjacent areas that can generate revenues and profits in the coming years.

Combined with an economy that has been rebounding since the 2008-2009 lows -- which has led to increased manufacturing activity, increased exports, the beginnings of a multi-year expansion in the commercial aerospace segment, and a high level of global security issues -- and the companies operating in the sector remain in a position where the strengths may counteract the negatives.

In fact, a number of executives in the most recent quarterly reporting period issued positive comments for 2011 and several analysts have forecasted that companies such as Lockheed Martin, which underperformed in 2010, should see a rebound in their shares later in 2011 and 2012.

It is our belief that the sector is much more stable than it is given credit for and while issues equate defense sector cuts with deficit reduction will likely impact the perceptions among the investor universe and impact some companies more than others, a long-term structural impact similar to the 1990s is unlikely. We base this belief on the following:

  1. Forecasted cuts in the defense budget are not likely to begin and take effect until October 2011 with the FY-12 budget; although there is an extremely low outside chance that the FY-11 budget (which has still not been passed) may see some changes when the incoming Congress arrives in January. Going forward, while the deficit and the national debt remain high priorities in the rhetoric of the campaign trail and on Capitol Hill, the reality is that Congress has become increasingly partisan in recent years. The likelihood that dramatic deficit reduction changes to the budget will take place is far from guaranteed and would mean the two parties actually cooperating on a very sensitive issue -- namely how much should be spent on national security. Is there waste that can be cut? Absolutely. Can we expect to see some restructuring in how DoD spends its money. Absolutely. The real question is what the impact of these changes will have on companies operating in the sector.
  2. We’ve seen this picture before ... fundamentally, the sector remains in a much stronger position than it did during the spending decline that took place in the early 1990s following the end of the Cold War. Many firms operating at that time were caught off guard a bit as the changes took place rapidly. This led to significant declines in the share prices of many companies and the mergers or acquisition between them as the defense industrial base found it necessary to reshape itself over the next decade. The current batch of sector executives worked in the sector at the time and saw the impact of what the cuts meant. The lessons learned from the period are still fresh in their minds. Knowledge that the defense budget, in or around FY-11, was set to peak has been known for the past several years, giving industry executives the time to build-up their balance sheets, make acquisitions, and restructure their operations. Aerospace and defense companies today, as a whole, have historic levels of cash on hand and extremely low debt levels. Firms have also been repositioning for the new defense environment by acquiring or expanding into commercial and non-defense adjacent markets -- markets that often have higher margins and hence increased profitability as compared to defense weapons systems. Commercial aircraft, helicopters; air, sea, and land robotics, and IT services; to name but a few.
  3. Increased marketing to global customers is being pushed by the White House who supported marketing aerospace products overseas and making long overdue changes to export licensing procedures. This is highlighted by the recent $60 billion deal to sell defense products to Saudi Arabia. Dozens of other multi-billion dollar deals have also been announced, approved by Congress, or are in process.
  4. Most defense firms are highly diversified, participating in numerous defense and commercial programs. Individual programs typically account for less than 5% of overall revenues; so cuts may impact a firm but not cause its collapse. Most of the firms in the SPADE Defense Index report that they receive less than 5% of their revenues from the war effort.

Challenges

The $100 billion a year reduction being floated is a big number. What has yet to be decided though are the specifics of where it will come from. A number of forecasts indicate that a large percentage could come from savings in health care, pensions and staff/support reductions. The likelihood that a large weapons system will be canceled is high -- if nothing more than as a symbolic measure. The likelihood that some systems in development are contracted or their schedules delayed to save money and that it is contracted to one of the big five prime contractors is also very high. However, investors will need to estimate what the budget decline means verses the sector’s positives (ie. the expansion in their commercial operations where they have increased margins and their entry into new higher growth activities).

This is the big challenge to investors in 2011 and 2012. Can revenues, earnings and margins overcome the negative budget news cycle? How well have the individual firms executed their strategy and how easy will they move through this period with less bumps than the early '90s?

A key is to not let those who talk about defense cycles influence your thinking. Today IS different. Past cycles have been defined by the development and the use of systems or war/post-war budgets. The U.S. may be exiting wars in Iraq and Afghanistan but previous declines have been marked by a more peaceful climate. The 1990s “peace dividend” followed the Cold War and the early '70s decline was post-Vietnam, etc. While enemies in the world remained (ie. Soviet Union in the late-1940s to early-1950s, post WWII) the immediate threat was less than the one we just faced. Today, that is not true. Terrorism still exists. Iraq, North Korea, and others are developing and flexing their nuclear muscles. China is a growing unknown. The threat today is equal or greater than what we’ve just faced. Doubt it? Just listen to the number of analysts on CNBC who predict 2011 will see a major cyberterrorist attack.

So what should investors do? It is my belief that 2% - 5% of one’s domestic allocation be in the defense sector -- at the high level it reflects the U.S. GDP share of the aerospace and defense sector, at the low, the amount the S&P500 underweights the sector. Consider it as insurance that since 1998 it has beaten or equaled the broader market or, in the case of last year, provided nearly a double-digit gain in what was considered a down year for the sector.

Source: Defense Sector Strengths Will Outweigh Negatives in 2011

Additional disclosure: I manage the SPADE Defense Index which serves as the underlying index to the Powershares Aerospace & Defense ETF (PPA).