By Keith Fitz-Gerald
While many investors are focused on the roles that Google Inc. (NASDAQ:GOOG) and Twitter played during Egypt's recent turmoil, I immediately zeroed in on all the American-made military hardware that exists in that region - and began to analyze the risk that investors face if the U.S. defense industry quite literally bet on the wrong horse.
Between 2006 and 2009, we sold more than $50 billion worth of weapons systems and related hardware to Middle East nations, according to the Congressional Research Service. The value of annual military contracts in the region has quadrupled since 2000, according to CNN.com.
And it doesn't look like things are slowing down - at least, not yet.
Impact of the "Obama Arms Bazaar"
Since U.S. President Barack Obama took office, there's been a major acceleration in the sales of frontline fighter jets, tanks and other U.S.-made hardware and weapons systems being sold overseas. According to the Defense Security Cooperation Agency (DSCA), worldwide sales zoomed from $18 billion in 2006 to $30.7 billion in 2009.
In 2009 and 2010, the U.S. Department of Defense notified Congress that weapons sales to foreign buyers could reach as much as $100 billion - almost an eightfold increase from the $13 billion that was the yearly norm from 1995 to 2005, Deutsche Bank AG (NYSE:DB) analyst Myles Walton told CNNMoney.com.
As a rule of thumb, those congressional notifications are more likely to translate into $50 billion to $70 billion in actual sales. About half of those deals are done with customer countries in the Middle East.
"There is an Obama arms bazaar going on," Arms Control Association Deputy Director Jeff Abramson told CNNMoney.
While the biggest buyers are countries such as the United Arab Emirates (UAE) and Saudi Arabia, Egypt accounted for about $2 billion worth of deals all by itself in 2009 - including one calling for the purchase of 24 F-16 "Fighting Falcon" fighter jets. This means that Egypt is second only to Israel in terms of equipment purchased and foreign "aid," which is how most of this stuff gets sold. Frequently, it's hard to separate the two, especially when the amounts of money are so large.
A case in point: The U.S. forked over $250 million in economic aid to Egypt, while sending 5.2 times that amount, or $1.3 billion, to that country's military in 2010 alone. Similar amounts are requested for this year and 2012.
But here's where this big recent run-up in foreign military sales starts to get a bit sticky: Many of the Middle East countries now experiencing unrest - including Tunisia, Jordan, Bahrain and even the UAE, to name just a few - are apparently the same nations that the United States has been supplying.
This raises two questions - in my mind, anyway:
- What happens to all of that hardware if the customers (the regimes) who bought it are quite literally thrown out of office like Mubarak was recently?
- And what are the risks to such major U.S. defense contractors like Lockheed Martin Corp. (NYSE:LMT), The Boeing Co. (NYSE:BA), Raytheon Co. (NYSE:RTN), and others if a newly formed regime turns hostile?
The answers may surprise you: The fallout from an ousted regime is not what you might expect; and neither are the risks.
If a regime that's a U.S. defense-industry customer gets overthrown or ousted, the United States doesn't just get to take the hardware or weapons-systems back, says Pieter D. Wezeman, a senior researcher with the Stockholm International Peace Research Institute. Instead, "the new regime would just inherit them" - much like Iran inherited dozens of the then-frontline F-14 "Tomcat" fighter jets back in 1979, when the Shah was overthrown as part of the Iranian Revolution, which enabled the Ayatollah Ruhollah Khomeini to come to power.
Since then, our government has spent hundreds of millions of dollars rounding up repair parts and destroying them - just to make sure that the now-retired (but militarily still lethal) Tomcats can't keep flying.
Unfortunately, despots are as inventive as they are opportunistic, which is why Iran reportedly still fields some 20 to 30 F-14 Tomcats that are virtually identical to the "Top Gun" fighter that was flown until very recently by the best-of-the-best in the U.S. Navy.
Moreover, rumors persist that the remaining Iranian F-14s are now equipped with Russian engines and radar that can keep them flying for a while longer.
Worker, Budget and Earnings Worries?
Aside from the security concerns, there are also economic worries. There are roughly 3 million people who work in the U.S. defense sector, according to the U.S. Bureau of Labor Statistics (BLS), which means any regime change "over there" could put the squeeze on our work force right here at home.
As recently as 2007, four of the world's five top defense firms and seven of the Top 10 were U.S. companies, says Richard A. Bitzinger, author of "The Modern Defense Industry." What's more, U.S. defense firms regularly capture more than 50% to 60% of the worldwide off-the-shelf arms sales.
Many analysts argue that overseas contract risks are not all that significant because overseas arms sales typically represent less than 20% of revenue for such firms as Lockheed Martin and Boeing. But analysts who make such arguments are out of touch with looming major shifts.
In the 10 years since 2001, U.S. defense spending has more than doubled - to $725 billion for the current fiscal year. That's roughly what is spent by every other country on earth - if you add all of their defense budgets together.
Now, with the fiscal 2012 budget out on the table and up for debate - and with budget deficits, the burgeoning national debt and the federal-debt ceiling exacerbating existing fears about the nation's long-term viability - a new "need-to-cut" sentiment is going to take hold in Washington.
Lawmakers are loath to cut sensitive entitlement programs - such as Social Security and Medicare/Medicaid - even though they account for about 60% of annual federal spending. That doesn't exactly leave cut-happy legislators a "target-rich" environment. So they'll go after defense spending, which only accounts for roughly 19% of the budget (if we're talking about DoD spending only), since that's politically much easier to paint with a "bad-guy" brush (an odd irony, since many of those weapons systems actually arm the very "good guys" whose job it is to protect us).
This newfound thriftiness regarding U.S. defense spending means two things for U.S. defense contractors:
- First, the overseas sales the afore mentioned analysts dismiss as irrelevant will take on an even greater importance as these companies (most of them publicly traded), work to maintain sales-and-earnings growth in order to keep their shareholders happy.
- And these firms may have to work harder to control their costs, which in most cases is a euphemism for slashing headcount. With unemployment still well above 9%, a major cost-cutting push by a sector that employs 3 million people won't be good for the U.S. recovery.
What to Watch For
Indeed, as our government has been so rudely reminded during the ongoing financial crisis, unemployment and underemployment can create a vicious circle that stretches far beyond lost wages. So budget cuts at home, combined with regime overthrows that lead to lost sales and lost markets abroad, may have a material impact on the U.S. economic rebound - and on U.S. stock prices.
Not all these companies are U.S.-based, meaning that - in terms of those stock prices - some are more vulnerable than others. But they all have U.S. workers. And they will all clearly be watching the events in Egypt as they unfold - and looking for possible fallout in other Middle East markets.
Here are some companies that have existing contracts with that country, according to the Department of Defense contract database:
- Lockheed Martin Corp. (LMT): This aerospace giant - which forged its reputation for building the red-hot P-38 "Lightning" twin-engine fighter back in World War II - just won a $213 million U.S. Air Force contract for Egypt's border- patrol program and a $46 million U.S. Army contract that provides night-vision technology for Egypt's Boeing-built AH-64 Apache helicopters.
- DRS C3 & Aviation Co.: A U.S. subsidiary of Italy's Finmeccanica SpA, DRS C3 & Aviation Co. is providing the Egyptian- border- patrol program with vehicles, equipment and logistic services - to the tune of $46.1 million - while also handling a separate $19.6 million Army contract for surveillance hardware.
- L3 Communication Holdings Inc. (NYSE:LLL) L3's Ocean Systems unit recently took on a $24.7 million Navy contract for sonar that's to be provided to the Egyptian Navy, and a $6.6 million Army contract for imaging equipment that's to be provided to Egypt's Army.
- Deloitte Consulting LLP: A consulting-industry heavyweight, the privately held Deloitte Consulting is involved in a $28.1 million Navy contract to provide planning and support for various Egyptian aircraft programs.
- The Boeing Co. (BA): The dean of the U.S. aerospace industry, Boeing is working on a $22.5 million Army contract that provides Egypt's Army with 10 Apache helicopters, as well as a $5.8 million Navy contract providing logistical support to Egypt - and to other nations in the region.
The timing couldn't be worse, given that U.S. federal budget and government-debt problems are certain to push along efforts to cut domestic U.S. defense spending. In other years, that would prompt U.S. firms to step up their sales efforts abroad. But additional regime changes overseas could block such efforts, leaving U.S. firms to cut costs - meaning workers - to keep lean and fit enough to keep shareholders happy.
It's obviously too soon to say who - if anyone - will be affected, or by how much. So right now, the best advice to follow is this: If you own any U.S. defense stocks, immediately consider placing very tight "protective stops" to protect your investments.