President Obama's Defense Plans: Sell, Buy Or Hold?

Includes: BA, GD, LMT, NOC, PPA, RTN
by: Scott Sacknoff

President Obama spoke from the Department of Defense on January 5, 2012, along with Defense Secretary Leon Panetta. In advance of the release of the FY-2013 budget, the White House and Pentagon spent time performing a defense review and defining the Joint Force of 2020.

As part of this, the goal was to reshape strategy and force structure to meet the security needs seen today and in the future. This includes:

  1. Maintaining the world's finest military and America's place and role in the world
  2. Avoiding hollowing out our military capabilities
  3. Savings in a balanced manner, with everything on the table and many recommendations that will face opposition; and
  4. To preserve the quality of an all-reserve force (ie. no draft)

Ultimately, the above goals were not a surprise and the speeches provided a philosophical strategy whose shift was already under way. There were some key points that were made though.

Below are my notes from what I heard in the two speeches and what it means for those investing in defense companies such as Lockheed Martin (NYSE: LMT), General Dynamics (NYSE: GD), Raytheon (NYSE: RTN), Northrop Grumman (NYSE: NOC), Boeing (NYSE: BA), and the 50-odd companies that comprise the Powershares Aerospace & Defense ETF (NYSE: PPA).

Although $487 billion over the next 10 years will be cut from future defense budgets and plans, this is not as severe as the worst-case scenarios called for by some opponents.

Money will shift into investing in technology and systems, with savings coming from a reduction in personnel within the Army and Marines . This is good news for defense contractors as it implies cost savings will come from non-purchasing accounts.

The U.S. Joint Force will be smaller and leaner; more agile and flexible for quick deployment using the most advanced technology. This confirms plans that reduce the size of the active Army and Marines; increase investments in to the Special Forces; an increasing shift toward using reserve forces in times of need for missions instead of relying on mostly active forces; and shifting skills formerly used by special operations forces (using UAVs, reconnaissance missions, etc.) to the mainstream military.

Shifting the strategy from being able to fight two major ground wars at the same time to being able to fight several smaller threats at once. The goal is to get in, execute a mission, and get out. Think about missions more like Seal Team 6 taking out Osama bin Laden than Iraq where we stayed to help secure and rebuild a country. Take care of what is needed, get out, and let the locals manage their own affairs while keeping a watchful eye on them from a distance and coming back if needed.

Keeping technology at the cutting edge and increasing investments. Cyberspace, space, C4ISR, and UAVs were mentioned specifically. These are all markets where companies have been making acquisitions to get in. They are the higher growth areas of the defense business. Compared with other ETFs, only PPA, which tracks our benchmark SPADE Defense Index, contains the non-manufacturing companies involved with cyberspace, space, and C4ISR.

Focusing on Asia and the Middle East -- areas of growing importance to the U.S. economy and the source of the biggest perceived threats.

The next budget will feature investments in new capabilities to "maintain a decisive edge" and tradeoffs from existing programs into new ones. This was anticipated by analysts and we've already seen some of this over the past year.

Lastly, and most importantly, President Obama said that the sector would see budget declines from what was forecasted but that actual dollars would rise (probably in inflated dollars not in real-dollar terms), and that the sector would not decline to pre-9/11 levels.This would be very good news for all companies operating in the sector.

Ultimately, not much of what was said was a shock to those who follow the sector. Strategically, the shifts that were detailed by President Obama and Secretary Panetta was under way.

From an investor standpoint, over the coming months and beyond the November elections, there will be increasing news flow on the defense sector and this will create some volatility. When the FY-13 budget comes out, on a program-by-program level there will be winners and losers; but from a company and sector standpoint, it appears that what was said in this press conference was mostly a positive. The President essentially put in a floor by stating that defense is important and while some cuts may occur, significant cuts will not happen.

Although budget risk to the sector remains, valuations in the sector remain well below the broader market. In addition, commercial aerospace is entering a multi-year bull market, defense companies continue to increase their dividends and share buybacks, and if President Obama has truly put in a floor on future defense cuts, then investors may find the sector increasingly more attractive than they did before his speech.

Disclosure: The author manages the SPADE Defense Index (NYSE: DXS), an investment benchmark for companies operating in the defense and homeland security sector. DXS serves as the underlying index for the Powershares Aerospace & Defense ETF (NYSE: PPA).

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