Notes on the Defense Industry and Stocks

$190 Billion Request for the War Effort

During September, the month Defense Secretary Robert Gates asked Congress for nearly $190 billion to pay for the war effort in Iraq and Afghanistan. This adds an additional $42 billion to the administration’s initial request of $141.7 billion earlier this year. Of this amount, $11 billion would be used to pay for additional armored vehicles to protect troops from roadside bombs.

Executive Comments from the Morgan Stanley Investor Conference

Raytheon (RTN) said it expects more sales to Middle East and Asia countries in the next three years due to a stronger petrodollar and the perception of a more intimidating China. According to CEO William Swanson, the firm receives between 18% to 19% of its revenue from overseas sales but this could climb to as much as 25% over the next 5 years. Swanson also said that the upcoming U.S. military reset* will be a big number for the company.

Northrop Grumman’s (NOC) COO Wesley Bush says that they see “very, very strong support for a solid defense budget" in both the Republican and Democrat parties. This is driven by the perception that there is a growing number of external threats and a need by DoD to improve the military's information technology.

Are Rules for Export Restrictions Lightening?

The U.S. and Australia have agreed to loosen restrictions on sales of U.S. armaments to Australia. Once finalized, the treaty will allow prescreened firms to export approved defense technology to Australia without going through the current licensing process. Instead, the firms will notify the State Department that the sale has taken place. The treaty must still be approved by the Senate.

Defense News in a recent article stated that defense contractors have long chafed at the lengthy licensing process required to secure the right to export military hardware and technology. According to Jeremiah Gertler, vice president for defense and international affairs at the Aerospace Industries Association, "the administration has welcomed suggestions for change [and] there is openness to reform. The reality is that companies in other countries are offering defense technologies to interested parties around the world. The U.S. sees an advantage to arming its allies and any efforts to reduce the cumbersome burden of export licensing of military technology would be a boon to defense companies.

Market Estimate - Commercial Aerospace

At the Latin America Airfinance Conference in Rio de Janeiro, Boeing (BA) predicted that the region’s airlines will need 1,730 airplanes worth $120 billion over the next 20 years as air travel in the region grows roughly 6.6% above the world average of 5%. Over the next 20 years 80% of planes delivered to the region will be single-aisle jets with 90 seats or more; planes with 200 to 400 seats are expected to make up 12%, and regional jets with fewer than 90 seats, 8%. Jumbo jets such as the Boeing 747 or Airbus A380 will be less than 1%.

Homeland Security Market

Industry executives and analysts estimate the U.S. market is valued at upward of $140 billion over the next five years. Foreign orders for equipment and services ranging from border security to cargo screening equipment could generate an additional $100 billion in sales in coming years. The Bush administration's $61 billion homeland security request for FY-08 "effectively quadrupled" the $16 billion spending of FY-00. This amount includes the budget for the Department of Homeland Security (DHS) as well as salaries for airport screeners and homeland defense spending by the U.S. military. Purchases of hardware, software, and services are picking up as priorities are established. Tim Josiah, Raytheon’s VPfor homeland security stated that, "Raytheon absolutely sees homeland security as a growth market, as an adjacent market to its principal defense marketplace. We are five years into a pretty intensive focus on this market area."

Support for NASA Remains Strong

The September 10th Houston Chronicle stated that congressional support remains strong even with NASA’s recent spate of bad publicity related to its astronaut core. Capitol Hill proposed funding the agency at levels exceeding the $17.3 billion requested by the White House with the House approving a $17.8 billion this summer and the Senate Appropriations Committee passing its version of NASA’s budget at $17.5 billion.

India a Top Market for Defense Contractors

Per the New York Times, military analysts expect India to spend $40 billion over the next five years on weapons procurement, making it one of the largest military markets in the world. Historically, Russia has supplied India’s military hardware. U.S. success in this market will depend on political relations and building partnerships.

Infotech as Future Growth Area

Lockheed Martin CEO, Robert Stevens, stated in September to the Wall Street Journal that the firm is shifting more of its resources to information technologies in an effort to diversify, support more of the federal government, and keep ahead of a projected decline in defense spending as the war in Iraq eventually winds down.

Billion Dollar Contracts

The Air Force will be awarding a $40 billion contract for 179 refueling tankers as early as December. The contract could be the first installment of a deal for 500 planes worth up to $100 billion. As much as $15 billion could be spent over five years through the contract to provide equipment, material and services to DoD’s Counter- Narcoterrorism Technology Program Office. The firms are: Arinc, Lockheed Martin (LMT), Raytheon (RTN) Technical Services, Northrop Grumman (NOC) Information Technology and Blackwater.

Honeywell (HON) will provide the major mechanical systems for Airbus' A350 aircraft including an auxiliary power unit and other equipment to supply pneumatic and electric power for the aircraft while on the ground or in flight, as well as environmental systems. Historically, Airbus would have done this inhouse. The contract is worth more than $16 billion over 20 to 25 years.

Raytheon (RTN) won a nearly $1 billion Navy contract for engineering and production work for the new DDG 1000 Zumwalt-class destroyer. The contract had been widely anticipated since 2005, when Raytheon beat out rival Lockheed Martin (LMT) to become the prime contractor for the radar, sonar, communications,and electronics gear on the destroyer. It was delayed while Raytheon continued to develop needed designs.

Boeing (BA) received a $1.1 billion contract for maintenance services for the KC-135 midair refueling tanker.

An ITT (ITT) -led team won a $1.8 billion FAA contract to start Air Traffic Control System. The team, which includes, SAIC (SAI) and AT&T., will build the first portion of a new satellite-based air traffic control system. The system will eventually replace the current radar-based air traffic control, providing a safer and more efficient way to guide planes through American airspace. ITT's contract should be complete by 2013. The full upgrade will cost more than $15 billion and take nearly 20 years to put in place.

Computer Sciences Raytheon, a joint venture of Computer Sciences (CSC) and Raytheon, won a $816.2 million DoD contract for space launch services. The GAO rejected a protest by Raytheon allowing L-3 Communications (LLL) to continue in its lead role in the $2 billion contract to produce at least 78 C-27J Spartan propeller-driven aircraft.

Mergers & Acquisitions

ITT (ITT) agreed to acquire EDO Corp. for $1.4 billion in a deal that will expand ITT's defense holdings. Both companies are constituents of the SPADE Defense Index. ITT will pay $56 for each EDO share (an 8.7% premium) and includes $120 million in debt and the anticipated conversion of convertible notes.

Additions and Subtractions to Index

On September 27, 2007, the SPADE Defense Index performed its quarterly review. The additions and subtractions to the Index are as follows:

Additions: GeoEye (NASDQ: GEOY): The company operates several satellites and produces and distributes high-resolution imagery to the military, intelligence community, and commercial customers. Ducommun (NYSE: DCO): The company manufactures components for military and commercial aircraft and space programs.

Subtractions: DirecTV (NYSE: DTV) and Echostar (NASDQ: DISH) - Both companies have invested billions in space systems which in turn helped to support the military space industrial base that builds and launches satellites for government customers. With the bulk of their space infrastructure development complete and in orbit, this segment of the commercial space sector does not have enough overlap with the defense and homeland security market to justify its continued inclusion. The Index continues to have high exposure in the area of space with 17 of the 20 largest firms in the Index maintaining space operations and capabilities.

Comments

[Uncle Bill]

This is just advertising for your company's product. No alpha here.

[lowellfield]

It's the Democratic party, Sackoff.

[DavidJackson]

Very interested in Uncle Bill's comment here. We're thinking of adding more sector coverage to Seeking Alpha, because we think good overviews of what's going on in each sector -- overall sector performace, stock performance, top industry news -- would be useful for investors and industry watchers, even if it isn't immediately actionable for stock pickers.

Any thoughts on this?

David Jackson
Founder, Seeking Alpha