The Defense Sector in 2008

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 |  Includes: BA, BAESY, EDO, FLIR, ITA, MMM, MTCT, NOC, OSK, PPA
by: Scott Sacknoff

Compiling a track record that many professional money managers and mutual funds would envy, the defense and homeland security sector outperformed the S&P500 benchmark for an eighth consecutive year. The benchmark SPADE Defense Index [AMEX:DXS] gained 22.17%; this was 18.64% better than the widely followed S&P500 broad-market index.

During this period, the SPADE Defense Index outperformed the S&P500 by more than 10% in six of the eight yearly periods and gained better than 19% in four of the previous five years. Since 2000, the SPADE Defense Index has produced a total cumulative gain of 161.27%, as compared to the S&P500’s decline of [0.06%], and the Russell 3000’s gain of 7.05%. The PowerShares Aerospace & Defense ETF (AMEX:PPA), which seeks to replicate the SPADE Defense Index, has seen 2007 inflows of 343.5% as investors added defense to their core portfolios.

The Midst of a Long Investment Cycle

Although much of the gains can be attributed to government spending in the aftermath of 9-11 and the war in Iraq, the defense sector’s positive performance predates the 9-11 attack on the U.S., and trends suggest that growth may continue even after a pullback from Iraq occurs.

Notably:

1. The mission to protect and defend the U.S. and its citizens remains a critical goal of government

2. Support for defense among Congress and political leaders remains strong.

3. The recently approved core Department of Defense budget for FY-08 is 10% higher than FY-07.

4. A tremendous need to recapitalize equipment used in Iraq and modernize defense equipment and systems--some of which date to the Eisenhower Administration. (For example, a contract to replace the Air Force refueling tankers is set to be decided later this month. Initially the contract is for 179 aircraft worth about $40 billion but could grow to $100 billion with additional orders. Both Boeing (NYSE:BA) and a team led by Northrop Grumman (NYSE:NOC) (partnered with EADS) have submitted their final proposals.)

5. Continued expansion in related business lines such as commercial aircraft. While the industry is cyclical in nature, most analysts believe that a downturn that will follow the investment cycle is still several years away. But as always, the biggest risk to the change fortunes of the sector is politics.

The Defense Sector and the 2008 Economy

There is currently a lot of pressure on the U.S. economy as issues related to the subprime loan crisis, inflation, and the possibility of recession come to the forefront. Although spending on defense and security is currently between 4% and 5% of U.S. GDP, economic issues such as the aforementioned tend to have less of a direct impact on the defense sector which derives much of its revenues from government budgets. While the sector may move in sympathy with the overall market at times, the underlying factors driving the defense industry remain quite different.

Mergers and Acquisitions

In December, BAE Systems (OTCPK:BAESY) announced that it was acquiring MTC Technologies (NASDAQ: MTCT) for $450 million including the assumption of $81 million in debt and they expected the deal to close in early 2008.

The Last Word on 2007

Returns by the “Big-5”prime contractors were at the middle of the pack producing single to low-double digit growth. The companies that performed best were some of the mid-caps that filled a critical wartime need or were acquired during the year. Although a few defense IT firms rebounded in 2007, for the most part, they continued to lag as money shifted from R&D and investment programs into war-related acquisitions.

Finally, to show how the winds of change affect individual companies, Force Protection [as well as other companies involved with mine-resistant [MRAP] vehicles and armored systems] which were highfliers for most of the year, saw their stocks collapse in November and December as the Marine Corps began questioning their future needs and plans Force Protection ended the year down more than 70% after being up more than 25% YTD through September.

Coming in late January - the FY-09 Defense Budget....