The Top 10 Defense Investment Questions Answered

The past three months have seen several newsworthy items of importance to the defense sector which were covered by the media and then which quickly faded from discussion. Even in the heat of a political campaign season, the release of the defense budget was greeted by politicians, who then quickly moved onto another topic. This is either an indication that they may all be in quiet agreement on the importance of defense or the realization that you cannot advocate reducing the defense budget and expect to win an election.

The Ten Most Asked Questions by Investors

(in no particular order)

1. The FY-09 Defense Budget was released in February; were there any surprises? Will the budget continue to grow?

The chart below (click to enlarge image) comes from the Department of Defense’s Green Book. The FY-09 budget is a record high for a single year excluding inflation. If we exclude FY-08 which includes supplemental spending, the core budget from FY-09 to FY-13 shows that the defense budget is forecast to grow by an additional $33.5 billion -- although the rate of growth has slowed. These figures are pretty much inline with what analysts expected. Funding for specific programs were also inline with analysts expectations and although some programs gained or lost, overall the budget contained no major surprises. Approval of the budget will fund the agency through September 2010, providing the sector with several quarters of defined growth.

2. Won’t supplement spending decline with a pullback from Iraq?

Supplemental budgets are likely to continue into the future although not at the magnitude that we have seen over the past few years to fund the war in Iraq. As troops and reservists return home, less will be needed to fund salaries, supplies and the cost for engaging an enemy in a remote location. It is anticipated that any pullback from Iraq will take months if not years to execute.

3. Can the industry still grow after a pullback from Iraq?

Trends over the next few years show that a significant decline in the sector is unlikely. Positive growth in the core defense budget, increased defense spending around the world, and a continuing upcycle in related aerospace industries will provide stability. As reservists stationed in Iraq come home and return to more normal activities, resources devoted to the war effort will be freed up and allocated elsewhere. Likely, much of this will go toward new equipment, systems, and R&D initiatives to “reset” the military’s capabilities -- all areas which private companies actively participate.

4. Will there be a peace dividend following Iraq?

Probably not and definitely not to the extent that we saw after the fall of the Soviet Union. Even after Iraq, our enemies remain and the importance of defense and homeland security have not diminished. Politicians now recognize (privately, if not publicly) that while they may be against the U.S.’s action in Iraq, national security is important and a failure to convey their support for it would be political suicide. Additionally, in the aftermath of a new attack, not only would their political career suffer but the party seen supporting cuts would be equally hampered.

5. What effect will the 2008 Presidential election have on the sector?

Between now and November, unless something unforeseen happens, any political risks are likely already priced into stocks. Depending on who is the Democrats nominee as well as the result of the November election, you could see movement based on perception versus any reality that might evolve -- a John McCain victory would likely be seen as a positive for defense, an Obama nomination and/or victory would be seen as a negative, and a Hillary victory is seen as neutral to positive. The reality is that all three have stated that they support defense initiatives and would execute a plan to withdraw from Iraq. Depending on who is in power, the only difference is the timing of a withdrawal. Ultimately however, the reasons given in the answer to the previous two questions remain -- the defense sector needs to be “reset”, the core budget will continue to grow, though more slowly than in past years, and the security of the U.S. and its citizens remains a core function of government and a vital need.

6. Why has the sector declined since November?

Since hitting its all-time highs in November 2007, the SPADE Defense Index declined in excess of 20%. The commentary in last month’s newsletter called this “irrational dejection”. As the market sank due to issues with the broader economy and unrelated to the defense sector, investors saw the gains in a sector that has outperformed the broader market for eight consecutive years and decided to cash out their profits while holding onto stocks in other sectors that had already collapsed on the hope they would rebound. During this period, there really was no defense-related news that justified the decline. On the commercial side, negative reaction to Boeing’s production delays related to its new 787 aircraft saw firms with exposure in this area decline. Delays at this stage of development are typical but it can push short-term revenue forecasts from one quarter to another. Long-term the orders are still in place. Once Boeing fixes the problems and begins deliveries to customers, the firm and the sector will begin to benefit as increasing revenues associated with the deliveries combined with reduced research and development expenses, show up on the bottom line.

7. Are investors staying the course?

Even with the recent declines in the sector, more than 70% of outstanding shares are being retained by investors in anticipation of a bounceback in the sector.

8. What is the impact of a foreign (non-U.S.) defense contractor winning a major aircraft development contract?

To most people, this was a surprise, especially in light that previous contracts awarded to non-U.S. contractors were much smaller in scale and with the fragile state of the U.S. economy at the time. With long development and operational cycles, large programs such as this are critical to firms. Anytime resources go to suppliers outside the U.S., the impact on local industry is diminished. Already EADS has attracted several similar contracts from foreign governments because of their win. That said, the impact on Boeing in the short-term should be tempered by the fact that are in an upcycle for commercial aircraft that will last until the middle of the next decade. The true impact of this loss will only affect the company when the commercial cycle runs its course.

In addition, while the total value of the contract was promoted to be around $40 billion, roughly half of that is planned to be spent in the United States or with U.S. contractors. The contract was also part I of III, leaving the door at least partially open for Boeing when contracts 2 and 3 are awarded. Meanwhile, we can all expect the political ramifications on this to pop into the news from time-to-time over the next few months as Congress debates changing the rules for contract awards and accusations that the Air Force changed its requirements or supplied misleading information to prevent Boeing from getting the contract.

Ultimately, U.S. manufacturers have proven resilient in the past and while competition in the short-term is usually perceived as a negative, in the long-term competition spurs innovation and costsavings.

9. Was the 17.6% rise in China’s defense budget a surprise? How can investors participate?

For the last several years, China’s budget for defense has grown in the double digits, today reaching $57.2 billion. Western estimates put their actual defense output at least two to three times higher, making it the second largest military in the world. Although the percentage at which the Chinese military budget is growing may seen large, it must be recognized that they started with a smaller base figure. Compared to the media hoopla, most defense analysts didn’t find the 17.6% figure all that shocking. As far how investors can benefit in this growth...they really can’t. Almost all of China’s military activities are ‘in-house’ at governmentowned firms not listed on the public financial markets.

While the occasional contract may be awarded to a company in Europe or elsewhere, these have generally been small contracts. In comparison, increased defense spending in India has a direct effect on outside manufacturers as a rise in their budgets is leading toward acquisition of Western and Russian defense equipment rather than an internal build-up of a military industrial base.

10. What areas of the defense sector are in favor at the moment? What are the hot areas for defense RDT&E investment?

The defense sector is inherently cyclical -- not just whether the sector is in or out of favor but also in the subsectors to which the defense department is allocating resources. At various times during its current eight-year run, there has been shifts as to which companies were in favor, rotating among large systems contractors, war-equipment suppliers, electronic devices manufacturers, information technology and network centric warfare programmers, and those involved with armor and systems, midcaps, homeland security, etc.

When we look at the top performers for 2008, we do not see any specific, short-term trends which one can play. The list is a mix of firms in all the aforementioned categories.

Summarizing the perspectives from several presentations given during the Cowen & Co. Aerospace & Defense Investors Forum, even in light of the slowing defense budget, they see growing demand for trucks and vehicles, new aircraft systems, information sharing, persistent surveillance, missile defense, enhanced situational awareness, navigation, advanced sensors, government services, and networked communications.

Comments

[website:]

The Fist answer would be the Economy!
any more quesions?

2008 Dec 31 03:38 PM

[randy01:]

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[randy01:]

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