June Defense Sector Update

In this month’s commentary, there are two trends I’d like to address, the second quarter rise in defense stocks, and a tip of the hat to...ourselves.

Merger Mania & Defense Supplier Base

With the exchange rate between the dollar and the euro offering tremendous purchasing power, European firms have been bidding for and acquiring U.S-based defense firms in order to gain a local foothold in this market and diversify from their home territory. Among the deals have been Finmeccanica’s (Italy) acquisition of DRS (proposed), Cobham plc. of SPARTA; and BAE’s acquisition of Armor Holdings, MTC Technologies, and United Defense. Meanwhile EADS (France) has indicated their interest in doing a $1 billion deal in the U.S. in 2008 and VT Group (UK) has doubled their target for U.S. sales from $500 million to $1 billion.

In addition, U.S. firms which collectively are only 10% off their all-time highs and flush with cash from the ongoing bull market in defense and security have also been quite active in acquiring smaller, niche organizations that can strengthen their product base for the anticipated shift in defense spending from military operations to acquisition, development, rebuilding, and recapitalization. Among recent deals are ITT’s acquisition of EDO, Northrop Grumman’s purchase of Essex Corp., and Raytheon’s acquisition of SI Government Solutions, a software company that protects government and commercial data. In addition rumors put defense electronics firm, Harris Corporation, on the block although the CEO denies the company is for sale (at least at the moment).

On average, the defense sector sees several hundred deals annually, although, pardon the pun, much of this flies below the radar of those outside the industry.

Defense sector M&A is a vibrant business and the U.S. Department of Defense has crafted an excellent system by which they fund and create small, entrepreneurial organizations either through direct contracts or through teaming and mentor programs.

That said, there is increasing concern about the impact of non-U.S. firms acquiring U.S. defense contractors. Coming on the heals of the EADS-Northrop Grumman contract win for the Air Force tanker, a several hundred billion dollar program, it can be expected that Congress (and others) will highly scrutinize these cross-border deals for political reasons even as prior approvals for several BAE-led deals were thought to pave the way for future cross-Atlantic acquisitions.

Even with rules governing international cooperation activities designed to protect (and limit) the exchange of advanced technology, ultimately we see new deals subject to scrutiny greater than that in the past.

For good or bad, international deals open up a market for mid-sized companies that U.S. companies might be unable to access because of concerns about reduced competition.

Replenishing the mid-tier supplier base will become an increasingly important issue for military planners in the years to come as greater resources are allocated to a tightening number of firms with the unique skills and capabilities to carry out the desired mission.

Changes to Sarbanes-Oxley or a waiver for defense sector firms who already go through a high level of oversight associated with government contracting could reduce the costs and encourage smaller defense firms to enter the public markets, access capital, and develop the next evolution of mid-cap suppliers. A diverse group of ideas but all interrelated.

Rebound in the Defense Sector

A tip of the hat to...ourselves. I’ve mentioned to a few people that we’ve never found the occasion to edit or remove any of the commentaries that have appeared in the past. The last two issues stated that a) a decline in defense stocks was an overreaction to issues unrelated to the sector, and b) a technical analysis showed that the sector was primed for a bounce up. Well for the quarter the SPADE Defense Index has outperformed the S&P-500 by 432 basis points and is up 10.19%. Those that actually read this commentary hopefully benefitted from this insight.

Looking forward, although past performance can’t predict future gains, we’ve decided to see how the index has performed during the summer months over the past few years.

In looking at the below table, we make five observations:

1. The SPADE Defense Index produced positive gains over the summer months in three of the last four years. In the exception, 2006, an investment at the start of June would still turn positive by September.

2. The S&P 500 produced negative returns in half the summer months, twice that of the SPADE Defense Index.

3. What happens in June has been a harbinger of what to expect in July and August. In 2005, 2006, and 2007, positive returns in June meant gains in July and August. In the exception, 2004, a down month in July was recaptured by September.

4. There is a negative correlation between the SPADE and the S&P500 during the June to August timeframe.

5. The SPADE Defense Index consistently outperformed the S&P500.

The Presidential Election

Although we’ve discussed this topic several times over the past year, much more attention will obviously be focused in this area as November approaches and the candidates address specific issues. As mentioned in previous newsletters there will be a lot of rhetoric as to should we stay (and if so, how long) or should we go (and if so, how quickly). Ultimately though, there are a number of reasons why spending on defense and homeland security will remain a key focus of government. On May 30th, comments on CNBC stated that the election should have little near-term impact on the defense sector.

With politics playing a key factor in defense spending, it is likely that we will be revisiting the election and its affect on the defense sector in future issues.

Budget Battles

Speaking of politics, there is growing concern that the FY09 budget might be delayed as the White House and Congress battle over appropriations. This could impact how the Pentagon moves forward on new or expanding programs. There is still plenty of time, but it is something worth keeping our eye on.

Similarly, there are political issues affecting passage of the latest supplemental spending bill. As in the past, we anticipate that Congress and the White House will eventually work things out and this is nothing more than political posturing in advance of the next election.
 

Comments

[NUJ:]

The interrelationship between US and UK (or Euro) business can only be a good thing, after all we are rumoured to be allies. The M&A playground is a great stimulus for business. However, as a Brit working in the UK, I do find it thoroughly frustrating that my American colleagues, vendors and customers cannot share information with me due to ITAR. We are working for the same thing but we make it so hard for ourselves. Purchasing an American company ensures that the technology and information can stay in the US, that's why we like to do it.

2008 Jun 10 03:28 AM

[User 137633:]

"a decline in defense stocks was an overreaction to issues unrelated to the sector"

Both ITA and PPA have underperformed the S&P 500 this year...they've been terrible etf's to own in 2008.

2008 Jun 19 03:23 PM