The Bear Market in Aerospace & Defense

Since the SPADE Defense Index  [Amex: DXS] peaked in October 2007, the aerospace and defense sector has been stuck in bear market territory for the past several months. It is a situation that has had more to do with broader stock market issues and perceptions of what will or what might happen to the sector a year or several years out than any specific business issue facing the sector today.

In fact, recent quarterly earnings posted by many of the sector’s companies have been positive, and in some cases show significant gains in revenues and earnings. Conversations with many firms at the recent Farnborough Air Show indicated strength in current and nearterm operations as they try to fill an ever increasing backlog of business.

For months, I’ve been saying that the trends are steady, business is strong, and the issues remain the same, yet like you I’ve watched valuations decline. So why then is the sector mired in a bear market having lost roughly a quarter of its value? And, importantly to investors at this point in time, where is the bottom and when should we see a turn?

This is what I plan to address in the coming paragraphs.

First, why does the sector remain near its recent lows?

1. Poor market conditions. Although the issues affecting the stock market and driving it downward (a weak dollar, banking/housing crisis, recessionary talk) do not have a direct relationship to the defense sector, investors have pulled out of A&D to capture the substantial gains they have seen over the previous eight years and presently just aren’t comfortable yet with coming back in.
2. Boeing (BA). It’s unusual to pin a decline on a single company but as one of the largest firms in the sector, a 30% decline in its valuation has had a major impact on the sector. In this case, production and delivery delays for the new 787 have affected not just Boeing but a number of its suppliers. Although this will likely only shift revenues and earnings to future quarters, a backlog that extends through the middle of the next decade remains. In the short-term it has been a drag on the sector but it is a situation that should rectify itself over time.
3. The November Presidential Election. In a prior newsletter we addressed the perception that a Democratic president would be bad for the defense sector showing research that indicated that the size of the defense budget had as much to do with the world the President governs in than the political party in charge (ie. it’s more a matter of timing than policy). FBR and LBJ, both Democrats, presided over a period of increased defense spending to fight WWII and the Vietnam War. Initial defense spending declines under Bill Clinton occurred as the military restructured to determine who and what we’d be fighting but by the end of his presidency overall spending on defense began to rise. While the perception remains that a McCain presidency would be good for the defense sector and an Obama presidency is an unknown or a negative, the reality is that no president can reduce spending on homeland security without significant backlash. What we hear is that an Obama defense budget will likely remain consistent with current projections -- although a shift in strategy is likely and individual programs might be impacted. A flattening of the budget is already taking place and it is a major concern of the Obama camp not be seen as weak on defense and security during the election as well as in the initial years of his presidency. So budget declines appear unlikely but a negative perception remains.

Which brings us to the question of has the decline left aerospace and defense stocks undervalued?

Historically, bear market declines in any sector or style occur when there has been a philosophical shift. Little has actually changed in the A&D sector during the past year and defense stocks are being driven more by the perception of investors rather than internal fundamentals.

Statistically speaking, there is evidence that the sector is undervalued. A review of the fundamental values of the 53 companies that comprise the SPADE Defense Index shows that 24, nearly half and representing a weighting of more than 37% of the Index, has a price-to-sales ratio less than one. In addition, more than half the Index trades with a forward P/E of less than 13 and more than a quarter of the companies now have a P/E less than 10.

24 of 53 companies have a P/S < 1.0

20 of 53 companies have a P/E < 12

11 of 53 companies have a P/E < 10

So what does all this mean? Arguably the aerospace and defense sector is the healthiest that it has ever been, with valuations that are highly attractive, all while the sector hovers more than 20% below its all-time highs.

Reasons We Could See an End-of-the-year Upswing

1. Any impact from the November elections will likely not be felt on the corporate bottom lines until 3Q09 or possibly 2010 at the earliest.
2. The effect of the airline recession and the rise in global oil prices on new plane deliveries will not be felt for several years. Airlines in the middle-East and Asia have been the drivers of the current boom and the clients for many of the early deliveries. These carriers are much healthier than U.S. airlines.
3. The global terrorism threat remains high from extremist nations and terrorists.
4. September and October will see a flurry of defense contracts that are issued at the end of the fiscal year and produce positive news for companies.
5. Nations in regions of turmoil that benefit from high oil, energy, and commodity prices, combined with a weak dollar, have made the acquisition of U.S. defense equipment attractive.
6. A forthcoming shift to a production phase for new military and commercial aircraft will reduce R&D expenditures in 2009 and boost the bottom lines of prime contractors and the supplier base.
7. Political rhetoric for the presidential elections will highlight the likelihood of a stable defense budget regardless of who wins the Presidential election.
8. Much of the unknown or negative news has already been priced into the current valuation.

Comments

[papita:]

loved the article. and for the many reasons mentioned, I am a buyer of Allegheny Technologies at these levels. Strong and steady is how I describe both their management and their business. Really a solid, well managed company. Should go a lot higher from here.

2008 Aug 07 07:47 PM

[mkreisel:]

When big wars are over, defense stocks go down. It's that simple.

If you check out what happened to BA, GD, and LMT between 1968 and 1974, you will have an idea about these stocks' near future.

2008 Aug 07 11:14 PM

[Chandler Lutz:]

Great Article...I am very bullish on the defense sector for the very long term (this is a China play no one really talks about)... I agree with many points that you make especially with regards to the political elections...I will making a wishlist of defense companies before the election...If Senator Obama wins it is possible that some of these stocks may decline to even more attractive levels (while the fundamentals will remain virtually unchanged)...I guess we'll just have to hope and wait and see...

2008 Aug 08 01:40 AM