Defense Investors in Today's Volatile Markets

The massive global sell-off in, well, everything, continues to impact investments made in the aerospace, defense, and homeland security sector.

With the market operating in uncharted territories, I’m now hearing commentators refer to the Panic of 1907 as the only corollary, it is hard to near impossible to provide a commentary that the market will bear out. With gyrations that can influence prices 5%, 10%, 20% in a single day without reasons other than the fear that has entered the market, discussing the underlying fundamentals almost seems trivial.

So instead, what I think would be beneficial is to answer the top things on the minds of A&D investors without delving into the market itself.

1. 2009 Defense Budget
2. Strike at Boeing
3. Third Quarter Reporting Expectations
4. Presidential Election
5. Afghanistan: Planning for a Surge
6. Tanker Contract
7. Global Defense Spending
8. Fixed Price vs. Cost Plus Contracts
9. Major End-of-Year Contracts Awarded
10. Loan Crisis/Liquidity Impact on A&D

1. FY 2009 Budget

President Bush signed the FY-2009 budget for the Department of Defense as part of the continuing resolution budget signed on October 1st. The legislation approved a $612.5 billion defense authorization bill which sets policies and a spending ceiling and includes $70 billion for Iraq and Afghanistan operations as well as a $487.7 billion for the defense appropriations bill to fund programs. $4 billion was cut from the president’s request as part of a recent practice by Congress in which they make it up in supplements and free up spending for domestic programs. (The budget approval was no surprise). Additional details on the budget can be found further down.

2. Strike at Boeing (BA)

Looks like this could be a long one. With the media’s focus on Wall Street and the global financial crisis there has been very little attention of the strike by the national media. It is expected that companies that rely on commercial aerospace will reduce their forecasts for revenues and earnings in the coming weeks, if they haven’t done so already. Boeing’s stock has already dropped to multi-year lows due to delays in delivering the new 787 aircraft and the current strike costing them an estimated $100 million in sales per day and analysts saying $2.3 billion in the third quarter. It’ll be interesting to see which side blinks first -- the union which is trying to protect itself from the reality that international sales are influenced by partnering with local manufacturers or the company that has seen its market value plummet. So far, Boeing’s customers have been patient and not cancelled orders. When it starts to hit employees in the wallet, will the union members blink or will the company acquiesce knowing that major future design efforts impacting this agreement could be years away?

Note: The IAM strike fund is $140 million and they say they can sustain a strike for up to six months. After three weeks out of work, union members are entitled to only $150 /week in strike pay.

Note 2: Many suppliers have announced layoffs or shortened work weeks to ride out a lengthy machinist strike. Other suppliers are using the strike to shift workers to reduce order backlogs from Airbus and Bombadier.

3. 3Q08 Reporting

Overall, the defense business remains strong with a defined government budget, long-term government contracts, and stable spending plans. What may impact some third quarter reports is the non-defense business lines of many firms.

Example: Some analysts are concerned that General Dynamics’ (GD) Gulfstream division may be affected by the existing/oncoming business recession as well as reduced demand from executives in the financial sector. Similarly, many major defense companies have some exposure to the commercial aerospace sector which has been impacted by the problems at Boeing.

4. 2008 Presidential Election

Valid or not, it is widely believed that a McCain administration would offer stable defense budgets. The great unknown is what would happen in an Obama administration. Recent comments from the Obama campaign should alleviate some investors concerns. According to Richard Danzig, a U.S. Navy secretary during the Clinton administration and a leading contender to be the Secretary of Defense, stated that he doesn’t see defense spending declining in the first years of an Obama administration. There are a set of demands that are very severe, very important to our national well being.

Regardless, there will be little time between the presidential winner assuming office in late January and the submission of the FY 2010 budget in February.

Among the initiatives that an Obama administra-tion may see are:

1. a shift in the Pentagon’s focus to buying greater numbers of less-sophisticated weapons systems;
2. a focus on cyber war-fare and UAVs; and
3. making sure DoD doesn’t become too focused on terrorists at the expense of traditional air and sea power.

In other words, this is what I’ve been saying --expect minimal change to the near-term budget over the next few years regardless of who wins; all that will change is how it is spent.

Obama specifics:

• Iraq: Remove 1-2 brigades a month but with no timetable subject to military commanders input.
• Afghanistan: Move 2 more brigades to the region
• Army/Marines: Supports the drive to grow the Army by 65,000 and Marines by 27,000
• Weapons: Unparalleled air power capabilities, modernizing current ship fleet, investing in small capable combatants, support concept of Littoral Combat Ship program.

5. Afghanistan Planning

An increased mobilization of activities in the Afghan region has already begun with a number of defense organizations issuing contracts and planning for a surge in the region. - DoD is seeking private contractors to clear landmines, build detention facilities, and provide roads for a growing presence in the region that would include 5000 additional troops. Solicitations have also been issued for 22 medi-um and heavy lift helicopters (Central Command).

6. Tanker Contract

The $35-$40 billion replacement tanker contract has been put on hold by the Air Force fol-lowing a request by Boeing for more time to evaluate the solicitation. The Air Force has deferred the decision to the next administration in what continues to be a politically-charged decision regardless of which way it goes. Meanwhile while Northrop says it might support a proposal to issue a dual award in which each firm would deliver one plane a month, Defense Secretary Robert Gates said he would recommend a presidential veto citing the added costs that come from having two companies build the same plane.

7. Global Defense Spending

Continues to rise in many places in the world. In the Nordic regions spending is on the rise due to a more aggressive Russia; China is increasing its defense budget by the double digits; and the middle east and asia continue to have pockets of volatility. Overall, global defense spending has passed the $1.2 trillion level, with the U.S. now spending less than half that amount. (See page 5 for top 10 budgets)

8. Fixed Price or Cost Plus

There is a growing belief that DoD will be shifting toward fixed price contracts in order to get a handle on major cost overruns in recent years. Although it means greater risk for the companies who bid on a project, it also provides the possibility of improved margins and the incentive to stay on budget and reduce total costs.

9. Major end-of-year contracts issues

A ‘right of passage’ in the September time-frame -- see below for some contracts.

10. Loan / Liquidity Crisis

I promised I wouldn’t go into details here but there are a few direct relationships that bear mention (since the media keeps asking us):

1. Commercial aircraft leases are loan/debt instruments and are directly impacted by the freeze in the commercial loan markets;
2. M&A activity - Wall Street is saying that even the best deals with creditworthy customers are being bypassed and the sector’s several hundred deals annually have slowed to a crawl; and
3. The rise in the dollar helps margins but makes international sales more expensive.

Contracts

• $15.2 Billion - Lockheed Martin (LMT) - the Pentagon plans to sell up to 75 F-35 Lightning II warplanes to Israel. Israel has asked for 25 F-35A mod-els with an option for 50 more jets, possibly including the F-35B model which has short takeoff/vertical landing capabilities.
• $11.7 Billion - U.S. Defense Security Cooperation Agency [DSCA] on Sept 9 announced 16 proposed weapons sales to primarily Middle East countries. $7 billion is for Terminal High Altitude Air Defense Units for the UAE.
• $6.5 Billion for Taiwan with arms including Apache helicopters; Patriot III, Harpoon and Javelin missiles; upgrades for Taiwan’s E-2T aircraft and spare parts for the Taiwan Air Force
• $5.11 Billion - Northrop Grumman (NOC) to build the aircraft carrier, USS Gerald Ford, due in September 2015.
• $5.6 Billion - Lockheed Martin - Supply wheeled vehicle support--both tactical and non-tactical to all branches of the armed services. $1.8 Billion - Lockheed Martin - To modernize the Canadian Navy’s Halifax-class frigates through 2017.
• 1.36 Billion euros - France increased 2009 defense spending to 32.02 bil-lion euros, a gain of 5.4% from 30.38B. Equipment acquisitions rises 10% to 17 billion.
• $437 Million - Raytheon (RTN) - 10 year contact to lead a team of companies and colleges to plan new training programs for air traffic control. $250 Million each - Raytheon & Lockheed Martin -- To develop a new air-to-ground missile system to replace the Hellfire and Maverick missiles.
• $125 Million - Northrop Grumman, to update over 31 months, the EA-6B Prowler aircraft with radar-jamming capabilities. Initial deliveries are due in 3Q10.

Inside the FY 2009 Budget

Some highlights include:

• $14.1 Billion - to the Navy for shipbuilding, a $1 billion increase and matches the president’s request to build eight ships.
• $6.3 Billion - to the Air Force including $2.9 B for 14 F-35 aircraft and $3.4 B for development
•  $3.6 Billion - to fully fund the Future Combat System
•  $2.9 Billion for 20 more F-22 fighters + $523 M to fund long-lead pur-chases of additional aircraft
•  $750 Million for National Guard and Reserves to fill ‘equipment’ needs.
•  $600 Million for advance procurement of two San Antonio-class amphibious transport docks.
•  $270 Million - Additional monies for the defense health care budget
•  $198 Million for 12 Army Armed Reconnaissance Helicopters
•  $150 Million - for a Fourth AEHF Communications Satellite

Comments

[PeteK:]

BA workers, look at GM & Ford, don't take your job for granted, pretty soon you may see the same result just like other struggling businesses, either "DEAD or OUT" !!!

2008 Oct 08 06:55 AM