Scott Sacknoff's  Instablog

The perception is that its been a tough year to be an investor in aerospace and defense. Yet even though for the first time in a decade its likely the sector won’t outperform the broader market, a 20% gain for the sector in 2009 and the Powershares Aerospace & Defense ETF (NYSE: PPA) is still possible.

With just a month to go in the year, the A&D sector has failed (so far) to break out of the trend of moving as the broader market moves. Even President Obama’s primetime speech calling for 30,000 more troops to head to the Afghan region has failed to spark a rush of investors into the sector. Overall though, the past month has seen some gains in performance and an increasing number of analysts being more positive about the sector.

 There was little in the speech that provided insight into the strategic changes in defense philosophy and future spending plans that will emerge from the 2010 Quadrenniel Defense Review however it did call for the addition of $30 billion and 30,000 troops for the Afghan-region effort while highlighting some of the budgetary pressures that he faces. Combined with some recent news and “trial balloons from Congress” the past month has given us some things to ponder about when identifying the direction of, and the factors that will influence the business and investment performance of the sector -- for the next month, the next year, and the next several years.

 1. The Concept of a War Tax: Congress in late November floated the concept of a special tax on high-income Americans to help pay for the wars in Iraq and Afghanistan. When discussed on CNBC it was pointed out that this is not a new concept, has been done in the past, and that it presents an interesting challenge to those who want to support our troops yet are against new taxes.
 
 2. The bad press concerning the launch of Boeing’s 787 Dreamliner aircraft has finally been supplanted by positive news focused on the anticipated first test flight, scheduled to take place most likely the week of December 14th but before the end of the month. Next year should see a shift from R&D to production and enable companies with commercial exposure to this program to begin recording billions in backlogged revenues.

 3. The growing threats in Asia and the Middle East continue -- Unlike prior “post-war” periods when defense budgets declined significantly, comparing today’s climate with that after the Cold War or Vietnam is folly. Military and defense needs will still exist after 2011/2012 when the Afghan and Iraq pullouts are proposed to be completed. In fact, if one looks at the news items on page 2 related to Iran’s nuclear expansion plans and China’s expanding cyberterrorism activities, calls for offensive weapons in space, and increasing naval capacities, a number of possible conflict scenarios can easily be seen....and this assumes that the violence associated with Islamic fundamentalism has been resolved.

4. As highlighted in the president’s speech, the vice that keeps defense spending in check is the economy and the national debt. Between now and 2013, it is likely that improvements in the U.S. economy and an expansion that creates jobs, leads to economic growth, and improves the tax revenue stream will relieve some pressure in the budget. Similary, the government relief programs have yet to be played out and the total cost may still be less than forecast once private companies repay the government. By the pullout in FY-12/FY-13, we’ll know more about our economic situation and the impact it’ll have on discretionary spending for the military. Until then though, future budget pressures are a risk although it appears that the FY- 11 and FY-12 budget levels appear stable.

The second factor impacting where monies in the defense budget go is the steady rise in military personnel costs; those associated with health care, retirement, training, housing, etc. In a flat budget environment, “M-1” increases
have to be offset with declines in procurement (P-1), R&D (R-1), and/or Operations (O-1). Reduced force levels after troops return from combat should help (and reduce O-1 costs and preserve procurement and R&D spending)
although the reality is that the budget is a complicated juggling act.

Ultimately though, these are not new problems. While they will impact the total amount allocated, from an investor standpoint, changes to which programs DoD invests in, the types of contracts, and how well individual firms have positioned themselves to align with strategic defense changes are more important to a company’s revenues and profits and their stock’s performance in the market.

It’s beginning to appear that there may be more positives for 2010 than negatives.

Disclosure: Manager, SPADE Defense Index

Defense stocks continue to exhibit signs of strength highlighted by the recent 10% increase in its dividend by Lockheed Martin (NYSE:LMT) and an upgrade of General Dynamics(NYSE: GD) by Morgan Stanley. 

Since the March lows in the market, the SPADE Defense Index has exhibited remarkable consistency, gaining between 4% and 12% in six of the last seven months (the only exception being a 0.85% decline in June). Overall, the sector rose more than 16% in the third-quarter and with recent gains is putting itself in position to challenge the S&P500 and outperform it for the 10th consecutive year. 

Actions anticipated for the final quarter of the year have started to come to fruition and should drive the sector over the coming months. Recent news has indicated that future budgets should be in line with analyst expectations and leaks about the QDR (quadrennial defense review) regarding the future direction of the Defense Department have not revealed any surprises. Additionally, DoD released a new request for proposal for the $35 billion aerial tanker program and President Obama has reiterated, vigorously, his support for ongoing and expanded activity in Afghanistan. The final quarter should also see a number of new defense contracts let and the first test flight of Boeing’s 787, which will likely provide a substantial boost to the share prices of a number of suppliers to the program.  Most importantly is the growing realization among sector analysts that the near-term budget for defense will remain relatively steady and not see the dramatic declines exhibited after prior defense spending peaks.

With defense companies much better prepared to handle this type of budget environment, many companies in the sector continue to see top line and bottom line growth while maintaining healthy margins; having expanded and diversified their operations over the past several years and built up their cash reserves. Investors for the most part have been divided equally into two camps -- those that exited the sector waiting to see how the companies would fare under a new budget environment and who are looking for a new entry point and those that have stayed the course and maintained shares as part of a diversified portfolio; happy with returns that have consistently tracked or bested the broader market and anticipating the next uptick. One thing investors in this second group have on their side is that the sector has tracked the market this year even while the five major defense companies have all underperformed the sector benchmark.  Both Raytheon (NYSE:RTN) and Lockheed Martin remain negative for the year with Northrop Grumman (NYSE:NOC) and General Dynamics positive but underperforming.  Only Boeing (NYSE:BA), whose share price has swung wildly in 2009 on various news items after a significant downturn in 2008, is ahead of the market.  With mid-cap defense companies leading the gains so far, a rebound in the U.S. economy will have an impact on several of the largest aerospace suppliers and news, such as the 787 test flight, will provide additional attention on the sector. 

The Powershares Aerospace & Defense ETF (NYSE: PPA) continues to be the option of choice of many investors looking for a diversified way to play the sector or who are unsure how upcoming news will impact individual companies and want to hedge their investments in an individual company. In addition, recent conversations with several money managers have indicated that they have been using the ETF recently for end-of-the-year tax purposes while staying exposed to the sector (ex. selling Lockheed Martin, for example, and capturing the decline over the past year but buying the ETF to stay exposed). 

Even in market conditions such as today, and looking back at its history of performance over the past twelve years, the defense sector at roughly 5% of U.S. GDP should be considered as a core element to any diversified U.S. equity portfolio.  With fundamentals (P/E, P/S, PEG) remaining strong and the technicals showing the sector steadily above its 200-day moving average, the underlying data relied on by many professional investors continues to indicate that a movement upward is not out of the question. The run for 10 (consecutive years outperforming the market) is entering into the final quarter homestretch.

The following is the author's commentary that appears in the September 2009 issue of "The SPADE Investor"

* The Chase for Ten
* All’s Quiet on the Analyst Front
* Market Drivers
* Technicals and Fundamentals Remain Strong
* The Upcoming News Cycle

The  Chase for Ten

Historically, aerospace and defense cycles can run 12-15 years. And for nine years running, the SPADE Defense Index has outperformed the broader markets. Even after huge gains by financial stocks since the March market bottom,defense stocks trailed the S&P 500 by just 3.5%at the end of August but have been making up ground lately.

A number of end-of-year events could aid the sector -- namely the start of a new government budget year, Boeing’s plans for the firsttest flight of the 787, and news that the QDR will show that future budgets will be flat and without major declines. All are positives.

Year-to-date, the stock performance of the sector has been dampened as investors speculate on what changes will appear in the QDR and we hit an anticipated peak in defense spending. In addition, twice as the market was beginning to climb higher, the run stalled based on the timing of news -- Boeing’s announcement shifting the 787 first flight schedule and Congress cancelling one jet fighter program in favor of another. 

As the defense budget is restructured and several large initiatives are cancelled / delayed in favor of newer ones there is PR impact but “the devil should be in the details.” For example, cancelling the F-22 was big news and  impacted the share price of Lockheed Martin but with the Pentagon’s plan to allocate dollar-for-dollar the resources to Lockheed’s F-35 fighter, the real impact was less than the media promoted. Initiatives related to unmanned vehicles, cybersecurity, persistent surveillance, etc. continue to provide opportunities for new business and increased competition.

Still after nine years of outperformance, the question for investors of course is, can the Index continue its run in what has been a negative news year. A third of the year remains and there are signs that the next few months could be a positive one for aerospace and defense companies. All’s Quiet on the Analyst Front
 

As the sector awaits firm news from the QDR and future budget details, investment analysts covering the sector have been very quiet. A search for recent analyst forecasts or comments on the sector revealed little. Here are two we found:

* Douglas Harned of Bernstein Research raised price targets on several aerospace firms stating that “Rising demand could help establish a recovery more quickly than in previous downturns...unlike previous periods when airlines placed orders after one year of profitability, orders now are already in place and the market is grappling with less excess capacity. Backlogs are now double what they were at similar points in earlier cycle.

 

Market Drivers

 

* Ryan Fuhrmann, CFA, stated, “In today’s stock market, defense is one of the few industries where investors can find appealing valuations and solid underlying business fundamentals to move portfolios forward.