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Aerospace & Defense: October 2009 Commentary
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 Chase for Ten
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.
The Chase for Ten
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
While the U.S. budget will likely be in a holding pattern with outside pressures upon it, longterm stability (ie. flat budgets) are seen with growth coming from international markets, new opportunities, and non-core defense business.
* New opportunities in persistent surveillance, UAVs, C4ISR, cybersecurity, homeland security, bunker busters, new fighter and tanker program opportunities, armored vehicles, and lasers.
* Growth from international markets and increased forecast as export restrictions loosen.
* Growth in new and and non-traditional defense business lines.
* Shift into the manufacturing phase for new aircraft including the 787 and future derivatives; theF-35 fighter, Air Force tanker, etc.; and a reboundfrom the bottom for companies exposed to thesmall aircraft market (ie. GD, TXT) as the economyimproves and homeland security needs expand.
* An increased focus on technology that keeps people and equipment further out of harm’s way and helps the military more rapidly deploy.
Technicals / Fundamentals Remain Strong
Technicals -- at 1726.68 the SPADE Defense Index and the Powershares Aerospace & Defense ETF(PPA) at $15.42 remain above their 21-day moving average ($15.04), 40-day moving average ($14.74), and 200-day moving average ($14.41).
Fundamentals
70.87% of the Index has a P/S <1
33.46% of the Index has a P/E <10
88.92% of the Index has a P/E <14
61.05% of the Index has a PEG <1.25
* YTD, only five are negative for the year -- Lockheed Martin, Raytheon, SAIC, Harris, and FLIR.
* 17 of the 20 largest companies in the Index have a P/E <14.
* 14/20 have a P/S <1.0
* 12/20 have a PEGs <1.2
The Upcoming News Cycle
Even the trade press has drifted into the summer doldrums. As we enter the final third of the year, we think there will be increased activity.
1. September: Less than past years, but we still anticipate a number of end-of-the-year contracts will be let. In addition, the re-launch of the $35 billion tanker contract should be announced.
2. October: The new fiscal budget year begins, expect a number of contract announcements.
3. 2010 QDR details and proposed spending --Word on the street is leaking that the quadrennial defense review will reveal that the budget will be flat for the next two years with no large declines, although what programs will receive money will change. Procurement is to remain greater than $100 billion annually.
4. The first test flight of the Boeing 787 (we believe this will really happen without any additional slips). Many defense companies have great exposure to commercial aerospace and this will affect a number of companies besides Boeing (eg. Precision Castparts, Goodrich, Moog, etc.)
* 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.
August Commentary
The SPADE Defense Index (NYSEarca: DXS) continues to trend upward in spite of the five largest defense companies contributing subpar performance year-to-date.
Since what is referred to as the “Haynes bottom”,after CNBC host Mark Haynes’ call of a market bottom in March 2009, the SPADE DefenseIndex is up more than 44%.For the market chartist, the SPADE DefenseIndex has broken out from its moving averages.
Index on August 4th: 1688.46
200 day moving avg: 1620.34
70 day moving avg: 1582.09
40 day moving avg: 1606.69
Trends that Could Move the Sector Higher
The pivotal event that will move the sector will be clarity from the Obama Administration and the Pentagon regarding their spending/budget plan for the next several years. We are not likely to get the specifics on the ongoing QDR or future (FY2011-FY2015) budgets for some time but it is likely that we will see two things:
1. FY2010 was the peak (unless a new worlddestabilizing event occurs, with Iran and its nuclear efforts being one of them); and
2. That future budgets will be much more stable than the massive declines that started at the end of the Bush I administration and extended through the Clinton administration. Already signs are emerging that a flat budget is the direction we are headed.
The FY-11 Budget
The military service (Army, Navy, Air Force) budget recommendations for FY-2011 are due to the Secretary of Defense in late August (2009) for initial review. As part of this, an estimated $50 - $60 billion worth of changes in existing programs are expected with the savings going toward new programs and initiatives. DoD (namely David Ochmanek, Deputy Assistant Secretary of Defense for Force Transformation and Resources) has stated that they are operating under a zero-growth initiative. Reading into this, one can make the assumption that the DoD budget will be flat and those forecasting significant budget declines will have to wait to future years of 2012 or beyond. Winners according to a intratheater cargo planes, UAVs, and countermine warfare systems with suggested losers as amphibious craft, heavily armored vehicles, and air defense systems. The fear of large budget declines has already been priced into the share prices of many defense sector companies and knowledge of future budgets can provide a positive upside.
News Events
Other near-term events with upside potential,include:
1> A split award for the $40 billion Air Force tanker program. A DoD request for new proposals is expected to be released by late September.
2> The first test flight and the subsequent first delivery of the Boeing 787.
3> An announcement from Congress that the now-cancelled F-22 fighter will be allowed to be exported to U.S. allies, and thus continuing the program without DoD funds.
4> Anticipated multi-billion awards from India for defense systems. In addition, continuation of the trend which has seen deals for the U.S. export of defense equipment and supplies surpass $40 billion annually.
5> Announcements of initiatives / contract awards that take place in the end-of-budgetyear / September timeframe. These can have a significant impact on firms. For example, the aware of MRAP (mine resistance armored) vehicles for Afghanistan to Oshkosh Truck has sent the stock soaring, more than tripling since its lows and that of Force Protection, a competitor in the field, down by more than 40% in July. Likewise, a new $10 billion classified imagery satellite program could benefit satellite imagery firms such as DigitalGlobe and GeoEye as well as other firms active in this area such as Lockheed Martin, ITT, and Ball Aerospace.
Downside Issues
But like every sector there are concerns.Congress is always an unknown and budget issues may force the hand of the White House and Congress to reduce spending across-theboard. Rising pension expenses is an issue facing several large companies in the sector, with Lockheed Martin, for one, announcing it affected its second quarter earnings. [A revitalized stock market should ameliorate this issue going forward.] Lastly news events, such as delays in or cancellation of programs, can have a nearterm impact even when it doesn’t affect overall company sales or earnings. Congress’ failure to approve additional funds to continue the F-22 was offset by F-35 spending, both Lockheed Martin programs, yet the company was impacted.) Even considering these, valuations remain attractive and there appears to be plenty of upside for investors to consider.
Scott Sacknoff is the Index Manager for the SPADE Defense Index. The Powershares Aerospace & Defense ETF (NYSE: PPA) is an exchange traded fund that is designed to track the performance of this index.
Defense Secretary Gates' speech boosts defense stocks
In listening to Sec. Gates speech, it appears that program cancellations were offset in many cases by program gains. Growth in the F-35 program is offset by canceling the F-22. New ship construction offset delays in others. Cancellation of TSAT is to be offset in part by additional AEHF satellite buys and new programs. Ultimately, the speech provides some answers to the unknown and will make it easier for analysts and investors to move forward. With defense stocks at technical and fundamental lows, these answers should provide a boost to the sector. Between the end of the speech and the end of the trading day, the SPADE Defense Index rose roughly 3.5%. Next up is what changes Congress will suggest to the Gates' proposal and details on the out-year budget -- expected when the President submits the full budget in late April, but likely, early May.
Scott Sacknoff, SPADE Defense Index manager