Three Reasons This Defense Cycle Is Different than Previous Cycles

Includes: BA, EADSY, GD, UTX
by: Scott Sacknoff

Both the SPADE Defense Index and the S&P 500 ended the month flat, holding on to large quarterly gains, which saw the sector rebound by more than 17% in the quarter and 37.6% from the market lows in March. Early gains in June were offset with declines following Boeing’s (NYSE:BA) announcement of further delays in the 787 program -- an issue which has been a drag on the sector for the past year. Progress toward testing, first flights, and a firm delivery date should provide a boost to the sector as the program moves from R&D into manufacturing; enabling firms across the sector to post revenues.

The impact of the Department of Defense’s program restructuring and cancellations that were contained in the FY-10 budget has proved to be more minimal than many originally feared. As anticipated, new opportunities have supplanted those that have been cancelled. While all parties -- companies, analysts, investors -- recognize that growth in the U.S. defense budget has likely peaked, numerous opportunities remain and are being identified.

Unlike previous cycles, this one is likely to be different for three reasons:

  1. After a buildup associated with military action, reductions in the U.S. defense budget have typically occurred with the world shifting toward a period of peace and a relaxation of world tension. This is not foreseen for the next decade and defense spending will likely not drop to the levels seen in previous post-war budgets.
  2. Defense firms have had adequate warning and seen the budget peak coming. To compensate they have shifted their capabilities to focus on new and emerging opportunities as well as building up substantial cash positions to weather any downturn in defense spending.
  3. The cycle for commercial aerospace which began an uptrend a few years back was put on hold with the global recession. As the budget for defense flattens over the next few years, commercial aerospace will begin to pick up as the economy improves, commercial travel expands, and airlines around the world take delivery to meet an anticipated surging traffic demand in Asia and the Middle East and to replace older aircraft with more fuel-efficient models.

Over the next several weeks, companies will begin reporting their quarterly results and defense companies should report stable and solid revenues with consistent margins. Companies with exposure to commercial aerospace should report the same, however projections may be tempered due to an unknown schedule following Boeing’s delay in the 787.

Paris Air Show Observations

Even in a economic downturn, this show draws more people and exhibitors than any other in the sector -- roughly 2000 exhibitor and 300,000 visitors. Among our observations:

  • More than half the companies attending were small and mid-sized firms, including a number that had never attended before and whose focus was on making contact with the larger firms.
  • New orders for aircraft were down substantially (which was expected). With delays in Boeing and Airbus (OTCPK:EADSY) programs, previous year orders for jumbo jets continue to fill the firms’ backlog and due to the current economy there is no rush by firms to place an order for planes not to be delivered for several years. Most of the announced orders were for smaller planes.
  • As was the case two years ago, fuel-efficiency initiatives were spotlighted by aircraft firms.
  • UAV capabilities continue to be showcased, front-and-center.
  • As far as contracts, United Technologies (NYSE:UTX) saw more than $3 billion in orders -- $590M for Pratt & Whitney from China Southern Airlines for engines and $2.6 billion for Hamilton Sundstrand.

Additional items which deserve mention up front...

A $106 Billion Emergency Spending Bill was passed by the Senate to fund the wars in Iraq and Afghanistan. It provides the Pentagon with an additional $80 billion for hardware not included in the original request, including $2.7 billion for cargo planes (C17 and C130J), $1.9 million for MRAP, and $600 million for F-22 stealth fighters.

QDR Update: Two-War Strategy Eliminated

The New York Times reported that the Pentagon is revising its long-held strategy that the U.S. will never had to face more than two opponents at once. The QDR will adopt a theory of hybrid warfare compelling military planners to prepare for traditional battles with nation-states while simultaneously fighting multiple insurgencies. Opponents to the plan say that Defense Secretary Robert Gates is going too far in emphasizing counterinsurgency at the expense of traditional warfare and weapons.

(Needless to say, there will be a lot of debate before the final 2010 QDR is released - SMS)

And lastly, a goodbye to General Dynamics (NYSE:GD) CEO Nicholas Chagraja who stepped down from the position. In his 12-years at the helm, the company grew by more than 700% to $29.3 billion.