Wednesday, August 11, 2010

Opportunity and Risk in the Aerospace & Defense Sector

Opportunity and Risk in the Aerospace & Defense Sector

August 11 2010 – (, a leading global investor and industry portal for the defense and security sector, within, provides defense investors with sector commentary from Scott Sacknoff, manager of the SPADE® Defense Index.

Opportunity and Risk in the Aerospace & Defense Sector

A short summary of the defense policy, the budget & investing.

by Scott Sacknoff, SPADE Defense Index

Read more from the Spade Defense Index:

#1: The Defense Budget is Going Down

Really? The media seems to focus on this but its not a real surprise to anyone who works in the sector, analyzes the sector, works in the government, or in Congress. Defense stocks are off 28% from its all-time highs having declined with the market decline of 2008/2009 and rebounding to the current level. In spite of the fear of a forthcoming budget contraction, many of the largest defense firms in the most recent quarterly reporting period posted revenues, earnings, and margins that beat analyst expectation, the sector remains tethered to the path of the S&P 500. The irony is that the defense budget has not yet declined and company's operating in the sector have yet to be impacted from what everyone expects will happen at some point.

Still, it is highly likely that the defense budget will not increase over the next several years due to the economic and budget situation facing the United States and the need to get our national debt and deficit under control. And it is highly likely that the budget devoted to defense activities will be smaller than we see today especially if the country does pull out of Iraq and Afghanistan within the next year and a half. That said, there are still some that maintain that the impact on the defense sector will be much less than many foresee because of the unwillingness of Congress, historically, to challenge what is and what is not needed in the defense sector. An article which appears in the Volume 17 #3 issue of 'Quest: The History of Spaceflight' goes into great detail the problems and issues that President Eisenhower faced trying to balance the budget while maintaining a strong defense sector. He feared that when a retired General was not in the White House it would be easy for the President and Congress to succumb to the advice of military personnel on what was truly needed to maintain a defense to protect the U.S. and it was usually much more than they actually needed. Reading the article it was remarkable how similar the situation is today. Yet, although the budget is tremendously important to the sector, today it is not the only factor one must consider.

#2 What May or May Not Happen

To head off any possible outside action, Secretary Gates and the Department of Defense have begun efforts to identify systematic waste and institute cost reduction measures. The hope is to keep the budget at or about the currently planned levels and use savings from efficiency measures for procurement and R&D. This would be a net positive to companies operating in the sector. War funding included, U.S. military spending in FY10 will approach $661B. The Defense Business Board estimates at least $200B ($1T over the Future Years Defense Plan) is overhead which would rank the agency 49th globally in GDP just behind Singapore and Portugal. A number of measures are being proposed including shutting the U.S. Joint Forces Command, freezing hiring (at the Office of Secretary of Defense, all Joint Staff directorates, and Combatant commands), eliminating redundant functions, reducing the DoD civilian workforce, and changing the rotation policy (which currently costs about $4 billion annually to move personnel from site to site). In addition, some personnel policy changes such as changing the way pay raises are calculated, raising DoD’s Tricare health care premiums, shifting retirees to the Medicare health system at age 65 (health care costs DoD $50 billion annually and is growing), and reducing the active force to levels seen earlier in the decade in 2003 are estimated to save the agency billions. In the immediate term, Sec. Gates is seeking to free up $101 billion over five years with each service freeing up $2 billion in 2012 and each DoD agency $1 billion. In 2013, the services ramp up to $3 billion with a peak of $10 billion in 2016.

#3: It’s easy to knock defense stocks but is there hidden value.

If Congress allows DoD to get its house in order the impact on companies operating in the defense sector might not be impacted as badly as some foresee. The share price of many defense stocks are already well off their all-time highs and fundamentals indicate some very strong companies maintaining substantial cash reserves

and low P/E, low P/S, and other favorable metrics.


Defense sector export revenues in 2009 were $38.1 billion and have been rising for the past several years. Countries in the Asia-Pacific region and the Middle-East were not hit as hard during the recent global economic downturn and remain committed to building up their defense capabilities. As an example Qatar has issued an RFP to acquire up to 40 fighter jets, Canada, announced plans to purchase 65 F-35 Lightning II fighter jets to replace some of its F/A-18 at a cost estimated to be around $400 million. South Korea set its 3rd phase fighter acquisition competition for 2012 where they anticipate acquiring another 40-60 planes by 2020 to bolster the 120 Boeing F- 15K aircraft they have already bought. And the 19 July 2010 Defense

News cited that the Asian market for the F-35 aircraft ($60M - $90M each) could be for more than 500 fighters over the next two decades. And Sikorsky (United Technologies) said it plans to double its international helicopter sales to about $2 billion a year by 2014.

European Economic Issues

Meanwhile economic and budget problems in Europe could be a net positive for the U.S. defense sector as resources are committed to debt reduction and the acquisition of U.S.-built equipment becomes cheaper than maintaining an indigenous capability. For example, in the United Kingdom, spending on research and technology has declined by 25% to 439 million pounds ($676 M) since 2007 and defense spending

cuts of 10%-20% are considered likely. Capabilities will either suffer or they will be supplemented by buying hardware from their allies.

Increased Commercial and Related Activity

Analysts see the commercial aerospace sector as beginning an upswing that will take it through much of the next decade as airlines around the world upgrade their fleets. Boeing (NYSE: BA) has indicated that it is fully booked beyond the middle of the decade and is increasing manufacturing to meet demand—and this is before the order cycle uptick from U.S. carriers which have delayed purchases because they suffered financially in recent years. At the Farnborough Air Show in July, $47 billion worth of contracts was announced, most of it commercial. Next year at the Paris Air Show (the show rotates sites), this figure should be much higher as government's get a handle on their budget situations and government-focused contracts are announced alongside the commercial activity.

Restructuring Operations

Defense companies have known that a peak in defense spending was coming and have been preparing for some time. Many have substantial cash on their balance sheets which will allow them to continue to shift into markets that they deem as faster growing. A leaner defense landscape will lead to an uptick in Mergers and Acquisitions. Boeing on 4Aug10 completed their $775 million acquisition of Argon ST and the private equity acquisition of DynCorp closed on 7July10. Meanwhile Northrop Grumman (NYSE: NOC) announced it was exiting its shipbuilding business which they see has "little synergy between this and their other businesses". And European aerospace and defense firm, EADS, announced that it plans to expand in the U.S. and has an estimated 8 billion euros ($10.3 Billion) to spend on an acquisition.

Our Destabilized World

The recent failed assassination attempt of the Iranian president and North Korea's capturing another South Korean vessel reveal that our view on safety can change quickly. At this time there are several dozen ongoing armed conflicts around the world that could remain at current activity or escalate at any time. What we are willing to spend in the aftermath of a terrorist or warlike act can quickly shift our spending priorities.

#4 So, what's the downside?

Although the actual impact on a company's revenue from changes in the government budget may not be felt for several quarters (due to the length of time between when the budget process begins and money becomes available to procure items or research), the announcement itself tends to move stocks in the sector. Negative news and rumors can drive stocks in the sector lower even when no action takes place. At this point it time it is not clearly known what role Congress will take in reducing defense spending and what it will allow the Pentagon to do. All signs point to the fact that the Pentagon's efforts to restructure its operations are being met positively by many members of Congress and the money it frees up will be used to rebuild its capabilities, supporting the sector as a whole. However, changes can and will impact specific programs as well as the companies working on them. As an example, companies receiving significant revenues from war-time operations are likely to see declines as the U.S. pulls out of Iraq and Afghanistan once additional acquisitions to replace spent materials and build-up capabilities is accomplished. Although most of the companies that trade on the stock exchanges are much less exposed to the war effort than the public would imagine, it is likely they would be negatively impacted in the short term before share prices rebound. Likewise larger companies are more diversified among programs, agencies, and customers, and hence more immune to individual wins and loses but are susceptible to greater impact when large shifts occur.

#5 So an ETF or Individual Company?

In this environment, picking an individual stock to play the sector can be more risky than investing in a fund or a fund as part of a larger strategy. The defense sector has always had its own nuances, such as companies not being able to provide details on classified sector contracts, a budget which has been estimated by the Washington Post to be $75 billion. With all the conversations about what and how DoD will restructure and how large its budget will be in coming years, the opportunities that the sector presents (which have included beating by better than 100% or tracking the market for more than a decade and with current valuations representing a business decline that has not yet appeared) is definitely offset by the risk of these new unknowns. Recent movements in some individual stocks can be dramatic and highlight the risks. After the resignation of the president and COO of Mantech (NASDAQ: MANT) for undisclosed reason, their stock decline by 18% in 2Q10 and was downgraded from buy to hold by BB&T analyst Mike Lewis. Comtech (NASDQ: CMTL) dropped 38% after losing an incumbent contract to Viasat (NASDAQ: VSAT). Meanwhile as I type this, satellite imagery firm DigitalGlobe (NYSE: DGI) is up 14% today after receiving a multi-billion contract. The benchmark SPADE Defense Index (NYSE: DXS), provides a useful measure to see how the individual companies stand up to the performance of the sector as a whole. As the underlying index to the Powershares Aerospace & Defense ETF (NYSE: PPA), it covers the breadth of the sector's activities, not a concentrated portion of it and represents firms whose activities are vital to the sector and vital to their companies operations.

With A&D representing 5% of U.S. GDP and the sector underweighted by the S&P500, investors should include the sector as a core element of their portfolio. At this time, the ETF appear to be less volatile, more diversified means to get that exposure.

Disclosure: Scott Sacknoff it’s the manager of the SPADE Defense Index, the underlying index for the Powershares Aerospace & Defense ETF (NYSE: PPA)

About the SPADE Defense Index

More info and previous interviews:

The SPADE Defense Index® (AMEX: DXS) is a modified capitalization-weighted index comprised of publicly traded companies that benchmarks the performance of companies involved with the defense, homeland security, and space marketplace.

The SPADE Defense Index has been developed to be used by investors, financial professionals, trade analysts, and media as a benchmark for publicly traded stocks involved in these business sectors. The Index can be used as the basis for a range of financial instruments including options and other derivatives, exchange traded funds, and conventional mutual funds.

For more information:

Disclaimers: The information presented in this interview is for informational purposes and should not represent a solicitation or an offer to purchase an investment product. SPADE and the SPADE Defense Index are registered trademarks of the ISBC.

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