Fire power

PUBLISHED : Tuesday, 28 April, 2009, 12:00am
UPDATED : Tuesday, 28 April, 2009, 12:00am

As the United States continues to expand its war on terror and looks to counter other global security risks - such as nuclear proliferation and cyber-warfare - the defence industry is expected to be a solid investment tool for years to come, analysts predict.

'So long as the US is actively involved in world affairs, defence spending will not markedly decrease,' says Lawrence Korb, an assistant secretary of defence during the Reagan administration.

'During the past decade it has gone up 40 per cent in real terms for the Department of Defence's (DOD) base budget - not including the wars in Iraq and Afghanistan.'

The defence industry seems to have it made thanks largely to continuing equipment needs in Iraq and Afghanistan, solid balance sheets at most defence contractors, stable businesses with large funded backlogs, US government outsourcing of information technology, training and logistics, and pensions that are largely reimbursed by Washington.

However, the share of defence outlays for research and development, and procurement of new weapons systems and aircraft, has been in steady decline since the 1990s.

It's a trend echoed by US Defence Secretary Robert Gates' proposal earlier this month to stop spending money on futuristic weapons programmes, such as the F-22 Raptor jet fighters and new presidential helicopters, and reallocating funds for weapons systems US soldiers can use against an actual enemy.

Mr Gates suggests that the Pentagon discontinue the F-22 programme after making 187 planes already ordered from Bethesda, Maryland-based Lockheed - the biggest US defence contractor. At US$140 million each, the F-22 is the military's most expensive fighter plane.

Mr Gates also declined a new fleet of Marine One presidential helicopters - costing US$13 billion. He says he will increase spending on equipment to target insurgents, such as US$2 billion more on reconnaissance and surveillance equipment, including 50 new Predator drones along the Afghanistan-Pakistan border.

A US$160 billion system of combat vehicles, bomb-hunting robots and flying sensors will also be cut, along with plans for missile interceptors to guard against attacks by rogue states. The navy will also re-evaluate buying new destroyers.

Right now, defence spending accounts for only 4 per cent of US GDP versus 6 per cent during the 1980s. The 40-year average is 5.2 per cent. Valuations for defence stocks are lower than in the 1990s.

The largest defence contractors are Boeing, Lockheed Martin, Northrop Grumman, Raytheon, L-3 Communications, General Dynamics, BAE Systems, Thales, Finmeccanica and EADS.

Most analysts contend that relative to others in their class, Boeing is overpriced, whereas Lockheed Martin and General Dynamics have outperformed the market in the past year. Northrop and Raytheon are regarded to have met earnings expectations.

Before September 11, 2001, defence shares usually traded at a modest 10 to 20 per cent discount to the market multiple. But, after the World Trade Centre attacks, defence budget growth outpaced general economic growth and share values increased.

Defence stock valuations appeal more now, despite possible budget cuts. In the 1990s, the median forward price-to-earnings ratio multiple group was 11 times - even as defence budgets shrank.

Short-term earnings will likely be above-average with most weapons makers possessing strong balance sheets and cash flow. So far this year, defence stocks have underperformed the overall market, with the S&P down 17 per cent and defence down 29 per cent as a group.

Nevertheless, New York-based Howard Rubel, a managing director with Jefferies & Company, is bullish and thinks defence investments 'should be part of a well balanced portfolio'.

Robert Stallard, a New York analyst with Macquarie Capital, agrees that defence stocks 'could be viewed as prudent relative to other equity investments', adding 'our target prices for defence stocks show considerable upside from the current prices'.

All analysts believe defence stocks are resilient because defence expenditures have little correlation with GDP growth and such companies are solvent. 'The main concern,' says London-based Zafar Khan, of Soci?t? G?n?rale, 'is that [US President Barack] Obama might cut [the] US defence budget. [But] we do not think [the] budget will be cut, [and] we expect growth.'

Cai von Rumohr, a Boston-based analyst at Cowen & Company, is optimistic about growth outside the western hemisphere. 'Just look at the backlog for F-16 [fighters] in Europe and Asia.'

His observations are borne out by the US$5 billion in executed contracts at the recent IDEX defence trade show in the United Arab Emirates (UAE).

'Despite the recession, I am a firm believer of following the smart money. Look at the recent spending in the UAE as an indicator,' says Dawn van Zant, founder of ECON and the, an umbrella of financial content portals.

Since the events of September 11, 2001, investment outlays for defence grew at 10 to 12 per cent annually for procurement of weapons systems and research and development in nominal terms, and 8 to 9 per cent in real terms.

The core US defence budget has gone from US$376 billion for fiscal 2004 to US$513 billion for fiscal 2009, and this has driven similar growth in the defence industry. The 2010 US defence budget is also up - US$534 billion for the Department of Defence base budget in 2010, according to reports.

Mr Khan says: 'The past five years have been very lucrative with top line growth of 7 per cent to 8 per cent for most industry players.'

He adds that 'this has been driven by the expanding DOD budget and the supplemental spending for the Iraq and Afghanistan wars'.

Mr Rubel says 'industry revenues and profits have expanded from US$245 billion to about US$336 billion from year-end 2004 through 2008. Revenues are expected to rise to US$352 billion this year. Profits were about US$11.3 billion in 2004 and rose to US$24 billion last year. The industry could generate about US$25 billion in 2009 profits'.

Dr Korb believes that defence investments are recession proof. 'We still keep buying planes, ships and tanks,' he says, adding that any decline will be low single-digit percentages because defence is always critical, even with a Democrat as president.

Mr von Rumohr believes defence is a relative safe haven in tumultuous times because such companies have fewer risks than the average business.

Defence investment is much more robust than those sectors which are related to GDP growth such as retailing or housing. The bright spots are, 'soldier-related expenditures such as salaries, food, clothing, housing and gear like night vision [goggles], and body armour is generously funded because you want troops in harm's way to be well equipped', Mr von Rumohr says.

Northrop expects to do well in cyber-war solutions because information technology is a force-multiplier enabling modern armed forces to do a little with a lot and seamlessly co-ordinate efforts between service branches.

However, Hong Kong-based Dorothy Lee, a director with private equity firm the Carlyle Group, once a significant defence sector shareholder, feels that the sector is subject to the vagaries of the market. 'We believe all investments are subject to economic and fundamental market changes in the overall economy and their own sectors,' she says.

Defence spending is not wholly recession-proof because tax dollars are finite. The US can't run trillions of dollars in deficits indefinitely, yet geopolitical threats are always growing and changing.

Both Mr Rubel and Mr Stallard think that while defence is less affected by general macroeconomic trends, it is not entirely recession proof.

Mr Stallard has recommended to institutional investors to have an overweight position in defence. 'Armaments are a misleading term, as defence companies supply a whole range or products and services, and not just armaments,' he says.

'Defence is more of a steady investment so [it] does well in the longer term,' Mr Khan says.

Looking at ethical considerations, Mr von Rumohr says the argument can be made that it is ethical to make systems that deter war because nations need to defend themselves, the companies are legitimate business and institutional investors are more focused on getting good returns to increase shareholder value.

'In terms of ethical issues, some call the defence stocks 'sin stocks' like gaming or tobacco stocks, but most agree that defence spending is necessary if not critical.

'Some of the most innovative technology comes from development within the defence sector that has beneficial applications for other sectors,' Ms van Zant says.

For example, worldwide company OSI Systems sells its products in markets as diverse as homeland security, health care, defence and aerospace.