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Whether There's Blood in the Streets or Not, Defense Stocks Play a Vital Role

July 23, 2011 | About:

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying that "The time to buy is when there's blood in the streets." Rothschild made a fortune buying in the panic that followed the Battle of Waterloo, but that's not the whole story. The original quote is "Buy when there's blood in the streets, even if the blood is your own." That's contrarian investing at its finest, the worst things seem in the market the greater the chances for profit. In an ironic twist on Rothschild's words, today the blood is no longer flowing in the streets, instead the bleeding is coming from the American defense sector.

"My hope is that what has been a culture of endless money...will become a culture of restraint," Defense Secretary Robert Gates said during a news briefing regarding the Pentagon's intention to drop some big weapon systems in order to re-allocate over $100 billion in the Defense Department's budget for use elsewhere (source material here www.marketwatch.com/story/us-drops-some-big-weapon-systems-to-save-cash-2011-01-06). The US Defense Department's plan to slow its budget growth over the next three years before flattening it in 2015 and 2016 has stirred debate over how US defense companies will respond.[b][/b]

"Shares for companies that provide equipment and services to the military may be facing years of sluggish growth and a slump after 2013, RBC Capital Markets said in a note to investors. "Although the base budget is still likely to show modest real growth over the next two years, the US fiscal situation is likely to result in further political pressure to cut spending," wrote analyst Robert Stallard. "We think the 'tipping point' for defense spending is still likely to come in the next presidential term, with a fresh mandate for fiscal austerity, and a tail off in the Afghan operations... Defense we see largely as a value trap." (from a MarketWatch article here www.marketwatch.com/story/defense-stocks-are-a-value-trap-says-analyst-2011-01-10)."

The defense industry is in transition as the US Defense Department cools down after a decade of rapid growth. Now that the Afghanistan and Iraq wars are being handed over to the State Department's diplomatic corps and the US debt issue has sparked conversation about fiscal austerity measures, it seems that the spending spree in defense programs started in WWII and kept alive by the cold war may finally be unwinding, as reflected in headlines like this one (www.engadget.com/2011/06/19/senate-denies-navys-missile-shooting-laser-funding-puts-the-ki/).

The obvious contrarian take on all of this is, "Since when has the US government ever reduced spending on anything"? The more pragmatic approach would be to gaze into our crystal ball (edgar.com) and see how the major US defense companies are positioning themselves ahead of the widely publicized changes in government spending. The most common response amongst the big US contractors is to diversify revenue streams by expanding into international markets, robotics, intelligence, surveillance, and reconnaissance (ISR), and by expanding their engineering excellence into the fields of energy and environmental business solutions.

This can be seen in Raytheon's (RTN) acquisition of cyber-security firm, Applied Signal Technology, a sector deemed immune to budget cuts in the aftermath of the Wikileaks and other headline grabbing scandals. But it can also be seen in the slow three year decline of Alliant Techsystems (ATK), the world's largest producer of solid rocket motors and ammunition, two "old-war" businesses in secular decline. General Dynamics (GD) is seeing mixed results. Their information technology business has seen revenue increase, while its combat systems business has seen revenue and profits decline.

I think there are three important takeaways from this

  1. The defense budget of the United States will flatten out during the next presidency.
  2. The money traditionally allocated to big weapon systems will now be invested in new technologies such as ISR, robotics and cyber-security.
  3. The old tanks and airplanes producers will have to rely on international sales to replace losses from the US.
Given the correction in valuations, at this point I don't think it makes sense to see the defense sector as a value trap (like RBC Capital, above), but rather to start thinking about who are the winners and losers under the new paradigm. The losers are big weapons systems producers and suppliers of old technology. Companies that focus on the traditional components of war like bullets and missiles, such as ATK, have the most to lose as the Pentagon shifts its focus to new technologies. Conversely, I would rate technology plays such as Harris (NYSE:HRS) SAIC (SAI) likely winners in the new approach to US defense spending. While any shift in military spending could significantly affect these companies bottom lines, they have each created an interesting technological niche. Harris has the only "joint tactical radio system" - certified tactic radio, and is the leader in military and public safety communications.

I happen to think that SAIC is best investment in the sector as they provide the largest pool of engineering talent and have an army of employees with security clearances, which gives the firm a distinct competitive advantage when bidding on programs of national importance. Within the defense sector SAI is well positioned in many of the faster growing segments. For example, its CloudShield cyber-security business is the industry leader in deep packet inspection. Also, the company is broadly diversified across many areas such as homeland security, energy and healthcare. The company has seen fairly consistent gross margins of 13%, and strong free cash flow yields near 10% since its IPO in 2006. Furthermore, the company has a history of buying back shares, making smart tuck-in acquisitions and has a fairly high employee ownership (www.beyster.com/SAIC-Solution-Singh-Review.pdf). The downside, of course, is that SAI happens to generate 96% of its business through federal, state and local government contracts. The remaining four percent is comprised of commercial contracts (www.saic.com/news/pdf/corporatefactsheet.pdf).

The question facing investors is do you really want to own the best house in a bad neighborhood, and to what extent have fears of a slow down in defense spending already been priced into the market? It is my opinion that the entire defense contractor sector has been priced down in lock step regardless of which sector that particular company caters to. This temporary disconnect in the market's understanding of how austerity measures will affect companies exposed to the defense sector has created an opportunity to enter a position in technology companies that fit the government's new agenda. There is no doubt that all of the defense contractors will be negatively affected by cuts to the US budget, but I think I have isolated one company that operates in pockets of growth within the government services sector.

Rating: 4.0/5 (20 votes)


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