Defense and aerospace contractors are experiencing two significant headwinds. We could describe the first as secular — the long-term draw down of forces as U.S. wars in Iraq and Afghanistan reach their questionably successful conclusions. The second is cyclical — the pressure on military budgets arising from the sequester, itself a consequence of the financial crisis and its aftermath.
Defense lobbyists have been hard at work on Capitol Hill to convince lawmakers of the dire effects of these headwinds, and the need to restore robust funding to the sector. But the fact is that there are tailwinds which are compensating for the difficulties the industry is facing. And judging from the performance of the big players this year, those tailwinds are stronger.
Long-Expected Changes
As far as the secular changes go, the current slowdown has actually been ongoing for several years, and contractors have been preparing for it. Lockheed cut 30,000 from its workforce in 2008; Northrop Grumman sold off its shipbuilding business in 2011 — both long before the sequester. Knowing that a secular slowdown is imminent or underway, any business will try to streamline, consolidate, and concentrate on its core competencies—and these businesses are no exception.
And the large defense contractors have weathered both the draw-down and the sequester well. They have low debt, good earnings, and good profit margins. Their stocks have appreciated handsomely in 2013. Should the stocks decline on a market pullback, they may become interesting investments.
New Opportunities
In addition to effective strategy in response to the end of hot wars and the constraint of the sequester, there are two areas of growth where defense contractors will be able to grow: in sales to developing nations, and in deployment of cyber-warfare systems.
Geopolitical Tensions Create Demand
Both the Middle East and Asia have been on the radar during the past year in terms of military tensions. Libya, Egypt, Syria, and Iran all show, each in its own way, the continuing risk and instability of the region — and regional leaders are not convinced that the U.S. government is ready to stand by them in the event of war or political turmoil. (Remarks from Saudi officials about the nuclear deal struck with Iran expressed particular dismay.)
In Asia, many governments are becoming increasingly fretful about China’s attempts to expand its area of influence—most recently in its declaration of a zone of Chinese air space over the East China Sea.
U.S. suppliers have been increasing their market share in sales to both of these regions, as can be seen from the figures below:
Conventional Arms Sales to the Middle East: Supplier Percentage of Value
Conventional Arms Sales to Asia: Supplier Percentage of Value
Source for above figures: Congressional Research Service
Cyber-warfare: The Next Frontier
Another secular tailwind for defense companies is the ever-increasing demand for capabilities in cyber-warfare, electronic surveillance, unmanned vehicles, and other novel systems. The U.S. military dominates the global cyber-security market; the Department of Defense reportedly has 7 million IT devices connected on 15,000 networks, all vulnerable to cyber-warfare attacks. DoD spending on cyber-security alone between 2013 and 2023 is estimated at nearly 0 billion, about 56 percent of the global market.
[Hear More: Cris Sheridan on HFT, the Surveillance Society, and Mathematical Governance]
Cyberwarfare: A Lucrative Frontier for Defense Contractors
Source: Daily Tech
So while conventional military budgets are shrinking, cyber-warfare budgets will find a way to increase, and defense contractors have positioned themselves to benefit from the transition.
Why They’re Doing Well
In short, the big defense contractors — Lockheed, General Dynamics, Northrop Grumman and others — are doing well because they’re doing what any other company would do under similar circumstances: finding niches, streamlining their work forces, and using their knowledge of their markets.
And smaller industry participants are probably even more flexible in executing the same strategy than their big-fish brethren. The advent of cyber-warfare in particular has given many companies exposure to the benefits of growth in this space — including those you might not think of as defense-related, such as Google and Apple. While we are not specifically recommending any companies in the sector, we are suggesting that on corrections they can be considered for investment because of the long term tail winds that the industry is enjoying.
For more commentary or information on Guild Investment Management, please go to guildinvestment.com.
