The Iraq conflict has been long and messy, but the US government hasn’t lost its appetite for military spending. According to the National Priorities Project, 40 cents of every income-tax dollar paid last year by US citizens went on military spending. With defence contractors vying to supply India and Japan with new fleets of jets, and US plans to modernise its ailing army, the defence sector is gearing up for a new wave of investment.
Defence stocks: a traditional safe haven
Defence stocks have long been regarded as a safe haven during market turmoil; the sector’s performance is not tied to movements in the market, but instead depends on political events and domestic security policies. And these are certainly working in its favour at the moment. Next year, the US defence budget will top a record $600bn, up 65% on 2001. And spending cuts in the near term seem very unlikely, regardless of which party is in power – after China recently, controversially, shot down a satellite with a ground-based missile, the Democrats won’t want to appear weak on security ahead of the 2008 election, says Dan McCrum in Investors Chronicle.
Of course, one major concern is that if the US winds down activities in the Middle East, larger defence programmes will be delayed. But even if the US steps down plans to introduce new armoury into its ranks, it will still have to upgrade the equipment it already has. For example, each of its 7,000 Bradley fighting vehicles costs £1m to fix and a further £3m to equip with modern communications systems. Some $48bn is allocated in the present US budget towards maintenance work alone.
Defence stocks set to benefit from modernisation
India and Japan are also modernising their military. US and European jet contractors are engaged in a “dogfight” to secure orders from India and Japan worth up to $15bn in total, say David Robertson and Leo Lewis in The Times. The Japanese have usually bought US military hardware in the past, but were irked that US Congress deemed the country was not “trusted” to buy US-manufactured F22 fighters. That’s good news for European jet makers, led by BAE (see box below), which hope to replace Japan’s fleet of F4s with the Eurofighter Typhoon, at $60m a piece.
In the UK, meanwhile, the sector is benefiting from measures taken by the Ministry of Defence (MoD) to deliver new contracts more efficiently. Under the new strategy, the MoD helps coordinate the use of equipment, specialist labour and support services in the industry, reducing costs and wasteful production, and cutting the risk of cost over-runs. A £20bn contract for UK-built Typhoons is expected to be signed with Saudi Arabia later this year and a host of smaller projects are in the pipeline. Consolidation in the sector is also likely to continue, with US groups Boeing and Northrop Grumman among those who have expressed an interest in buying peers in the UK.
“Taken together, then, the picture is of an industry insulated from the economic cycle,” says McCrum. Even in the case of an economic downturn, the timescales on large individual programmes, typically ten to 15 years, mean that any changes to spending will take a while to have an impact; and governments will be reluctant to scale back modernisation programmes once they have embarked on them. We have a look at the companies set to benefit below.
Defence stocks: two safe plays
“As a pure defence play, BAE (LSE:BA) is well-placed across the key areas of future spending on land, sea and air programmes,” says Dan McCrum in Investors Chronicle. Contracts won from the US Department of Defence to refurbish US Bradley Fighting Vehicles, for example, boosted operating profits by 38.5% to £1bn last year. With a heavy advance expected when the Saudi Typhoon contract is signed and further interest from Japan and India in the aircraft, the company justifies its “overweight” rating from JP Morgan. The company’s shares also trade at a discount to the European defence sector, on a forward price/earnings (p/e) multiple of 14.9, and a prospective dividend yield of 3%.
Another good bet is General Dynamics (NYSE:GD), largest supplier of equipment to the US army. General Dynamics is the only builder of tanks, infantry combat vehicles and nuclear submarines in the US, which it also maintains. It already has a large portfolio of projects fully funded, with a contracted backlog twice as big as annual sales. Recent troubles, including cost over-runs and problems with a new amphibious craft, have seen shares trade at a lower p/e than the other three big US defence contractors, at about 18.3 times earnings compared with the industry average of 20 times. But long-term investors should look beyond this “to see a solid company in an indispensable industry”, says Barrons