Interview – June 27, 2008

The first half of the year has been filled with economic news that has led to broad market declines and the U.S. market remains in negative territory approaching double digits.  What I like to address today is the overall state of the market, how the aerospace and defense has performed for the first half of the year, and the trends and factors that will influence how the sector performs in the second half.

As we chat today, there is significant downward pressure on the market with oil prices rising to all-time highs, reinvigorated concerns about the banking and housing markets, a recession in the U.S. and perhaps globally, and a declining dollar, although its held steady in recent months vs. the euro and the pound.  The past week has been one of the market’s worst and some analysts are now saying the decline might continue through 2009 before the market rebounds. With all of this hanging over the head of investors, I thought it would be useful to address the current circumstance with regards to the defense sector. 

Although defense and security is relatively independent of the economic issues currently affecting the broader market, it has for the most part moved in sympathy with the markets downward this year.

Aerospace and defense stocks began the year in negative territory as investors sold the sector to raise cash and capture gains generated from the past several years.  In April and May, the sector rebounded to gain more than 10% to pull it even with the broad market S&P500 index, although investors seemed less interested in the sector with their primary focus being on the broader economic issues.  

In June, and the past week, the market has taken a dramatic turn and aerospace companies have been significantly hard hit which I will address in a moment.  From a defense perspective, the interesting thing is that there has been no real news. Although the $40 billion Air Force tanker contract has been put back into play and several Air Force leaders have been replaced, the immediate impact of these events on stock prices is limited.  The key drivers of the sector remain the defense budget and supplemental spending packages.  In these two areas, there has been no real news as the budget for the next two quarters is a known and Congress is actively working on the next budget and supplemental spending packages to fund defense activities around the globe and to reset military capabilities.

As the defense sector enters a period of questions related to a slower rate of government budget growth and a new presidential administration, reduced interest in the sector was inevitable although many opportunities remain.   We have chatted with some savvy investors who saw the declines earlier this year and recognized that the positive trends that have driven the sector higher these past several years haven’t changed, so they deduced that the market oversold the sector and, in April and May, they were rewarded with better than 10% gains.

Now in June, we see the Index and the sector dropping to similar recent lows amid concerns about the effect that oil prices and a recession will have on companies with exposure to commercial aerospace.  Boeing (NYSE: BA) is at a 30-month low after Goldman Sachs downgraded the company to a sell and yesterday companies like United Technologies (NYSE: UTX) and Honeywell (NYSE: HON) dropped roughly 5%, volatility uncommon in large-cap diversified industrial firms.

In downgrading Boeing, the Goldman Sachs’ note essentially said that higher oil prices would lead to poor finances for aircraft operators who will then delay ordering new places or deferring existing orders.   Likely all true, but the question we need to ask is, how much does this really matter?  The counter-argument being the following. First, that new orders at this time are not critical as Boeing and its suppliers have a full backlog for the next several years.  While Wall Street typically looks toward the next quarter’s performance, or the one beyond that, Boeing is taking orders for deliveries in the middle of the next decade.  While delivery schedules to specific companies will undoubtedly change and some orders will be cancelled, with a multi-year backlog it is likely that the true impact won’t be known for several years and a recovery could happen in advance of when the impact would be felt. Right now, we are just dealing with speculation.  Secondly, healthy airlines will want to upgrade to the newer, more fuel efficient planes which are designed to save them substantial money in operations.  And third, once the new 787 completes testing and enters the delivery phase, R&D costs will drop substantially improving the firm’s cash flow and earnings.  Since I can’t envision the air travel industry disappearing even as oil prices rise, a rebound in commercial aerospace is likely even if the timing is not known. And this presents an opportunity for those that time it right.

Getting back to the performance of the overall sector, the volatility in the broader market definitely has parallels in the defense sector.  Through May, there were a number of companies that had gained better than 30% whereas the worst performers in the industry were down more than 50%.  The large defense companies had essentially been neutral with Lockheed Martin, Raytheon, General Dynamics, and Northrop Grumman all flat for the year through May.   This is something we all should have expected given the likelihood that the sector will be shifting from a wartime spending pattern to one focused on recapitalization and investment. 

Shifting from the trends to a technical analysis of the sector, looking at the past four years, we noticed something interesting.  In particular three trends.  June is a good harbinger of what to expect in the market. Gains and losses in June were followed by the same in July and August.  Although I must point out that the markets had been relatively flat in each year.  Secondly, the defense sector had a negative correlation with the market in each of the four years.  If the S&P went down, the SPADE Defense Index was up. And third, in three of the four years, the sector was positive in advance of the end-of-budget-year contracts awarded in September.  In all four years, even summertime declines in the defense sector became positive returns by the end of September.

Of course, as they say, past performance is not indicative of future gains but I did find it interesting that the pattern was consistent over the prior four years time-period. Although I’m sure it’d be interested to do further research into prior years to see how far back this trend goes. That said, although the summer months in the past years were relatively quiet and the start of summer 2008 has been anything but, this recent history bears consideration.

Which brings us lastly to the second half of the year.  The market looks like it will remain volatile so buying on the dips and selling when the market seems comfortable, is being touted by analysts. 

For the defense sector, the biggest drivers and obstacles to the sector’s growth have not really changed.  Any world situation requiring a new military engagement or a risk to security would provide a positive bump. Comments from the Obama campaign signaling funding stability or growth for defense activities after an Iraq pullback or a vice-presidential choice with a strong defense background would also likely provide a bump. And based on comments from defense executives, I’d expect many of them to continue to report strong quarterly results. 

Key obstacles remain political rhetoric between the White House and Congress or on the campaign trail regarding the budget and future spending, although this affects the mentality of investors but not always the revenues and earnings of companies.  Analyst comments like the recent downgrade of Boeing and the commercial aerospace sector can have a great impact but I believe that these currently reflect concerns that likely will not impact the short-term bottom lines.

Overall, I believe that the sector encompassing defense, homeland security, and commercial aerospace still has a number of positive drivers that have yet to play out.  Considering the current economic climate and market volatility, the sector should definitely be part of one’s portfolio diversification options.  And it wouldn’t surprise me at all if the SPADE Defense Index, as well as the Powershares Aerospace & Defense ETF (AMEX: PPA) that tracks the Index, continue to outperform the S&P500 for a ninth consecutive year. 

Thank you for your time.

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. Powershares is a registered trademark of Powershares Capital Management.