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Defense Sector Q&A: Scott Sacknoff of the SPADE Defense Index Gives Insight into Recent Performance of Defense Stocks

“Index is at a higher level than we were at the peak of defense spending” - Scott Sacknoff

Point Roberts, WA / New York, NY - June 19, 2013 (Investorideas.com Newswire, www.homelanddefensestocks.com (HDS)) Investorideas.com, an investor research portal specializing in sector research including defense and Homeland Security stocks issues a recent interview with Mr. Scott Sacknoff of the SPADE Defense Index (NYSE: ^DXS), the underlying index for the Powershares Aerospace & Defense ETF (NYSE: PPA).

Scott Sacknoff discusses the recent performance of the defense sector.

HDS: As the aerospace and defense sector surges and hits all-time highs, we've decided to chat again with Scott Sacknoff, manager of the SPADE Defense Index to get his insights into this move. So Scott, I'm sure not many people realize that we are at historical highs.

SMS: Yes, I am sure it is surprising to many but today the Index is at a higher level than we were at the peak of defense spending. Investors have been recognizing the sound balance sheets of the companies within the sector, their track record of solid dividends, and that the fear of sequestration has not yet had a dramatic impact on the bottom lines of firms. As the broader market powers higher, so has aerospace and defense. And today the sector is up nearly 20% year to date and more than 30% over the past twelve months. Overall, we're above the previous historical highs by a few percent.

HDS: So sequestration had no impact on the firms?

SMS: No, it definitely impacted individual programs and workers but a lot of the cuts so far have come from improvements in efficiency, canceling or delaying programs that had not yet seen contracts awarded, or shifting the spending timeframes on new programs and hardware delivery. The changes impact readiness by the military and what they have at their disposal but shifting delivery of say, 5 planes form 2017 to 2019, frees up budget space in 2017 but doesn't impact revenues of companies reporting today in 2013, only backlog. As we all know, lots can happen in the world and quickly so spending reductions through 2020 does provide the Pentagon with some flexibility. At least for the moment.

HDS: You mentioned that the companies had sound balance sheets, can you go into this a bit further.

SMS: Sure. Unlike the late 1980s / early 1990s after the Soviet Union fell when the government tried to implement a peace dividend with draconian cuts that caused the sector to react quickly and with painful reaction to their stock prices, the current post-Iraq, post-Afghanistan world was a known for several years prior to peak Pentagon spending. During that time, many defense companies restructured their debt they had on the books, right-sized employment levels, sold/divested slower growth operations, and repositioned themselves into markets they could best compete in. All the while expanding their competitiveness into international markets. Today, the firms are reaping the rewards of these efforts.

HDS: And investors are starting to notice.

SMS: Yes. Finally. The most recent quarterly earning releases were a wake up call to many analysts and investors. Although the index had declined by a third into the bear market territory as the market retreated in 2008 and 2009, since early 2009, the sector has been on a steady uptrend, gaining more than two and a half times since the lows. The media continued to focus on the unknowns of sequestration and it was only until the past quarter when it became clearer as to what and how sequestration would impact the sector, that one could become more comfortable. Quarterly earnings accelerated this comfort level and combined with the sound balance sheets companies were able to take actions that the investor base noticed. This included announcing a number of dividend increases and stock buybacks including that by Northrop Grumman, which is reacquiring a staggering and unheard of 25% of the float. Goldman Sachs came out with conviction buys on both Lockheed Martin and Northrop Grumman. Jim Cramer on CNBC cited Boeing, United Technologies, Honeywell, and Precision Castparts as among his favorites. And analysts started to upgrade companies and the sector as it recognized the strengths of the sector: namely international defense sales and commercial aerospace, which so far have offset any declines from sequestration and which are growing markets.

HDS: Can you address two recent events related to the sector: the Boston Marathon bombing and the NSA's PRISM cell phone and internet monitoring program. How do these impact defense and homeland security stocks?

SMS: Well, any time there is an incident it raises awareness of the sector and puts a spotlight on the companies. Unfortunately, there is rarely a direct play one as security activities tend to be performed by a rather diverse group of companies. Some may get more exposure for a short period of time but ultimately we see interest in a range of firms. In Boston, the ability to identify and track down the bombers took great effort to gather video from private store video surveillance and that provided by private cells phones in order to identify possible witnesses and the instigators. It showed the weakness in the system is that it still requires a lot of manual effort to identify what you are looking for. Automation is making progress but is still many years off and a number of firms will be working on solutions. Ultimately though, I can't easily make a connection between any individual company or product category that benefits from this tragedy.

As far as the NSA PRISM program, which proactively collects data before incidents (instead of waiting for the public to provide it freely afterwards), the program was actually discussed several years ago without the PRISM name being known. Classified or not, it came up several years ago when Congress was debating security measures as well as in discussions about the phone companies not saving as much historical data as they used to. A warrant, of course, is of no use if the data isn't collected or saved. But like the Boston bombing, finding and using data is different than collecting it.

Booz Allen, who employed the perpetrator for the past three months, obviously took a hit in the market in the short term. The bigger question is if their procedures were at fault. This will determine whether or not there is a longer tem impact to their business. Few NSA companies are public: KEYW Corporation (KEYW) and Mantech (MANT) along with the larger defense IT contractors, but I am not sure if there is a play here either. The bigger news incident that impacts defense investors is likely Syria.

HDS: Why is that?

SMS: The public confirmation from non-U.S. sources that chemical weapons are being used against the populace provides the U.S. government with a public reasons for supporting the rebels including providing them with American hardware, weapons, and supplies. As the contingency budget for Iraq and Afghanistan goes down, new monies could be added for Syria. Not large sums, of course, since a direct intervention is unlikely, but new, unanticipated funds none-the-less.

HDS: Lastly, any final thoughts?

SMS: Only that we've begun to see a trading volume pickup and inflows into the Powershares Aerospace and Defense ETF (NYSE: PPA). It think there is a relative floor to the defense sector as a whole. Our research has shown that any time the sector has declined in the past 30 years; it recovered to previous levels within 2 to 3 years after factoring in dividends, so principal has been protected. This is truly important to many investors. The inflows into the ETF indicate to me that non-core investments are starting to flow back into the sector and there are people willing to place a bet on the sector, not just an individual company. And this is a very positive sign.

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