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Is "War on Terror" a Boon for the Defense Industry?


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U.S. defense companies are benefiting from the ongoing warfare in the Middle East and elsewhere. Europe, the Middle East and Asia haven’t let demand flag, resulting in a steady inflow of defense dollars.

The terror spawned by the Islamic State of Iraq and Syria (ISIS) has deepened the resolve of the West to fight it. The increased threat of global terrorism means more spending on defense and intelligence services. This has drawn market watchers to closely track defense stocks and the sector overall.

The aerospace and defense sector is expected to return to growth going forward from declines in the past three years that bore the brunt of weak U.S. defense budgets. The increase in the domestic defense budget and growth in defense budgets of important allied nations around the world spurred by emergent global security threats are expected to aid the sector as a whole.

But no country in the world can match the U.S. when it comes to military spending. In the U.S., military spending consumes two-thirds of the discretionary budget, way ahead of the second-spot occupant China and third, Russia.

Increasing threats and the need to safeguard the interest of nations and people have pushed up demand for U.S. weapons exports, benefiting U.S. defense manufacturers. The ISIS and Syrian conflict, continued saber-rattling by North Korean leadership and high tensions over the disputed ownership of islands in the East and South China Sea are some of the ongoing global flashpoints.

Many of the defense majors are doing a decent job, propelled by the following strategies:

Budget Stability: On the eve of Halloween 2015, Congress approved a crucial bipartisan budget agreement, in line with the White House. Although it was $5 billion short of the President's 2016 defense budget request, the comprehensive two-year budget deal, unveiled on Oct 26, 2015, is expected to give Pentagon planners the fiscal stability they have been pleading for. This deal is also a reprieve from situations involving government shutdowns and lengthy stop-gap spending measures.

Adding to the positive sentiment, U.S. Defense Secretary Ash Carter unveiled the fiscal 2017 defense budget this February. The contemporary political scenario, marked by Russian assertiveness and the brutal rise of the ISIS, has reshaped spending priorities to a large extent.

Among the priorities, the budget will seek a major boost in funding for the fight against ISIS as part of its FY 2017 defense budget request. This signifies a potential stepping up of U.S. military efforts. The $7.5 billion request for the fight against the Islamic State is up about 50% from the FY 2016 allocation.

The Obama administration has decided to boost the European Reassurance Initiative budget to $3.4 billion for fiscal year 2017 to support military training and exercises on the continent. This is almost a four-fold increase from 2016's $789 million that will likely help the U.S. to reinforce its military stance in Europe in view of Russia’s ominous moves in Eastern Europe since the annexation of Crimea in Mar 2014 and the ensuing war in eastern Ukraine.

The proposed budget will also seek to enhance spending in several key areas, including cybersecurity, electronic warfare and increased security for crucial U.S. satellites. $8.1 billion of funds for submarines (with over $40 billion in the next five years) brings into focus the likes of Huntington Ingalls Industries, Inc. HII and General Dynamics Corp. GD.

Foreign Military Sales (FMS): The big defense operators are expanding their markets, with foreign sales acting as a key top-line growth driver. Driving the demand for foreign sales is a number of escalating regional conflicts, such as, the ongoing Syrian civil war, the unsettled situation in Iraq, Yemen and Libya, and tensions in Eastern Europe. Apart from the U.S., U.K. or France, a number of emerging markets as well as nations, such as, India, Japan, the United Arab Emirates, Saudi Arabia and Brazil are increasing defense spending and generating business for the U.S. aerospace and defense companies.

Notably, defense stocks are in the spotlight as countries in Europe and the Middle East may need to ramp up their defense spending in order to combat the threats posed by ISIS. Indeed, Britain has planned to boost its defense equipment budget by 7% over the next 10 years. The total budget amounts to approximately $270 billion, including the uplift in equipment spending, the purchase of nine new Boeing BA P8 maritime patrol aircraft and two new strike brigades by 2025.

In fiscal 2015, sales under the government-to-government FMS Program totaled $35.35 billion, according to the Defense Security Cooperation Agency. The U.S. government is on track to approve nearly $40 billion in FMS in the 2016 fiscal year that ends on Oct 1, as per a top Pentagon official.

In this regard, it is worth mentioning that foreign military contracts are a vital growth driver for Raytheon Company (RTN - Analyst Report) too. The company has been witnessing a steady rise in international sales over the past few years. International bookings comprised 31% of total company bookings in the second quarter of 2016. International sales increased 8% in the quarter while 42% of the total backlog was from international customers. Rising demand from the Gulf countries as well as the Asia-Pacific region will likely be the company’s primary revenue driver.

Restructuring/Acquisition: To maintain margins in a tough business environment, companies are squeezing costs out of their operations and diversifying into new business areas. Commercial aviation is one such diversification play, with opportunities in the emerging markets driving the trend.

New macro challenges are prompting industry players to revisit their business models. One such example is Lockheed Martin’s two recent strategic moves – a planned spin-off or sale of its government IT and technical services businesses and the acquisition of Sikorsky. This prime defense contractor became an even bigger aerospace powerhouse as it scooped up Black Hawk helicopter maker Sikorsky Aircraft from United Technologies UTX for $9 billion in cash.

Another defense contractor, Rockwell Collins Inc. COL is known to acquire assets having the same line of business, thus helping it to expand its core offerings. The 2013 ARINC Inc. acquisition was a major leap forward for the company. More recently, the company expanded its Information Management Services portfolio by adding Pacific Avionics in Mar 2015.

Increase in Cyber Spending: Computer attacks are among the most pressing security challenges facing the U.S. Increasing cyber-attacks, terrorism threats, and enhanced geopolitical instability are driving focus toward electronic warfare, C4ISR (Command, Control, Communication, Computers, Intelligence, Surveillance and Reconnaissance) and cybersecurity. In this context, Obama in the fiscal 2017 budget proposal has asked for $19 billion for cyber security across the U.S. government, an increase of $5 billion over fiscal 2016.

Next-Generation Technology: At the macro level, there has been a gradual shift in defense spending patterns. In response to asymmetric terrorist threats, the emphasis appears to have shifted to high-tech intelligence equipment, replacing demand for conventional big guns and heavy armor.

The major industry players have, in response, resorted to bolt-on acquisitions to plug gaps in their product offerings. A focus on R&D is also helping these companies to develop next-generation technologies essential in a climate of fewer programs and reduced budgets.

The Pentagon intends to invest $2 billion over the next five years to acquire more of Raytheon’s Tomahawk missiles and upgrade their capabilities. This would bring the U.S. inventory of the missiles to more than 4,000.

Northrop Grumman NOC is bringing more focus to its airborne and space ISR business by realigning its divisions. In particular, the emphasis is on ISR systems, advanced electronics and software development technologies. It is the proud owner of the popular Global Hawk, an unmanned system with the ability to transform itself into an operational weapons system when required. Northrop also boasts products like the E-2D Advanced Hawkeye, which provides 360-degree surveillance at all times.

Apart from the ISR business, Northrop Grumman will register higher growth from major weapon-procurement programs of the Pentagon. Carter's fiscal 2017 budget emphasizes the need for a new Air Force Long Range Strike Bomber (LRS-B) awarded in Oct 2015 to Northrop Grumman. The Air Force plans to buy 80 to 100 of the new airplanes, and the contract could go up to $50 billion to $80 billion.

Although sequestration casts a shadow of uncertainty on long-term funding for periods beyond fiscal 2017, we are bullish on Engility Holdings, Inc. EGL, sporting a Zacks Rank #1 (Strong Buy). We are also positive on stocks like Huntington Ingalls Industries Inc., General Dynamics Corp., CAE Inc. CAE and KLX Inc KLXI, all four carrying a Zacks Rank #2 (Buy).

Bottom Line

The U.S. defense majors will likely rule in the near term as the world comes together to combat the brutal jihadist group ISIS. With two years of budget security, investing in defense looks to be a good idea now, particularly buying the blue-chip stocks on the dips.

Check out our latest “Aerospace & Defense Stock Outlook” for more on the current state of affairs in this market from an earnings perspective, and how the trend is shaping up for this important sector of the economy now.

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