Thursday, February 25, 2010

Bullish on Defense?

Earlier this week I went to see Doug Harned of Bernstein. Doug follows the Aerospace and Defense group.

I've always liked Bernstein research. Their analysts seem to spend an extraordinary amount of time getting to know their companies and industries. While their stock recommendations do not always work out (whose do?) I always walk away from their meetings with a little more information.

So I was surprised to hear how positive Doug was on the defense sector. But, after hearing his explanation, I am tempted to say that I might have to change my opinion.

Up to now, here was my thought on the group: With the Iraq war winding down, and with the scheduled plan for withdrawals of at least a portion of the US military in Afghanistan, it seems logical that defense spending would be a likely target for budget cuts, especially in the era of trillion dollar fiscal deficits.

But Doug sees it otherwise. He said that no one in the military expects their budgets to be cut. Here's why: the age of our military equipment is as old as it has been in decades. For example, according to Doug, the average age of our aircraft is 25 years. Even allowing for the 60 B-52 bombers (which date back to Vietnam war days) this is extraordinary old.

The stress on, say, the F-18's (which have been flying for 25 years) has begun to show on the equipment, even with proper maintenance. Moreover, the older planes are much more vulnerable to new missile technology that is already available in Asia.

Thus, programs like the F-35 are not just desirable, but necessary.

He went on. If you believe that our only possible enemies are al Qaeda, then perhaps you don't need to spend so much on defense. On the other hand, if you want to maintain a superior military to the Chinese or Russians (which virtually everyone in Washington wants), you need to keep spending.

This is why the Obama budget calls for a larger percentage increase than any of the budgets in the Bush years.

Then there is the threat of cyber attack. Our infrastructure in general - and military in particular - have become heavily reliant on the Internet and satellite communication. Any serious cyber attack on these areas could have a devastating affect on our military (note the reaction of the US government to the recent cyber attack on Google). Serious funds need to be spent in this area to safeguard our systems.

Interestingly, the leaders in protecting military cyber security are names like Lockheed Martin and General Dynamics. Companies like Raytheon and L-3 also do work in this area, but Doug argued that they are less important than the existing defense companies.

And yet the relative valuation of the defense stocks stands at its lowest relative multiple since the end of the Vietnam war.

Put another way, Doug said, where else can you find a high quality group of companies whose revenues will almost certainly grow for the next few years trading at historically low relative multiples - and where the consensus seems to be leaning in the opposite direction?

I need to do more work in this area, but I think that Doug might be on to something.