The Financial Times October 28, 2012

Booming market in US defence stocks

By John Dizard

Speculators and even longer-term investors are always looking for that trade that will work out with a “trigger event”: some action or decision by a known person or group that happens at a distinct point in time. After all, what good does it do you to have even the best possible analysis of underlying value in some asset if the market doesn’t agree with you for a long time, if ever?

There you are, bleeding away your costs on your short position, or underperforming the market on your long position, with your partners gradually losing interest and taking back their money…it’s sad. With a trigger event, you have a bit more confidence that you will get paid.

So you would think that the scheduled mandatory cuts in the US defence budget coming up at the beginning of next year would provide an element of certainty to a decision to sell, or underweight, US defence contractors’ shares. It’s understood that some of the cuts may be postponed by the immediate post-election session of the existing Congress, but surely, given that spending reductions will be concentrated on equipment rather than personnel, the contractors face a bleak future, yes?

Well, the equity market says no, they won’t. Since the middle of this year, the market appears to have come to know something that the open political discourse does not. As the mandatory cuts in procurement that are part of the “fiscal cliff” come closer, defence shares have been rising in price.

There are two possible explanations that come to mind. One would be that investors are looking forward to a period of merger and acquisition activity within the industry, which would lead to takeover premiums in buy-out deals, along with greater efficiencies in the use of capital. Some of that happened during the last period of defence procurement cutbacks, at the end of the Reagan-era Cold War spending boom.

The other would be that there might be some “contingency,” as they call wars now, in a future that’s foggy to us, but clearer to the market. Yes, everyone agrees that the American public, and the politicians, are war-weary, and want to do “nation building at home”. Also, both presidential candidates made clear in the last debate that they don’t want another war in the Middle East. That doesn’t mean we won’t have one.

To this point, one of the best-performing defence equities since the industry’s valuation upturn in mid-summer has been Alliant Techsystems (ATK). The stock has risen by over 22 per cent since July, well ahead of the major indices. That doesn’t seem to be based on any exciting current news; ATK’s first quarter revenues and profits, announced on August 9, were flat as a pancake. As you can’t tell from the name, ATK is a classic munitions company: it makes bombs, rocket motors, ammunition, and the like. It’s much more interesting for politicians and armchair generals to talk about fighter aircraft, drones, tanks, or aircraft carriers, but none of those things can do much if they run out of bullets.

A few months ago, I asked a senior British staff officer what the most salient lessons of the Libyan intervention were. He replied that the allies had run short of munitions much faster than expected. That makes sense, because throughout history armed forces run short of munitions much faster than they expect. Fighter jets, ships, and special operations forces are photogenic, while ammunition bunkers are not.

The other point about ATK is that with an equity market capitalisation of a little over $1.8bn, it is a relatively bite-sized company from the point of view of any future M&A wave. Wall Street may like megadeals with megafees, but the Department of Defense, which must agree any deals, has become wary of excessive growth through acquisition.

John Pike, a longtime Pentagon budget analyst, now with GlobalSecurity.org, says of Pentagon-agreed M&A, “You would have to look at the standalones [as distinct from huge prime contractors]. I think any mid-tier standalone company is potentially in play.”

As for consolidating the bigger companies, he says, “they blow hot and cold on it”. The collective Pentagon thought is that in the past, contractors such as Boeing or Lockheed Martin grew too fast through mergers, and lost management control of procurement programmes.

Even so, one larger contractor, Northrop Grumman, has also seen its stock rise by over 22 per cent since the summer. Northrop is very active in developing advanced UAV’s, or drones, and is also known to…well, it’s hard to know all of what it does, because so much of it is paid for out of the enormous “black” budget.

When the Pentagon gets around to real procurement cuts, as distinct from the certain-to-be-bridged fiscal cliff, it will give relatively favourable treatment to the producers of these weapons of the future.

For all the political fulminating, there really aren’t many industries that have a more secure future than the US defence companies. They don’t have to make excessive capital spending commitments to secure their future; much of the development money and cost of new facilities are picked up by the taxpayer. No auto manufacturer really knows what its sales will look like in the first quarter of next year, but the defence contractors do. When spending cuts come, they will be spread out and comfortably financed.

Then there’s always the upside potential of one of those “contingencies”.