This Veterans week, defense spending made its way back to Capitol Hill... The world is catching up with the U.S.'s military dominance. Emerging markets are increasing defense spending and capabilities, and the U.S. is changing its spending strategy. So who will benefit from changes to the U.S. defense budget?
At the end of October, President Barack Obama approved the Defense Department’s $680 billion budget for fiscal 2010, which included funding to increase military personnel and support the wars in Iraq and Afghanistan. The difference in this bill, as compared to the previous administration’s, is the transition from big-ticket items for conventional warfare to funding for more troops and equipment for fighting smaller wars.
The new bill also allows for the Pentagon to increase its intelligence services that had been most recently contracted out to private businesses. Of the $680 billion, $550 billion is allocated to the Defense Department and the national security programs of the Department of Energy; $130 billion is earmarked to support the ongoing conflicts in Iraq and Afghanistan.
Defense companies are beginning to shift their models to the mindset of the new Administration. For example, just announced this morning, KKR & Co. and General Atlantic LLC agreed to pay $1.65 billion for a Northrop Grumman Corp. (NOC:NYSE) government-consulting unit. The company put the division up for sale to address concerns among lawmakers that some defense contractors were not complying with new conflicts-of-interest regulations.
Aggressive Changes
“Northrop seems to be moving out aggressively to reshape its portfolio to meet the characteristics of the Obama era,” said Loren Thompson, an analyst at Lexington Institute in Arlington, Va., to Bloomberg News. Northrop concluded “that they didn’t want to endanger their military satellite business with business that appears to be incompatible” with the new rules.
The Northrop deal is seen as just the beginning for shareholders as the administration shifts the defense spending strategy that has been so common for decades in Washington. As MarketWatch reports:
The 2010 bill authorizes the purchase of 30 F-35 Joint Strike fighters, built by Lockheed Martin Corp. (NYSE: LMT). It also includes funding to develop an alternate engine by General Electric Co. (NYSE: GE) and RollsRoyce Group (UK: RR), which created a dustup between the White House and Congress.
Obama had threatened to veto the bill only if funding for an additional engine interfered with procuring the F-35, so Congress took the cash from elsewhere. Congress also allotted $1.1 billion for nine F-18 jets and $1.4 billion for three littoral combat ships, one less than the Pentagon request.
Congress also rolled back the Pentagon’s request for more unmanned aircraft, lowering the procurement number by 12 to 35 Sky Warriors, built by General Atomics.
Conversations about additional funding will certainly continue as the Foot Hood massacre maintains its headline status. The question forthcoming will be how additional funds will be allocated: To equipment or domestic security?
Heads or Tails?
“After eight years of war, we must sustain our efforts to restore military readiness in order to meet current military challenges and prepare for the future,” said House Armed Services Committee Chairman Ike Skelton (D-Mo.), to MarketWatch.
But that might not be happening...
Defense spending is becoming a smaller piece of the budgetary pie.
While spending on defense appropriations will increase just over $200 million for 2010 – basically a rounding error in Washington – the overall budget has ballooned, with the American Reinvestment and Recovery Act (ARRA) responsible for much of the growth.
By 2014, discretionary defense spending will outpace other discretionary spending by a scant $6 billion, the lowest such figure for years.
What’s more, the 2010 defense budget actually came in above the president’s request, with Congress pushing it back into (slight) growth. Obama wanted to cut defense appropriations by just over $1 billion.
Add in the shift in strategy towards small warfare, away from large – and the general penchant for Democrats to cut defense spending – and there is a better-than-average chance that large defense companies will face contracting demand over the next few years.
Of course, defense contractors aren’t helped by stories of selling 12-cent washers for $19, as Aecom recently did.
Nor has the shift towards pay-for-results models, which, since 2004, has required defense contractors to deliver before receiving large checks – and which has transferred some of the costs for servicing vehicles back to the manufacturer.
Finally, with the nation still in perilous financial waters – yet with the nation’s military still strong and relatively unchallenged – focus has been yanked from next-generation fighter planes and upgrading battleships. Today, America is more concerned with the public option and corporate bonus structures; even with the Fort Hood tragedy fresh, defense is currently an afterthought.
At least, in the minds of many Americans. Global defense spending is a different story, though...
Global Security
As President Obama and the First Lady visited the Fort Hood Memorial Service Tuesday, the Department of Defense wasn’t only dealing with an internal investigation, but it had to rethink its strategy regarding missile defense on the West Coast. The risk of increasing a defense operation will be setting off a destabilization reaction from China.
“We have to be cautious about missile defense… [which] can be destabilizing if you are not careful,” said Air Force General Kevin Chilton, commander of Strategic Command and one of the military’s brightest brains, to Military.com. When the U.S. places anti-ballistic missile assets on the West Coast, “What does it make the Chinese think…?” he asked. But the difficult calculus of deterrence includes other threats, Chilton made clear: “On the other hand, how do you deal with a North Korea?” Then he added Iran to the threat equation.
All of these potential geopolitical conflicts will result in additional spending by the Government with Defense contractors and vendors reaping the benefits. Bank of America Merrill Lynch held its 2009 Defense Outlook Forum today and all signs are pointing to additional spending by global governments to assist their objective for security.
“I’ve never seen this much opportunity in terms of competitions,” said Christopher Raymond, vice president of business development at Boeing Co.’s (BA:NYSE) defense unit, during today’s webcast. “Countries must assess the capabilities they need from military jets, helicopters and ground equipment, taking into account weapons systems they can deploy as well as the emerging technology for unmanned craft.”
Upgrades, Upgrades, Upgrades
Companies like Boeing are taking advantage of the worn-down equipment and making themselves available to countries seeking to upgrade its defense initiatives. As The Wall Street Journal mentions:
Some 38 countries require “offsets” for costly investments in U.S. military equipment, to bring economic compensation with things like local jobs. With the recession, work is slow at some local factories, giving Boeing and other contractors a chance to provide work there.
It’s clear that Boeing’s strategy for growth can now be focused on international defense. During the company’s third-quarter earnings conference call last month, Boeing’s president, chairman and chief executive officer, Jim McNerney, was quite vocal about focusing on international governments. He said the company would continue moving into international defense markets and investing in new areas, such as intelligence, cybersecurity and unmanned systems and services.
And, as explained at the Bank of America Merrill Lynch webcast, Boeing’s international commercial airplanes business gives it a leg up on competitors when defense budgets begin to shrink. Overall, Boeing is the top U.S. exporter of commercial airplanes, by annual sales.
International Military Spending Grows
So who's spending more?
For years, the U.S. has spent more on defense than the rest of the world combined. Today, America spends almost 5% of GDP on defense. China, by comparison, spends roughly 1.4% of a much smaller GDP.
Make no mistake: America will continue to have the largest military in the world – by an extraordinary margin – for years to come.
But, as America’s share of world GDP continues to shrink, so too will America’s dominant edge in military spending.
For shareholders of companies like BAE Systems PLC (BA:London), Lockheed Martin Corp. (LMT:NYSE), Boeing Co (BA:NYSE), Northrop Grumman Corp. (NOC:NYSE) and Raytheon Co. (RTN:NYSE), this hiccup in growth is not an option. As publicly traded companies, the focus will turn to the international stage as a way to increase revenues and expand market share.
“Major defense companies are facing lower spending in the U.S. and Europe, but shareholders are still demanding growth so arms makers are turning to emerging markets for business,” said Guy Anderson, lead analyst at defense consultancy Jane’s Information Group.
The largest growth in military spending will be in smaller and developing countries. China’s military spending is undergoing rapid expansion – with double-digit growth now and for the foreseeable future.
As China grows, so do its neighbors. Taiwan must increase defense purchases to continue to have a deterrent to invasion. India must increase defense so as to not lose influence in shared border states – not to mention to protect against Pakistani instability. In fact, India’s defense spending rose over 34% this year.
Even Japan, which already possesses one of the largest militaries in the world, must increase defense spending to offset China’s superior numbers, and China’s nuclear weapons.
Meanwhile, even as Russia turns more hawkish, former members of the Soviet Union increase their deterrent force in order to protect their borders. Every satellite state looks at Georgia, and Chechnya, and starts purchasing weapons.
In all, the four BRIC nations now account for 15% of worldwide defense spending.
And then there's the Middle East...
Tensions Rising – Again
The Wall Street Journal recently commented on the demand for fighter jets by Arab sheikdoms. To wit:
Defense spending in the Middle East is expected to reach more than $100 billion by 2014, or 11 percent of arms orders globally, according to consultancy Frost & Sullivan.
This splurge on new weapons come as a relief to U.S. and European defense companies looking to boost overseas sales to help hedge against belt-tightening at home. The administration of U.S. President Barack Obama has made health care a priority and drastically cut military spending, including a high-profile measure to strip $1.7 billion from the budget for F-22 Raptor fighter jets.
“Threats including those from Iran or the instability surrounding Afghanistan and Pakistan, Iraq, and most recently Yemen certainly add to the need of Gulf states to review their defense policy,” said Christian Koch, director of international studies at the Dubai-based Gulf Research Center.
Iran, Iran, Iran
Iran's nuclear aims, no matter if they are peaceful or war-like, could lead to proliferation of nuclear technology – something the U.S. greatly fears.
"The fact is that that enrichment very much increases tension in the Middle East, and it may even lead to other countries in the Middle East thinking of going for enrichment," former U.N. weapons inspector Hans Blix said, as reported by CNN.
And it's not just nuclear weapons that are causing tensions to rise in the Middle East...
In fact, Iran is calling for Russia to "honor a contract to sell a missile defense system to Iran," says Reuters. The contract was for the S-300PMU1 air defense missile, also called the SA-20. This weapon can reach targets up to 90 miles away, and is designed to take down cruise missiles and aircraft. The systems can be mounted on trucks, too.
Bloomberg reports that Iran has been stockpiling "dangerous conventional weapons" too.
On Sept. 28, the country test-fired a missile with a range of 1,240 miles.
Middle East Spending Spree
This buildup of power and weapons in Iran has sparked moves by neighboring countries, like Saudi Arabia and the UAE to upgrade military forces and technology.
"The spending offers U.S. and European defense companies such as BAE Systems Plc and Lockheed Martin Corp. as much as $40 billion in sales, mostly in the next two to five years, analysts estimate. Some of these deals may be discussed at the Dubai Air Show starting Nov. 15," says Bloomberg's Henry Meyer and Sabine Pirone.
According to the article, Saudi Arabia is considering another purchase of jets made by Eurofighter Jagdflugzeug GmbH (a joint venture by BAE, Italy's Finmeccanica, and the Franco-German EADS) to build on the 72 jets it bought with a $7.25 billion contract back in 2007; six frigates from Italy's Fincantieri for $2.2 billion; and even warships from France's DCNS.
The UAE may spend as much as 8 billion euros on 60 Rafale jet fighters from France's Dassault Aviation; $7 billion on a missile defense system from Lockheed Martin and Raytheon; and may buy four C-17 military transport planes from Boeing.
Any buildup in the Middle East is cause for concern here in the U.S.
In the wake of last week’s sudden attacks on Fort Hood and this week’s Veterans Day celebrations, many on Capitol Hill are beginning to discuss another subject other than healthcare: Defense Spending. If lawmakers feel more money is necessary to keep the country safe, any increase in the defense budget could offer tremendous opportunities for shareholders of defense companies.
The United States Marine Corps celebrated its 234th birthday Tuesday, which also happened to be the eve of Veterans Day.
The editors and staff at the Taipan Publishing Group thank the Marines, and all other members of our armed forces, for their service in protecting our lives and freedom. Their sacrifice deserves every respect and honor we can give them.
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