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The Defence Market 2003 and the Iraq Conflict |
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(Source: Frost & Sullivan; issued March 18, 2003)
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This article will analyse the prospects a few of the major companies in the defence market in 2003 and forecast the effect of the war in Iraq on defence stocks.
It is important to note that defence companies will not necessarily benefit from a war in Iraq. There are a number of companies that have already been badly affected by the forthcoming conflict due to a variety of reasons.
Any analysis of the market is difficult at present since defence stocks are undergoing a-one-time, one-off revival as defence moves to the foreground of political issues. This trend started in the United States and will gradually spread to Europe as resurfacing national interests gradually dismember alliances that maintained peace in Europe.
This one-off revival is not just due to the increase in defence spending that has come about since 9/11. The events of 9/11 had coincided with a number of other events in the defence sector. All these factors combine to make defence stocks attractive at the moment.
Throughout the nineties defence contractors incurred unsustainable levels of debt as they acquired a large number of companies to maintain momentum in an ever-decreasing pool of funding. Much of this debt has been cleared in large debt-reduction programmes that were primarily funded through the sale of non-core business units. Defence stocks are also likely to benefit from good access to capital markets and large government IT projects that will form homeland security.
There remain risks of course. The two main risks are disruption in the budget from continued military transformation and increasingly stringent programme accountability. The current war in Iraq also poses an unlikely but not entirely improbable risk. If the war in Iraq is significantly lengthened there is bound to be a disruption in programmes, as procurement funding for the conflict will be channelled into consumables as a priority. Finally, any company with a large exposure in the civil aviation market is likely to suffer well into 2006.
Investors should be warned that defence stocks traditionally tumble after a war. This combined with the downturn that has been seen over the last five months in the defence market due to investors buying into overly depressed technology stocks, implies that a good time to invest in defence stocks would be after the Iraq war.
Companies that will benefit from a short three-week war will be those that supply consumables that form the content of the logistics train.
Alliant Techsystems supplies the rocket motors that make up many of the missiles that will be used against Iraq in the event of a war. Alliant Techsystems has a very large exposure to this market and would benefit from orders from the U.S. Government to restock its missile inventory. However, Alliant Techsystems also supplies the booster rockets for the space shuttles. Due to technical problems there are not likely to be many launches in the near future.
Raytheon and United Defence make the bulk of the munitions that will be used in a conflict against Iraq. Raytheon will certainly benefit, as its direct attack missiles will be used extensively during the war. However, Raytheon continues to disappoint as it fails to capitalise on many of the technical and positional advantages that it has.
United Defence makes the dumb ammunition and could benefit if the Iraqi army decides to fight. United Defence is a much better long-term investment than it was a couple of years ago, as it has quietly diversified its portfolio away from traditional 'low-tech' manufacturing, technology, and systems. Finally, L-3 Communications creates many of the spare parts and subcomponents that will be used in or as consumables.
In terms of urgent operational requirements and for immediate changes after the campaign there is set to be a further increase in ISR (Intelligence Surveillance and Reconnaissance) activity. This market is already a large growing one. However, it might attract further resources post-Iraq, as shortfalls are realised and rectified. There are a number of companies in this marketplace that provide the finished system, but it might be worth watching companies that supply the radar subcomponents and the optical units such as DRS have an extremely competent portfolio.
Currently the ISR 'crown' is held by Northrop Grumman that enjoyed a remarkable run of success in recent years. However, Boeing and Raytheon are both serious contenders for this position. Northrop Grumman is well positioned to retain the crown with its procurement of TRW and its high-capability ISR assets.
If there is a substantial urban battle, then we can expect companies that supply body armour and protective clothing to receive orders through lessons-learnt requirements. This is a difficult one to judge because there are such a lot of small companies that provide ballistic and explosive protection. However, closer examination of products and their applications during urban campaigns will give insights into companies that can be backed.
With regard to the rest of the market, here is an analysis of some of the companies that could be worth looking more closely at or steering well clear of.
General Dynamics could be this year's winner as it has diversified its capability and has acquired or merged high-technology business units such as CDC and Motorola Defence in the past couple of years. With a solid management structure and a flexible business structure, General Dynamics will not see dynamic growth, but will certainly provide stability.
BAE has been strongly criticised recently due to the losses it incurred on the Astute and Nimrod projects. BAE has gone from being the golden boy of the nineties to the bane of the markets in the last year. A catalogue of other disasters such as the loss of Bowman, the loss of Watchkeeper, and the failure to win the CVF outright, have contributed to this share price decline. More importantly, the market has lost confidence in BAE's board. The public falling out between BAE and the MoD was not patched up by the departure of John Weston last year, as Mike Turner immediately stepped into the breach to take up exactly the same seemingly antagonistic stance.
However, BAE is in a unique position for a European defence company as it now generates more income in the United States than in the United Kingdom. Indeed BAE is the only company in Europe with a substantial market share in the United States. As the United States is the key market at the moment, BAE is in a very strong position compared to its competitors. With the MoD agreeing this month to burden part of the substantial costs incurred on the Astute and Nimrod and to allow more time for risk reduction, BAE is in a good position to move on from these projects that were problems. Finally, BAE has a habit of reinventing its self. BAE always manages to get involved in a project regardless of the outcome. There are only a handful of projects in the United Kingdom that BAE is not involved in. Indeed BAE has a very substantial order book.
With regard to mainland European companies, and in particular Thales and EADS, they are now unlikely to capitalise on the spending increase in the United States.While EADS might gain access with a change of government, Thales is cut out of the U.S. market for the long term.
Thales' growth was up 20 percent in the year to May 2001. Much of this growth came from expansion in the United Kingdom along with a string of acquisitions in the United Kingdom. Thales has done very well in establishing itself as the primary supplier of Optics in the United Kingdom, turning a radio exporter into a prime contractor and managing to become the design authority for CVF However, opportunities for growth in Europe are now extremely limited. In the worldwide market, Thales had previously been able to benefit from the massive subsidies that Giat Industries and DCN received from the French Government. However, this is now drawing to a close as funding for these companies dries up. With this support gone, the foreign military sales budget of the United States becomes an increasing problem for Thales.
With 80 percent of its turnover coming from its civil business, EADS has been attempting to grow its defence business to spread the risk. However, there do not remain that many substantial opportunities in the defence sector; the market in Europe is stagnant, the U.S. market is closed thanks to Schroeder, and thus, this is going to be a particularly hard expansion if it happens at all. While its share in the Eurocopter business is paying handsome dividends, this is not going to be enough to steer EADS away from deeper waters as the A400M hangs in the balance in coming weeks.
To summarise, there are few obvious bets. The transformations threaten a number of projects and offer new opportunities while the war offers an uncertain factor. However, there is money to be made, and close on the heels of the war, there will be some bargains to be picked.
-ends-
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