In The Line Of Fire

In The Line Of Fire
March 20th, 2009  
Team Infidel

Topic: In The Line Of Fire

In The Line Of Fire
The Economist
March 21, 2009 Defence companies

Why America’s defence industry is in for some lean years

Experience suggests that shares in defence companies can offer a safe haven for investors during periods of economic turbulence. During the previous two recessions, American defence shares outperformed the market. That is not surprising: more than any other industry, defence is a client of government. And governments set military budgets according to their involvement in wars and their perception of external threats—neither of which has much connection with the business cycle.
But in this downturn, something different is going on. So far this year the S&P 500 index has fallen by 14%, but defence shares have fallen by 22%. The cloud hanging over the industry is the gloomy conviction that after eight years of George Bush, during which the Pentagon’s budget more than doubled to $666 billion, Barack Obama is determined to change things.
The reduction in spending is not exactly imminent. The budget for 2010, which will be announced next month, was largely set by the outgoing administration and will be close to 2009’s $654 billion. Because of the winding down of operations in Iraq, the Office of Management and Budget currently expects a 4% increase in base funding over 2009—not exactly short rations. It is what will happen in the subsequent years that is worrying the industry.
He has not gone into specifics, but in the past few weeks Mr Obama has given glimpses of his thinking. At a White House fiscal-responsibility summit on February 23rd, he singled out the project to produce a new presidential helicopter as “an example of the procurement process gone amok”, and assured his former rival, John McCain, that curbing procurement excesses was one his most urgent priorities. The next day, in a speech to Congress, Mr Obama promised to “reform our defence budget so that we’re not paying for Cold War-era weapons systems we don’t use.”
On March 4th he went further. Citing a recent report from the Government Accountability Office (GAO), which found that 95 big weapons contracts were over budget by a total of $295 billion, he contrasted projects “designed to keep the American people safe” with those “designed to make a defence contractor rich.”
Adding congressional firepower to the president’s statement of intent is a bill introduced in February by Carl Levin, the chairman of the Senate Armed Services Committee, and Mr McCain, the committee’s senior Republican. Its aim is to force the Pentagon to get tough with military contractors that fail to deliver the goods.
It seems clear that Mr Obama is willing to scale back or scrap projects that are of decreasing relevance to America’s 21st-century security requirements, or have become embarrassing money pits. The VH-71 programme to replace the helicopters used to carry presidents around certainly falls into the embarrassing category. Lockheed Martin and its partner Augusta Westland, a subsidiary of Italy’s Finmeccanica, are on course to supply 28 helicopters at a cost to taxpayers of $13.2 billion.
But more important are the really big-ticket items that are likely to face much tougher scrutiny under the new regime. The air force would like a second batch of F-22 fighters to add to the 187 it will already have by 2011. But after spending more than $62 billion so far on the Lockheed Martin/Boeing plane, spectacularly capable though it is, Mr Obama and Congress may decide that enough is enough. The F-35 Joint Strike Fighter is another programme that looks vulnerable. The GAO said this month that the total investment to acquire 2,456 planes and support them in service will exceed $1 trillion.
The GAO and the Pentagon are also at odds over the army’s $159 billion Future Combat Systems (FCS) project, led by Boeing and SAIC, a systems integrator. The GAO reckons FCS is running about $21 billion over budget, and said last week that the programme had “spent about 60% of its development funds, even though the most expensive activities remain to be done before the production decision”. Nobody would be surprised if Mr Obama opted for a cheaper, later and less ambitious version of FCS. The same applies to missile defence, only more so—Mr Obama is a declared sceptic about the whole idea.
Defence firms still have some attractions for investors. As Noah Poponak of Goldman Sachs points out, most have strong balance-sheets and cashflow, and the geopolitical landscape is no less threatening. And shares of European defence firms have not been hit as hard as those in America. Having largely missed out on Mr Bush’s party, they are facing less of a hangover now. But with a military budget almost as big as the rest of the world’s combined, even quite small changes in American defence spending have big consequences for the industry. Military spending moves in long cycles. After ten fat years, some lean ones are in store.

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