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2 weeks ago

Understanding Aerospace & Defense: 3 Takeaways on a Sector Poised to Soar

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Last week, I had the opportunity to meet with leaders from some of the nation’s most interesting aerospace and defense companies. We discussed their perspective on national security, defense and intelligence funding and what’s in store for the sectors in the coming years.

Needless to say, I came away impressed.

Sure, China and Russia are making strides with respect to technology and defense. But this progress has spurred a refocusing in Washington. To a person, every public and private sector leader was all in on U.S. military superiority as a global competitive advantage. From investment in science and engineering education, to funding cutting-edge technologies in the defense sector, military prowess is an obvious priority.

In fact, while the sophistication of global threats and geopolitical uncertainties are increasing, I will venture that our technology, capability and investments have undergone such rapid transformation that we are better positioned than ever to defend against threats to national security.

For investors, this means that the Aerospace and Defense sector is worth revisiting. Here are three key sector takeaways from my time in D.C.

Under the radar, no more.

Any investor attention tends to be directed at legacy blue chips like Lockheed, Boeing and Northrop Grumman. Even then, this sector flies generally, “under the radar” (no pun intended!) as consumers don’t interact daily with these products and services.

But as the U.S. works to outpace the world, many of these companies that aren’t household names are making headlines as they undergo a 21st century, high-tech transformation.

Consider the work that CACI, SAIC, and ManTech are doing today: complex IT network integrations, domain security, information services, encrypted communications and global logistics. These companies are reinventing themselves as major tech players and delivering systems support to critical defense programs.

  • ManTech is developing sophisticated cyber-solutions for the Defense Department,
    Department of Homeland Security, Naval Warfare Systems Center, FBI, Department of Health and Human Services and other federal agencies, fixing web vulnerabilities, reverse-engineering malware and conducting advanced forensics to keep networks safe.
  • CACI boasts unmanned aircraft systems technology to identify and intercept rogue drones and other unmanned aircraft.
  • AeroVironment has designed a kamikaze-like missile that is hand-launched, fits in a backpack and packs enough punch to destroy armored vehicles. Called “Switchblade”, it uses daytime and infrared cameras, as well as video-game-like target tracking to destroy stationary and moving targets. To reduce collateral damage, operators can redirect it up to four seconds from impact. The company is doing $75 million per year in what’s now thought to be a multi-billion dollar market.
  • Even established contractors like Northrop Grumman are accelerating innovations to keep pace with the emphasis on military advancement, updating F-16s with new radar and introducing F-35s which are part of the government’s planned $391 billion investment over the coming decade in supersonic warplanes.
  • Leidos is leading a tactical biometric collection effort to help capture and incorporate biometric data[1]. This helps the Department of Defense verify identities of U.S. adversaries. Notably, the program includes exploiting characteristics of an individual’s voice, giving insight to who is communicating with whom, deepening mission intelligence.

Utility-like 

It’s easy to forget that aerospace and defense companies are fundamentally like utilities from a revenue profile. Often, they weather recessions well and are difficult to compete against. As well, these companies deliver consistent growth on predictable demand. A big reason why is that the U.S. Government is the primary end-consumer for these companies. This is notable, as the government remains the single biggest consumer of goods and services on the planet. Consider that the U.S. defense budget under President Trump – which passed the U.S. House in July for fiscal 2018 – has grown to nearly $700 billion. The Intelligence budget alone will eclipse $70 billion next year. As well, the budget environment and growth potential are both expected to go up even further under the current administration.

Additionally, U.S. defense companies are also seeing rapid international market opportunity. From escalating issues with North Korea to the $110 billion deal signed between the U.S. and Saudi Arabia, the sector is suited to take advantage of prevailing regional tensions in key global markets.

Cyber: the new attack front

Since its founding, the U.S. military has focused on war on three key fronts: air, land, and sea. Early 20th century innovations introduced space. Today, cyber is an emerging and important area for defense.

In a recent discussion on cyber warfare, New York Rep. Elise Stanfanik, chair of the U.S. House Subcommittee on Emerging Threats and Capabilities remarked, “From my perspective, information warfare is 21st-century warfare. Technology and the digital revolution has changed everything in society…”[2]

Economically speaking, it is estimated that cybercrime damage will eclipse $6 trillion by 2021. Yes, $6 Trillion.  This is a remarkable amount of nefarious activity, considering the US economy (the largest in the world) is just shy of $19T.  If this ends up playing out, then this will be the greatest transfer of economic wealth in human history and will mean an estimated $1 trillion spent on counter-security cumulatively in the next five years[3].

The demands to combat cyber vulnerabilities and bolster military systems means a lucrative growth opportunity for defense-tech companies. There will be unprecedented funding (my time with President of the Professional Services Council, an expert on government spending, confirmed another likely $50 to $60 billion next year) to compete for talent and boost innovation.

Today’s approach to defense is evolving.

Warfare is evolving, battlefronts are evolving, protection means are evolving.

The level of required advancement and funding for companies to support defense priorities means this sector is more important than ever to understand. It’s vital to our military and national security and a several hundred billion dollar industry with predictable revenues – plus room to run.

Of course, the sector is not without challenges. Government spending and debt issues will continue to be politicized. Partisan scrutiny could impact future allocations to the sector. Sequestration, outsize valuations and relatively slow revenue growth metrics can all affect these equities. Investors should exercise caution, but there is new vigor in the space.

Bottom line, U.S. spending on defense is going up.

These companies have funding, talent and the backing of the world’s greatest superpower. Many of them have competitive moats around them. Just think of how difficult and expensive it would be for a startup to try and disrupt fighter jet manufacturing! The steadiness in revenues is unmatched. Growth may not be explosive, but it’s measured and consistent.

These companies are operating in an elite space and as they help wage war on new cyber threats, their futures look bright.

[1] http://investors.leidos.com/phoenix.zhtml?c=193857&p=irol-newsArticle&ID=1772727

[2] http://www.aviationtoday.com/2017/11/30/dod-taking-mission-specific-approach-growth-cyber-threats/

[3] https://cybersecurityventures.com/hackerpocalypse-cybercrime-report-2016/

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