The Attack On Defense


The 28 aerospace and defense companies in the S&P 1500 Index combined to generate about $371 billion in revenue in the last year, up from $290 billion five years earlier. Over the last 10 years, the S&P 1500 Aerospace & Defense Industry Index delivered an annualized return of 7.6%, versus 3.5% for the broader index.

Defense is and will remain a huge and lucrative business. But the industrywide growth seen over the last five years is not likely to continue over the next five or 10 years.

U.S. defense spending will account for an estimated 20% of all federal expenditures in 2011, less than half of the proportion in 1962. Partly because of competing priorities, U.S. defense spending is expected to begin falling in 2013 — a big change for an industry that has seen overall U.S. defense spending rise at a 9% annualized rate over the last 10 years. The war on terror and operations in Iraq and Afghanistan have accounted for much of that growth.

Does that mean you should avoid defense stocks? Not necessarily. 2010 defense spending of $667 billion put the U.S. at No. 1 in the world, 28% higher than the total amount spent by Nos. 2 through 10. But military spending outside of North America has risen at an annualized rate of nearly 4% over the last decade, according to the Stockholm International Peace Research Institute, with Asia, South America, and Eastern Europe growing expenditures at an annual clip of at least 6%.

Many U.S. defense contractors sell to foreign militaries, and some should also benefit from America's shift in focus toward maintenance, intelligence, and technology spending. During the last 10 years, spending on personnel and research have declined as a percentage of total defense outlays, while spending on operations and maintenance rose.

Over the last year, the Department of Defense has cut or eliminated spending on several huge weapons and vehicle programs, including the cancellation of $13 billion for hybrid landing crafts and battle trucks being made by General Dynamics ($71; GD) and a proposed reduction in orders for Lockheed Martin's ($79; LMT) F-35 fighter jet. Defense officials have been particularly vocal about the high cost of space programs, staples of Boeing ($76; BA) and Lockheed.

The Department of Defense has shifted some of that spending to unmanned weapons systems, intelligence-gathering equipment, and naval vessels. The military continues to modernize its information-technology systems and is also choosing to upgrade some of its older vehicles and equipment rather than spending on new programs.

Going forward, as the U.S. scales back in Iraq and Afghanistan, spending on new combat equipment is likely to decline. Today's fast-paced, regional wars rely less on traditional tanks and planes, and current Defense Department leaders seem skeptical of their value. As such, companies that rely heavily on large, high-dollar contracts for traditional weapons and vehicles could end up scrambling. At the same time, companies that focus on intelligence and reconnaissance aircraft, shipbuilding, and equipment repair and maintenance should have an advantage in coming years.

At the moment, the Forecasts does not recommend any defense stocks for purchase.

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