BofA with the Q&A.
Aerospace & Defense: the paradigm has changed, Ron Epstein, Head of US Aerospace & Defense research
1. Ron, you’ve written recently that, because of the Russia/Ukraine war, “the defense paradigm has changed. How has it changed and what does it mean for US defense companies?
As we think about the events unfolding in Eastern Europe, there has been a tectonic shift in geopolitical stability. Europe has not seen anything like this since WWII and theU.S. and its NATO allies now have to focus on managing escalation along Russian borders. The U.S.’s focus on non-nation state terror is effectively over in our view and now the U.S. National Security establishment has to balance it all-non-nation state threats, great power competition and any other unforeseen threats. During the Cold War, the U.S. spent about 7% of GDP on defense, a figure that has now fallen to about 2.8% of GDP. We estimate this could rise to at least 3.5% to 4% of GDP on the paradigm shift(Exhibit 11). Thus, there is likely upside to defense budgets in theU.S. and Europe. We now expect U.S. defense spending in 2023 to be $800bn+ with the likely return of Overseas Contingency Operations (OCO) Funding. We expect the NATO “soft” target for defense spending (2% of GDP) to become a“firm” target or floor. Currently, only four countries meet this target; there are 20+ more to go.
2. As national security becomes a greater area of focus, what could that mean for equity valuations? How does that compare with the multiples companies in your coverage are trading at today?
In a rising defense budget environment, defense stock multiples should typically rise. Currently, that implies moving from a 20-30% discount to the market to a 20-30% premium. History suggests that this is particularly the case when the increase in spending is catalyzed by an exogenous factor.
3. Which areas within your coverage will likely receive the biggest boost from increased spending (i.e. hypersonic missiles, space capabilities, cybersecurity, etc.) and which companies are best positioned to take advantage?
We identify the companies with exposure to this theme in the short term as those that support the “boots, beans and bullets” trade. In other words, short term beneficiaries will be those dealing in land systems and other supplies required to project power and hard force along a border or offer defensive positioning – boots, beans, bullets, tanks, missiles, air defense systems, radios, etc. In our coverage universe, this group would include GD, RTX, LMT, and LHX.
From a longer term perspective, this would imply the ability to project power over long distances, in which deterrence becomes a paramount concern. This likely bolsters the case for U.S.’s Ground Based Strategic Deterrent (GBSD) and all the other strategic weapons (the B-21 bomber and the Columbia Class SSBN). It will likely give rise to a more hawkish tone in the U.S.’s Nuclear Posture which is slated for release later this year. It could boost demand for the F-35, less so domestically but likely internationally. The 156 cap on F-35 production rates now seems too conservative with risk to the upside. The key players for strategic weapons are GD and NOC whereas LMT is a key beneficiary of increased F-35 sales (as is NOC, as a large subcontractor).
Through the “boots, beans and bullets” strategy, we expect heightened demand for support activities – logistics, facilities/bases operations, training, food services, translation services, aircraft and tanks maintenance, etc. We believe the defens services companies, such as LDOS, CACI, BAH, MANT, and PSN, could benefit from this trend.
Another area of focus is cyber warfare, both offensive and defensive. When focusing on Great Power Competition, this is particularly a concern given both China’s and Russia’s cyber operations. The biggest potential beneficiaries of funding for cyber defense, in our coverage, are BAH, GD, NOC, RTX and MANT, which boasts 45% exposure to cyber activities.
4. What’s the latest on supply chain exposures for US defense companies, especially in terms of components imported from Russia and China?
From a supply chain perspective, 35% of Boeing titanium parts come from its joint venture with the Russian company VSMPO-AVISMA (UMB), and 50% of Airbus’s titanium is sourced from VSMPO-AVISMA. These relationships could complicate the supply chain recovery from the COVID-19 pandemic. In addition, some of the largest forging presses in the world are at VSMPO-AVISMA, which could trigger a shortage of forging capacity. Depending on how this all plays out, we will most likely see the industry diversify away from Russian sourcing, which will require a significant capital investment in the supply chain by the OEMs.
5. What has the rise of ESG investing meant for defense companies? Do you expect allocations to change as investors embrace a “peace through strength” approach?
Germany’s Chancellor Olaf Scholz recently revealed that he seeks to increase Germany’s defense spending to more than 2% of GDP and deliver weapons to support Ukraine. The news comes as the largest war in Europe since WWII rages on, and one has to wonder if Continental European views on defense are changing. In recent years, ESG funds have taken a dim view of defense. According to Morningstar data, North American and European Aerospace and Defense stocks are only held by 2% of ESG funds and in most cases have a portfolio weighting of 1% or less.
The trend accelerated this past year due to the EU’s Sustainable Finance Disclosure Regulation, which established that such investments must be publicly disclosed. From our experience, most Continental European investors can no longer allocate funds to defense. This is even the case for funds that are not ESG specific. So far, this has not been the case in the US, and we don’t expected it to become the case. Not surprisingly, this has driven a clear valuation gap between US and European defense stocks.
The management teams we speak to worry about the defense sector being shunned and the negative implications this could have on the broader capital formation process for the sector. Initiatives on sustainability and ESG sometimes contradict other priorities around national security. As we are currently seeing in Eastern Europe, defense technology, when used properly, underpins democracy and freedom and promotes a safer, more inclusive and greener world. Ultimately, ESG and sustainable investing does not exist without freedom of choice. Maybe in the wake of the events playing out in Eastern Europe, sustainability investors and ESG funds will open the aperture on their definition of defense, which could boost the multiples across the A&D sector globally.