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What a Chopped US Military Means to your Portfolio

Written By Briton Ryle

Posted February 25, 2014

Units engaged in war need to adapt to changing conditions on the battlefield or they simply will not survive. For their own part, companies engaged to the business of war need to adapt to changes on the political battlefield, or they will not survive either.

As the need for a U.S. military presence in Afghanistan and Iraq subsides, American politicians are scaling back on military spending. Funds which were previously used fighting terrorist-sponsoring regimes are being redeployed in the fight against unemployment and the ever present threat of a relapse into recession.

Defense Secretary Chuck Hagel yesterday announced a proposal to reduce the size of America’s army, closing military bases and cutting other expenditures straight across the military. The casualty roll will now list not the names of soldiers but the names of companies – as contracts are cut, factories are closed and spending priorities are shifted.

Which companies are better poised to survive? Which will fall? Investors need to adapt to a series of changing conditions to avoid taking collateral damage in their portfolios.

Defense Cuts

The main thrust of the spending cuts – which will be elaborated upon by President Obama when he delivers his 2015 budget speech – is on downsizing personnel and retiring antiquated fleets. But that does not mean the nation’s war machine is simply gearing down. National security threats still exist. Politicians are simply redirecting military funding to new types of threats.

“We are repositioning to focus on the strategic challenges and opportunities that will define our future: new technologies, new centers of power and a world that is growing more volatile, more unpredictable and in some instances more threatening to the United States,” Hagel revealed at his recent press conference.

As the nation’s war machine of the future will face “a more volatile, more unpredictable world that requires a more nimble military”, the requirement is for better technology which ultimately reduces the need for so many soldiers. The plan thus proposes cutting the number of active-duty Army personnel by about 77,000 from 522,000 currently to about 445,000 – the smallest number since World War II. The Army National Guard will also have its number reduced.

Manufacturers of personnel uniforms, gear and equipment will likely take some shrapnel from this cut, such as American Apparel (NYSE: APP), “an industry leader in manufacturing combat and utility uniforms for the Department of Defense,” as it proudly boasts at its website. Already reeling by accounting irregularities, the stock recently plunged 30% from $1 to 70 cents per share and should be avoided for now.

Another casualty of the proposed cuts is the elimination of the entire fleet of A-10 aircraft and cold war U-2 spy planes – to be replaced by cheaper and better equipped unmanned aerial vehicles such as the reconnaissance drone RQ-4 Global Hawk made by Northrop Grumman (NYSE: NOC).

Pentagon press secretary Navy Rear Admiral John Kirby revealed that Hagel had consulted closely with military heads on where to best implement budget-savings without compromising the military’s effectiveness.

“He has worked hard with the services to ensure that we continue to stand for the defence of our national interests — that whatever budget priorities we establish, we do so in keeping with our defence strategy and with a strong commitment to the men and women in uniform and to their families,” Kirby explained.

“But he has also said that we have to face the realities of our time,” Kirby elaborated. “We must be pragmatic. We can’t escape tough choices. He and the chiefs are willing to make those choices.”

It all comes down to a simple case of out with the old and in with the new. And investors aught to be ever ready to make similar choices with their investments according to frequently changing government spending priorities.
If you don’t want to get caught on the wrong side of a government budget cut, you might simply opt for a company that has diversified interests in civilian projects in addition to military ones. Quite possibly the safest such hybrid investment is Boeing (NYSE: BA).

Diversified for Survival

Government contractors – especially technology companies – are by nature not nimble at all. It takes years, decades even, from the drawing of the first blueprints to the rolling out of a combat-ready vehicle, aircraft or vessel.

On each contracted requisition, dozens of firms from large caps to micro caps and everything in between come together with their own unique contributions to the project. All such companies flourish as long as the government checks keep coming. But when a program is axed and the funding stops, which of all the companies involved do you think have the higher survival rate?

While small firms devoted to a single program can often provide investors with tremendous upside profit potential for their simple, cost efficient structure, that same singularity of focus can bring their companies down when government priorities change.

Don’t get me wrong, though. Small specialty contractors make great “lottery tickets”, and there’s nothing wrong with that. But investors will want to limit such risks to an exceptionally small portion of their portfolios. The larger stakes should be made with companies that are diversified enough to benefit from government contracts while still having thriving civilian-based activities to back them up during periods of spending cuts.

Boeing’s Survivability

Notice how Boeing fits that bill perfectly…

“The Boeing Company, together with its subsidiaries, designs, develops, manufactures, sells, services, and supports commercial jetliners, military aircraft, satellites, missile defense, human space flight, and launch systems and services worldwide.”

Now that is a diversification bonanza! Not only is the company diversified across sectors – commercial, military and space – it is also diversified across activities, from designing to manufacturing to servicing.
In juggling such diversification, the company operates in five segments (as outlined by Yahoo! Finance):

• “The Commercial Airplanes segment develops, produces, and markets commercial jet aircraft for various passenger and cargo requirements, as well as provides related support services to the commercial airline industry” including “technical advice to commercial and government customers.”

• “The Boeing Military Aircraft segment is involved in the research, development, production, and modification of manned and unmanned military aircraft and weapons systems for the global strike and vertical lift, mobility, surveillance, and engagement.” Remember Hagel’s announcement of the retirement of the A-10 and U-2 recognisance planes? They are being replaced by drones – a program which will remain for the foreseeable long-term future.

• “The Network & Space Systems segment is engaged in the research, development, production, and modification of electronics and information solutions; strategic missile and defense systems; space and intelligence systems; and space exploration products.” At some point in the future, the moon will be revisited, and Mars will also bear the footprints of humans. You can bet Boeing parts and equipment will make those journeys too.

• “The Global Services and Support segment offers a range of products and services comprising integrated logistics, including supply chain management and engineering support; maintenance, modification, and upgrades for aircraft; and training systems and government services, such as pilot and maintenance training.” This segment is almost funding-reduction proof. Regardless of what government contracts are awarded or cancelled, pilot training and logistical services will always be required.

• “The Boeing Capital segment facilitates, arranges, structures, and provides financing solutions, such as equipment under operating leases, finance leases, notes and other receivables, assets held for sale or re-lease, and investments for its commercial airplanes customers.” This segment too has few susceptibilities to change – whether changes in government policies or even changes in governing parties – since financing will always be in demand.

Regardless of which party occupies the White House – whether they are for expanding military operations or shrinking them, whether they introduce new programs or axe those of the previous government – Boeing has enough legs under the table to keep it upright should a leg or two get knocked out from under it.

Investors don’t need to be convinced of its investment potential as its stock has climbed steadily over the years, growing nearly 285% over the past five years compared to the S&P 500’s 140%.

On a scale of 1 to 5 (1 being a strong buy and 5 being a strong sell), 22 brokers surveyed generated an average rating of 1.8 – one of the strongest buys out there. Currently trading at around $130 a share, forecasts range from a low target of $132, a high target of $175, and a mean (average) target of $152.64 over the next 12 months.
Boeing Chart

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Joseph Cafariello