Investors take aim at the defense industry

Since the events of September 11th in New York and Washington 10 years ago, the annual defense budget in the U.S. has grown by almost 70% in real terms. But buckling beneath USD 14.3 trillion debt, the U.S. has shifted to “embrace an unfamiliar strategy: spending less money,” according to Bloomberg Business Week. The tightening of global defense budgets was the stark backdrop at last week’s DSEI conference in London, the world’s largest arms fair. We look at investor sentiment towards the arms suppliers including European Aeronautic Defence And Space Company (EADS:EAD), Force Protection Inc. (NASDAQ:FRPT), Lockheed Martin Corporation (NYSE:LMT) and Finmeccania Spa (BIT:FNC), as they embrace a new era of thrift.

Average short interest across the global Aerospace and Defense sector stands at 2.9% of total shares, which is on par with the S&P 500. However, there are a number of stocks that see short interest above average, the most striking being Lockheed Martin Corporation.

Reports that the Pentagon may delay work on its costliest weapons program, have shifted the spotlight onto Lockheed Martin Corporation, which manufactures the F-35 fighter. According to Reuters, this type of contract restructuring can result in a “death spiral,” as the project, which accounts for 20% of LHM’s revenue, could drag down production and see costs surge. The stock is already the fifth most shorted in the sector, with 7% of its total shares out on loan. Some volatility can be observed in the holdings of institutional investors who lend, but they continue to hold a respectable 20% of the company.
 

European Aeronautic Defence and Space Company NV (EADS) is diversified through its commercial aerospace business, Airbus. Standard & Poor's has just raised its outlook from stable to positive thanks to the group’s strong credit management during the downturn. The company sees short interest in line with the sector average, but has been subject to short covering since mid-August as the percentage of total shares on loan has fallen from an annual high of 5% to 3.5% of the total shares. Institutional investors who lend have expressed positive sentiment and steadily added 17% to their total holdings following the dividend in early June, raising their total holdings to 82 million shares.
 

Smaller and niche defense companies have profited over the past 10 years, but could be most at risk with all their eggs in one basket, according to The Financial Times . Force Protection Inc., a specialist maker of military vehicles has a large order with the U.K. government but faces uncertainty regarding the second phase to this contract. Short interest picked up in April, rising from less than 1% to 3% of total shares outstanding on loan – still below the sector average. Institutional investors who lend their shares have remained loyal to this firm, gradually increasing their current holdings to one quarter of the market cap.

Italian industrial company, Finmeccania Spa is the second largest supplier to the U.K.’s Ministry of Defence. Despite its diverse spectrum of products and services and the CEO reassuring shareholders that the group still had a strong pipeline, the share price dropped to new annual lows last week. Short interest has averaged 2% of the total shares, but has trebled in the last six weeks to 6% of the total shares making it the tenth most shorted stock in the sector. Institutional investors who lend have turned bearish towards the company, having reduced their total holdings by 20% after reaching annual highs in July.

Bottom line

Uncertainty is the new byword for the defense industry, as budget cuts filter through to the manufacturers. The big question is whether firms are able to refocus their efforts on nations with deep pockets and/or significant security threats on their borders, which are likely to remain big purchasers of equipment – such as Gulf Arab states and China. The uncertainty is reflected in securities lending flow, with three quarters of stocks in the global sector having observed an increase in short interest over the past quarter. However, institutional investors are taking a long term view and still own a healthy average of 20% of the global sector.