Oppenheimer Sees Big Contraction In U.S. Defense Market

Oppenheimer & Co. financial analyst Myles Walton foresees a major contraction in U.S. defense demand over the next several years. In a November 5 note, Walton stated, “We still expect a typical multi-year downcycle in investment spending, which could amount to 40% declines in the annual addressable market vs. the peak in 2008.” A decline of 40% would be consistent with the falloff seen after the Vietnam War and Cold War, but few if any defense companies are projecting a corresponding decline in revenues or returns.

That may be partly due to the fact that money appropriated for programs in a given year often is not actually spent until much later, so sector results lag budget trends. But Walton’s thesis that coming declines are “baked into the shares” seems rather improbable, given what happened to Lockheed Martin last month. Unlike competitors, it sought to give the investment community some forward visibility into business prospects, and money managers reacted by driving the stock down much further than actual results justified. That reaction suggests that many managers haven’t assimilated the possibility of downturns as sizable as what Walton and others are forecasting.

Merrill Lynch analyst Ron Epstein has long contended that the real driver of defense demand isn’t threats or general economic conditions, but partisan control of the federal government. Based on detailed statistical analysis of military investment spending over the past 50 years, Epstein found that partisan control of the Senate and the White House accounted for about 90% of all variation in weapons outlays (the statistical correlation in the House of Representatives was more muted). Partisan influence was so pronounced — with Democrats always cutting and Republicans always adding — that Epstein estimated a President McCain might spend up to $100 billion more each year on military hardware and contracted services than a President Obama. So far, the Obama Administration seems to be following the Epstein playbook, but few investors have probably “baked” that into their expectations.