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"What is this guy thinking!?"
That's the reaction a lot of investors had last week. After reading about Defense Secretary Gates' controversial decisions to ax the F-22, gut the Future Combat Systems program, ground President Obama's new chopper, and make numerous other cuts, it was easy to conclude that SecDef was unilaterally disarming -- and unilaterally depriving defense industry investors of their profits. (Never mind that Gates actually asked for a 4% increase in overall defense spending.)
You asked for it, you got it
Well, guess what, Fools? Following last week's bombshell, Gates did a strafing run on the survivors this week, outlining his thinking on the upcoming Quadrennial Defense Review (the Pentagon's quick-reaction, four-year answer to the Communists' venerable five-year plans). Opining that the military needs to start preparing for "the wars we are most likely to fight -- not just the wars we're best suited to fight," Gates mused publicly over the fate of the Navy's planned next-generation cruiser, the Air Force's need for a new stealth bomber, and other planned uber-weapons.
Tailoring his comments to his audience (officers at the Air War College at Maxwell AFB), Gates hinted that weapons systems such as Lockheed Martin's (NYSE: LMT ) venerable F-16 and Boeing's (NYSE: BA ) just-as-dated F-15 are fast becoming anachronisms. If General Dynamcs (NYSE: GD ) can build an unmanned aerial vehicle (UAV) with greater range, lower fuel requirements, and no risk of harm to its nonexistent pilot, do we really need to be spending tens of billions developing supersonic stealth fighter jets? In an Iron Curtainless world, where we more often find ourselves fighting cave-dwelling fanatics armed with AK-47s, do we really need invisible battle cruisers and robotic tanks?
Take the much-lamented Lockheed F-22 Raptor, for example. Ballyhooed by some as the best plane in the air for killing other planes -- but mocked by others as an aircraft based on 1980s technology and better suited to taking on Brezhnev's Red Army than bin Laden's followers -- Gates decried the Pentagon's habit of buying weapons "that are so costly and complex that they take forever to build and only then in very limited quantities."
Idle speculation, idled defense contractors
This is more than just bureaucratic navel-gazing, folks. What Gates says in words today may become reality in the 2011 defense budget. As such, his thoughts pose real risks to the revenue streams at the nation's defense contractors.
Gates' comments suggest a bout of Pentagon-rethink regarding concepts like the FB-22 Strike Raptor (a long-running bomber concept based on the F-22 platform) and the even more distant 2037 Bomber. His thoughts should incite worry, too, among the two teams vying to build the nation's next-generation aerial refueling tanker.
The more I listen to Gates' pronouncements, the more convinced I become that he's infatuated (and not necessarily wrongly so) with the idea of converting our Air Force from a manned force to a force comprised largely of unmanned, robotic fighter drones. Discussing the soon-to-be-restarted competition between Northrop Grumman (NYSE: NOC ) and Boeing to build the KC-X refueling tanker, Gates wondered aloud whether we'll really need the full complement of 179 tankers originally envisioned. As Gates points out, our current fleet of UAVs isn't even designed for midair refueling. And if these flying model airplanes don't need midair fill-ups, that would logically diminish our need to build midair filler-uppers.
Crisis and opportunity
Here's where we make the obligatory reference to the debatable Chinese symbol that tells us that any problem can become an opportunity for profit if we look at it the right way. You see, on the surface, Gates' musing poses significant and expensive threats to the defense contractors. But investors who can read the tea leaves correctly just may find themselves capable of profiting from his pronouncements.
Yes, big-ticket defense systems may be going the way of the dodo -- but that leaves more money for companies picking the Pentagon's pockets with lower-priced alternatives, right? Take UAVs, for example. Flip over any fighter-builder at risk of funding cuts, and you'll likely find potential profit from the shift to UAVs:
- Boeing's got the ScanEagle, Lockheed Martin the Desert Hawk, and Northrop the Fire Scout.
- Textron (NYSE: TXT ) owns the Shadow system for the time being, while Honeywell's (NYSE: HON ) T-Hawk is enjoying remarkable success.
- Meanwhile, L-3 Communications (NYSE: LLL ) is making a name for itself in communications gear, to help all these flying robots phone home to mama.
What's true up in the air works at sea level as well. Take the Littoral Combat Ship (LCS) being developed by twin teams at Lockheed and General Dynamics, for example. Hardly a speech goes by without Gates singing the LCS' praises, citing its versatility and ability to move in shallow waters where aircraft carriers and submariners fear to tread.
Truisms become so for a reason, Fools -- because they're true. Our task as investors is not to lament the Pentagon's rethinking of its spending priorities, especially when there's a fair amount of sense behind it. True, Lockheed, Boeing, and other benefactors of now-outmoded weapons systems are losers in the current round of cuts, but they also have the potential to profit from the new realities. Remember, defense spending was actually up 4% for next fiscal year. Our job is to find the best ideas, and the best companies, under the new regime -- and invest in them.
(And if you need a little help with that, feel free to grab a free copy of the latest issue of Motley Fool Rule Breakers. We never planned to become the Fool newsletter with the most intense focus on high-tech defense companies ... but as it turns out, quite a lot of them have made their way into our portfolio quite by accident. Discover them here.)