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If you think the growing economic crisis is hitting you hard, consider its effect on the most vulnerable of our corporate citizens: the defense contractors.
A Reuters report yesterday suggests that happy days may not be here again for the defense industry -- at least not unless the economy perks up. The cascade of failing Wall Street banks, and the resultant tightening of lending that's already being felt on Main Street, is expected to hurt tax revenues and crimp defense budgets well into the new administration.
Memo to the next commander in chief
No other aspect of the defense industry has a higher profile right now than the Air Force's new fighter-jet programs, involving the F-22 Raptor and F-35 Lightning II. The Pentagon is looking for some 1,700 F-35s to be built over the next few decades and also wants to more than double the existing fleet of 183 F-22s. But the presidential candidate who inherits the current economic mess will have to do more with less, and that's bad news for defense contractors.
Built by Lockheed Martin (NYSE: LMT ) -- with wings by Boeing (NYSE: BA ) and engines from United Technologies (NYSE: UTX ) -- the F-22 aims to become the dominant air-superiority craft of the new millennium. It will inherit that role from the venerable F-15 Eagle (a Boeing bird). In contrast, the Lockheed/Northrop Grumman (NYSE: NOC ) F-35 aims to replace the Lockheed/General Dynamics (NYSE: GD ) F-16 and become the world's premier strike fighter. The new birds do have one thing in common, though: They both cost a wing and a leg.
The high cost of progress
And in the end, it's that cost that could determine the programs' futures, their technological improvements over older warbirds notwithstanding. Because however good the new tech may be, these next-gen fighter jets cost orders of magnitude more than the planes they're meant to replace. Here's how a few competing weapons systems break down:
- F-22 Raptor: $191 million apiece.
- F-35 Lightning II: $104 million.
- F-15 Eagle: About $30 million.
- F-14 Tomcat: Upward of $40 million.
- F-16 Falcon: Most cost anywhere from $15 million to $30 million, depending on the options. Adding a sunroof, Sirius XM radio, and a spoiler could set you back a bundle.
The Pentagon's shrinking wallet, and how to play it
So here's the question for investors. How do you hedge the risk that a stagnant U.S. economy, declining tax revenues, and a consequently tight defense budget will threaten the cash flows of Lockheed, Boeing, and the like in the coming decade?
I think the Pentagon's been trying to teach its new birds the wrong tricks. In a world preoccupied with the "Global War on Terrorism," it doesn't make sense to be spending $100 million apiece on planes that will drop bombs on people carrying $100 Kalashnikovs.
Sure, we still need high-tech warbirds to counter a rising, heavily militarized, and ever-wealthier China. True, too, Russia's actions in the Caucasus remind us that the Bear is no longer hibernating. The natives are restless, and it seems prudent to keep a few long spears lying around to ward off the Bear when it gets too frisky. So I expect that the government will keep buying F-22s and F-35s -- just maybe not as many as Lockheed investors might like.
Moreover, buying Lockheed on fears of a dampened defense budget seems to me a good hedge. The company is having no trouble selling its supposedly now-obsolete F-16 to foreign buyers, and if the U.S. finds itself temporarily strapped for cash, I wouldn't be surprised to see the Air Force requisitioning a few extra late-model Falcons to bridge the gap between "need" and "want."
Still, I suspect that when it comes to lower-intensity conflicts, the Pentagon will conclude that the more cost-effective means of fighting insurgency reside in the robotic hands of unmanned aerial vehicles. A Predator drone can be had for just a few million dollars, and a more advanced Reaper will set you back less than $10 million. Honeywell's (NYSE: HON ) RQ-16A "micro" air vehicle is also inexpensive, and other small, "surgical-strike" UAVs, such as AeroVironment's (Nasdaq: AVAV ) planned Switchblade, will likely price below $1 million as well.
We all have to learn to live within our budget at some point; I suspect that the Pentagon's time is rapidly approaching. And if that's true, investors can profit by shopping downmarket from super-duper fighter jets to the humble, but cost-effective, UAV.
Learn more about the economic dynamics betwixt F-16 and F-35 in: