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$1.7 Billion in Weapons Heading for Taiwan -- and China's Not Happy

By Rich Smith – Dec 20, 2015 at 10:13AM

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Will China retaliate? And if so, against whom?

 USS Carr (FFG-52) is one of two decommissioned U.S. frigates in line for sale to Taiwan. Image source: U.S. Navy, Photographer's Mate 1st Class James Foehl.

The headline practically says it all. On Wednesday, the United States announced plans to sell $1.7 billion worth of hi-tech weaponry to Taiwan. In response, China fired off an immediate diplomatic protest, and demanded that the U.S. retract the arms sale.

According to official Chinese policy, Taiwan is still part of China proper, and so "China resolutely opposes the sale of weapons to Taiwan by the U.S.," said Vice Foreign Minister Zheng Zeguang in a diplomatic meeting. But what is it exactly that China is upset about?

Taiwan's shopping list
Here's a quick rundown of the weapons systems on Taiwan's shopping list, as notified to Congress in a series of eight announcements by the U.S. Defense Security Cooperation Agency, the Pentagon arm responsible for coordinating foreign weapons contracts:

  • 769 TOW 2B radio-frequency-guided anti-tank missiles manufactured by Raytheon (RTN). Cost: $268 million.
  • 250 Block I-92F MANPAD Stinger missiles -- also from Raytheon: $217 million.
  • 13 CIWS gun systems (and 260,000 rounds of 20mm armor-piercing ammunition for them to shoot with). CIWS's manufacturer? You guessed it: Raytheon. And they'll get $416 million for this portion of the arms deal.
  • 208 Javelin guided anti-tank missiles, manufactured by... Raytheon! (And also Lockheed Martin (LMT 0.58%). The two companies build these as a joint venture.) Value: $57 million.

Caution: Javelins at work. Image source: U.S. Army, Sgt. 1st Class Rodney Jackson 18th MEDCOM, Pacific Public Affairs.

That's it for Raytheon's share of the contracts, but already it's a pretty sizable deal -- just under $930 million, assuming a 50-50 split with Lockheed Martin on the Javelin revenues. But Taiwan isn't done shopping yet. Moving on to the rest of the list, we find:

  • 36 Assault Amphibious Vehicles (AAVs) manufactured by BAE Systems (BAES.Y -0.60%), of which 30 will be armed with .50-caliber M2 machine guns and six more with 7.62mm M240 machine guns: $375 million.
  • And also $120 million worth of "life cycle support" for Multifunctional Information Distribution Systems Low Volume Terminals (MIDS/LVT-1) and Joint Tactical Information Distribution Systems (JTIDS) previously sold to Taiwan. Rockwell Collins (COL) builds both these items, and so will probably -- but not necessarily -- be named prime contractor on this sale.

And finally, we have a couple of items for which the Pentagon has given no guidance as to who will be named prime contractor, or share in the revenue from the sale.

  • Two decommissioned Oliver Hazard Perry-class frigates (FFG-7) will be refurbished and upgraded with new fire control systems, anti-submarine warfare systems, towed-array sonar systems, MK-75 76mm guns, missile launchers, and CIWS weapons systems (see above), prior to commissioning into the Taiwanese Navy. Total value: $190 million.
  • And several Taiwan Advanced Tactical Data Link Systems will be installed on six Perry-class frigates (including the two being sold as part of this deal) and four Lafayette-class frigates. These systems, which enable beyond-line-of-sight data links among warships, are valued at $75 million.

Thus, the arms being sold come to at least $1.718 billion in value. Media reports are citing a total value of $1.83 billion, though, which may imply additional weapons are included in the deal but their sales have not yet been notified to Congress. That or the final $112 million worth of sales may concern equipment not restricted for foreign export.

In any case, this is clearly a big deal -- the first such sizable arms sale to Taiwan that's been approved in four years -- and it's something China is not at all happy to see go through.

Why that's a problem
In total, we're looking at just under $2 billion worth of new weapons sales for these defense contractors. This sounds like good news, but it could also turn into bad news. According to a statement by China's Foreign Ministry, "to safeguard the nation's interests, the Chinese side has decided to take necessary measures, including the imposition of sanctions against companies participating in the arms sale to Taiwan."

How exactly China might retaliate isn't exactly clear, however. As the numbers above show, Raytheon is the primary beneficiary of this arms deal, selling products that make up roughly one-half of the deal's total value. But as a defense contractor dealing in sensitive military technology, Raytheon is generally forbidden by U.S. law from selling such products to China in any case. It's hard to see, then, how China could successfully levy "sanctions" on Raytheon.

The situation with Lockheed Martin and BAE Systems is similar. Lockheed may see some hit to sales of civilian Sikorsky helicopters in China. But its minimal role in the Taiwan arms deal makes this seem unlikely. BAE USA's parent company, being British-owned, may have freer rein to operate in China, and thus be more vulnerable to retaliatory sanctions.

From the U.S. perspective, though, the risks of Chinese retaliation would seem to fall most heavily upon Rockwell Collins. As a broadly diversified aviation avionics company, Rockwell Collins gets less than half its revenue from defense industry work. According to data from S&P Capital IQ, about 58% of Rockwell's revenue is commercially derived. Assuming at least some of this revenue comes from China, those revenues could be at risk. Then again, Capital IQ data indicate that less than 10% of Rockwell Collins' revenue comes from the Asia-Pacific region as a whole, much less China in particular. So, even here, whatever Rockwell revenues are at risk, they can't amount to much.

The upshot for investors
China's threats notwithstanding, the country just doesn't seem to have many levers to pull to punish the companies involved in this arms deal. (Albeit, once they realize this, China might elect to punish all U.S. companies with interests in China, regardless of their involvement with Taiwan.) What is certain is that with nearly $2 billion in defense tech revenue involved, the Taiwan arms deal is good news for U.S. defense contractors working to diversify their revenue streams away from a constrained U.S. defense budget.

That's the point to focus on today. The money spigots from Taiwan just got turned back on, and it's U.S. defense contractors who will benefit.

One of the more fearsome weapons included in this week's Taiwan arms package is the Raytheon-built CIWS weapons system, seen here in action during a live-fire exercise aboard an Oliver Hazard Perry-class guided-missile frigate -- also for sale to Taiwan. Image source: U.S. Navy, MC3 Frank J. Pikul/NPASE East.

Rich Smith owns shares of Raytheon. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 300 out of more than 75,000 rated members.

The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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