It all sounds very sci-fi, but it’s happening now (and making us some serious money).
I want to talk about something a little less flashy but perhaps even more important to keeping our armed forces effective when boots are on the ground.
It’s not headline-grabbing, and you certainly couldn’t call it “state of the art.” In fact, at less than $5 billion, it’s a relatively small, overlooked niche in one of the world’s most lucrative, high-profile sectors.
That’s just one of the reasons why I love it right now.
The upside is huge… market-crushing.
Big Changes Are Coming to Europe
The world has changed over the past eight months. Defense spending is coming out from under the onerous “sequestration” limits that kept it tightly capped for years.
What’s more, U.S. President Donald Trump has put America’s European Union (EU) and NATO allies on notice that they will have to beef up their defense spending to meet the treaty’s “2% obligation.”
That’s going to have some unintended knock-on effects, and this is exactly the right time to get in front of them.
You see, historically, much of Western Europe’s defense spending ends up here in the United States, with our defense contractors. This is largely because NATO was content to let the United States take a leading role in collective defense. There are European defense firms, of course, but mostly they’re absolutely dwarfed by the likes of Lockheed Martin Corp. (NYSE: LMT), Northrop Grumman Corp. (NYSE: NOC), and Boeing Co. (NYSE: BA).
Now, NATO has seen some changes in its 68-year history. The end of the Cold War, for instance, opened up the alliance to several former Warsaw Pact adversaries, and the Sept. 11, 2001, attacks on New York and Washington, D.C., “refocused” the organization on security concerns like global terrorism.
The new administration in Washington means change is coming again. The Europeans see they might not be able to take a leading U.S. role for granted anymore, and there’s quiet acknowledgement that defense spending in the alliance will have to increase in the face of Vladimir Putin’s resurgent, ambitious Russia.
The plan is now for NATO and the EU’s member states to develop a more robust, “homegrown” pan-European defense posture, with European defense contractors set to reap the most business.
Up till now, each country has built up a national defense force, by and large, with its own equipment.
Just last month the head of the European Union noted that while the United States has one main battle tank for its armed forces, Europe has 17. Wheeled and tracked vehicles are absolutely critical to fielding armies, getting them where they need to be, and keeping them supplied.
Harmonizing and rationalizing these vehicles among Europe’s allied militaries means big opportunities for military contractors with the capacity and technical knowledge to provide said vehicles for the future European defense force.
Unfortunately for U.S. contractors, most European countries are more interested in building up their own countries’ defense firms than handing the builds and maintenance contracts over to American firms.
Now, don’t worry for a second about our plays in the U.S. defense sector. It’s not going anywhere, and the growth potential here on military spending is staggering. What’s more, we’re in the middle of a broader trend where U.S. contractors are picking up dollars spent by non-European allies, like Australia and Japan.
Nevertheless, I think there’s going to be one really big winner in this pan-European defense effort…
The “Best of British”
I really love BAE Systems PLC (OTC ADR: BAESY)’s position in this space. It’s the Mary Careybiggest defense contractor and the third-biggest worldwide, based on 2015 revenue.
BAE is the successor company to legendary British aviation and shipbuilding firms that helped win the First and Second World Wars. BAE’s “heritage” includes…
- Supermarine Aviation, whose Spitfire fighter ruled the skies during the Battle of Britain,
- Yarrow Shipbuilders, which built the Royal Navy’s first-ever destroyers,
- and Vickers, which gave the “Senior Service” its first-ever combat submarines.
On the civilian side…
- De Havilland Aircraft Co. built the world’s first commercial jet, the Comet,
- And British Aircraft Corp. built the world’s first supersonic commercial aircraft, Concorde.
These days, BAE is a globally focused operation that’s only improved on its impressive forbears’ groundbreaking work.
In an interesting twist, this British contractor even supplies the U.S. military, providing the perfect template for European military forces looking to “simplify.” In July 2016, the U.S. Army released its top 10 wish list of projects it hopes to get on the books in coming budget cycles.
Some are relatively small but important items like new hand grenades or better tourniquets, but a significant number are about armored vehicles and mobile artillery.
That’s right in BAE’s wheelhouse.
In 2005, BAE bought the company that built the Bradley Armored Multi-Purpose Vehicle (AMPV). The Bradley has been a workhorse for moving Army troops since then. After years of service, it’s now getting rebuilt from top to bottom – a $300 million buildout.
When the U.S. Army needed firepower and mobility, BAE came in with the Stryker Dragoon, a contract worth $666 million.
On the heavy mobile artillery side, there’s BAE’s M109 “Paladin” 155 mm Howitzer. In one form or another, the Paladin has been the Army’s go-to mobile cannon since the 1960s.
Over the years, there have been a number of programs to replace Paladin but nothing seemed to work as well. Now there’s Paladin Integrated Management (PIM) underway to upgrade parts, subsystems, and equipment, as well as companion Field Artillery Ammunition Service Vehicles (FAASV). Price tag: $636 million.
That’s $1.2 billion in new business, just in the United States and just in the next year. BAE can and will sell these systems all over the world, especially to the more than 29 European allies looking to operate on consistent, harmonized platforms.
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The Market Hasn’t Priced in This Growth Potential
While BAE is up 15% year to date and is still throwing off a juicy 3.1% dividend yield, much of that progress doesn’t include these big European and U.S. projects because the budget process isn’t official yet.
But the fact is, when the economy is sluggish and politicians’ popularity is mediocre or worse, there’s nothing better than defense spending to perk things up.
It’s an easy sell, and the defense sector is a massive employer. Most firms have strategically built out their operations so there are large clusters of employees scattered across many jurisdictions.
The logic is when times get tough, if you cut defense, you lose workers, and no politician, even in Europe, wants to face reelection after a major employer has left town.
But beyond the pragmatic, the simple fact is an independent British military contractor is much more appealing to Europe, the Middle East, Asia, and other emerging markets than a U.S. contractor at this point. India will likely be a big client moving forward, as well.
BAE is perfectly situated to become an even bigger global military player in coming years with its ability to work domestically and abroad with equal and unrivaled ease. It won’t be long before the market realizes this, at which point its current $32.58 entry price will be a distant memory.
- Strategic Tech Investor: Laser Arms Race Gives Savvy Defense Play Even More Firepower.
- Strategic Tech Investor: Here’s the Real Story Out of Farnborough – and the Best Way to Play It.
- Strategic Tech Investor: The Defense “Supercycle” Just Put Its Sights on Helicopters.
- U.S. Army: The Top 10 Army Modernization Efforts of 2016.