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Defense Stocks and Ukraine
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Highlights!
-Beyond a knee-jerk price move for U.S. defense stocks and most European defense stocks, fundamental impacts might rest with further DoD relief from sequester and another reassessment of U.S. strategy as the QDR looks now DOA.!
-We concur with consensus that direct U.S./European military involvement is extremely unlikely, however, there may be some investment themes to play though to possible assistance to Ukraine, Poland and Baltic states. As well, Middle East dynamics might change further, but to us, there are more variables here, with some potentially negative for U.S. defense.
-Besides U.S. defense stocks, others to take a look at include BAE Systems, Elbit and Thales.
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Discussion!
This research note is being written late the afternoon of March 2 so it's possible our thoughts are overtaken by events by Monday AM, but we wanted to share our thinking in time for the open of European markets and for clients who may be huddling this evening over the crisis and its impact.Here's what we are thinking:
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There are no military options for Europe and the U.S. in this crisis.That came through loud and clear in all that we read and heard this weekend and during a conference call the Atlantic Council held on Sunday. U.S. and European pressure on Russia will be diplomatic in an attempt to isolate that country. There is no appetite in the U.S. or among NATO states to engage in a military conflict with Russia over its movement of military units to Crimea and we expect that reticence to remain in place if war breaks out between Ukraine and Russia. No one wants to tussle with a nuclear armed state.
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Another QDR DOA.We can't help but equate this week's release of the DoD's QDR
(Quadrennial Defense Review), with the one that was released just after the 9/11 attacks in 2011. It was voided by the 9/11 attacks. U.S. defense policy has rested on the notion that it could "re-balance" to Asia, while still maintaining a focus on Middle East stability. Europe was a snooze--an afterthought. That has changed and implications will need to be explored in coming days and weeks.
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Sentiment could shift to fundamental changes for U.S. defense.This crisis is arguably one of the largest the Obama Administration is facing and we doubt the diplomatic symbolism of strong condemnation and
Defense
March 2, 2014
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Byron Callanbyron.callan@capalphadc.com (202) 527-0277
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Tickers:
BAESF, ESLT, HO FP, GY, RTN, ORB, LMT, NOC, AAWW, EADS
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attempts at isolation will change Russian behavior at least as far as its initial actions in Ukraine are concerned. We would still expect international issues to take a back seat to domestic issues in the U.S. mid-term election in November as the Ukraine-Russia crisis is not going to likely have a direct impact on lives of Americans. However, it could elevate national security to a broader discussion in mid-term elections and that alone might spawn budget changes:
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• It might make the alternative DoD funding plan of $26 billion more palatable for FY15.!
• It could bolster support for spending on some programs/systems that Russia finds odious, particularly missile defense.!
The go-to stocks for missile defense remain Gencorp, Raytheon and Orbital Sciences. The majority of the $26 billion would fund readiness, but it could buy back some of the F-35s that are cut in FY15, so Lockheed Martin and Northrop Grumman benefit marginally from that change. We should get a better sense of these changes depending on how the crisis unfolds but also what Congress does with the FY15 budget request this spring and summer. Pressure for deeper Army reductions may ease and the idea that the U.S. can save defense funds by making additional reductions to European based forces will be out the window.
European defense is a tougher call.
A clearer picture may emerge in coming days based on statements and actions of European leaders in order to gauge how this crisis could impact defense spending in Europe. Thales (HO FP) has some risk exposure here though it may not be material. There has been cooperation on military avionics with Russia and Thales owns 35% of DCNS (major French naval shipyards). DCNS is building two Mistral-class amphibious assault ships with the first to be delivered in late 2014 to Russia. This buy looks far less certain now, though we suppose other states could buy these ships.
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Poland's defense modernization plans could receive more attention,particularly investment in an air defense network. We had been thinking that Airbus had the lead in this program with Raytheon also competing, though Thales could also participate. German plans to cancel part of a Eurofighter buy might get a second look. BAE Systems is the pure play here (and would benefit from U.S. sentiment/funding shifts too.)
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Wars are audits and will influence militaries.The last conflict that Russia fought was against Georgia in 2008. That was a five day conflict, though there were a number of moves prior to that.
Strategically, Russia achieved its goals, but a number of observers
commented on the relatively poor tactical showing of most Russian units and in particular the subpar performance of its airpower. This report 1 issued by the U.S. Army Strategic Studies Institute (SSI) is a good overview of these assessments.
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!http://www.strategicstudiesinstitute.army.mil/pdffiles/PUB1069.pdf
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A broader conflict with Ukraine is orders of magnitude more complex than the war with Georgia. For starters, Ukraine has 45 million people versus Georgia's population in 2008 was about 11% of Ukraine’s. While there is a Ukrainian Marine unit based in the Crimea, the bulk of Ukraine's armed forces are garrisoned in the Kiev, Odessa and Carpathian military districts, which is legacy of Soviet/Warsaw Pact dispositions. We seen some suggestions in the press that Ukraine's military is far more capable than Georgia's but we are not so sure of that (though Ukraine's is far larger).
•Georgia had upgraded its tanks and infantry fighting vehicles with
"reactive armor, night vision equipment, advanced radios and superior fire control systems with Israeli assistance" according to the SSI report noted above. Russian armor did not have these capabilities in 2008 and it remains to be seen how much progress has been made since then.
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•The IISS "Military Balance 2014" notes that Ukraine's "armed forces have suffered from inadequate finances and a 2006-11 defence programme was significantly underfunded." Fighter pilots fly approximately 40/hours a year compared to 60-100 hours for Russia.!
•In the Georgia conflict, Russian military equipment evidenced extensive breakdowns. We would be surprised if Ukraine's was in better shape and it may face more daunting challenges to move equipment and units to the eastern part of the country.!
It's hard for us to envision a conflict where a whole new set of lessons are learned by militaries around the world--nothing akin to the 1991 war with Iraq, for example or even the insurgency in Iraq in 2004-07, or even a U.S.strike on China's embassy in Belgrade in 1999 during the war over Kosovo.
But there are some tacks for investors to consider:
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•There may be some aid to Ukraine. Outright arms shipments are too provocative and would trigger a strong Russian response.However, provision of intelligence to the government in Kiev would be one type of aid. There's no way for us to quantify how U.S. or European intelligence assets are re-distributed and how this could impact individual contractors.
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•In a post-conflict scenario, there might be weapons sales to Ukraine but affordability remains a major issue. Forget about notions of Ukraine in 2015-17 buying F-16s or F-35s. It's 2013 defense budget was $2 billion and its already weak economy is going to be slammed by this crisis even with some IMF/U.S./European financial aid. U.S. and European firms have not been in the market to upgrade older Russian or Ukrainian gear--that's been mainly an Israeli niche. Elbit (ESLT on the NASDAQ or ESLT.TA on the Tel Aviv stock exchange) may be worth looking into as a potential beneficiary.Other states bordering or near Russia with former Soviet gear may also look at upgrades to their military.
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Middle East/SW Asia impacts harder to map out and may be mixed.The Russia-Ukraine crisis has potential implications for Syria, Iran nuclear
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talks, U.S. forces in Afghanistan and other regional issues. We think this is a harder call from a defense stock perspective:
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•A conflict between Ukraine and Russia could siphon off defense exports both countries make to others in the Middle East and Latin America. Ukraine is the fourth largest defense exporter in the world after the U.S., Russia and China. It will need what it has. As we wrote last week, Russia and Ukraine cooperate extensively on armsshipments was detailed in this report 2by C4ADS released last year.
Oktyabrsk/Nikolaev is the preferred port in Ukraine used for ocean shipments of major Russian and Ukrainian weapons, including support for the Assad regime in Syria.
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•The U.S. relies on northern routes through Russia for Afghanistan logistics support as well as routes through Pakistan. A cut-off of these northern routes is going to increase U.S. logistics costs even if it is just to remove troops from Afghanistan. (Atlas Air might be worth a look if that happens).!
•We doubt that it is Russia's long-term strategic interest to see a nuclear-armed Iran so we don't see this as a major new change.!
•The impact on energy prices may be another dynamic. One of our sources hypothesized that while there might be short-term positive impacts on energy prices, there is excess capacity in Saudi Arabia and Libya could supply far more oil. A crisis could thus ultimately see a sharper reduction in energy prices and that could impact the pace of Middle Eastern weapons purchases.
Memo to countries--don't give up nuclear weapons.
An interesting issue raised during the Atlantic Council conference call was the Budapest Memorandums on Security Assurances 3 that were reached in 1994. That agreement signed by Russia, the U.S., U.K and then France and China stated that none would attack Ukraine, Belarus or Kazakhstan as an assurance for those countries to give up nuclear weapons that were left over from the Soviet Union. We wonder whether the current crisis would have erupted if Ukraine still had nuclear weapons and that vulnerability may not be lost on others. There's no actionable defense theme here, other than the observation that nuclear weapons may proliferate in the aftermath of this crisis.
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! media.wix.com/ugd/e16b55_ed93e67e18137ba2d9b15837fa992895.pdf
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! www.cfr.org/arms-control-disarmament-and-nonproliferation/budapest-memorandums-security-assurances-1994/
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5 Analyst Certification
The following analysts hereby certify (1) that their views about any and all of the subject companies and securities discussed in this report are accurately expressed and (2) that no part of their compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed in this report: Byron Callan.
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Important DisclosuresThis publication is for private circulation and distribution in its entirety; it is provided to you for information purposes only. This is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. Capital Alpha Partners, LLC makes every effort to use reliable, comprehensive information, but we do not represent or warrant that it is accurate or complete. The views in this publication are those of Capital Alpha Partners, LLC and are subject to change without notice. Capital Alpha Partners, LLC has no obligation to update its opinions or the information in this publication. Neither Capital Alpha Partners, LLC, nor any respective officers, directors, partners, employees, or affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. Analysts may own securities of the issuers discussed herein.
