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Defense Sector Continues as Robust
Don't say that you haven't been warned. Big cuts are
imminent in the US defense budget.
By James. H. Smith
October 24, 2005
The Pentagon has told the US armed forces to cut US$8 billion from fiscal
year 2007 budgets -- and this may just be the tip of the iceberg.
In an October 19 memorandum to the armed services and defense agencies,
acting Deputy Defense Secretary Gordon England indicated that both had until
October 21 to outline their proposed cuts, with final decisions about the US
defense budget to be made in the next several weeks.
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The good news is that the US$8 billion in cuts are spread out across the
spectrum, with an estimated US$2.3 billion for the Army, US$2.2 billion for
the Navy, US$2.1 billion for the Air Force and US$900 million for
defense-wide accounts, according to Washington-based sources.
By dividing the cuts almost uniformly, major defense contractors for the
most part will not be affected as badly as if the defense budget were to be
weighed against individual agencies.
While defense contractors are bracing for a downturn in spending on weapons
systems and hardware, robust activity continues in the information
technology and homeland security sector.
The biggest indicator of this trend is the expected initial public offering
(IPO) of Qinetiq, a defense research agency partly owned by US private
equity firm Carlyle Group. This IPO has been discussed previously in this
column.
Qinetiq may launch its IPO as early as next month on the London Stock
Exchange, valued at between GBP400-500, according to sources close to the
process.
But the Qinetiq offering is only one of several deals that have been
completed or are in the pipeline.
Behrman Capital, a private equity investment firm based in New York and San
Francisco, announced on October 20 that its portfolio company Hunter Defense
Technologies, Inc, a manufacturer of military and homeland defense products,
has acquired PowerSystems International, Inc (PSI) in a transaction valued
at approximately US$40 million.
Based in Natural Bridge Station, Virginia, PSI is a developer of power
generation systems, power distribution and control equipment, and
environmental control units for military applications.
The deal confirms interest from the financial community in providing capital
to the defense sector.
The transaction was bankrolled with an undisclosed amount of equity and an
increase of existing debt.
Behrman Capital financed the transaction through a combination of debt and
new equity. Hunter's US$15 million revolving credit facility has been
expanded to US$20 million. In addition, Hunter has added approximately
US$27.5 million to an existing term loan to help fund the acquisition.
Merrill Lynch Capital and Madison Capital Funding served as co-lead
arrangers and joint bookrunners for the term loan. The financing is being
provided by a consortium of approximately 20 lenders.
Goodwin Procter LLP acted as legal advisor to Behrman Capital and Hunter for
the deal.
Washington, DC-based Williams Mullen represented PSI and its stockholders in
the transaction.
Also indicative of continuing interest in the defense sector, PowerShares
Capital Management is expected to see its PowerShares Aerospace and Defense
Portfolio begin trading on the American Stock Exchange on October 26 under
the symbol "PPA".
The portfolio is an exchange-traded fund designed to track the SPADE Defense
Index which is comprised of publicly-traded companies focused on homeland
and border security, space industry infrastructure, and technological
innovations in warfare.
Companies within the SPADE index must trade for at least US$5 per share,
have a market capitalization of at least US$100 million, and trade a minimum
of one million shares per month. The SPADE Defense Index is a modified
market-cap weighted index that is rebalanced quarterly and reconstituted
annually.
The PowerShares Aerospace and Defense Portfolio includes companies focused
on developing products for markets such as border security, biometrics and
screening systems, surveillance, GPS equipment, data security and
encryption, armored military vehicles, aircraft and helicopters, missiles
and munitions, battlespace awareness, simulations and war gaming, and the US
intelligence sector.
Bruce Blake, president of PowerShares Capital Management, told Investor
Ideas that the portfolio will provide investors with "broad exposure to the
defense sector."
He said, "I think there is substantial interest in the US defense sector."
He added that the portfolio will include large defense contractors as well
as small-cap companies.
What may further buoy the defense sector is a comment letter sent by the
Aerospace Industries Association of America to the US Defense Acquisition
Regulations Council.
The association is asking the Pentagon to rescind a proposed regulation
aimed at protecting sensitive US technology.
The association maintains that new export controls add a new level of
oversight with increased costs without a corresponding advantage.
The group maintains that new oversight could possibly conflict with,
existing Commerce and State Department regulations.
While it would be unfair to maintain that companies in the US defense sector
are more interested in making money than in insuring that sensitive
technology does not fall into unfriendly hands, US defense companies -- and
investors -- should not be hampered by rules initiated by conflicting
bureaucracies.
Disclaimer
James Smith is an independent columnist for this web site. James Smith may
hold long or short positions in any of the stocks mentioned in this article
and those positions can change at any moment.
InvestorIdeas.com Disclaimer:
www.InvestorIdeas.com/About/Disclaimer.asp, InvestorIdeas is not
affiliated or compensated by the companies mentioned in this article. James
Smith is a freelance writer. Nothing in the articles should be construed as
an offer or solicitation or recommendation to buy or sell any specific
products or securities. Past performance does not guarantee future results.
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