The Next Frontier For Aerospace and Defense ETFs

by on July 21, 2010 | ETFs Mentioned:

Few industries will look back on the last several years fondly, remembering a stretch of surging demand and reliable sources of organic growth. But for aerospace and defense firms, the last decade has been a remarkable run, including the last two years that saw many other corners of the economy battered by the recession. Ongoing–and occasionally escalating–initiatives in Iraq and Afghanistan have boosted bottom lines for manufacturers of weapons and defense systems. But the recent boom may now be drawing to a close, forcing this recession-proof sector to look elsewhere for expansion opportunities. “For the past decade, U.S. defense firms have enjoyed strong growth, as Pentagon budgets doubled to roughly $700 billion a year amid wartime spending,” writes Nathan Hodge. “Now companies are bracing for a downturn and looking to foreign customers to cushion the blow.”Boeing, the Chicago-based defense contractor that generates significant revenues from the U.S. government, plans to increase international sales to account for 20% to 25% of revenue over the next five years, up from 16% at present. As the U.S. government tries to rein in defense spending, the company is beginning to target international customers. “What you are going to see is kind of a moderate growth that you’ve seen over the last five years,” said Dennis Muilenburg, President and CEO of Boeing Defense, Space, and Security. Boeing hopes to target international markets that are looking to expand defense operations while continuing to maintain market share in the massive U.S. market [also read Boeing Evades Competition, Puts Defense ETFs In Focus].

Lockheed Martin Corporation CEO Robert Stevens sees his firm in the same boat. Stevens recently mentioned that he sees potential for extreme growth potential in Asia and the Middle East. India is currently negotiating a deal to purchase $5.8 billion in cargo planes, while Taiwan is spending $3.1 billion for United Technologies Black Hawk helicopters, and Australia has a $2.1 billion helicopter deal on the table. Even Canada is beefing up its defense budget; the country is purchasing $377 million in radios, mobile radars, and vehicles.

Currently, the U.S. accounts for about 45% of global military spending (or about $1.57 trillion annually). Although the U.S. will continue to be a major player in the defense market, many analysts see that percentage gradually slipping over the coming decade.

While expansion into international markets is an excellent opportunity for U.S.-based firms, significant risks exist. Domestic manufacturers will likely find it difficult to break into markets that have military agreements with other nations or have political disagreements with Washington. U.S. firms are forbidden to export the F-22, the most progressive U.S. stealth fighter, and may not engage in weapon trade with Cuba, Iran, Syria, North Korea, and Burma. Moreover, competition from foreign providers is expected to be fierce.

Aerospace & Defense ETFs

The defense sector has long been seen as a “recession proof” industry that shrugs off economic downturns. Now this corner of the market faces a new challenge: expanding into new markets as expenditures on the homefront begin to decline. The ability of U.S. firms to achieve this objective will have a big impact on the ETFs profiled below [for more ETF ideas, sign up for our free ETF newsletter]:

  • iShares Dow Jones U.S. Aerospace & Defense ETF (ITA): This ETF tracks the performance of the Dow Jones U.S. Select Aerospace & Defense Index, a benchmark that measures the performance of the aerospace and defense sector of the U.S. equity market. The largest individual holdings of ITA are in United Technologies (8%), Boeing (8%), General Dynamics (6%), and Lockheed Martin (6%), four companies that are looking to expand their market share in India and other international markets. ITA is up slightly on the year, and charges an expense ratio of 0.48% [see Wednesday's ETF To Watch: ITA].

  • PowerShares Aerospace and Defense ETF (PPA): This ETF tracks the performance of the SPADE Defense Index, a benchmark that includes companies engaged in the development, manufacturing, operations, and support of U.S. defense, homeland security, and aerospace operations. The fund’s top holdings include Honeywell (7%), United Technologies (6%), Lockheed Martin (6%), and Boeing (5%). PPA charges an expense ratio of 0.60%.

Disclosure: No positions at time of writing.