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Cheap Oil Doesn't Dampen Industry's 2016 Outlook

January 30, 2016 (Photo Credit: Staff Sgt. Marcy Copeland, 56th Fighter Wing Public Affairs)

WASHINGTON — Despite plummeting oil prices, international demand for defense products remains strong, including in the oil-rich Middle East, multiple defense executives said during fourth quarter earnings calls last week.

On call after call, analysts pressed management at top defense firms about the impact of low oil prices on their outlook for 2016. The general consensus was that international markets will continue to present an opportunity for organic growth.

Marillyn Hewson, Lockheed Martin’s president, chairman and CEO, said over the next five years, she expects half of F-35 sales to come from the international market.

"We are not seeing a lot of pullback on expenditures on national security” because of oil prices, she said. Lower oil revenues can put pressure on nation’s budgets, “but they are still going to buy the products and capabilities and technologies they need to enable them to protect their citizens and to deal with their security issues.”

In 2015, international sales accounted for 21 percent of Lockheed’s total corporate sales, an increase of 6 percent from the previous year, according to company filings.

For Northrop Grumman, international sales represented 14 percent of its 2015 total, a 10 percent increase from 2014, said Ken Bedingfield, corporate vice president and CFO.

“We expect international opportunities to be an important source of growth for the company over the next several years,” he said.

Raytheon CEO Tom Kennedy said the company has not seen any decrease in demand caused by oil prices.

“The global threat environment continues to drive demand for Raytheon solutions,” he said. “It is clear that short-term shifts in economic growth factors have taken a back seat to ensuring the sovereignty and security of the nations that face these security threats.”

Despite falling oil prices, tensions in the Middle East have countries spending on missile defense, long-range radars, modernized command and control systems, sensors, cybersecurity and precision munitions, he said.

Phebe Novakovic, General Dynamic’s chairman and CEO, echoed her counterparts’ remarks, telling investors that international orders have continued to increase, particularly on combat systems.

“So far, we have yet to see any impact from oil prices in the Mideast,” she said. “From my perspective, defense spending is completely determined by the threat. And the threat environment in that world has gotten nothing but worse.”

Byron Callan, an analyst with Capital Alpha Partners, cautioned against blanket statements about the international market, adding that he is skeptical of companies that say oil prices have no impact on any of their defense business.

“If [threat environments] are the only thing that drove spending, you would not have the Budget Control Act, you would not have had the cutbacks in Malaysian defense. Countries have to fund this stuff, and they do have other needs to keep citizens satisfied. And there are other ways to buy security than buying high-end conventional weapons systems.”

Oil producers in the Middle East have seen prices rise and fall, and the recent drop won’t automatically result in reduced spending, said Andrew Hunter, director of the Defense-Industrial Initiatives Group at the Center for Strategic and International Studies.

“Countries in the Middle East, the ones that are the big players, don’t want to overreact to the current oil price. They’ve been in this business a long time, and they understand that prices go up and they go down,” he said.

And while no one country or consortium has the ability to single-handedly manipulate the market, oil prices are where they are right now in part because of the amount of oil Middle Eastern nations produce, he said.

“They’re not helpless in the face of the market,” he said.

Additionally, the recent nuclear deal between the US and Iran will likely raise security concerns in the region, providing extra motivation for defense spending, he said.

Management teams also indicated they would continue to deploy capital on share buybacks and dividends, a strategy that kept investors happy during trough years of US defense spending. Last year saw Lockheed Martin spend $5 billion on buybacks and dividends, while Northrop Grumman returned $3.8 billion to investors, Boeing went for $9 billion and Raytheon bought $1 billion worth of shares.

Hunter, noting that US defense budgets are expected to grow in coming years after several years of decreases, suggested that consequently, the defense market is entering a new phase. This may attract a different kind of investor, one who is less focused on short-term income and more on long-term growth opportunities.

“As new kinds of investors take an interest in the defense market, and that’s a big assumption there that they will, the messages and priorities that shareholders are transmitting to executives, are probably going to change,” he said. “It sounds like the CEOs aren’t signaling that they are ready to change yet, but it does seem like that change is on its way.”

Buybacks and dividends may be losing some of their cache, Callan said.

“Organic growth will continue to matter, and there’s no one size fits all based on defense spending here,” he said.

Several firms, including Lockheed, Booz Allen Hamilton and L-3, indicated they see increased opportunities to spend more on research and development. Raytheon’s Kennedy said he expected to spend 3 percent of sales on Independent Research & Development (IR&D) in 2016, the same as 2015.

“To ensure Raytheon's long-term competitive advantage, we have increased our Independent Research and Development, capital expenditures, and other investments to fund the development of the advanced game changing technologies of the future, ranging from hypersonics and cyber security to directed energy,” he said.

Email: aclevenger@defensenews.com.

Twitter: @andclev

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