Wall Street and the Pentagon The Economic and Business Outlook for the Defense Market David J. Berteau July 19, 2010 Presentation to the National Contract.

Wall Street and the Pentagon

The Economic and Business Outlook for the Defense Market

David J. Berteau

July 19, 2010

Presentation to the National Contract Management Association

2

PART ONE: The Economic and Business Outlook for the Defense Market

PART TWO: The Effects of Policy on the Financial Health of the Defense Industry

PART THREE: How Does the Market View the Defense Industry?

AGENDA:

3

Part One: Defense Outlays and the Federal Budget Deficit 1947-2020

Source: OMB; CBO; analysis by CSIS Defense-Industrial Initiatives Group

-400

-200

0

200

400

600

800

1,000

1,200

1,400

1,600

1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 Est.

2015 Est.

2019 Est.

US

$, b

illio

n (

con

stan

t FY

2009

)

Net Interest (Interest Rate + 1%)

Net Interest

Federal Budget Deficit

Federal Budget Deficit (Interest Rate +1%)

National Defense

4

The Near-Term Challenge: DoD Budget Authority, 2001-2015Including Supplementals (current US$, bn)

Source: DoD Comptroller; analysis by CSIS Defense-Industrial Initiatives Group

297328

365 377 400 411 432480 513

531 549 563 578 594 610

1917

7291 79

124169

187 153 163 159

50 50 50 5050 4030 20

100

200

300

400

500

600

700

800

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Cur

rent

US$

, bn

Base Budget (BA) OCO to Base OCO "What if" OCO

Base Budget

OCO

5

Part Two: The CSIS Defense Index

• CSIS selected 34 companies (including legacy companies) that reflect the diversity of the industry supplying the Defense Department• Revenue: ~$100m to $45bn+• Electronics to heavy metal • Both products and services

• Companies added as data become available

• Benchmarked to S&P 500 and S&P 1500 Industrials – broad mix of products and services and company size

Year 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09Companies 17 17 17 19 20 22 23 22 20 22 20 21 22 23 21 20 19 23 24 24 23 23 23

6

Operating Margins, 1988-2009including CSIS Defense Index (revenue weighted)

*Excluding Defense ** Excluding Defense & Financials

Source: Bloomberg, analysis by CSIS Defense-Industrial Initiatives Group

0%

2%

4%

6%

8%

10%

12%

14%

1988 1991 1994 1997 2000 2003 2006 2009

CSIS Defense Index S&P 1500 Industrials* S&P 500**

7

Cash Flow Return on Investment (CFROI), 1988-2009 including CSIS Defense Index (revenue weighted)

Source: Bloomberg, analysis by CSIS Defense-Industrial Initiatives Group

*Excluding Defense ** Excluding Defense & Financials

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1988 1991 1994 1997 2000 2003 2006 2009

CSIS Defense Index S&P 1500 Industrials* S&P 500**

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Part Three: What Do Investors Think?

Key Points:

1. Wall Street is a short-term actor with a long-term view.

2. Investors’ perception is that the defense budget has peaked and, as a result, that revenue growth for defense companies may have peaked as well.

3. Current P/E multiples have already priced in not only a significant reduction in the top-line budget but also program uncertainty.

4. Markets are concerned with U.S. fiscal austerity—deeper cuts in defense budgets?

5. Investors are concerned that DoD does not have a contingency plan to preserve critical niche capabilities.

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Index Performance, 1999-20101999 = 100

Source: Bloomberg, analysis by CSIS Defense-Industrial Initiatives Group

50

100

150

200

250

300

350

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Spade Defense Index S&P 500 Index S&P 500 AERO Index

Top Bottom Middle

1999=100

10

Defense Stocks Performance Parallels the Broader Market 2010 Index Performance, Year-to-Date (2010 = 100)

Source: Bloomberg, analysis by CSIS Defense-Industrial Initiatives Group

90

95

100

105

110

115

120

1/1/2010 2/1/2010 3/1/2010 4/1/2010 5/1/2010 6/1/2010 7/1/2010

Spade Defense Index S&P 500 Index S&P 500 AERO IndexTop Bottom Middle

11

Index Performance, 1999-2010 (2010 = 100)

40

60

80

100

120

140

160

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Spade Defense Index S&P 500 Index S&P 500 AERO Index

2010 = 100

Middle Top Bottom

Source: Bloomberg, analysis by CSIS Defense-Industrial Initiatives Group

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P/E Multiples: Price / Trailing 12M Earnings (as percentage of S&P 500 P/E)

* Big 4: Lockheed Martin, Raytheon, Northrop Grumman, General Dynamics

Source: Standard & Poor’s, Bloomberg, analysis by CSIS Defense-Industrial Initiatives Group

0

1

2

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

S&P 500 Big 4 Avg.

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About CSIS At a time of new global opportunities and challenges, the Center for Strategic and International Studies (CSIS) provides strategic insights and policy solutions to decisionmakers in government, international institutions, the private sector, and civil society. A bipartisan, nonprofit organization headquartered in Washington, DC, CSIS conducts research and analysis and develops policy initiatives that look into the future and anticipate change.

Founded by David M. Abshire and Admiral Arleigh Burke at the height of the Cold War, CSIS was dedicated to finding ways for America to sustain its prominence and prosperity as a force for good in the world.

Since 1962, CSIS has grown to become one of the world’s preeminent international policy institutions, with more than 220 full-time staff and a large network of affiliated scholars focused on defense and security, regional stability, and transnational challenges ranging from energy and climate to global development and economic integration.

Former U.S. senator Sam Nunn became chairman of the CSIS Board of Trustees in 1999, and John J. Hamre has led CSIS as its president and chief executive officer since April 2000

CSIS does not take specific policy positions; accordingly, all views expressed in this presentation should be understood to be solely those of the author(s).