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Old 24th Jun 2010, 14:16   #1 (permalink)
Ecce Homo! Loquitur...
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Pentagon Suffers Death by a Trillion Cuts

The Motley Fool: Pentagon Suffers Death by a Trillion Cuts

"Fire in the hole!"

He didn't come right out and shout it, but Defense Secretary Robert Gates probably should have given investors a warning of this sort earlier this month, when he announced plans to slash the defense budget by $100 billion. Across the length and breadth of the military-industrial complex, defense contractors are hunkering down, and preparing for the worst.

It's not exactly as if Gates has been shy about acting on past threats, after all. Last year we described a whole series of cuts implemented at his behest; one after another, multi-billion dollar efforts to develop Future Combat Systems, build F-22 Raptor fighter jets, and test an Airborne [email protected] fell to the budgetary axe.

What's next on Gates' chopping block? The secretary hasn't exactly kept it secret. In recent weeks, he has criticized:

General Electric's proposed alternate engine for the Lockheed Martin F-35 fighter, which "probably does not meet the performance standards that are required." (For the record, GE disputes the characterization, arguing its engine is "exceeding all of its performance goals" -- but admits it will need at least $1 billion to complete development.)

Boeing's C-17 transport aircraft, lumped in with the GE engine under the category "unneeded programs."

General Dynamics' $13.2 billion amphibious landing craft. Neither "necessary [n]or sensible," says Gates.

And Northrop Grumman's aircraft carriers? "Do we really need 11 carrier strike groups …when no other country has more than one?"

But if all of that isn't enough to shake defense investors' confidence, there's a new report out that suggests Gates' wide-ranging axe-wielding is only the beginning.

Remember the Lorax

So far, Gates has been waging a one-man logging expedition in the defense industry thicket. He's quick with an axe, but to really do some damage, you need a Lorax-style chopping machine -- and wouldn't you know it? One just appeared.

A couple weeks back, the "Sustainable Defense Task Force" -- a group comprising policy experts and spending activists, backed by Reps. Barney Frank on the left and Ron Paul on the right -- published a report proposing to take Gates' $100 billion, five-year defense cuts and expand them five to 10 times. Over the course of a decade, the SDTF argues we should cut defense spending by nearly $1 trillion (all the cool analysts these days use the "T" word. "Billions" are so last millennium).

Now, the report stretches to 40 pages in length, so I won't bore you with the details. But here are the highlights: For starters, SDTF takes every program that Gates wants to cut and stamps it "Approved." But that's just the beginning.

SDTF would also cancel Textron's V-22 Osprey tilt-rotor aircraft, further postpone implementation of the KC-X Tanker Program, and slash the U.S. Navy 20% in size, retiring two aircraft carrier battle groups and cutting the fleet to 230 ships. Also retired from service: Thousands of nuclear missiles, 50,000 ground troops in Europe and Asia, and the entire F-35 fighter jet program (which was just getting warmed up).

Clearly, these proposals will spark controversy. Naturally, I've got my own opinions of 'em … but I'm not getting into a policy debate here. (However, if you want to debate the wisdom of the military rollback, and the necessity of curbing deficit spending, feel free to do so in the comments section below.) Rather, I want to highlight two crucial points investors need to consider in light of the SDTF's proposals.

Death by a trillion cuts

First, we're no longer talking about a "$100 billion scenario." When Gates suggested cutting spending by $100 billion over five years, the logical assumption was that presidential-congressional horse trading would ensue, resulting ultimately in Pentagon spending cuts somewhere above $0, but below $100 billion. That scenario is now out the window. Now we're more likely talking cuts of somewhere between $100 billion and $1 trillion over the next decade.

This is not good news for investors in defense companies. Revenues will drop, valuations will fall, and industry consolidation is likely as the defense majors scramble to shore up their revenue streams. (On the plus side, they'll probably do this by buying up smaller players like UAV-specialist AeroVironment, so keep your eyes peeled for M&A activity. Acquisition premiums are in the offing.)

As the world turns, the pendulum swings

A second investment opportunity may open in Europe. Here's why: Few would argue that the U.S. needs to spend $500 billion a year and more to "defend" itself. We've got, what? Canada to our north, Mexico to our south, and what on our flanks? The Maginot Line's got nuthin' on the U.S. Simply put, America is not a nation surrounded by enemies. We spend $500 billion a year not to defend ourselves, but to defend our interests, and our allies, around the globe: Protecting international shipping lanes. Dissuading Somali pirates. Combating international terrorism.

Whatever your opinion of how much we spend on the efforts, you cannot deny that the tasks need doing -- and if the U.S. rolls back its spending on these fronts, chances are, someone else is going to have to step in and fill the gap. Will it be booming industrialist China that picks up the slack? A re-emergent Japan? Or will Europe find its way out of its economic hole and increase its historic underinvestment in defense?

Foolish takeaway

Whoever the "somebody else" turns out to be, it's likely we'll see their defense companies grow in revenues and earn more profits going forward. As U.S. defense spending shrinks, the world is turning multipolar again. Invest accordingly.
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Old 24th Jun 2010, 14:23   #2 (permalink)
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One small nitpick
"Do we really need 11 carrier strike groups …when no other country has more than one?"
The "when no other country" argument is a deliberate red herring. It is irrelevant how many carriers anybody else has. The American strategic imperative is that of expeditionary capability: we don't sit around waiting for things to happen, we go forward and get involved in things, which requires portable capability. One cannot rely on basing arrangements alone, since political attitudes change from time to time. See Turkey, 2003, if anybody doubts that, or "good bye" from President Aquino in the Early 1990's.

Until the stratego-political complex agrees how many options they want to no longer have, at complexity levels from deterring war to full blown conflict, one has to have X capability resident. The XXIth century is a come as you are environment, particularly in the maritime arena. If you don't have the round in the clip, you won't get resupply before the fight is over.

That said, the investment advice rings true. The world is getting more multipolar, which means more unstable, politically.
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Old 24th Jun 2010, 15:27   #3 (permalink)
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If selling the carriers maybe they will do a "buy 2 get 1 free" deal ;-)
Serriously wasn't there talk off India buying a due out off service carrier from the US navy cheap (ie a dollar) as long as they bought F/a-18's????

If America wants to be the world police they need the equipment to do it, don't think they could operate the way the UK forces have had to operate ie so thinly based .
So in my opinion it's more about how they wish to be seen and how they want there infulence to be enforced !
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Old 24th Jun 2010, 15:31   #4 (permalink)
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I wonder which other countries have Carrier Strike Groups...? Does 1 CVS, a Type 23 and a Type 42 qualify as a CSG ?
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Old 24th Jun 2010, 15:43   #5 (permalink)
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How about America knocks the 'World police' job on the head?

It might help prevent attacks.
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Old 24th Jun 2010, 15:56   #6 (permalink)
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Yeah ok, and watch the rise in blockades, piracy and closed shipping lanes.

As much as we like our spam cousins to be the brunt of the joke we do need them and the CVBG's to keep the world moving.

I'd give it 2 years until the world shrinks out of the "global village" if the carriers went whoopsie.

We would probably starve - well you lot would, I'd go and hide somewhere good....
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Old 24th Jun 2010, 16:08   #7 (permalink)

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The spam defence budget is greater than the next 40 combined.

They must have lots of friends.
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Old 24th Jun 2010, 17:43   #8 (permalink)
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Cornish Storm

I couldn't agree less.
If the septics knocked off their mooching about and interfering in other countries, they'd be liked a lot better. This may lead to less need for the 'global police' thing. Or less wars maybe- well at least the ones the yanks start.

That would be nice.
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Old 25th Jun 2010, 00:23   #9 (permalink)
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Yeah ok, and watch the rise in blockades, piracy and closed shipping lanes.
The russians and the french are better at dealing with that than you. Next question!
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Old 26th Jun 2010, 20:07   #10 (permalink)
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Not everyone agrees with Mr Gates' "the future is today" way of thinking. He one of the intelligence community that failed to predict:

The end of the Cold War
The tensions and conflicts in the Balkans
The rise of Al Qaeda
The problems in post Saddam Iraq

So when he predicts that the future will be exactly like today....well, perhaps a pinch of salt is needed.

See: SECDEF and the Doctrine of Sufficiency
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