New administration in the US could
make radical cuts rather than freezing
or trimming its defence budget, perhaps
focusing on big-ticket programmes
􀀗 We believe negative newsflow could
impact European Aerospace & Defence
stocks from Q1 2009
􀀗 Cutting BAE Systems to UW from N;
maintain N on Thales & Ultra Electronics;
OW on Finmeccanica, Cobham &
QinetiQ; OW (V) on MTU & Rheinmetall
Does he mean us?
“Budget reform is not an option. It is an imperative. We
cannot sustain a system that bleeds billions of taxpayer
dollars on programs that have outlived their usefulness, or
exist solely because of the power of a politician, lobbyist or
interest group. We simply cannot afford it.” President-elect
Obama, news conference, Chicago, 25 November 2008
President-elect Barack Obama has made an early point of
stating that his fiscal stimuli and social programmes demand
discipline elsewhere in the federal budget. We believe that
the defence budget includes a number of controversial multibillion
dollar programmes that could fit the new
administration’s criteria as potential savings.
In this note, we examine the US defence budget, concluding
that those stocks under coverage with significant Department of
Defense exposure should now be viewed with increased
caution, more so because, during 2008, these names have been
among the best performers in our industrials universe.
We are reducing our target price on BAE Systems from 510p
to 300p, and our rating from N to UW. We maintain a N
rating on Thales, with the target reduced from EUR40 to
EUR31, and retain a N rating on Smiths Group with the target
reduced from 1,050p to 900p. We cut our target on
Finmeccanica from EUR18.73 to EUR14, but maintain an
OW rating. We are reducing our target on Cobham from 255p
to 235p, maintaining OW. We are reiterating a N rating on
Ultra Electronics, OW rating on QinetiQ and OW (V) ratings
on Rheinmetall and MTU (all with targets maintained).

Investment conclusion 3
Pressuring the defence 4
Company profiles 11
BAE Systems 12
Cobham 17
Finmeccanica 21
MTU Aero Engines 24
QinetiQ 27
Rheinmetall 31
Smiths Group 34
Thales 38
Ultra Electronics 42
Disclosure appendix 50
Disclaimer 53

Investment conclusion
􀀗 Reviewing outlook for European defence coverage post US
election; new administration could announce big defence cuts
􀀗 Adjusting valuations to account for potential negatives from US
defence and possible near-term adverse newsflow
􀀗 Cutting BAE Systems to UW from N; maintain OW on Finmeccanica
and Cobham, OW(V) on MTU and Rheinmetall and N on Ultra

Following the US presidential elections, we
review the outlook for our European defence
coverage, in particular for companies with large
US Department of Defense (DoD) exposure.
President-elect Barack Obama has made it clear
that the difficult economic scenario in the US and
his planned fiscal stimuli and social programmes
demand increased discipline elsewhere in the
budget. We see a possibility of the new
administration resorting to large cuts in defence
budgets rather than merely freezing or trimming
spending (which we believe is the consensus
expectation). In our view, the defence budget
includes a number of controversial multi-billion
dollar programmes that could fit the new
administration’s criteria as potential savings.

In light of this, we review the outlook and
valuations for European defence stocks under
coverage, particularly those with large US defence
exposure. We believe there is a need for increased
caution on the defence names, not only because of
the increased risk to revenues in the medium term,
but also because defence stocks have been among
the best performers within our industrials universe
over the past six months.
The table below outlines the changes to our ratings,
target prices and earnings estimates for the
European defence stocks we have under coverage.

Pressuring the defence
􀀗 Historical evidence shows a reduction in deployment of troops
overseas is a huge factor driving cuts in equipment procurement
􀀗 Forecasts from the GEIA, a major industry lobby, suggest
substantial procurement cuts during Obama’s first term, with the
Army potentially the hardest hit of the three services
􀀗 We identify a number of big programmes that could be at risk and
examine the exposure of the European players

Outperformance of defence
The table below shows the year-to-date
performance of those stocks within our universe
that we consider predominantly defence stocks
(rather than civil or other industrials).

The table shows that the pure defence stocks have
generally been among the best performers in our
industrials coverage universe, while to varying
extents, these stocks trade on valuation premia to
the wider industrials peers (further details in the
company profiles, p11 onwards).

Balance of evidence
In this report, we summarise our view of the
direction of US defence spending and its likely
impact on the European defence sector. We
conclude that the election of a Democrat President
is a neutral to slightly bearish signal for defence
procurement spending.
The withdrawal of US troops from overseas
deployments (which we assume will be happening
in the coming few years) is a distinct negative
signal for defence spending.
The direction of defence spending is not the sole
determinant of defence stocks relative
performance, however. For example, in 1975-79,
with defence spending declining sharply relative
to GDP, the defence sector outperformed.
Nonetheless, for our European sector coverage,
we conclude that the outlook for US defence
spending should be counted as a negative factor
when valuing the stocks.

Democrat president – mixed
signals from history
The chart above shows the level of defence
spending in the US as a percentage of GDP since
1960. The track record of Democrat presidents
has generally been to reduce defence spending
relative to GDP, but this has been a trend across
presidencies of both parties (note how America
has ‘demilitarised’ over the past 50 years).
Among Democrats, the Kennedy/Johnson
presidency inched defence spending up only from
9.3% of GDP to 9.4%, in spite of committing the
US to Vietnam, while the Carter and Clinton
presidencies both cut.
Among Republicans, both Reagan and GW Bush
raised defence spending as a proportion of GDP,
while GHW Bush reduced it moderately, and
Nixon/Ford made the biggest reductions of any
presidency of either party over the past 50 years.
We conclude that switching from a Republican to a
Democrat presidency is not in itself a huge signal

either way, but tilts negative for defence spending.

Drawdown of troops from
overseas theatres
Troop deployments have a far more unequivocal
impact on defence spending: the fewer troops
are deployed, the lower the defence
procurement spending.
The important distinction we make here is to look
specifically at procurement spending rather than
general defence spending. One might easily argue
that of course defence spending rises when troops
are in action overseas, because there is a cost of
supporting the military campaign itself. However,
the chart on the next page shows the correlation
between deployment and procurement spending,
which excludes Operation and Maintenance spend.
We therefore conclude that if, as we expect,
President-elect Obama draws down troops from Iraq
and does not commit to any new campaign (this
scenario is of course not guaranteed), we believe this
would point to reduced procurement spending.

Big programmes
A number of major US procurement programmes
are surrounded by controversy, with critics
claiming that very high-end technologies fail to
address the threats that America is likely to face in
the coming decades (although one might argue
that these critics are in fact guilty of looking
backwards at Iraq and Afghanistan rather than
looking forwards in their threat assessment).
President-elect Obama was unique among the
presidential candidates (from either party) in
singling out certain major programmes where he
argued money was being wasted, specifically
Missile Defense and the Army’s Future Combat
Systems programme. But these are by no means
the only programmes that could be considered for
downsizing, backsliding, or complete cancellation.
The table on the following page shows the largest
10 programmes currently underway.
We include a commentary about views expressed
by Obama or senior US politicians regarding these
programmes. We would note, however, that Obama
stated repeatedly on the campaign trail that he had
not reached decisions on any of these programmes.
We consider four major programmes in more
detail: Missile Defense, F-35, F-22 and FCS.

Missile Defense
Obama has commented that he would “cut
investments in unproven missile defence
systems”. The programme would not have to be
either cut or continued as one entire unit.
Missile Defense comprises three main phases:
Boost Phase Defense, Midcourse Defense and
Terminal Phase Defense. Each of these three
phases consists of a number of component
systems. Missile Defence could be subject to a
slowing of investment across the whole
programme, a reduction in the scope of any of the
three phases, or a withdrawal of capabilities from
a given geographic region (eg, abandon terminal
phase shield for Poland).
FCS
The Future Combat Systems programme, like
Missile Defense, is an umbrella programme
encompassing a number of different technologies.
There has been criticism of the growing cost of
the programme from both sides of Congress, and
one school of thought contends that the
programme should be abandoned entirely, with
the military purchasing piecemeal the various
technologies it requires.

F-22 Raptor
The most expensive fighter aircraft ever built, the
F-22 Raptor is designed to replace the F-15 in the
‘air superiority’ role, meaning eliminating enemy
aircraft. Critics argue that the programme is a
legacy of the cold-war fighter technology arms
race and not suited to 21st century threats. The
current production programme envisages final
total production limited to 183 units, finishing in
2011, down from 650 units planned when the
programme was originally launched in 1991.
In 2007, an appropriations bill amendment was
proposed by Republican Senators John Warner
and John McCain to limit the potential to extend
the programme. Their proposal was defeated by a
coalition of both Republicans and Democrats who
preferred to maintain the option for more F-22s.
However, the McCain/Warner proposals highlight
the fact that it is not only anti-military Democrats
that are in favour of capping the F-22. Support from

the likes of John McCain would make it easier for
the Obama administration to cut F-22 funding.
And, indeed, more recently the undersecretary for
procurement at the US Air Force, John Young,
has commented that he is “surprised and
dismayed” that Lockheed Martin has threatened to
invoke penalty clauses if the Air Force refuses to
take delivery of its full quota of aircraft in 2009.
The very fact that this avenue has been explored
implies that not even the 2009 production target is
safe, much less the plans for later years.
F-35 joint strike fighter – problems?
The F-35 has recently been dogged by speculation
that its development and pre-production phase is
not going to plan. For example, a story in the
Western Australia News, 10 September 2008,
suggested that combat simulation exercises had
fallen well short of expectations, according to
“sources close to the exercise”. The report was
cited in a debate on the floor of the Parliament of

Australia (a major partner in the development
programme). Reuters (19 September 2008) carried
a rebuttal from Major General Charles Davis of
the F-35 programme, who claims the leaks were
concocted by the manufacturer of a rival fighter
jet. More recently press speculation has appeared
(eg Bill Gertz, Washington Times defence
columnist, in his internet blog (14 November
2008) claiming that House Democrat Chair Nancy
Pelosi has suggested F-35 be reviewed with a
mind to reducing funding.
One option to reduce funding for F-35 would be
to propose extending the F/18 Hornet programme,
while delaying entry into service of F-35 in order
to enhance its capabilities.
An independent forecast
The following chart shows the equipment
procurement projections from the Government
Electronics and Information Technology
Association (GEIA), an industry body
representing the defence equipment
manufacturers. GEIA members include BAE
Systems, Lockheed Martin, Boeing and Northrop
Grumman. We believe the GEIA has little
incentive to ‘low-ball’ with its estimates, as this
would only reinforce the idea for politicians that
cuts are already accepted by the defence

community. We would therefore argue that these
numbers should be regarded as a realistic starting
point for assessing the scale of potential cuts.
We note that Bill Clinton cut defence procurement
spending by 34% during his two terms in
government, whereas the GEIA forecast has
Obama cutting by just 14% over a hypothetical
two terms. Obama starts with a defence budget
25% higher in real terms than Clinton’s starting
point (but lower as % of GDP) or 85% higher in
real terms versus Clinton’s end point.
These numbers suggest to us it is perfectly
realistic to suppose Obama could make larger cuts
than the GEIA forecasts. This is a sobering
thought for defence stocks, particularly for Army
equipment spending, which is in any case coming
down by 40% in the next four years under the
GEIA forecast.
GEIA: US defence equipment procurement estimates (USDbn)
0
20
40
60
80
100
120
140
160
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Army
Air Force
Nav y
DefenceWide
Source: Government Electronics and Information Technology Association (GEIA)