The Middle East has been a land of opportunity for the defense sector in recent years, as a series of conflicts in the region has led to oversized spending on armaments by both the U.S. and local players. But the latest twist of uncertainty, low oil prices, threatens to eat into the business of some contractors as once-deep pocketed customers become pickier.
For most of recent history the volatile Middle East has been good to War Inc. Saudi Arabia alone spent $80.9 billion on its military in 2014, ranking fourth globally, according to the Stockholm International Peace Research Institute, and neighbors United Arab Emirates and Turkey are also among the world's top spenders. In total the region spent nearly $200 billion on military in 2014, a 57% increase from 2005.
But the high oil prices that bankrolled much of that spending have come crashing down, and with it surely some future spending plans. Cowen & Co. earlier this week downgraded Harris (HRS) , citing fears of an oil-related delay in radio orders, and warned that other second-tier defense names could also face shortfalls.
With conflicts in Syria and against the Islamic State of Iraq and the Levant still going strong weapons procurements, including missile defense systems and munitions provided by the likes of Raytheon(RTN) - Get Report and Lockheed Martin(LMT) - Get Report should hold up well. But the analysts warn that vendors supplying less-urgent gear like Harris radios could be in for some disappointment.
Lockheed Martin is a holding in Jim Cramer's Action Alerts PLUS portfolio.
In addition to Harris Cowen's Cai von Rumohr and Gautam Khanna list L-3 Communications(LLL) - Get Report , Oshkosh(OSK) - Get Report and FLIR Systems(FLIR) - Get Report as companies that appear more cautious about defense sales in the region. "In general this reflects the fact that they sell gear for which replacement needs are less critical, lead times are shorter, and backlogs are not in place," the analysts wrote.
Indeed some of the companies have warned investors that Middle Eastern sales could be challenged. Oshkosh CEO Wilson Jones told investors in late January that oil prices have caused "some budget concerns," while L-3's Mike Strianese around the same time said that "things that were once priorities are not tomorrow or it's taking a longer time to close."
The potential slowdown in Middle East sales comes at a tricky moment for the defense sector. Bulls will note that after years of budget battles and sequestration threats the worst from Capitol Hill appear to be over, and nearly all of the major presidential candidates are promising robust Pentagon spending in the years to come.
However, major defense contractors complain that the number of big-ticket U.S. weapon systems platforms up for bid in the years to come is on the decline, and European nations are ill-positioned to pick up any slack. With top tier consolidation among defense primes seemingly blocked by the Pentagon, the defense sector needs to look to new markets for growth.
Absent an oil price recovery, don't expect that growth to come from the Middle East.