Regardless of econom-ic conditions, wars and peacekeeping missions continue, making defence one of the best “defensive” subsectors during tough times.

However, many companies in the subsector are not pure defence plays; most are also involved in the commercial aircraft business. So, investors have to decide how deep, long and widespread the current global economic slowdown is going to be before picking investments in this subsector.

If you’re pessimistic and think a U.S. recession will occur and bring with it a marked slowdown in global growth, you probably want to stick with companies that have significant exposure to defence and/or exposure to a number of industrial subsectors that are relatively recessionproof, including defence.

But if you think a U.S. recession will be shallow and short-lived, with little impact on the rest of the world, you have a wider choice because demand for large aircraft, particularly from emerging markets, should remain strong.

An industrial conglomerate many analysts think is worth considering is United Technologies Corp. of Hartford, Conn. (See page 43 for more on UTC’s defence exposure; and Investment Executive, December 2007, page 48, for more on the overall company.) However, a purer defence play is London-based BAE Systems PLC, the largest defence company in Europe.

There are also a number of suppliers to the aerospace and defence subsector worth considering. These companies have all seen their stock prices drop in recent months and a number of analysts think the prices have fallen more than they should have — if the U.S. slowdown is contained and doesn’t have a major impact on global growth. If the global economy manages about 4% growth in 2008, vs 5% in 2007, demand for large commercial aircraft should remain strong and any dampening effect on business-jet orders will probably be short-lived.

As such, global money managers recommend four companies that supply the aerospace and defence industry: Montreal-based CAE Inc.; Charlotte, N.C.-based Goodrich Corp. ; Cedar Rapids, Iowa-based Rockwell Collins Inc. ; and London-based Rolls Royce Group PLC.

Here’s a look at these four companies, as well as BAE:

> Bae Systems PLC is a military electronics giant that offers steady growth as a result of its wide range of clients. Analysts who like BAE include Charles Burbeck, head of global equities at HSBC Halbis Partners in London; Tina Cook, analyst with Charles Stanley Equity Research in London; analysts with J.P. Morgan Securities Inc. in New York; analysts with the London office of UBS Ltd. ; and, in Frankfurt, Uwe Zoellner, lead manager of Templeton European Corporate Class Fund, sponsored by Toronto-based Franklin Templeton Investments Inc.

In reports released in January, J.P. Morgan and UBS analysts had 12-month price targets of £5.5 a share and £5.7 a share, respectively, for BAE’s stock. The shares closed at £4.73 on Jan. 31.

In a Jan. 22 report, Cook predicts BAE’s revenue will be £17.3 billion in the fiscal year ending Dec. 31, 2008, up 13.6% from an estimated £15.2 billion in 2007. This incorporates BAE’s acquisition of Australia-based Tenix Defence, which was announced in January.

Cook expects earnings per share will rise by a comparatively modest 12.5% to £0.32 in 2008 vs £0.28 in 2007, as BAE absorbs the cost of integrating the Tenix business. However, she predicts EPS will jump a further 15.2% in 2009 while revenue increases 6.3%.

The J.P. Morgan report calls for an average annual increase in EPS of 10% from 2007 to 2011, with excellent cash flow. It believes upside surprises should continue to be driven by “much improved program execution,” capital reallocation and exports. The key risk is a possible withdrawal from Iraq or scaling down the campaign after this year’s U.S. presidential election.

BAE has “fantastic political connections,” says Burbeck, “which are very important in the defence industry because it’s the governments that buy.” The firm does a lot of business in the U.S. — which is unusual for a non-U.S.-based company — and Burbeck considers it a cheap way to get exposure to U.S. defence spending.

Zoellner agrees, pointing to the great U.S. demand for armed vehicles. The U.S. has updated its airborne forces’ system but not that of its ground forces. The U.S. has realized that in large-scale conflicts, the military needs to be on the ground, he explains. He notes that BAE also signed a contract in September with Saudi Arabia to provide 72 fighter aircraft.

@page_break@The most lucrative part of most sales is in the aftermarket, which are contracts to maintain and service equipment after the sale. In the case of the Saudi Arabian deal, that should go on for 20 years. Zoellner thinks there could be 20% upside to BAE’s stock. The aftermarket business follows the model used by Gillette Co., which makes most of its money selling replacement razor blades for use in its razors.

The UBS report suggests BAE is making “good progress in its core strategy to become a systems house rather than a product manufacturer,” citing a number of transactions the company made at the end of 2007.

BAE reported net income for the six months ended June 30, 2007, of £518 million vs £406 million during the same period a year earlier. Revenue was £6.3 billion vs £5.8 billion. Long-term debt was £2.4 billion as of June 30.

> CAE Inc. has a world-leading franchise in making flight simulators and pilot training programs, says Mark Chaput, a portfolio manager with I.G. Investment Management Ltd. in Montreal. CAE has dominated the simulator market globally for 10 years, has 75% of the market and is “regarded as the best.” About half the business is training, and 40% of its revenue comes from defence contracts.

Chaput has a high regard for CAE president and CEO Robert Brown, who has done a “fantastic job” in building the training part of the business, which was launched shortly before he joined the company in 2004. The company initially bought some training centres but now opens its own.

Reports issued by UBS and Toronto-based TD Newcrest both rate CAE a “buy,” with 12-month price targets of $15 a share and $17 a share, respectively. The shares closed at $11.28 on Jan. 31, down from a high of $14.45 in July 2007.

A Nov. 9 UBS report called the shares “oversold” at around $12.50.

TD Newcrest’s Jan. 24 report points out that CAE is a much different company than it was in the previous downturn. Not only does military revenue now account for 45% of total revenue, but with the emergence of Asian and Middle Eastern airline infrastructure, there’s a global shortage of pilots, which plays into CAE’s strong training division.

CAE reported net income of $77.6 million for the six months ended Sept. 30, 2007, vs $63.4 million for the same period a year earlier. Revenue was $712.2 million vs $582.2 million. Long-term debt was $337.4 million as of Sept. 30.

> Goodrich Corp. produces a variety of components and systems for commercial aircraft, including landing gear, wheels and brakes, sensors, aircraft interior products and engine systems. It also supplies aircraft and satellite systems to the space and defence markets.

Again, the lucrative part of Goodrich’s business is in aftermarket service contracts, which are driven by plane usage. For example, Goodrich gets a certain amount of revenue for each takeoff and landing on its landing-gear service contracts. This is a much steadier business than selling components on a “need only” basis — let alone selling the aircraft themselves.

Zoellner suggests buying shares of Goodrich on weakness.

A Nov. 16 UBS report says the outlook for the aftermarket and for margin improvement is brighter than Goodrich is assuming. The report rates the stock a “buy” with a target price of US$81 a share. The shares had a tremendous run in 2007, ending the year at US$70.61 vs the US$45.84 at which they traded at the start of the year. They then took a downturn early in 2008, closing at US$62.45 a share on Jan. 31.

An Oct. 31 J.P. Morgan report was “neutral” on the stock. Nevertheless, it expects Goodrich’s margins to improve, driven by sourcing to low-cost countries. The report also notes that Goodrich is looking for acquisitions, preferably in defence-related businesses.

Net income was US$351.4 million in the nine months ended Sept. 30, 2007, down from $383.2 million during the same period the year prior. Revenue was $4.7 billion vs $4.2 billion. Long-term debt and capital lease obligations were $1.7 billion as of Sept. 30.

> Rockwell Collins Inc. Chaput calls it a “fantastic” company that a lot of other firms would like to own. Its products — aviation electronics, as well as airborne and mobile communications products for both the commercial and defence markets — are “really high value and have high margins,” he says.

In addition, Chaput considers Rockwell president and CEO Clayton Jones “one of the best,” saying that he has done a great job managing the company, including bringing down its debt.

There’s a huge focus on research and development at Rockwell, with almost 20% of revenue going toward R&D. Rockwell uses R&D to get commercial terms on defence contracts, Chaput says. This results in margins for the firm that are about twice as high as the 10%-12% that is typical for defence suppliers.

Chaput expects Rockwell’s EPS to grow by 15%-20% a year in the next two to three years, assuming there’s no significant slowing in global economic growth.

Both UBS and New York-based Argus Research Co. have issued reports rating Rockwell a “buy” with a 12-month price target of US$85 a share. The shares closed at US$63.13 on Jan. 31, almost US$12 off its US$76 peak this past November.

However, J.P. Morgan’s Oct. 31 report gave Rockwell a “neutral” rating, foreseeing slowing revenue growth in both its commercial and defence divisions but expecting operating margins to expand in its commercial business lines while coming down slightly in defence.

Rockwell reported net income of US$154 million in the three months ended Sept. 30, up from US$143 million during the same period a year earlier. Quarterly sales were US$1.1 billion vs US$1 billion. Long-term debt was US$228 million as of Sept. 30.

> Rolls Royce Group PLC is a major manufacturer of aircraft engines. It has improved its market share in the past 10 years and it shares the market with UTC subsidiary Pratt & Whitney and Fairfield, Conn.-based General Electric Co.

Like other component suppliers, Rolls Royce makes most of its money from spare parts and maintenance, Zoellner says. In this case, the typical contract contains a fee for each hour flown.

There’s some short-term risk if global economic growth slows markedly, as that would decrease hours flown, Zoellner says. However, he points out that the stock price, at £4.82 on Jan. 31, was down 17.4% from its £5.66 peak this past October. He thinks a lot of downside risk is already priced into the stock.

A Nov. 12 J.P. Morgan report suggests the stock could fall further. The report’s 12-month price target was £4.25, saying that the shares are expensively priced for “near-peak cyclical earnings.” The report adds: “EPS growth is set to slow to borderline double digits due to slowing aftermarket growth from unsustainable levels, plus U.S. dollar and commodity cost headwinds.” In short, the return of capital “may be more limited than some expect.”

Net income was £303 million for the six months ended June 30, 2007, vs £617 million for the same period a year prior on revenue of £3.6 billion vs £3.4 billion. Long-term debt was £1 billion as of June 30. IE