Invesco Aerospace & Defense ETF: The Importance Of Military UAVs In Modern Warfare

A year ago, we did a thorough analysis of why we believe that iShares US Aerospace & Defense ETF (ITA) might be a good investment. We remain positive about the long-term prospects of the US aerospace & defense industry, given the ongoing threat to the entire Western world and particularly the eastern NATO flank after Russian President Vladimir Putin's decision to invade Ukraine. This action has prompted many Western NATO countries to provide weapons, military equipment, and financial & humanitarian aid to the Ukrainian people in their fight to protect their homeland. In light of the current geopolitical landscape, which is marked by tensions in Europe and Asia, increased government spending on defense by NATO countries, and advancements in modern warfare technology, we believe that long-term secular trends remain positive for investors in US defense manufacturers.

In this article, analyzing Invesco Aerospace & Defense ETF (NYSEARCA:PPA) we will focus on the defense UAV industry, as it has been a game-changer so far when it comes down to modern warfare in Ukraine. Both sides have used UAVs for reconnaissance, surveillance, and precision strikes, which completely change the nature of warfare compared to traditional methods used in World Wars I and II, as well as the Vietnam War in the 1970s. As a result, many military analysts, generals, and personnel in NATO departments of defense recognize the importance of UAVs in modern warfare and are likely to allocate significant capital to technological advancements and future purchases of such products for defense purposes.

UAVs usage in Ukrainian Military Conflict

During the current military conflict in Ukraine, UAVs have been used extensively in support of both Ukrainian and Russian forces. They are typically used for reconnaissance and surveillance, as well as for attacking valuable military targets such as artillery positions or key defense points with highly sophisticated precision strikes. This makes them a very valuable asset in modern military operations, saving soldiers' lives by relieving them of the need to carry out difficult reconnaissance or surveillance missions deep in enemy territory. In the early stages of its ill-fated invasion of Ukraine, the Russian Army had a great deal of trouble because the Ukrainian Army was able to monitor in real-time all major movements of Russian forces on or near the front line.

The Starlink system provides Ukrainians with an essential satellite-based communications platform capable of collecting and delivering data from multiple streams, including video captured by UAVs. However, a month ago Elon Musk decided to stop providing Starlink satellite services for the use of drones by the Ukrainian army, which clearly reflects their importance and effectiveness in modern warfare.

“Using Starlink with drones went beyond the scope of an agreement SpaceX has with the Ukrainian government, Shotwell said, adding the contract was intended for humanitarian purposes such as providing broadband internet to hospitals, banks and families affected by Russia's invasion.

"We know the military is using them for comms, and that's ok," she said. "But our intent was never to have them use it for offensive purposes."

(Source: Reuters)

We are talking about short-range combat UAVs, typically used on the front lines, with a typical range of 5 to 10 km. Another very important aspect of UAVs is their cost-effectiveness, as they are much cheaper to produce than traditional manned aircraft such as the F-16.

For example, the standard version of the F-16 costs about $90 million, while long-endurance UAVs such as the MQ-9 Reaper, produced by General Atomics Aeronautical Systems (GD), costs about $30 million. In addition, long-range UAVs are capable of staying aloft for hours or even days, whereas traditional manned aircraft usually have to make frequent stops due to pilot fatigue or possible fuel shortages.

Our readers should also bear in mind that traditional manned aircraft also require trained pilots to maneuver them, which involves salary costs, health insurance costs, costs for specific pilot training and military training, etc. This is also one of the problems that the Ukrainian army has recently faced with the possible delivery of F-16s from Western countries, as Ukrainian pilots are not sufficiently trained to fly them. Therefore, we believe that the role of all types of UAVs in modern warfare is very important, and the key question remains whether a country like Ukraine has the sufficient production capacity to manufacture them for its military purposes, and sufficient budget allocated to defense spending to purchase them from the major US defense contractors included in this ETF.

“One lesson is that drones have been democratized, accessible to anyone with a few hundred dollars and a bit of technical knowledge. In Ukraine, DIY hobbyists have modified and weaponized small, inexpensive commercial drones by outfitting them with high-resolution cameras and explosives.”

(Source: The Conversation)

The Russian army decided in November 2022 to step up its targeted attacks on key Ukrainian energy infrastructure using Shahed 136 drones manufactured by Iranian military companies. These are basically unmanned medium to long-range drones that hit the target and then blow themselves up.

Suicide ‘kamikaze’ drones strike Kyiv in Russian attack

They make things very complicated for Ukrainian air defense systems, as the Russian army usually conducts air strikes in patches of - 95 different types of UAVs combined with 5 missiles. While the Ukrainian air defense systems are busy shooting down these UAVs, Russian hypersonic cruise missiles such as the modern Kh47-M2 Khinzal or soviet-era X-22 “Burya” fly through and eventually reach their final targets. We have said a lot about the effectiveness of UAVs in the Ukrainian military conflict, which is why it is important for major military powers to invest in and develop, and technologically advanced, anti-drone and aerial defense systems as well.

General Market Dynamics

According to a report by Fortune business insight, the global UAV market size was valued at $10.72 billion in 2019 and is expected to reach $25.13 billion by 2027, representing a CAGR of 12.3% during the forecast period. Perhaps this CAGR figure does not look so attractive considering the annual inflation we have faced over the past year. However, we find the growth of the UAV market to be stable over the next 5-10 years, especially when we talk about the use of various types of UAVs for defense purposes. The projected CAGR number is still higher than the general risk-free alternative, the 10-year US Treasury, which currently yields about 4%.

The UAV manufacturers tend to have a diverse customer base, including the U.S. Department of Defense(“DoD”), and various law enforcement agencies, and have recently expanded into other industries as well, including civilian industries such as agriculture, transportation, and energy. It is important to note that the defense industry is highly competitive, especially in the field of UAV manufacturing, and major manufacturers are essentially competing for every dollar they can get from the US DoD budget.

It is a bit difficult to find publicly available information about the exact revenue stream from UAV sales, as these contracts between the US Department of Defense and major defense contractors are usually classified by nature. For example, Boeing (BA) has reported $23.16 billion, or 35% of total revenue for its defense, space, and security segment in fiscal 2022. In the most recent 10-K, we couldn't find an exact revenue figure for drones, as the company mostly reports sales of manned military aircraft and helicopters. Similarly, Lockheed Martin (LMT) has reported net revenue of $26.98 billion or roughly 41% of total revenue for its aeronautics segment in the fiscal year 2022. Unfortunately, there was no reported data on military UAV sales. Another major U.S. defense aerospace manufacturer, General Dynamics, has also only reported a revenue figure of $8.56 billion, or 22% of total revenue, for its aeronautics segment in the fiscal year 2022. We can sum up that at this point, major defense contractors do not see UAV sales as a major segment to report accurate numbers about to the public, but this trend will most likely change in the future as companies begin to emphasize it more than traditional manned aircraft. We may not be able to provide a thorough financial analysis at this time, but we remain optimistic that we will be able to do so in the future.

Nonetheless, individual defense UAV manufacturers will have to invest heavily in R&D to build technologically advanced products to gain a competitive edge over their competitors and maintain the trust of the major customer in question - the US DoD. That is why it is better to buy an ETF or create a portfolio of stocks that are manufacturing UAVs, compared to investing in an individual company and trying to find a market winner. Especially when we talk about the defense industry, which is heavily dependent on government contracts combined with very high regulatory burdens to enter the industry. This makes it almost impossible to compete with well-established companies like Raytheon (RTX), Lockheed Martin, or General Dynamics.

ETF Market Performance

According to the figure above, in terms of year-to-date performance, PPA slightly underperformed compared to its peer ITA and likewise, there was a wide underperformance of roughly 500 bps compared to the SPDR S&P Aerospace & Defense ETF (XAR).

If we take a look into a longer time horizon - 5 years, then things completely change. PPA had the highest 5-year total return among the group, and the gap was approximately 700 basis points compared to XAR. Furthermore, the PPA’s outperformance was much wider by approximately 2550 basis points compared to ITA. This analysis clearly indicates that even though all three ETFs primarily focus on the aerospace and defense industries and have a similar portfolio construction, there is still a significant gap in terms of performance over a longer period of time.

According to the figure above, in terms of year-to-date performance compared to major stock market indexes, PPA performed pretty much in line with S&P 500 (SPY), slightly outperformed Dow Jones Composite (DJIA), while there was a wide underperformance of roughly 800 bps compared to the Nasdaq 100 (QQQ). We have been expecting this year-to-date performance - in line with the general market - as the aerospace & defense industry is a bit slow in its stock market mechanics. Companies in this industry tend to be large manufacturers that work on long-term commercial and government contracts and have steady cash flows over a long period of time. This is definitely not something as volatile and exciting as investing in high-tech stocks, or anything that has its business model surrounded by investments in AI or blockchain.

If we look into a longer time horizon - 5 years, then we can identify that PPA has performed quite closely compared to DJIA with only around 300 basis points of underperformance. Furthermore, this gap widens to approximately 1200 basis points compared to SPY, while QQQ has been the best performer among the group, with a total return of 83.52%. Our readers should keep in mind that the defense industry tends to be resilient to general market cycles and is, by nature, a countercyclical investment. Unfortunately, when military conflicts like the ongoing one in Ukraine arise, the burden of financing war and the resulting destruction can harm the overall economy. However, defense manufacturers can benefit from increased government contracts and large purchases of military equipment during such times.

It is always important to take a look into dividend yields when we are conducting relative ETF analysis. According to the figure above, we are slightly surprised by the low dividend yields ETFs are offering as they are below 1%. In times of near-zero interest rates, such a figure might even have been reasonable, but these days 10-year US Treasuries offer around 4%. Our readers should decide for themselves whether they are willing to take on all the risks associated with investing in the PPA ETF at a dividend yield of 0.69%, or whether they would be more comfortable holding a risk-free equivalent in 10Y US Treasuries at a higher annual yield. We continue to believe that investors who are looking for stability in their portfolio and are not primarily focused on income-producing investments could still prioritize actual portfolio holdings of the PPA ETF and its defense industry exposure, which should perform well over the next decade or even longer given the current geopolitical landscape.

Key Risks

Government contracts are a significant source of revenue for many defense contractors, and any changes in the US regulatory and political approach towards the general US defense industry could negatively impact the long-term financial and business performance of companies included in this ETF.

To illustrate, suppose that the ongoing conflict in Ukraine escalates into a nuclear conflict between Russia and NATO countries. In such a scenario, there could be a significant negative impact on the regulatory and political approach toward the US defense industry. Politicians may initiate the process of de-arming the US and cut the annual spending budget of the Department of Defense. This would have a profound effect on the entire US defense industry, as there is no short-term alternative to quickly replace government contracts with commercial ones. It could also create a significant challenge for defense UAV companies, which will need to invest heavily in R&D to transition their business model from defense to civilian purposes.

Another key risk that we see for companies included in this ETF is any geopolitical tension with China. This is because many of the parts used to assemble UAVs are produced by Chinese companies. If the relationship between the US and China were to break down, this could have a negative impact on the supply of parts from China, and domestic US manufacturers would have to rely on local American sources and materials. Additionally, there is a potential threat from any software developed by Chinese companies that could be used in the UAV manufacturing process or later in combat, as it could be malfunctioned or even steal data critical to national security.

Unfortunately, if such risks materialize, they could create a higher barrier to entry for new companies, since it is much more expensive to produce their own software systems, parts, and materials than to rely on cheaper sources from overseas, such as the Chinese market. However, if the UAV defense industry becomes monopolistic or cartel-like, then there is a problem of market share concentration leading to issues with the pricing power. UAV defense contractors may use this as a bargaining tool to get the highest possible share of government contracts at the highest possible price for them. In the end, this may lead to US taxpayers bearing the burden of such practices out of their own pockets.

Conclusion

We would like to conclude this article by highlighting the growing significance of UAVs in military operations in the years and decades to come. For instance, in the event of China launching a military operation against Taiwan, which is an island, the use of aerial military reconnaissance, surveillance, and precision strikes will become even more crucial. In this context, UAVs offer a more cost-effective solution, as compared to the use of cruise missiles or manned military aircraft. Moreover, the secular trends in the defense industry have remained strong over the past year, as reflected in the performance of this fund.

Based on our relative performance analysis, this ETF has generated returns in line with its peers and broader stock market indices so far in 2023. Over a longer period of 5 years, it has performed well relative to its peers, while underperforming the S&P 500 and Nasdaq 100 indexes. Nonetheless, it offers a really low current dividend yield of 0.69%, which might discourage some dividend-seeking investors from investing in this ETF. However, we remain optimistic about the long-term performance of this ETF, primarily due to positive secular tailwinds including (1), an intense global geopolitical landscape which is marked by various ongoing and developing military conflicts, (2) subsequently increased defense spending by major governments, (3) technological advances in areas such as UAVs for modern military operations, which may be reflected in the Ukraine conflict.