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By Matthew Coffina, CFA and Neal Dihora, CFA | 06-25-2013 10:00 AM

Budget Cuts Haven't Narrowed Defense Moats

Short-term budget worries don't dent our favorable view of the defense industry's competitive advantages, says Morningstar's Neal Dihora and Matt Coffina.

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Neal Dihora, who is an equity analyst covering the defense sector. We're going to talk about the prospects for defense and his top idea in the industry.

Neal, thanks for joining me.

Neal Dihora: Thanks for having me.

Coffina: So, the defense industry tends to have a lot of wide-moat companies. Can you tell me the main sources of economic moats for defense?

Dihora: Yeah. So, the defense industry has pretty much narrow- and wide-moat companies in general, and the biggest contributor is what we call intangibles, really the know-how to produce large projects over a lot of different supply bases across the entire U.S. For example, the F-35 has constituents in 48 states. So, the ability for Lockheed Martin, the company that sort of procures the F-35, to be able to go and manage the entire supply chain is a pretty immense task. And that's one of the big reasons why almost all the defense companies have some sort of moat rating because they all have intangibles they've learned through over the last 50 to 100 years.

Another one is low costs. A lot of these facilities that the defense companies operate were actually owned by the government, and they were basically transitioned over to the big defense contractors kind of for free, and so it's really difficult to replicate that sort of cost.

And finally the big one is switching costs. So, once you have a platform in play, everybody in the armed forces has to be retrained for you to move to a new platform, which is a really immense cost. I mean, think about old people, new people, everybody coming to the channel and having to be retrained on a particular platform, say, the F-16. I mean, it's been around for 35 years now. When we transition over to the F-35, it's going to be a really big cost, so the Pentagon, the Defense Department, and the Air Force have been talking a long time to move this transition.

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