Interview – July 6, 2007

HDS: Hi this is Ann Marie Fleming with HomelandDefenseStocks.com.

HDS: We are once again joined by Scott Sacknoff, manager of the SPADE ® Defense Index, ticker symbol, DXS, who will update us on how defense and security stocks have done over the first six months of the year, which stocks and segments have performed the best and what analysts expect to see in the second half of the year. In addition, we’ll be getting some observations from him about the recent Paris Air Show that drew several hundred thousand attendees. Mr. Sacknoff, thank you for joining us.

SMS: My pleasure Ann Marie.

HDS: So we are now halfway through 2007. How is the sector been performing for investors?

SMS: Well Ann-Marie, the SPADE Defense Index is once again outperforming the broader market, as defined by the S&P500, by more than 9.50%, gaining 15.59% so far in 2007. Considering the sector is in year 8 of beating the market and at least year 10 of a bull-run, I’d imagine investors in the aerospace and defense sector continue to be pleased.

HDS: Can you tell us which companies or segments have been driving this performance?

SMS: First of all, companies involved with armor and armored vehicles have done exceptionally well. The Pentagon has cleared the U.S. Army to rush orders for Mine Resistant Ambush Protection Vehicles to help protect troops in Iraq. This could mean contracts worth more than $20 billion over the next several years and it is the primary driver behind the recent performance of Armor Holdings (which is being acquired by the UK’s BAE Systems), Force Protection, and Oshkosh Trucks. Indicative of this contract’s importance is that, Force Protection’s stock declined last month by more than 20% as analysts questioned whether they would receive as much of the MRAP contract they originally estimated. It should be noted that Force Protection is still up nearly 20% this year.

Homeland security stocks such as TASER, L1 Identity, and OSI Systems have also rebounded from sub-par performance last year to be among the sector’s leading gainers.

HDS: What about the laggards?

SMS: Of the ‘big five’ defense prime contractors, only Northrop Grumman, which underperformed its competitors last year, has produced double digit gains this year. Lockheed, Raytheon, and General Dynamics have produced returns in the 2 - 5% range with Boeing only slightly higher. Year-to-date, the laggards include several defense IT and service firms, a recent IPO, and several smaller companies.

It is interesting to note that the defense IT and service firms, whose value has declined significantly as DoD shifted spending and contracts to meet the immediate needs in Iraq, have begun to rebound. In particular, we’ve noticed a number of recent M&A transactions in the sector, and this may indicate a turnaround.

HDS: Going forward, where is the defense and security sector headed?

SMS: Well, the last few years have seen great strength in defense manufacturing and prime system contractors as equipment has been purchased in significant quantity to meet the needs of Iraq. When expenditures in this area slow, we should once again see the defense services business outperform. Investors should be aware that the defense business is cyclical by nature – not just in build-up versus peace dividend but also in research and development versus production. New technologies can take 10-20 years to develop and become operational. The war in Iraq delayed the R&D cycle but it is still critical. With many systems nearing their operational end to their life, and I am amused when I see some systems are referred to as Eisenhower-administration developed systems, the 2010s are likely to see a period of significant reinvestment in both physical and network centric technologies.

HDS: And near-term, what about the second half of 2007.

SMS: Well over the last several years, the third quarter that includes September, has historically been strong as the government awards a large number of contracts spending fiscal year-end monies. The passage of the DoD supplemental spending bill will also enable DoD to re-allocate resources toward R&D projects whose funding shifted to pay for the war in Iraq.

The fourth quarter also tends to be a strong period but can vary due to a number of market-related factors such as end-of-year profit taking to early betting on how strong one believes the FY09 defense budget proposal will be when it is announced in late January / early February.

HDS: What about the investors’ themselves? Have you noticed whether the sector is gaining favor?

SMS: There have always been investors interested in the individual companies just like there will always be those who ignore aerospace, defense, and security in principle. That said, since the beginning of the year, we’ve seen a rise in the number of individuals and institutions who have added the sector to their holdings. The easiest way to monitor this inflow is via a fund like the Powershares Aerospace & Defense ETF, which tracks the performance of our index. Their fund has seen the total number of shares in its PPA product more than double since the beginning of the year with assets under management rising from $109 million to more than $240 million.

HDS: Which brings us to the Paris Air Show. You’ve just returned. Can you tell me what you observed?

SMS: Paris is always a good show and while it is heavily focused on commercial aviation, there is considerable focus on defense and other related technologies. For those unfamiliar with its size, the show attracts several hundred thousand people with exhibits from more than 2000 companies and more than 350 corporate chalets. Since the show is heavily international – more so than any show in the U.S. – it gives the opportunity to chat with executives from around the world, observe their exhibits, and see what they are promoting in order to gain a better perspective on the trends.

HDS: And what did you notice?

SMS: In particular, three things:

• The Boeing – Airbus battle was ‘front and center’ – not just in the announcement of sales and contracts (which saw Boeing announce $15.9 billion in firm sales during the week) but in rhetoric as to who’s in the lead as well as the shear number of suppliers the sector relies upon. Airbus had announced more than $75 billion worth of deals but many analysts questioned how much was real versus potential orders as well as when these orders were booked.
• The truly global nature of the A&D business. Whereas attention here seems to focus on the U.S. market and U.S. companies, the business is heavily international. According to SIPRI, the U.S. represented 46% of the global defense spending in 2006. When it comes to the commercial market for aircraft and space systems, the U.S. share is also less than half.
• Based on the resources devoted to staff, exhibits, promotions, and events at the show, the A&D business is remarkably healthy. Although there are concerns about the flattening of the defense budget in the coming years, executives believe the sector will remain strong as international A&D sales rise, export-licensing restrictions among trading partners relax a bit, and their commercial endeavors remain strong. Analysts see the commercial aerospace cycle extending at least two more years as U.S. carriers place orders after years of straightening out their finances and buyers in the Middle East and Asia continue to expand.

HDS: This has been great. Thank you for joining us today. If you are interested in getting more information about the SPADE Defense Index, please visit www.spadeindex.com. Historical data for the index can be found using the index symbol ‘DXS’.

And as always, the information presented in this interview is for information purposes and should not represent a solicitation or an offer to purchase an investment product. Investors interested in the Powershares ETF trading under the ticker ‘PPA’ should visit the powershares.com website for a prospectus.

Disclaimers:  The information presented in this interview is for informational purposes and should not represent a solicitation or an offer to purchase an investment product.  SPADE and the SPADE Defense Index are registered trademarks of the ISBC.  Powershares is a registered trademark of Powershares Capital Management.