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6 defense stocks for tomorrow's warfare
The military's shift from big ships and tanks to high-tech battlefield tools and spycraft may lead investors to shy away from the sector. But these stocks should still do well.
By Michael Brush
Defense stocks have roughly tripled in value since 1992, riding a wave of ever-larger defense budgets that have reversed Clinton-era cutting and helped retool the U.S. military to deal with new threats and new wars.
But with federal deficits swelling and the cost of the Iraq war cutting into what we might otherwise spend on big weapons programs, it might appear that the halcyon days for defense stocks could be numbered.
The defense budget -- excluding supplemental funding used mainly for the Iraq war -- should grow about 8% over the next three years, according to projections by JSA Research, an independent defense sector research group in Newport, R.I. Thats much lower than the 30.6% growth in spending from 2001 to 2005.
The Quadrennial Defense Review, a four-year defense-spending blueprint to be unveiled in February, is expected to call for a continued shift away from the big ships and tanks designed to fight a conventional war against a powerful foe like the former Soviet Union. It will favor, observers say, high-tech gadgets and communication tools that can serve as force multipliers, helping soldiers on the ground get more bang for the buck.
But all this might not be as bad for defense stocks as it appears. Defense spending isn't something that's turned off at the snap of Donald Rumsfeld's fingers, after all.
"Even if you cut off the funding spigot tomorrow, there is an awful lot of backlog in the pipeline, says Jon Kutler, president of Quarterdeck Investment Partners, an investment bank that specializes in aerospace and defense. Congress will do what they typically do, which is stretch out programs to make it appear there are short-term savings.
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Paul Nisbet of JSA Research says that some contractors have enough long-term contracts in place that they can actually cut the marketing budgets used to land new deals. Defense companies also have huge cash flows that they can use to pay back debt, reduce interest expenses and buy back shares. Most defense companies will have double-digit earnings growth in the next year or two, and it could even last for three or four more years, says Nisbet, who has buy ratings on many of the big contractors.
Cheap and visible
And many of the stocks, even after a big run-up, still look cheap. Martin Pollack, a defense analyst at NWQ Investment Management, calculates that Lockheed Martin (LMT, news, msgs), Northrop Grumman (NOC, news, msgs) and Raytheon (RTN, news, msgs) currently sell for 10% to 15% below where they should be trading. Pollack believes the big defense contractors have good earnings visibility, meaning it's easy to predict their financial future.
Heres a brief look at the three he favors:
Lockheed Martin
Some investors worry that aerospace and defense contractor Lockheed Martin will fall victim to reduced spending on big aircraft programs like the F-22 stealth jet, the F-35 joint strike fighter and the C-130J tactical transport plane. Thats one of the main reasons the stock trades at a discount to other defense contractors.
But it is clear that these programs are going to be continued even if they may be reduced, Pollack says. Lockheed Martin has a solid backlog of orders worth roughly $74 billion, or about twice its annual sales. Lockheed is using its $3 billion-plus in annual free cash flow to reduce interest costs by paying down debt, a program that should be complete by 2008, says Nisbet.
Northrop Grumman
This defense contractor has a hand in everything from military electronics and information technology to ships, avionics and unmanned aerial vehicles. But worries about cutbacks in spending on ships have some investors concerned, putting pressure on Northrops valuation. Fears of significant contraction in shipbuilding are overblown, maintains Pollack. Troy Lahr, defense sector analyst at Stifel Nicolaus, projects Northrup will produce $1.6 billion in free cash flow in 2006, which will support an ongoing share buyback program.
Raytheon
Raytheon's key strengths are in areas like missiles, communications, and infrared and radar technologies. It also produces business jets and turboprop aircraft. Raytheon has minimal exposure to cuts in big-ticket programs. Instead, its shares are cheap because it is a turnaround in progress under relatively new management, following a series of missteps in the 1990s. The company should have more than a billion dollars in free cash flow this year, which it will use to pay down debt.
Spy plays
Another way to play defense spending trends is to buy shares of the smaller companies that benefit from the new priorities of the defense agencies.
Michael Lewis, an analyst with BB&T Capital Markets likes Applied Signal Technology (APSG, news, msgs) and Argon ST (STST, news, msgs), which sell spy tools to intelligence agencies, and United Industrial (UIC, news, msgs), which makes unmanned aerial vehicles.
These three are in the sweet spot of defense spending, and that fact is recognized by the huge defense contractors, making the smaller stocks potential acquisition targets, says Lewis.
Indeed, there have been several of these kinds of buyouts in recent months. General Dynamics (GD, news, msgs) announced plans to purchase Anteon International (ANT, news, msgs), Lockheed Martin bought a private information technology company called Sytex, and L-3 Communications (LLL, news, msgs) bought Titan, an information-technology company. Lewis and other defense-sector analysts expect this trend to continue.
Applied Signal Technology
This company makes equipment used to analyze digital signals. That could mean eavesdropping on cell phone conversations, identifying the electromagnetic signature of a ship, or analyzing radar images.
These are areas that are becoming more important because we are pulling in much more data from the hostile areas of the world, says Lewis.
The shares are not cheap, trading at 23 times this years earnings. But analyst Tim Schwartz, with the Ave Maria Catholic Values Fund (AVEMX), says his fund holds Applied Signal anyway because earnings should increase 20% to 25% a year over the next several years. We think this is going to be a growing market and this is one of the few companies in this area, Schwartz says.
Argon ST
Argon makes surveillance and reconnaissance systems, primarily for the U.S. Navy. One risk is that the company has exposure to the defense departments Aerial Common Sensor program -- a plan to use small jets loaded up with spy gear -- which may get cancelled. Argon is otherwise insulated from a slowdown in defense spending, as it works solely in intelligence gathering, says Lewis. The stock trades at 22 times 2006 earnings. But that doesnt bother Lewis because the company has above-average expected growth rate of 28% a year in the medium term.
United Industrial
This company gets just over half its revenue by making the Shadow 200 spy in the sky unmanned aerial vehicle used by the Army. Trading at 15 times 2006 forecasted earnings, United Industrial looks a lot cheaper than most defense technology stocks, which trade for about 19.7 times projected earnings, says Lewis.
United Industrial is held back because it has a slow-growing energy division and faces asbestos-litigation risk. But Lewis is fairly confident growth in military segments will pull the company through any problems here and has a $50 price target on the stock. It recently sold for $42.
With any intelligence-related plays, predicting results -- or even knowing what the companies do -- is a challenge, because much of their business is secret. But they have a good record of selling to spy agencies. And as long as terror risks persist, the government isn't likely to cut its budget for spying on the bad guys.
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.
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