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Defense stocks are a good offense
In the year since the terrorist attacks, defense stocks have marched to market-leading gains, though not without a few battle scars. Any retreat in prices could signal opportunity to investors.
By Jon D. Markman
The lesson of Sept. 11 for politicians, citizens and investors alike is brutally plain: Might makes right.
Osama bin Laden and his gang of delusional misfits got away with murder in the 1993 World Trade Center bombing, the 1996 truck-bombing of U.S. barracks in Saudi Arabia, the 1998 truck bombing of U.S. embassies in Kenya and Tanzania and the 2000 attack on the USS Cole in Yemen. More than 400 people died in these attacks, and the American response amounted to a couple of unsuccessful cruise missile launches and unsatisfying court convictions.
Undeterred by any reasonable show of retaliation on our part, bin Laden and his buddies in Baghdad and elsewhere learned that Americans were not up to a fight -- so they took their show on the road by totaling the twin towers in New York. We battled back briefly with a set of proxy warlords in Afghanistan, but the fact remains that our dead are not yet avenged.
We have 3,000-plus reasons to head back to the Middle East and finish the job that previous administrations should have completed long ago. And when we do, the bombs, bullets and radar from an incredibly capable set of U.S. defense contractors will once again lead the charge.
In the immediate aftermath of the World Trade Center and Pentagon attacks last year, shares of Lockheed Martin (LMT, news, msgs), General Dynamics (GD, news, msgs), Raytheon (RTN, news, msgs), Northrop Grumman (NOC, news, msgs) and United Technologies (UTX, news, msgs) predictably rose in a gut-level response to expectations that all fiscal restraints would be lifted from Pentagon spending. I wrote in a column on Oct. 10, 2001, Why booming defense stocks could lead the market, that defense stocks were likely to be the new market leaders as they were among the few and the proud whose prospects for predictable earnings growth for the next few years were clear, so long as they didnt screw up.
In the fullness of time, not only have prospects continued to brighten for the companies that defend U.S. interests, but they have so far eluded the accounting, insider-trading and personality scandals that have plagued other industries. The defense industry ran through its gauntlet of scandal more than a decade ago, and the green-eyeshade guys at the federal Defense Contract Audit Agency seem to have shut down contractors' once-ample taste for cheating and gouging.
In the sell-off of the past four months, several defense-complex stocks have come under selling pressure because of problems in their commercial aviation divisions. But that may turn out to be the opportunity that investors needed to invest some hoarded cash. Which ones?
2 strongholds to consider
Lets start with General Dynamics, which rose as much as 40% from its post-Sept. 11 low and has since given most of it back. General Dynamics has been grounded in large part because of lowered guidance on deliveries of its corporate jets, the Gulfstream IV and V and worries about diminished margins for a new line of lower-cost business jets announced this week. Along with a few other bits and pieces, the concern is limited to just a fraction of General Dynamics commercial aviation business, which amounts to just 25% of total business. So essentially, a cut of 5% in General Dynamics expected earnings has pushed the stock down 25%. (On Tuesday, the company said NetJets, a unit of Berkshire Hathaway (BRK.A, news, msgs), had placed a $1.5 billion order for 50 new G150 jets, one of the companys new line of planes.)
Perhaps portfolio managers believe that, once the company is on the slippery path of lowering expectations, it will do so again, a fair enough assumption these days. But the company is going to have considerable military business and will grow rapidly as a warship, gun system and electronics systems vendor. High on the list is the DDG 51, or Arleigh Burke, class of destroyers fitted with Aegis combat systems. Independent defense analyst Paul Nisbet says few investors recognize that the fiscal 2004 Defense Department budget will include funding for three Aegis destroyers at $1 billion apiece - two of which will be started right away by General Dynamics. The company is expected to get contracts for five more Aegis ships at the same time, though it wont get funding for these in 2004. Payments for this business, Nisbet believes, will more than make up for the thinning of the high-end Gulfstream business after fiscal 2003.
The current price of General Dynamics shares, around $80, might well be a reasonable entry point, with the understanding that if the market craters over the next couple of months, better entries or opportunities to add will emerge. Its forward price-to-earnings multiple, at 15, isnt much more than its expected three-year growth rate of 13% -- and will probably rise as investors come to appreciate its ship-building story.
Raytheon, the nations fourth-largest defense contractor, has suffered several unfortunate blasts to its shares in the past year unrelated to the military business, including the botched sale of a civil engineering division, setbacks in its planned sale of the Beechcraft private plane division and a slowdown in production of its own line of business jets. These issues have obscured the fact that 85% of Raytheons business is high-margin military command-and-control electronics and missile systems (including the Tomahawk and Patriot). Management is reasonably strong, the valuation is pretty low and 12%-to-14% annual growth seems like a lock once those distractions are put aside. Now trading around $35.50, a return to the mid-$50s should be within reach over the next two years, a 50% move -- and theres a 2.2% dividend yield. Again, bumps in the overall market could provide even better buying opportunities over the next couple of months.
3 to hold -- for now
Defense contractors to avoid or hold, for now?
Boeing (BA, news, msgs) shares have been justifiably rocked because of the companys heavy reliance on the airliner business, which has been cut in half, and the threat of a prolonged mechanics strike. The Chicago-based company has a terrific military and space business, but it has never faced so severe and rapid a downturn in its share of its all-important commercial aircraft division. Consider that currently there are a couple of thousand aircraft worldwide that are parked. Two-thirds of them may never fly again, but the rest will -- soaking up potential demand for Boeings talents. The stock trades at a forward P/E multiple around 12. While that seems low, its actually pretty rich considering that the companys growth rate probably wont exceed 5% over the next couple of years.
Northrup Grumman, which I have recommended below $100 twice before, has very little commercial aviation exposure but looks a little pricey at the moment. It may also be distracted by its rapid pace of acquisitions recently. If you can buy it again under $100 (its now $124) in the next couple of months, youll probably have another good entry for a company that has transformed itself into a one-stop shop for electronics systems, nuclear-powered subs, aircraft carriers, the B-2 bombers and, after its TRW acquisition is complete, defense satellites, high-energy lasers and computer systems. Its forward P/E multiple, around 19, however, is not much of a premium over its expected growth rate around 15%. If big-cap growth caps return to favor, this stock will probably advance without a return to the sub-$100 level.
Another powerhouse thats not cheap is Lockheed-Martin, the nations No. 1 defense contractor. This manufacturer of everything from the F16 jet fighters and the C-130 transport jet to missiles, fire-control systems and computer systems integration saw its shares zoom to $70 from $38 in the wake of the terror attacks, then settled back to the mid-60s. At this level, the stock looks fairly priced with a historically high forward P/E ratio of 26, a big premium over its expected growth rate of 14%. A return to the low $50s, where it spiked during Julys big market down-move, would be a smarter starting place - though, again, if growth stocks take off in the fall, it may never get there.
All in all, over the next few years, investors are going to be reminded every three months during earnings season that these companies are for real -- and their so-far untainted market leadership will last as long as Congress remains committed to improving the Pentagons capacity to pound our many enemies.
Fine Print
Investors who prefer smaller defense contractors should take a look again at Alliant Techsystems (ATK, news, msgs). This explosive mid-cap manufacturer of gunpowder, ammunition, mines and aircraft weapon systems was one of the greatest stock stories of the bear market, rising steadily from a low of $16 in early 2000 to a high of $76 in April 2002. It fell all the way back to the low $50s during the July sell-off of all defense stocks, but it has returned to the low $70s. The company has steadfastly recorded 15% growth rates and does not appear likely to back off. Another return to the $50s in any sell-off over the next two months would provide another good entry point. At the moment, shares are richly, but not unreasonably, valued with a 21 forward P/E multiple. As soon as commercial aviation appears to perk up, which it inevitably will at some point in the next couple of years, shares of Goodrich (GR, news, msgs) will merit a look. Its stock doubled in the wake of Sept. 11 but has since fallen all the way back -- a trip from $17 to $34 and back to $20. Formerly a tire maker, its now entirely focused on aviation systems and trades at just eight times forward earnings, a discount to its probably 12% growth rate, Nisbet says. Goodrich also sports a 3.9% dividend yield. One red flag though: Debt is a problem, as Goodrich has financed its way into its new field. Another, much larger company in the same category is United Technologies. To be sure, United Technologies is highly leveraged to the economy because it owns the largest air-conditioning maker, Carrier, and the largest elevator maker, Otis. But it has considerable commercial aviation and defense exposure as well, with Sikorsky helicopters and Pratt & Whitney engines. The valuation is decent, at 13 times forward earnings and an expected growth rate of 12%. But investors may not give the company the benefit of the doubt until improvements in both the airliner and commercial construction businesses are on the horizon. Contrarian-minded speculators could have a bargain here. And lastly, keep an eye on opportunities to purchase L-3 Communications (LLL, news, msgs), an admired defense electronics contractor thats trading right in the middle of its historic valuation zone with a forward P/E of 24 vs. expected growth in the high teens.
Catch live commentary with Jon Markman on Webfn.com on Mondays at 3:30 p.m. (PT).
While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to jmarkman@microsoft.com.
At the time of publication, he owned no stocks mentioned in this column.
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