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Defense shift yields 5 strong stocks
Companies like Armor Holdings and United Defense Industries are benefiting as the nature of war changes.
By Jim Jubak
War is different these days, and the kind of defense stock most likely to show gains is different, too.
As hard as it is to remember while youre watching the evening news, the world is safer than it was, say, 40 years ago. School children dont practice duck-and-cover drills, and we dont walk around worrying that the world could turn into a radioactive cinder at any moment.
But that doesnt mean the world is a safe place, just that the wars arent global but relatively local. So the weapons on the front lines are assault rifles, grenade launchers, Bradley fighting vehicles, roadside bombs and body armor.
You cant see that shift to smaller weapons in the governments defense budget because overall defense spending is dominated by the big-ticket stuff like fighter jets and cruise missile destroyers. The big dollars that propel the shares of a defense company upward still come from winning contracts for the next generation of expensive weapons like those.
Dirty, grinding wars
But the shift is there if you look at the spending trends for repair and maintenance, armor upgrades, ammunition, vehicle replacement and logistics and communication support. Dirty, grinding wars like the one in Iraq are big consumers of the mundane war supplies. The additional spending on these items isnt enough to add much to the revenue stream of a big defense company like Boeing (BA, news, msgs) with its $51 billion in sales. But it can be a huge bump in the revenues of a smaller defense contractor that specializes in this kind of work, companies like Armor Holdings (AH, news, msgs) with $446 million in sales.
This kind of defense spending also is much less cyclical than the boom-and-bust world of billion-dollar per weapon Pentagon contracts. Bullets and Bradleys have to be replaced every month as long as theres fighting somewhere. And unless you think the world is about to become a peaceful place, this kind of spending is with us for the long haul.
So here are five companies that are likely to benefit from this new pattern in defense spending. I mentioned three of them on my regular 11:20 a.m. ET Wednesday appearance on CNBCs "Morning Call." The last two are exclusive to MSN Money readers.
Adding armor
Armor Holdings. Congress has added about $1 billion for armored vehicles and $195 million for personal armor plates to the fiscal 2005 defense budget. The Army already has an outstanding solicitation for a three-year contract for 1.7 million armor plates. Armor Holdings has about a 40% share of the armor plate market, so the companys likely share of that contract is about $100 million a year. Thats a big hunk of revenue for a company showing 12-month revenue of $446 million.
Armor Holdings is picking up revenue from other armor programs as well. The company is set to deliver armor packages for 3,400 Humvees in fiscal 2004, with orders for about 7,000 more. Armor Holdings just raised $140 million in a 4 million share follow-on stock offering to be used for acquisitions. The shares trade for 17 times projected 2004 earnings per share.
Betting on the Future Combat System
United Defense Industries (UDI, news, msgs). United Defense Industries is the U.S. Armys No. 2 provider of ground vehicles such as the Bradley, and the company has been busy with upgrades to these aging platforms. It's is in line for a contract to provide armor for the Stryker family of vehicles, the successor to the Bradley, but the companys future in the vehicle business is bound up with the Future Combat System, the successor to the interim Stryker.
United Defense Industries is also in the bullet business, building artillery systems, naval guns and missile launchers, and producing the various precision munitions used in current high-technology warfare.
United Defense has a lot riding on the Future Combat System, and investors looking to put a value on the stock need to remember that any big, new weapons program carries the risk of cancellation or cutbacks. The stock trades at just 13 times projected 2004 earnings per share in reflection of that risk.
Going digital
L-3 Communications (LLL, news, msgs). L-3 Communications is a major force in the developing digital battlefield. The company specializes in the high tech communications gear (and training) that todays soldiers use to figure out whats happening on the battlefield and to communicate, display and analyze that information -- all the while keeping the enemy from eavesdropping.
The company has a substantial non-defense business as well, utilizing many of the same technologies, in the aerospace, homeland security and high-speed/secure communications sectors. As a result of that non-defense business, L-3 Communications tends to trade at a higher multiple than the average defense company. L-3 Communications trades at 19 times projected 2004 earnings per share.
Two exclusive picks for MSN Money
Engineered Support Systems (EASI, news, msgs). Ive written about this company in past Jubaks Journals, but I cant emphasize strongly enough how unusual it is to find a company in any sector, let alone the defense sector, that can consistently grow earnings per share by 20% to 30% a year. Yet Engineered Support Systems has pulled off exactly that trick for the last five years, with earnings per share growing at an average of 34% a year.
Engineered Support Services has found its logistical expertise in heavy demand in any era of rapid deployment on far distant battlefields. And I see no reason to believe that expertise is likely to become less valuable or less in demand. Earnings growth is likely to average near 20% a year for the next five years. The stock trades at 21 times projected fiscal 2004 earnings per share.
General Dynamics (GD, news, msgs). General Dynamics is the most reliable grower among the defense industry majors, which is why Ive included it here with four smaller players. The company threw off cash flow of $1.4 billion after capital expenditures in 2003 and used some of that cash to make acquisitions in the sector. Increasingly General Dynamics is looking to Europe for those acquisitions, with deals this year in the United Kingdom and Austria. Using its cash flow to acquire new businesses, and the recovery of its commercial jet unit, should let General Dynamics keep its growth rate well above that for the rest of the sector even as growth in defense sales slow to 5% near the end of this decade. General Dynamics trades at 17 times projected 2004 earnings per share.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned shares in the following equities mentioned in this column: Engineered Support Systems. He does not own short positions in any stock mentioned in this column.
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