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After a bum 12 months, it looks as though the defense industry shooting straight again. In 1999, whatever news the sector ran up the flagpole -- such as shrinking Pentagon expenditures or earnings shortfalls -- got the wrong kind of salute on Wall Street. This year, though, tank and aircraft builders have suddenly beat the market, posting nearly a 6% gain since Jan. 1 and a jaw-dropping 33% in just the past three months. Shares of Northrup Grumman and Lockheed, in fact, have pasted tech stocks with 50%-plus rallies over the past 13 weeks, while Cordant Technologies, a maker of rocket-propulsion systems, has lifted off to a 73% gain year-to-date, thanks to its buyout by Alcoa.
Why defense couldn't muster much firepower last year is no mystery. Outside of the conflict in Bosnia, no threat of war existed perked up weapons demand. With the Cold War all but forgotten, a massive arms buildup seemed as remote as a resurrection of the Eastern Bloc. Not only that, merger integration problems for key industry players such as Lockheed Martin and Raytheon wounded earnings and left investors in retreat.
It's little wonder, then, that a Standard & Poor's index for the group finished the year down 6.5%. And the index did better than several key stocks. Lockheed Martin and Raytheon fell nearly 50%, clobbered by late-year earnings disappointments.
STILL CHEAP.
Analysts say the factors that have led to defense's rebound could well point to further upside for the group. Start with the fact that after logging no more than an average annual 5.4% gain over the past five years, vs. a 21.7% yearly clip for the S&P 500, the industry's stocks looked cheap at the beginning of 2000. They still do. Even after a strong rally over the past quarter, defense shares are trading at a price-to-earnings multiple of 16 on estimated 2000 earnings, compared with about 29 for the S&P 500, according to Morningstar. "Remove a larger name like Lockheed Martin, and you'll see there are a good number of stocks [whose p-es] are in the single digits," says Paul Nisbet, an analyst with JSA Research.
Moreover, it looks as though the industry may soon be able to count on growth -- something it hasn't experienced since the Iron Curtain came down. To modernize the armed forces, the Pentagon is planning a sizable boost in its procurement budget for the first time in nearly 15 years. Deutsche Banc Alex Brown analyst Christopher Mecray says this year's 9% or so increase in spending is just the beginning and that the Defense Dept. should average 7% annual spending increases over the next five years.
"There's the chance if Bush gets elected this fall that procurement increases might rise to as much as 10% yearly," adds Nisbet. Wall Street thinks that kind of lift for the industry's top line will fuel yearly earnings growth in the low teens, according to Zacks Investment Research.
Beyond that, defense stocks have historically weathered interest rate hikes with less damage than much of the market has suffered. And as a kicker, the group's average dividend yield of 1.7% exceeds the S&P's payout of 0.7%.
SMALLER PREY.
Defense contractors could also benefit from consolidation: With their shares still priced low, analysts expect another round of mergers to start soon -- with some twists. For one thing, don't look for blockbusters. Since Washington turned up its nose at Lockheed's proposed union with Northrup in March, 1998, the bigger players have hunted smaller prey.
Another new wrinkle is that horizontal is in, and vertical is out. Indeed, Lockheed's attempt to use mergers to beef up specific projects has taught the industry that marriages of like businesses lead to big integration headaches. As a result, analysts say the favorite targets of big contractors are now mid- and small-cap manufacturers that can help a company expand its portfolio of weaponry.
One of the Street's favorite companies, General Dynamics, has taken the idea of horizontal integration a step further with its acquisition of the business-jet maker Gulfstream. GD, the nation's largest builder of tanks and naval vessels, now gets 30% of its sales from Gulfstream, which is expected to provide a nice boost to the company's bottom line. Moreover, a practically debt-free balance sheet and shrewd acquisitions within the defense industry have helped burnish the company's reputation as one of the best managed in the business.
IN THE STOCKADE.
"GD is a safe play in this market," declares Deutsche Banc's Mecray. "The company has beefed up its presence in defense electronics through acquisitions, and its shipbuilding and armored vehicle manufacturing should see benefits from increased international sales." On Wall Street, 8 of the 10 analysts who follow the stock rate it a strong buy or buy, and consensus estimates are that General Dynamics' earnings will grow an average 10.6% annually over the next five years, according to Zacks. Mecray currently holds a 12 month price target of $70 a share for General Dynamics, which closed on June 16 at $55.
If General Dynamics wins points for strong management, Orbital Science, a maker of satellites, has been exiled to the stockade because of a major gaffe -- overstating revenues and earnings for several years. As investors fled, the stock sank nearly 60% in 1999 and 31% so far this year. All of which has made Orbital a potential favorite of contrarians.
The company has spent the past few years preparing two satellite networks -- ORBCOMM and ORBIMAGE -- that will offerdata, communications, tracking services, mapping, and imaging capabilities to corporations and government agencies. JSA's Nisbet says both could turn profitable in 2001 on their way to becoming a meaningful driver of earnings for the company. What's more, any potential competition for ORBCOMM, which has won contracts from the likes of Qualcomm, Shell, Wells Fargo, and Wal-Mart, is two to three years away, says Nisbet. Currently, six of the eight analysts who follow Orbital rate the stock a strong buy or buy, and Wall Street predicts that its earnings will grow 41% annually over the next five years. Nisbet thinks that Oribtal, which closed on June 16 at $12.81 a share, could hit $40 by year's end, $59 by the end of 2001, and by 2003 could climb as high as $125.
For fund investors, Fidelity's Select Defense & Aerospace portfolio (FSDAX) is as close a fit as you could ask for. Year-to-date, Fidelity's offering has risen 7%, following a 1999 in which the fund sidestepped a miserable year for defense stocks with a 11% total return. The fund has posted a 10.6% average annual total return over the past three years -- and it counted General Dynamics as its No. 2 holding earlier this year, with 9.41% of assets invested in that stock.
No matter which way you buy defense stocks, this may be the first year in some time in which you'll have a decent chance to win the day.
Anderson teaches journalism at the City University of New York. His Sector Scope column appears every other Monday on BW Online
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