By David Shook With George W. Bush taking office on Jan. 20, defense stocks should stay at the lofty valuations they enjoyed during the last half of 2000, when investors figured the hawkish Texas governor would likely win. This industry is a cluster of heavyweights -- big boys such as Boeing (BA) and Raytheon (RTN.B) -- surrounded by hundreds of smaller companies that feed off the crumbs. (In this case, the crumbs are the less-lucrative Pentagon contracts.)
The perception now on Wall Street is that conditions are so favorable to the defense industry -- because of increased defense spending by the Bush Administration over the next four years -- that many top industry picks, including shipbuilder General Dynamics (GD), have had their ratings knocked down because the stocks are overbought. Does that means investors can forget about the defense industry? Not exactly. A couple of gems may still be out there.
TAKEOVER TARGET? Take tiny United Industrial (UIC), a designer of unmanned aircraft for the military. This relatively obscure company, with a much smaller stock float and less liquidity than larger players, has gained 35% over the past 12 months, $8.50 to $11.50 a share. Pretty good -- but the stock may not have risen as much as the majors because it mostly flies under Wall Street analysts' radar. As the big players add specialty divisions to take advantage of the Bush-Cheney Administration, the company could end up being a takeover target, triggering a nice run-up in its stock.
Then there's Northrop Grumman (NOC). This sector heavyweight, which investors nearly wrote off in 1998 after the government blocked its sale to Lockheed Martin (LMT), is now engineering a takeover of its own that positions it particularly well to benefit during the Bush years. Grumman makes the electronic brains behind some of the most sophisticated weapons and navigation systems in the military.
But what makes Grumman most interesting is its deal, announced Dec. 22, to acquire electronics maker Litton (LIT) for $5.1 billion in cash and debt assumption. A favorite on Wall Street and a maker of advanced electronics and surface combat ships for the Navy, Litton bolsters Grumman's information-technology systems for military navigation, guidance, targeting, and radar identification. Like Grumman, it's a company with a diverse range of defense contracts -- and there's little overlap between the two.
THREE STEPS. The all-cash deal will make Grumman heavily leveraged. Chief of Investor Relations Gaston Kent says its debt-to-market-cap ratio will balloon as high as 65% -- a lot even for a company with Grumman's sizable cash flow. But Kent sees the deal as a three-step process that Wall Street is buying. "We'll get the cash from the banks up front, get the deal done, and do an equity offering on the back end to get the balance sheet back in order."
The stock offering could raise more than $1 billion to pay down debt, but it doesn't erase all the risk. Merrill Lynch analyst Byron Callan likes the deal anyway, saying Grumman "might be the most interesting one in our sector if this Republican Administration makes major changes to defense programs." Total defense spending is already slated to rise steadily from $279 billion to $294 billion in 2003, according to federal budget estimates. And if Bush increases spending further, Grumman's acquisition of Litton will have been timed well.
Says Merrill Lynch analyst Callan: "The combined company is a powerhouse in Department of Defense information technology." Investors already like what they see: Over the last 12 months, Grumman's stock has soared 71%, to $88 a share, similar to the types of gains enjoyed by jet-fighter maker Lockheed and General Dynamics.
LESS RISK EXPOSURE. Just as important, unanticipated changes in defense-spending allocation may not hurt Grumman as much as some others. For example, Boeing and Lockheed are vying for the fattest Pentagon contracts for the planned Joint Strike Fighter. But support for the JSF may be cracking. Grumman stands to gain if Lockheed wins because it has contracts to supply electronics for Lockheed-made JSFs. Should the program be scrapped or scaled down, Grumman would have less exposure than Lockheed or Boeing because it's not a direct competitor for the lucrative deals.
Rather, Grumman is targeting a broad range of contracts across all branches of the military as Congress doles out $60 billion for weapons procurement this year -- up from $45 billion in 1998. Among the dozens of technologies the Northrop side of Grumman makes, one major unit -- which makes unmanned aircraft for military reconnaissance -- has become a niche for none other than United Industrial, the undervalued New York-based company with a market cap of only $140 million.
Why focus on such a puny player in defense? John Garrity, an analyst with Investec Ernst, puts it this way: United Industrial has no debt and roughly $2 a share in cash. The stock trades at about 10 times fiscal 2000 earnings projections and eight times 2001 earnings estimates. Plus, it pays a dividend yield of 4% -- high for any industry.
What's more, United Industrial is in the process of shedding its nondefense businesses and becoming an industry pure play. That's why Garrity sees a strong likelihood that it could be acquired by a larger contractor, he said recently.
"THE BEST CUSTOMER." "Our strategy has been to divest noncore assets and strengthen our position in various niche-defense markets," says United Industrial CFO Jim Perry. One of those core businesses is unmanned vehicles (UV). The company recently lost a major UV contract to Northrop Grumman but gained one from the Army. Perry says the deal could generate $300 million for United Industrial over five years.
One major stockholder, Kennedy Capital Management's Tim Hasara, whose firm owns nearly 1 million United Industrial shares, says he believes the company is getting prettied up for a possible sale to a larger outfit. Another major investor, Steel Partners, has been trying to get management to sell out or otherwise jump-start the stock for several quarters now.
"The defense industries have gone through a consolidation period where the companies left now are much stronger. There's less competition," Hasara says. "Investors can now make a fair return. The Pentagon is the best customer in the world." With much of the big action in defense stocks already behind us, United Industrial and Grumman are two stocks that could be in line for some respectable price gains. Shook covers financial markets for BW Online in New York