By Gene Marcial Already, some investment pros are girding for a U.S. attack on Iraq. Their line of thinking: Which stocks will triumph if America launches military action against Saddam Hussein? Ever since President Bush's January State of the Union speech in which he characterized three nations as forming an "axis of evil," led by Iraq, speculation has accelerated about an imminent U.S. move against Iraq.
While it's inherently unsettling to think about ways to profit from war, Wall Street is always on the outlook for an investment opportunity. And defense companies are the natural first place it looks at such times.
"A U.S. military campaign to oust Saddam Hussein's regime should benefit companies that produce 'military consummables,'" such as ammunition and spare parts, argues analyst Byron Callan at Merrill Lynch. He has yet to factor in earnings projections for such companies. But Callan figures that outfits facing a "material change" in their earnings include Alliant Techsystems (ATK), Raytheon (RTN), and possibly L-3 Communications (LLL). They have the highest percentage of sales from such consummables, notes Callan.
CERTAIN SCENARIOS. Alliant now trades around 89, after hitting its high of 92 on Oct. 8, 2001, and its low of 65 on Sept. 10. Raytheon is now 38, nearly at its high of 38.65 reached on Feb. 1 2002, after hitting its low of 24 on Sept. 10. L-3 is now 109, also just about at its high of 109.72 on Feb. 15, after seeing its low point of 60 -- also on Sept. 10.
He expects that investors could have a knee-jerk reaction and simply buy more defense stocks in general if a war against Iraq is launched. But Callan cautions that certain war scenarios may not benefit all or most of the defense stocks. An attack on Iraq could also have a negative impact on commercial aerospace suppliers, since air travel could again be curbed by the threat of terrorism.
Callan heads a team of analysts that track defense and aerospace stocks at Merrill Lynch. Members of his group include Ronald Epstein, Geoffrey Tomlinson, and Suzzane Kecmer.
The safest course for investors, Callan advises, is to own stocks that could have the highest potential of upward revisions in their earnings estimates. Among the companies that should benefit are those that make such products as air-to-surface missiles, Tomahawk cruise missiles, and precision-guided weapons used in air and naval strikes. Also in the same category are ammunition for heavy ground forces and spare parts for aircraft and helicopters, such as electronic warfare systems and engine components.
TOP RATINGS. Of the eight defense/security-oriented stocks that he follows, Callan has a strong buy rating on Alliant, which produces ammunition, rocket motors, and fuzes -- the mechanical or electrical mechanisms used to detonate a wide range of explosives. Some 42% of Alliant's sales are generated by these products. The company is the largest supplier of ammunition to the U.S. Army for infantry and armored vehicles.
Callan has intermediate-term buy rating on six of the other seven stocks in this group. The six are Moog (MOG.A), a producer of spare parts for aircraft and helicopters, which generate 26% of the company's sales; Goodrich Corp. (GR), the former tire maker that now makes military equipment including aircraft and helicopter spare parts, which account for 16% of sales; Raytheon, whose military products include laser-guided weapons, Tomahawk cruise missiles, and radar parts, which contribute 10% of sales; L-3 Communications, a producer of fuzes and microwave components, which generate 8% of sales; Lockheed Martin (LMT), a manufacturer of missiles and aircraft parts, which account for 5% of sales; and General Dynamics (GD), which makes ammunition among other defense equipment.
An assault against Iraq, notes Callan, would mark the third time in a little more than a decade that the U.S. has undertaken a concentrated military operation against that country. In 1991's Desert Storm operation, the U.S. repelled an invasion by Iraq of Kuwait. In 1998's Desert Fox operation, the U.S. and Britain launched a four-day intensive air campaign against Iraq in response to its expulsion of U.N. weapons inspectors.
FACTORS TO PONDER. In the 1991 and 1998 conflicts, the weapons mostly used used included Tomahawks, air-launched cruise missiles, laser-guided and unguided weapons, air-to-surface missiles, and the so-called dumb bombs used mainly by B-52 bombers. In the war against Afghanistan's Taliban in 2001, a new weapon was introduced: GPS-guided weapons. Callan says these cost $15,000 to $20,000 each, with Boeing being their prime supplier.
Clearly, a host of factors must be considered in the event of a U.S. attack against Iraq, says Callan, including how big an American force would be needed and what the strategy is. Some of the variables he sees include the rate of munitions spending and the amount of air operations that will be deployed, and whether ground forces would be committed, including heavy armor. The last factor is important for Alliant, says Callan, and to some extent for General Dynamics, because they supply ammunition for M-1 tanks and medium-caliber ammunition used by attack helicopters and by Bradley armored vehicles.
The broader ramification that Callan sees is an expansion of overall U.S. defense spending. For investors, the job comes down to determining which military stocks would benefit the most. This could be a case where defense is the best offense for investors. Marcial is BusinessWeek's Inside Wall Street columnist