Defense Stocks Are Going Great Guns

The Great Defense Shakeout has cost hundreds of thousands of workers their jobs and pushed the states of California and Connecticut into recession. But Wall Street's view of what's left of the military-industrial complex is anything but gloomy. Because of consolidation and relentless cost-cutting, a more efficient military sector is emerging--and defense stocks have become the darling of investors, even as weapons makers idle more production lines.

Now, the Clinton Administration is giving the defense stocks even more firepower. In its first stem-to-stern review of U.S. military forces, the Pentagon has signaled that protecting critical defense technologies and easing the pain of downsizing for workers and communities will be elements ef its industrial policy. The Clinton defense plan, unveiled on Sept. 1, is less drastic than some had feared. It amounts to "a soft-landing approach for defense," says PaineWebber Inc. analyst Jack Modzelewski.

The defense stocks' popularity is a dramatic turnaround from the late 1980s. Despite the Reagan-era military buildup, defense contractors' earnings were savaged by losses on fixed-price contracts. From 1985 to 1990, an index of defense stocks created by Modzelewski tumbled 23%, while the Standard & Poor's 500-stock index climbed 54%. But since 1991, Modzelewski's index has been an eye-popper, up 140% vs. 38% for the S&P 500. That's because profits climbed as managements shed their traditional obsession with amassing ever-fatter order books and focused instead on the bottom line. Contractors slashed investment and payroll and poured the money instead into bigger dividends, stock repurchases, paying down debt, and modest acquisitions.

Even Grumman Corp., which was reeling a few years ago, is looking smart. Earlier this year, it raised its dividend 20%--the first increase since 1985. Phil Friedman, who follows defense for Morgan Stanley & Co., thinks Grumman will increase earnings by 14% next year, and 17% in 1995. On Sept. 8, when the overall market fell, Grumman shot up nearly $2 a share, or 5.6%.

Some key defense contractors will walk off with real plums from Washington. The Administration's plan gives a green light for construction of a $1.8 billion Seawolf attack submarine at General Dynamics Corp.'s Electric Boat Div. in Groton, Conn. The Navy doesn't need another Seawolf, but it will order one anyway in order to keep the yard running until the turn of the century, when work can start on a more advanced sub. The move gave an added fillip to GD's stock, which is trading at close to its 52-week high of 98. The stock has rocketed over the past two years as management has sold off division after division and showered shareholders with the proceeds via stock repurchases and special dividends.

The other clear winner is McDonnell Douglas Corp. The aerospace giant got a firm go-ahead for a new version of its F/A-18 Navy fighter-attack jet. And the Pentagon's acknowledgment of the need for more airlift capacity seemed to assure the future of McDonnell's C-17 Air Force transport jet, which has been plagued by delays and cost overruns. McDonnell's stock is trading in the mid-80s, up from 34 a year ago. Analyst Cai von Rumohr of Cowen & Co. thinks McDonnell's stock price could reach $115 over the next year, fueled by plentiful cash flow, growth in earnings, and a go-ahead on the C-17.

Although the Pentagon is paring back orders for new ships, planes, and tanks, it will continue to extend the life of existing weapons by adding new missiles, avionics, and radar. That brightens the prospects for defense-electronics companies, such as E-Systems, Loral, Martin Marietta, and the Hughes Electronics subsidiary of General Motors, which trades as GM Class H stock.

While there will be no big losers from the Administration's new defense plan, some companies--Lockheed Corp. in particular--came up a little bit short. The company took a hit from the Pentagon's decision to stop buying its F-16 fighter next year. Speculation that the Air Force may stretch out purchases of Lockheed's F-22 advanced tactical fighter didn't help, either. Still, the stock, at 62, has been little changed in recent weeks.

BOTTOMING OUT. But how long can the defense stock rally continue? Many analysts expect robust earnings growth of 10% or more for a couple of years even while revenue growth is at best flat. And some, including Wolfgang Demisch of Bankers Trust Co., think that while overall defense spending will continue to shrink, the procurement and research budgets are beginning to bottom out. Demisch is bullish on the ability of McDonnell Douglas, General Dynamics, Raytheon, and Lockheed to continue making money off a smaller defense pie. Rebounding foreign sales and a more favorable Pentagon attitude toward acquisitions should help keep defense stock prices moving up.

Some players, such as Raytheon Co. and Rockwell International Corp., have already diversified into commercial markets and plan further forays to keep growing. But most of the major contractors, haunted by failed moves into civilian markets when defense spending tailed off in the 1970s, are shunning diversification and sticking to their guns.

In the near term, most analysts expect their favorite defense stocks (table) to shine even as overall defense spending falls. But cost-cutting can boost profits only so far. To continue to reward shareholders over the longer term, these defense companies will have to devise new ways to build their revenues.

      Stock                  Price     P-E     Dividend
                                      ratio     yield
      E-SYSTEMS             47 1/2     13.8     2.3%
      GENERAL DYNAMICS      95 5/8     10.0     1.7
      GENERAL MOTORS CL.H   33 7/8     16.5     2.1
      GRUMMAN               35 1/2      9.5     3.4
      LORAL                 60 3/4     13.0     1.8
      MCDONNELL DOUGLAS     83 3/4     13.4     1.7
      RAYTHEON              62 7/8     12.8     2.2
      ROCKWELL INTL.        35 7/8     14.4     2.8
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