Gung Ho for Defense Stocks

Many leading U.S. weaponsmiths have lost ground lately on the Street, which means some good companies are selling at great prices

By James A. Anderson

In turbulent times like these, investors usually find safe harbor in defense stocks. The sector tends to remain steady when the economy is bumpy. Why? Industry revenues are pegged to military budgets and locked-in contracts, not economic cycles. "The aerospace and defense sector traditionally moves on its own, politically driven cycle and performs well when stock markets stall," says Credit Suisse First Boston analyst Pierre A. Chao.

Yet the defense-stock battleship seems to have sprung a leak since the beginning of the year. A Standard & Poor's index of 13 defense and aerospace shares has dropped 11.1% so far in 2001, compared with a 12.2% loss of the S&P 500. In fact, such big names as Boeing (BA ), Lockheed Martin (LMT ), Northrup Grumman (NOC ), and United Technologies (UTX ) all got caught up in the market's March mudslide, each falling 6% or more in the past 30 days.


  Beyond the massive stock sell-off that hit the market last month, a few other factors have assaulted the defense industry. Start with the fact that the sector enjoyed a fabulous 2000. Last year, defense and aerospace shares soared an eye-popping 56.5%, a far cry from the 9% drop experienced by the S&P. This year, some investors packed it up and took profits, apparently worried that defense issues couldn't stay strong forever.

Also, there are worries the industry might be in for a major shakeup. U.S. Secretary of Defense Donald Rumsfeld, has announced he wants a top-to-bottom review of the military, with results due to come out in late April or early May. A few big weapons programs may end up being lopped as a result. And there's concern that a worldwide slowdown is bound to crimp the outlook for the commercial aerospace operations of such companies as Boeing and United Technologies. Already, the airlines have begun to gripe about their numbers in 2001.

Time for a retreat from defense stocks? Maybe not. Many of these concerns are overblown. Start with the sector's valuations. Analyst Paul Nisbet, who heads JSA Research, a Newport (R.I.) outfit that keeps tabs on the industry, says defense shares have made advances within the past year, from an average price-earnings multiple of about 9 to their current 16. Still, he notes, there are a number of smaller components-and-parts companies that are trading at multiples in the low teens. Says Nisbet: "That leaves a large group of mid- and small-cap stocks we feel could outperform in the year ahead."


  And despite whatever scale-backs come of the Pentagon's review, analysts still point out that increases in military spending begun during the Clinton Administration will probably accelerate now that Republican George W. Bush is at the helm. In fact, says Nisbet, look for procurement outlays to increase 50% over the next four years, from $60 billion in 2002 to $90 billion in 2006. "While there may be somewhat less money put into the big fighting machines of old, it looks as if there will be plenty spent on smarter, stealthier weaponry," he explains.

Chances are the commercial aerospace business, too, will pass through 2001 relatively unscathed. In 2000, Boeing and Airbus shocked onlookers with big boosts in orders for commercial planes, with heavy demand from leasers and Asian airlines. Lehman Brothers analyst Joseph Campbell says that barring a major worldwide recession, sales for the segment could rise nicely over the next few years. He notes that the market for aircraft is tight and airlines are more likely to retire old planes than scrap new orders. And Boeing, the biggest manufacturer around, has cushion aplenty for the coming year in the form of backlogged orders for more than 1,600 aircraft.

It's not so much Boeing's business as its attempt at a corporate makeover that has made the company one of Wall Street's favorites in the group. The old line on the Seattle company was that it ran a good business prone to volatile swings every few years. One reason was its intense competition with Europe's Airbus, which meant Boeing could only manage the thinnest of margins despite its 50% share of the world's passenger-plane market. Management, however, has launched an effort to change that. The company is aggressively cutting costs -- boosting its operating margins from a lowly 1% in 1998, when the company was strapped to meet production schedules, to 8.2% last year. Longer-term, the company aims to raise that figure to 11.5%, closer to the S&P's average 12% margins.


  Boeing is also making a brave attempt to change its culture. It has announced plans to move out of its Seattle headquarters, to new digs in Chicago, Denver, or Dallas -- all to be more accessible to both commercial customers and Washington (D.C.)'s political scene. At investment meetings recently, management announced plans to introduce a swift, midsize aircraft -- the 20XX -- to counter rival Airbus' focus on jumbo jets.

"It's an intriguing idea," says Nisbet of the 20XX. "I'd be worried if I were in Airbus' boardroom." It doesn't hurt that Boeing posted a 27.6% rise in profits last year. Fifteen of the 20 analysts that follow the company rate it a strong buy or buy, according to Zacks Investment Research, and consensus estimates look for the company to increase earnings an average of 15.8% annually over the next five years. Lehman Brothers' Campbell holds a 12-month price target of $70 a share for Boeing, which closed on Apr. 2 at $55.02.

A smaller-cap play in the group is EDO (EDO ), which makes high-tech components for aircraft and submarines. EDO has a number of things going for it these days. For one, the company's niche businesses have done well. At its Mar. 29 close of $13.90, the stock carried a p-e of 12.4 times consensus estimated 2001 earnings as calculated by Zacks. Also, says JSA analyst Peter Arment, the company stands to benefit from a round of consolidation that is sweeping the defense industry's component suppliers. Both analysts who follow EDO rate it a strong buy or buy. Consensus estimates look for the company to boost earnings an average of 17% annually over the next five years.


  The best play on the sector for fund investors is probably Fidelity's Select Defense & Aerospace (FSDAX ) portfolio. The fund is off 7.81% so far in 2001 after posting a 18.9% total return last year. It might be worth a look.

Don't let the defense industry's recent retreat scare you. "We're bullish on a number of names in the industry," says Nisbet. "And with their recent pullbacks, we like those same stocks even more." There are reasons for the industry -- and select stocks in the group -- to continue on an upward trajectory.

Anderson teaches journalism at the City University of New York. Follow his twice-monthly Sector Scope column, only on BW Online