Commentary: Defense: A Minefield for Investors

By Stan Crock

On the surface, the news about defense stocks looks bullish. The Bush Administration seeks a $329 billion Pentagon budget for 2002, a hefty 9% rise from 2001. For months, Wall Street analysts, such as those at Lehman Brothers Inc., have predicted that arms procurement spending--the key to industry profits--will jump from $62.1 billion in 2001 to $85 billion in 2005. And despite campaign rhetoric about junking cold war weapons, on Aug. 17, Defense Secretary Donald H. Rumsfeld said: "We have not been talking about cutting programs."

Earnings look healthy, too. Analysts expect industry profits to climb 17.7% this year and 16.3% in 2002, according to First Call/Thomson Financial. Defense "is a relatively stable business, with long-term positive budget trends," says Clifford F. Ransom II of State Street Research & Management Co., an industry investor.

Yet a look behind all the good news suggests that things are not so rosy. For starters, defense stocks are in the stratosphere, despite recent weakness. The Standard & Poor's Aerospace & Defense Index has gained 44% since the market turn on Mar. 24, 2000--while the S&P 500-stock index has fallen 24%. More fundamentally, the defense sector may no longer be the safe, recession-proof haven investors have come to love. For the first time in memory, defense could be subject to the business cycle. As slow growth shrinks federal receipts and the budget surplus, the Pentagon is becoming vulnerable. As a result, "valuations are really out of whack," according to Charles A. Gabriel Jr., a Prudential Securities Inc. analyst. They're fetching around nine times cash flow, their common valuation measure. That matches their 20-year high and is 50% above the 1990s average.

NOT SO FAST. High multiples may have been justified a year ago, as companies saw the fruits of a big increase in the weapons portion of the Pentagon budget, which soared from $45 billion in 1998 to $62 billion in 2001. In the short term, companies will continue to benefit from outlays already in the pipeline. But that is about to change.

Just take a close look at the 2002 budget. Even if the military gets its money, weapons makers would see little of the increase. Most of it would go for personnel and maintenance of bases and weapons. Low-margin research and development would rise, but profitable arms procurement actually would drop in 2002. Nor would 2003 look much better. Rumsfeld says the Pentagon would need an additional $18 billion for the defense budget to keep pace with inflation. With the budget surplus shrinking fast, as the White House conceded on Aug. 22, Rumsfeld is unlikely to see those dollars. Procurement in 2005 could stay closer to $70 billion, way below what Wall Street expects. The bottom line: Anyone counting on defense stocks as refuges from a turbulent market could be disappointed.

Crock covers defense from Washington.

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