Defense Stocks: Hold Your Fire

Despite reports that the Pentagon may allow weapons makers to earn higher profits, S&P is still cautious on the group

By Robert Friedman

Defense contractors soared Wednesday after Morgan Stanley predicted that the Pentagon will permit them to generate operating profit margins greater than the current 15% ceiling.

The Pentagon has been working to improve the financial health of the U.S. defense industry, especially after September 11. One of its latest reform proposals would allow defense contractors to keep a portion of savings from plant closings and other cost reduction programs. The government has responded by boosting payments to defense contractors and eliminating the regulatory requirement that weapons makers defray the cost of developing experimental weapons.

However, none of the major contractors are posting defense-related margins anywhere near the current limit. Moreover, always-shifting Pentagon strategies and Congressional priorities materially raises the probability of lower-than-expected sustainable defense spending hikes. Most defense contractors are trading at or above their sustainable cash earnings growth power.

Standard & Poor's is keeping its 5 STARS (buy) rating on Boeing (BA ), and reiterates its 3 STARS (hold) rating on General Dynamics (GD ), Northrop Grumman (NOC ) and Raytheon (RTN ). S&P is keeping its sell rating on Lockheed Martin (LMT ).

Robert Friedman is an aerospace & defense analyst for Standard & Poor's

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