Where to Ride Out the Iraq Storm?
By Gene Marcial
With war rhetoric heating up to its highest levels yet, the stock market continues to erode. Rocked by an impending conflict with Iraq, investors are rushing for the exists. Where do you hide or park your money in these days of doom and gloom? For some courageous few, the place to be is defense and energy stocks. To such professional value players, these groups have never been more attractive -- or cheap.
"Now is the time to buy stocks that won't get hurt -- or will even benefit -- if the Iraq situation worsens," says investment veteran Stephen Leeb, president of Leeb Capital Management. Defense and energy companies are the two clearest beneficiaries of any hostilities in the Persian Gulf, he contends. Leeb thinks the big guns in defense are the surest bets: Northrop Grumman (NOC ) and General Dynamics (GD ) top his list. In energy, Leeb favors Anadarko Petroleum (APC ) and ConocoPhillips (COP ).
Defense stocks look like a no-brainer in the current situation, since they should harvest gains from increased military spending. Yet at this point, they haven't been the big winners that people would expect. In mid-2002, their share prices anticipated the conflict with Iraq and rocketed to high levels, only to come down in November. Consequently, defense stocks have underperformed in the past several months. This big drop, however, is in fact a great buying opportunity, argues Leeb.
General Dynamics, now trading at $61 a share, is way down from its 52-week high of $111.18. And Northrop, now $88, is also well below its 52-week high of $135.
From here on, says Leeb, the U.S. will obviously need a very strong military apparatus to protect its interests -- particularly oil -- in the Middle East, especially if Iraqi dictator Saddam Hussein has been ousted. Moreover, the U.S. will, more than ever, need a strong homeland defense infrastructure after its invasion of Iraq -- which appears to be a foregone conclusion to many. The U.S. has to expect increased terrorist activity at home.
In Leeb's view, Northrop and GD fit the bill in such a scenario. Northrop is now a "complete defense company with unassailable stakes in every major defense-related area, including electronics and network-centric warfare," notes Leeb (see BW Online, 1/7/03, "The Network Is the Battlefield"). "We expect profits and cash flow to grow at double-digit rates for the foreseeable future," he says. Northrop trades at a discount to the S&P 500-stock index and comparable defense contractor Lockheed Martin (LMT ). This points to a dramatic upside potential for Northrop during the next 12 to 18 months, Leeb adds.
Its free cash flow of an estimated $7 a share, figures Leeb, will likely rise to well over $11 a share by 2005. He expects Northrop to earn $5 a share in 2003, vs. diluted earnings of 34 cents in 2002. His stock price target: $100.
GD gets marks nearly as high as Northrop, says Leeb. What has been weighing down GD shares is its ailing Gulfstream aircraft unit, which generates some 25% of total revenues. Gulfstream will limit GD's price-earnings expansion even when the company turns the corner, warns Leeb. But GD is "a prime defense contactor with a high level of free cash flow and strong growth prospects in the forseeable future," says Leeb. He thinks the stock, now trading at a p-e of 11, is a bargain up to $70 a share. He sees GD earning $5.50 a share in 2003, vs. $4.52 in 2002.
In energy, oil-company share prices have lagged behind the jump in crude prices. Tina Vital, oil analyst at Standard & Poor's, thinks worries about the sustainability of oil's current prices and the fate of the U.S. economy, given the prospect of war in the Persian Gulf, have contributed to the oil stocks' weakness. But she sees the price of oil remaining high in the forseeable future. And Vital says S&P economists still believe that the U.S. economy will pick up in the second half, which would bode well for oil demand.
One of Leeb's oil picks, Anadarko, trading at $46 a share -- off its 52-week high of $58 -- is an independent oil-and-gas explorer with operations in the U.S. and Canada, as well as Tunisia, Algeria, West Africa, Venezuela, Oman, and Qatar. Anadarko is a prime example, says Leeb, of how the prices of crude oil and gas and the stock prices of oil companies are out of sync. Anadarko's share price has yet to catch up with the spike in natural gas -- its most important commodity. Gas has nearly tripled in price, and oil -- which accounts for more than 40% of production -- has also moved up sharly.
"This huge disconnect means Anadarko trades at a substantial discount to its underlying value," says Leeb. Its earnings in 2004 could easily exceed $6 a share, he figures, up from an estimated $3.90 in 2003. His stock-price target: $70.
ConocoPhillips, an integrated energy company that explores for, produces, and refines oil, is trading at $49 a share, down from its 52-week high of $64. Leeb singles it out among other integrated oil companies because of the synergies from the 2002 merger of Phillips and Conoco, which created the ConocoPhillips giant. Cost savings plus modest production increases should translate into double-digit profit growth for at least the next three years, he estimates.
ConocoPhillips' current PEG (price-to-earnings ratio divided by its growth rate) is the lowest in its class, notes Leeb. Like many other major oils, ConocoPhillips is also attractive for its 3% dividend yield, says Leeb, whose price target is $50.
With the major stock indexes trading around their recent lows, these oil and defense shares could provide at least some shelter from the storm spiraling out from the widely feared -- and expected -- conflict with Iraq.
Marcial is BusinessWeek's Inside Wall Street columnist