Ready To Come Back To Earth

Defense is blazing hot. But most stocks are already in the stratosphere

Now that Carlyle Group has bolted from the defense industry, other investors may want to ask themselves why. The buyout behemoth, which ranked as one of the Pentagon's 15 biggest defense contractors between 1998 and 2003, sold its last major holding, United Defense Industries Inc., in 2004. By 2005, Carlyle didn't even make the top 100 and has just 1% of its assets in the sector today. "The smartest guys in defense investing are out," says industry expert Pierre Chao of the Center for Strategic & International Studies think tank. "What do they see that everybody else doesn't?"

Defense companies have been on a tear since 2001, when U.S. troops invaded Afghanistan. The stocks of the biggest players--Boeing (BA ), Lockheed Martin (LMT ), General Dynamics (GD ), and Northrop Grumman (NOC )--have all at least doubled in that time. The spade Defense Index, which tracks large and midsize companies in the industry, has soared 150%, compared with a 40% gain for the Standard & Poor's 500-stock index.

But with most companies trading near their peaks, the price of war stocks is pretty high. At a recent 91, Boeing, which is also benefiting from strong sales in its commercial airplane division, sells for 42 times current earnings, compared with an average of 21 for the s&p 500. The industry, which is usually cheaper than the index, has a rich price-earnings ratio of 26. Even General Dynamics, a relative bargain at 19 times earnings, trades above its five-year average of 15.5. It's not sustainable, says Prudential Equity Group (PRU ) analyst Byron Callan. "It's too late to buy, but too soon to sell."

While Northrop Grumman, General Dynamics, and Lockheed Martin declined to comment on their stocks, Jim Albaugh, CEO for Boeing's Integrated Defense Systems, seems unfazed by the recent runup. "You will see some pretty robust [defense] spending" over the next couple of years, predicts Albaugh.

For now at least, he's right: Defense spending is going up. On Feb. 5, the White House asked Congress to cough up $481 billion for the Defense Dept.'s regular operations--an 11% increase--on top of $235 billion for the continuing wars in Iraq and Afghanistan. Already military leaders are replacing damaged equipment and replenishing shrinking ammunition and weapon stocks, which will help outfits like Armor Holdings Inc. (AH ), a key supplier of bullets and body armor.

The Pentagon also has plans for some big purchases. The Air Force just requested $4.6 billion to buy 20 F-22 Raptor fighter jets made by Lockheed Martin, Boeing, and United Technologies (UTX ). The Marine Corps placed a preliminary order with General Dynamics and Force Protection Inc. (FRPT ) for 125 Cougar vehicles, lightweight armored tanks that protect troops from improvised explosive devices, the No.1 cause of deaths and injuries in the Iraq war. Right now, the tab for the contract is just $67 million, but it could be worth north of $2 billion to General Dynamics and Force Protection if the Marines order all 4,100 vehicles from them. "There's an immediate need, a product that fills that need, and the likelihood for profitable new sales in the near term," says Cai von Rumohr, a veteran aerospace and defense analyst for Cowen & Co.

Yet much of this good news is already priced into defense stocks, as investors have bid up the shares way ahead of the benefits to company coffers. Even more worrisome for this cyclical group, defense spending may be close to peaking, assuming the security situations in Iran and North Korea don't intensify. Historically defense budgets have dropped dramatically following a major conflict. After the Cold War ended, the Pentagon cut its purchases on major weapons by about 71%, from roughly $58 billion a year in the mid-1980s to $16.9 billion by 1994, according to the Congressional Budget Office--a dynamic that forced the consolidation of the industry in the 1990s.

Add in declining support for the Iraq war, the long-term budget challenges facing the U.S., and a Democratic Congress clamoring for cutbacks, and the Defense Dept. may be on a spending diet in the near future. "If our presence in Iraq abates, there is some risk to defense spending dropping off," says Joseph Nadol, an aerospace and defense analyst for jpmorgan Securities (JPM ). "The group overall could be vulnerable."

By Dawn Kopecki and Stanley Holmes

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