Defense Stocks: Advance or Retreat?

Defense contractors have the luxury of worrying less than other companies about the economy. But that doesn't mean they don't worry. With sales driven by U.S. defense spending—often with budgets set well in advance—the industry is less vulnerable to cyclical slowdowns. But, unfortunately for investors seeking stability and consistency, defense companies are hardly predictable investments these days.

Among the volatile factors the industry must deal with are a surplus of international crises: a disputed election and unrest in Iran, threats from North Korea, a planned U.S. withdrawal from Iraq, and an escalation in Afghanistan. Also, and perhaps most significant, the industry must plan for new leadership and new priorities in Washington.

All have the potential to drastically affect the level of defense spending in the U.S. and abroad for the next decade. When President Barack Obama took office, investors initially sold defense stocks, worried the incoming administration would slash defense spending.

The Obama Administration's proposed budget eased some of those fears. Under Secretary of Defense Robert Gates, a Bush Administration holdover, the changes have been less drastic than some predicted, says Collins Stewart analyst James McIlree. "The specific proposals just weren't that severe, vs. [investors'] fears," McIlree says.

dialing back

But significant worries remain. Part of reason is the vast increases in defense spending since the 2001 terrorist attacks. After years of outsized increases, "there's been a general consensus that defense spending could not continue to grow at a faster rate than the economy," McIlree says.

Policymakers in Congress, the White House, and the Pentagon are also contemplating big shifts in spending. "There are some programs being put on the back burner," says Morningstar (MORN) analyst Anil Daka. "Other programs are being put on a fast track."

Tools used in military intelligence, surveillance, and reconnaissance are popular among policymakers, McIlree says. Unmanned aerial vehicles are getting more funding. Based on experiences in Iraq and Afghanistan, the military's priority is on weapons and tools for "asymmetrical warfare," not wars with other major nation states, says Standard & Poor's equity analyst Richard Tortoriello. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (2).)

shifted priorities

Tortoriello says the recently proposed defense budget is just a first step in setting the Obama Administration's long-term priorities. More significant changes could be coming. "I expect defense spending to fall going forward," he says. Defense budgets could be squeezed by the recession and rising budget deficits, with new spending instead going toward economic stimulus, financial bailouts, and health-care reform.

Undercutting this trend: the numerous international crises that the new Administration has already dealt with in its first six months. Those could require more defense spending whether fiscal watchdogs like it or not. Lawmakers may worry about rising federal budget deficits, Daka says. But looking at news from around the globe, "there's absolutely no indication that the threats have come down."

The U.S. may spend less in Iraq as forces are withdrawn. But the government in Iraq may still spend heavily on weapons and defense products provided by U.S. defense contractors, Daka says. The nuclear threat from North Korea could stimulate more defense spending by U.S. allies such as Japan, which is seeking U.S.-made fighter planes, he notes.

The shares of defense companies retain some advantages over other stocks. Long-term government contracts mean steady, predictable cash flow. For example, S&P's Tortoriello notes, a new budget often doesn't affect a defense contractors' actual financial results for two years.

a backlog of orders

Top defense companies General Dynamics (GD), Lockheed Martin (LMT) and Northrop Grumman (NOC) each has a backlog of more than $70 billion in orders, Daka notes.

But by offering such a wide variety of products, these big defense companies could be especially vulnerable to a defense-spending slowdown.

"If you are in the right programs in defense"—those currently favored by generals and lawmakers—"you can still have a good business," Tortoriello says. For defense giants like Northrop Grumman, "it's very hard to be in the right programs because you're in every program. So if there are cuts to the budget, you're going to feel it."

One strategy defense contractors may use to keep up with changing trends: acquisitions. Strong cash flow gives big defense companies' the buying power to pick up areas of business they're missing. "If you don't have those assets, you can go out and acquire them," McIlree says.

Defense stocks have a reputation as a stable, defensive sector. However, these days, the international and political backdrop for defense contractors is no more predictable than the outlook for the broader economy. Defense executives and investors will need extra foresight to navigate through what could be unsettled times, both in the U.S. and abroad.

Before it's here, it's on the Bloomberg Terminal.