Barron's Cover
Starship Troopers
New weaponry will shake up the defense industry -- and investors
By ERIN E. ARVEDLUND
Any investor who wants to know how President George W. Bush will affect defense stocks should
peruse Tom Clancy's latest bestseller, "The Bear and the Dragon." In a disturbing glance into the
future, Clancy depicts the Chinese Army doing battle with Russia, which is in turn is backed by
NATO forces, including the U.S. The fiery battle scenes are right out of science fiction, complete
with laser guns blasting and unmanned fighter drones launching precision missiles.
Just as catapults and caldrons of boiling oil gave way to the cannon, so too a lot of 20th century
military hardware is now becoming outmoded. This puts many investors in a position that's not so
different from those proud cavalry officers early in the last century as they looked across the
battlefield to see armored tanks approaching at a rapid pace, prepared to blow their once-vaunted
horsemen to smithereens.
Such seismic changes in defense strategy are no doubt on the minds of President Bush and his
defense secretary, Donald Rumsfeld. Right now Rumsfeld is conducting a thorough review of
military forces and Pentagon spending. The outcome could surprise Wall Street. Defense stocks
have surged mightily in the past year, partly on the expectation that the Bush administration would
spend lavishly on traditional defense programs. Among the principal beneficiaries of this stock
market rise have been the Big Five: Boeing, General Dynamics, Lockheed Martin, Northrop
Grumman and Raytheon. (See chart, And Then There Were Five.) On average, the share prices of
the Big Five jumped 46% last year, even at the Standard & Poor's 500 Index fell 10%. But the fact
is, not all of these companies will gain equally from the Bush Administration's defense outlays.
Indeed, some of them could be hurt seriously, as longtime weapons programs are deemed
unnecessary.
Military planners are divided about how much President Bush will seek to increase the U.S.
defense budget during his administration. Pentagon spending will total $293 billion this year,
amounting to roughly 3% of the U.S. economy. That compares with 10% under Eisenhower and
8.6% in the Kennedy-Johnson era.
Although it seems likely that President Bush will increase military
spending in the third and fourth years of his administration, right now his
priority is getting his $1.6 trillion tax cut passed.
When the time does comes to spend more on defense, the defense
contractors that stand to gain are those that specialize in the kind of
high-tech weaponry portrayed in Clancy's thriller. TRW, for example,
makes laser guns that can be mounted on trucks and used to shoot
down rockets. Then there's Alliant Techsystems, the leading U.S.
supplier of ammunition, which is ready to arm a new generation of
fighter aircraft. In addition, the Pentagon's need to up grade its
computer systems is likely to benefit companies such as EDS and Cisco
Systems.
Perhaps the biggest undertaking advocated by Bush is a national missile
defense system that would blast enemy rockets out of the sky shortly
after they lift off. That program could cost anywhere from $30 billion to
$50 billion. If the system is approved, one of the chief winners would be Boeing, which has been
chosen as the lead contractor. That could mean as much as $6 billion in revenue for Boeing over
the next six years.
Among the weapons programs that stand a chance of being cut are the V-22 Osprey, a troubled
tilt-rotor aircraft used mainly by the Marines; the Army's Crusader, a heavy-duty tank and Cold
War relic, and lastly, the Air Force's F-22, a top-of-the-line fighter jet that sells for $180 million a
copy.
A cutback of the Osprey program would hurt Boeing, as well as subcontractors Raytheon and
Textron, but the damage would be far less than the gains the aerospace giant stands to make on
national missile-defense and other new high-tech programs. Killing the four-ton Crusader would
save the Pentagon considerable funds: 1,100 of the tanks are expected to cost $13.7 billion. The
companies behind that program are General Dynamics, Lockheed Martin and United Defense, a
private company owned by the Carlyle Group, a firm run by former Defense Secretary Frank
Carlucci and former Secretary of State James Baker, among other well-connected notables. (For
an interview with Carlucci, see story, Ex-Pentagon Chief)
One of the toughest decisions facing Rumsfeld concerns fighter planes. The most advanced, the
F-22 Raptor, is made by Lockheed Martin. But it is possible that the F-22 will be abandoned in
favor of a Joint Strike Fighter, to be used by all branches of the service and cost "only" $30 million
to $40 million each. Choosing the Joint Strike Fighter would benefit Boeing, but it could hurt
Lockheed if the program is chosen at the expense of continuing production of the F-22. The
damage to Lockheed would be partly ameliorated by the fact that Lockheed would be a junior
partner to Boeing in making the Joint Strike Fighter, however.
However these decisions fall, it's clear that Wall Street can no longer
simply bet on the defense industry's Big Five prime contractors.
Investors need to seek out other companies with expertise in modern
equipment such as sensors, radar, satellites, secure communications
and precision weaponry. What follows is a handicapping of the
prime contractors and their stocks, ranked by the amount of
Pentagon revenue each garnered in the fiscal year 2000. We also
look at small and mid-sized defense companies that appear to be
undervalued.
The nation's largest defense contractor is Lockheed Martin, with
$25.3 billion in annual revenue, about 60% of it from military sales.
Since the beginning of last year, its shares have surged 72% to a
recent high of $37. Part of the stock's strength lately owes to the
company's announcement earlier this month that earnings are
expected to grow 25% to 30% this year. Right now, the shares are
trading at 26 times those expected earnings.
Although Lockheed could lose out if the F-22 program were cancelled, that is by no means a fait
accompli. Another major piece of military hardware could provide Lockheed with considerable
upside, and that's the futuristic-looking DD-2l stealth destroyer. In a face-off, Lockheed Martin is
offering the Pentagon a design for the destroyer. Even if Lockheed doesn't win the contest,
however, the company could get to help make as many as 16 destroyers of the 32 likely to be
ordered. The total bill for the ships is expected to run to $25 billion. Getting into a stock at its
52-week high can be dangerous. But the defense industry has to be evaluated based on long time
horizons. Jarl Ginsberg, portfolio manager with BlackRock in Philadelphia, points out that when
defense stocks swooned in early 1999, Lockheed shares gave up nearly all the ground they had
gained in the previous six years. Even though the stock has nearly doubled since early last year, it
still has room to go, Ginsberg believes. Boeing is the nation's second largest defense contractor, but
it is by no means a pure play. The company's heavy presence in airliners and space gear mean that
Boeing derives only $12 billion from military sales out of total annual revenue of $57 billion.
As noted, Boeing stands to gain as much as $6 billion in revenue from its role as prime contractor
for the national missile defense system favored by George Bush. While there is sure to be
opposition, the missile system will get strong support from Vice President Dick Cheney, Secretary
of State Colin Powell and National Security Adviser Condoleezza Rice. And you can expect
Secretary Rumsfeld to push particularly hard. In 1998, he chaired a commission on ballistic missile
threats that ignited the Republicans' current enthusiasm for erecting the missile shield. After jumping
61% last year, Boeing shares this year have slipped about 10% to a recent $58, partly on concerns
about heightened competition from arch-rival Airbus Industries. While Boeing may do quite well in
the defense portion of its business, that simply may not be enough to boost earnings and the stock
price meaningfully. Given those cross currents, the stock looks to be fairly valued and probably
won't jump much this year.
Raytheon, the nation's third-largest defense contractor, has $16.9 billion in annual sales, and $6.3
billion of that comes from the military. The company's shares led the decline in defense stocks two
years ago after the announcement that it would fall short of Wall Street's earnings expectations.
After several other earnings disappointments, new Chairman Dan Burnham had to announce last
week that profits this year could come in as much as 12% below expectations. The shares fell $2
on the news, to finish the week at $33.50. "The earnings guidance was unexpected," said Deutsche
Banc Alex Brown analyst Christopher Mecray. "I regard it as overly conservative."
Indeed, at current levels, the shares look promising to
some investors. Raytheon's main attraction is that it
makes exactly what the Pentagon needs for 2lst Century
warfare, including radar and missile guidance systems.
In fact, it is also the leading maker of missiles. While
traditional weaponry such as planes, tanks, ships and
submarines will be used in the future, they will all be
closely tied to something called "informational warfare,"
which refers to sophisticated electronic surveillance,
tracking and guidance systems. Another ray of hope:
Raytheon said last week that the national missile defense
program has the potential to increase the company's
revenue by $5.3 billion over a five-year span.
Brandes Investment Partners in San Diego is Raytheon's largest shareholder. Brandes senior
analyst Paul Korngiebel sees great upside for contractors such as Raytheon and TRW because
they have valuable technology patents that could form the basis of profitable spin-off businesses.
"You should see increasing revenue growth and maybe a leaner cost structure after Raytheon's
restructuring over the last 12-18 months," says Korngiebel. "And they might have positive earnings
surprises over next two years as well." "Quarter-to-quarter earnings can be lumpy over time," he
admits, adding, " We're saying we think the lumps are going to work out satisfactorily for long-term
investors. We're more than happy to be buyers from frustrated short-term sellers." Over the next
three to five years, Korngiebel sees Raytheon shares surging as high as $60.
Northrop Grumman's shares shot up 53% last year, before rising a further 4% this year to $86.50.
Despite these gains, the stock trades at only 12 times this year's expected earnings.
Northrop is in the DD-2l race, thanks to its recent acquisition of Litton, which owns Ingalls
Shipbuilding. An even more important ace in the hole could be the B-2 stealth bomber, which was
used to great effect in the Gulf War and is said to be a favorite of Vice President Cheney. Northrop
is willing to turn out 40 more of the sleek black jets at $500 million a copy, half the price they
commanded a decade ago. If the Joint Strike Fighter is approved, Northrop would build half the
aircraft. If the program is rejected, look for rekindled interest in the B-2 down in D.C., which
wouldn't be such bad news for the company.
In all, Northrop's annual revenue should hit $15 billion this year. With earnings expected to grow
7% to 10%, even after backing out pension-fund gains, and the price-to-earnings ratio fairly low,
Northrop shares look like a pretty safe bet.
General Dynamics shares leaped 50% last year, in part because of confidence in
shareholder-friendly Chief Executive Nicholas Chabraja. This year, though, the shares have fallen
from $79 to $66 due to a stall in earnings growth. The company is by no means a pure defense
play, as one third of its $10.3 billion in annual revenue comes from Gulfstream, the maker of private
jets that General Dynamics recently acquired.
General Dynamics ranks as the largest shipbuilder in the U.S., turning out Arleigh Burke-class
destroyers and Seawolf submarines. Hopes for expansion of the military ship business rest in part
on the DD-2l stealth destroyer. This $47 billion program is being pursued by two teams, one led by
General Dynamics and Lockheed, the other by Litton, which was recently acquired by Northrop
Grumman.
General Dynamics could be hurt by a cancellation of its plan to do large-scale production of the
Advanced Amphibious Assault Vehicle. The amphibious vehicle is being developed jointly by the
Marines and General Dynamics. Delivery of more than 1,000 production models is scheduled to
begin in 2005. Including potential overseas sales, the value of the amphibious program could
exceed $5 billion, says Loren Thompson of the Lexington Institute.
Even though General Dynamics is widely agreed to be a well-run
company, Chabraja will likely find it difficult to find growth, despite his
purchase of fast-growing Gulfstream in 1999. If America needs fewer
tanks, ships and submarines, General Dynamics will be hurt more than other defense contractors.
Even some of the company's longtime fans see little upside in the stock.
Beginning in 2003 or 2004, budget money should be earmarked for less expensive, smart
battlefield systems like the kind promoted by William Owens, former vice chairman of the joint
chiefs of staff, the top coordinating body for the military. The overall trend in warfare is fighting at a
distance. That means introducing military equipment for tracking enemy movements by computer, a
practice that relies on information from spy satellites, unmanned drones, robots, radar and other
sensors. In this world of high-tech warfare, many small and medium-sized companies stand to
benefit. We came across quite a few with annual sales in the $2 billion to $5 billion range, many of
them reasonable priced. "Valuations on these companies really out of whack with the rest of the
sector," opines Paul Nisbet of JSA Research in Newport, R.I. "They not being valued anywhere
near as richly as larger companies."
Among his favorites is Orbital Sciences, which provides satellite services. He also likes B.F.
Goodrich, which is now out of tires and heavy into industrial products with military uses. In this
smaller company class, John Allen with Quarterdeck Investment Partners points to CACI
International, which provides networking for warfare needs to U.S. defense and civilian agencies.
Don't be surprised to see the Big Five looking for acquisitions among the smaller fry. The takeover
candidates include DRS Technola manufacturer of seals and clamps in the aerospace
industry, and Hexcel, which sells lightweight composite materials for various defense purposes.
"L-3 Communications is always one people look at" as a possible target, says Ginsberg of
BlackRock. L-3 has become the leading supplier of flight-data recorders, or "black boxes," to the
defense and space sectors. But with a growing arsenal of communications products for aerospace,
defense and commercial uses, L-3 has said it wants to be the acquirer, not the acquired.
Then there's EDS, which last year inked a $6.9 billion contract to build and maintain a computer
network for the U.S. Navy and Marines. The EDS network will serve 360,000 sailors, Marines
and civilians and will extend to 300 bases in the U.S. and beyond, from Guam to Iceland. EDS
could bring in $10 billion if the contract extends to its full eight years. Major subcontractors for the
project include Raytheon, MCI WorldCom and Dell Computer. Access to the new network will be
by password and encrypted card, and Navy personnel may use a scan of a thumbprint to log on to
the network.
It's a world away from the pigeons that carried battlefield news back in Napoleon's day. But there's
no avoiding the future. With the technology of warfare changing so rapidly, investors had best be on
guard. |
