Shares That Could Welcome a War
Merrill Lynch defense analyst Byron Callan still thinks an Iraq conflict is coming, and he has a list of companies that stand to benefit
Gene Marcial is BusinessWeek's Inside Wall Street columnist
The Feb. 19, 2002, edition of this column carried the headline "Striking Saddam: Some Stocks Could Soar". Now, Iraq and Saddam Hussein have become the hottest topic in Washington, the U.N., and around the world. The question everyone is asking: Should the U.S. launch an attack on Iraq?
Even after Baghdad announced late on Sept. 16 that it would allow U.N. weapons inspectors back into Iraq without preconditions, the White House is expressing skepticism about Saddam's real purpose. The Bush Administration says this is just another ploy aimed at dividing the U.N. over the question of a U.S. war against Iraq.
However, for some on Wall Street the more relevant question, again, is: Which stocks will benefit from a war that President Bush seems determined to carry out?
BIG WINNER. Byron Callan, defense analyst at Merrill Lynch, was among the first to consider the possibilities back in February. His answer: A U.S. assault aimed at ousting Saddam's regime should boost companies that produce "military consummables," such as ammunition and spare parts. At that time, the companies he believed would benefit included Alliant Techsystems (ATK ), Raytheon (RTN ), and L-3 Communicatuions Holdings (LLL ). They have the highest percentage of sales from such consummables, Callan argued.
Alliant has been a big winner since, rising from 58 a share (adjusted for a 3-for-2 split) in February to 73 on Sept. 17. Raytheon is off, however, down from 38 to 36. And L-3 has edged up from 54 (adjusted for a 2-for-1 split) to 57.
Now, Callan has refined his list of recommended defense stocks. He's more convinced that investors, including those who focus on small-caps, should have exposure to this sector because of the greater probability that a conflict will indeed take place.
QUICK VICTORY? Military experts have put forward several war scenarios. Some of them, Callan notes, could hurt defense stocks. Here's one: The U.S. and its allies achieve a quick victory, Saddam is either killed or captured -- and no major terrorist attacks occur. "This scenario could be a negative for defense stocks," he say, because the U.S. would have removed a military threat. And because the war ended quickly, existing stockpiles would prove adequate. So defense stocks could drop as investors put their money into more economically sensitive sectors.
But here's the scenario Callan thinks will happen, despite Iraq's latest attempt to head off an attack: The U.S. launches a massive air/missile assault on Iraq, followed by a ground invasion, which takes longer than anticipated and consumes more material than had been expected. Still, the U.S. is ultimately victorious.
"This scenario would be good for defense stocks, and it may be what the defense group is now discounting," says Callan. Demand for spare parts and ammunition could increase above levels now planned, he says.
THE LATEST LIST. With this in mind, here are Callan's current recommendations, which he's sticking with even after Iraq's Sept. 16 announcement:
Alliant Techsystems, a leading supplier of ammunition and rocket motors, is still his top choice. Now at 73, Alliant should hit his 12-month target of 80, says Callan, based on his esimates of it free cash flow.
IDT (IDE ) and United Defense (UDI ) mainly provide support and upgrade equipment. Callan points out that while they may not necessarily benefit directly from an Iraq attack, they could move in sympathy with a broader defense-stock rise. Both are trading around 23 a share now. He figures IDT should approach 30 in a year, and United Defense could climb to about 28.
For value investors, Callan recommends Moog (MOG.A ), Rockwell Collins (COL ), and Triumph Group (TGI ). These companies are traditionally considered commercial aerospace stocks, with only about 25% of their sales coming from the defense market. And they generally sell at valuations much lower than pure defense stocks. However, they could benefit from a surge in demand for spare parts, which Callan argues could offset any weakness in their commercial aerospace business.
According to Callan's estimates, Moog, now trading at 31, could hit 45 in 12 months. Rockwell Collins, now about 20, has a 12-month target of 26. And Triumph, now around 32, could hit 52 in a year, says Callan.
WATCH FOR LEAKS. Defense stocks are apt to move on news of specific military budget changes, says Callan. "We would pay particular attention to a reallocation of funds" from existing programs into new weapons systems, says the analyst.
What's the downside of buying defense stocks now? The big risk -- as far as investors are concerned -- is that a war might be averted. But since Callan thinks the probability of a conflict is high, the only conditions that could affect his price targets, he says, include changes in defense spending plans, programs, and product performance.
Longer-term, investors should watch for news or press leaks on Defense Dept. budget planning for fiscal years 2004-09, advises the Merrill Lynch analyst. Indeed, changes in military spending may spell the real story and future for defense stocks.
Marcial is BusinessWeek's Inside Wall Street columnist
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