A Call to Arms Awakens Defense

But the size and shape of the buildup remains unclear
OCTOBER 1, 2001
Business Week

At first blush, the Sept. 11 attacks on the World Trade Center and the Pentagon seemed to have transformed the prospects for defense contractors. Prior to those suicide missions, Congress was aiming to hold defense spending to a modest 5% increase next year. Procurement was basically flat. No surprise, then, that expectations for the sector were lackluster at best. Says Robert Torray, manager of the $1.7-billion Torray Fund, which owns big stakes in General Dynamics Corp. (GD ) and Raytheon Co. (RTN ): "Before this began, I didn't think [defense stocks] were going up at all."

When the markets reopened for trading on Sept. 17, however, the defense sector defied the overall plunge. Average gains for defense contractors ranged from 15% to 20% on the first day of trading and remained high in the following days. Raytheon, which makes Tomahawk cruise missiles, set the tone: Its stock surged by 25%. The largest defense contractor, Lockheed Martin Corp. (LMT ), climbed by 15%. And L-3 Communications Holdings (LLL ), a defense technology company, was the day's overall leader--with a 38% gain. About the only big defense contractor that fared poorly on the first day of trading was Boeing Co. (BA ) Shares at the nation's No. 2 defense contractor fell 18% on fears that commercial jet sales, which still account for nearly 60% of Boeing's revenues, will plummet.

Boeing aside, many investors figured that with all the saber rattling in Washington, military spending was bound to grow. Indeed, the most aggressive analysts conjecture that the 2001 defense budget of $302 billion will balloon 30% or more by 2003. And about one-third of every defense dollar flows to the defense contractors in the form of procurement, research, or development. "Everything we thought we knew about the budget a week ago is meaningless now," says Loren B. Thompson, an analyst for the Lexington Institute, a defense-industry think tank.

LOOSER PURSE STRINGS. Increased military spending is assured. But even with the Congressional purse strings loosened, it's unclear how much that will boost industry revenues. That will depend on what type of war is ultimately conducted and how long the operations last. These questions--which can't be answered right now--have caused other analysts to be skeptical about the sector's prospects. Even some of the contractors are unsure that Congress' new willingness to spend will be central either to helping antiterrorist efforts or their own businesses. Says James Fetig, director for corporate relations for Lockheed Martin and a retired U.S. Army officer: "We think it's premature to speculate how recent events will affect the defense industry. Investors should not expect a windfall."

One way to get a handle on how the sector will do is to look at past military engagements, such as the Persian Gulf War in 1990. The invasion of Kuwait sent the general market skidding by 15%, while defense stocks climbed by 17%. Yet a few months later, after U.S. tanks started to roll, markets rebounded sharply. That signaled the start of the 1990s bull market--and the defense companies were ultimately left out. The cold war ended, and defense spending fell, which prompted massive consolidation within the industry. Boeing gobbled up McDonnell-Douglas Corp. and Rockwell Aerospace. Northrop (NOC ) snapped up Grumman Aerospace and then combined with Litton Industries. Lockheed Corp and Martin Marietta Corp. both swallowed other companies, then merged into the largest defense contractor of all.

Defense-industry gains were short-lived, too, following the Kosovo crisis in 1999. After that engagement began, defense stocks rose 5% to 10% but then tumbled after three months, largely because it was clear that U.S. involvement would be on a relatively small scale. "If this is a sustained conflict, we're looking at a strong growth market," says Richard Aboulafia, an analyst at the Teal Group in Reston, Va. "But if the Taliban turn over [Osama] bin Laden in the coming weeks, then it's a Kosovo effect."

BULLETS AND BOMBS. If it's a drawn-out affair, conventional investor wisdom is that some military contractors will prosper. The favored companies are those that make military electronic and surveillance gear and "consumable" products--the trade's lingo for bullets and bombs. Northrop Grumman Corp., for example, is big on information technology and also makes the Global Hawk unmanned reconnaissance plane. Another long-standing favorite, General Dynamics, makes Aegis destroyers, encryption tools, tactical-communication systems, and countermeasures against chemical and biological weapons. A new favorite, Raytheon, produces surveillance and reconnaissance radar, and laser detection and night-vision systems. Some smaller players include Alliant Techsystems Inc. (ATK ), the largest supplier of ammunition to the U.S. military, and L-3 Communications, which makes defense electronics, flight data recorders, and bomb-detection gear.

A limited Afghan engagement, meanwhile, would probably use a combination of special-forces operations and air power. Certainly that could drive up demand for additional spare military parts, bullets, smart bombs, and various cruise missiles. But in general, antiterrorist actions are more "manpower-intensive than equipment-intensive, and most of the planned emergency antiterrorist funds will not be directed toward equipment procurement," says Christopher Mecray, analyst for Deutsche Bank Alex. Brown.

On balance, defense spending increases need to be fairly broad for most of the primary defense contractors to show significant earnings growth. "Talk of World War III is grossly overblown," adds Byron Callan, a veteran Merrill Lynch & Co. aerospace analyst. "We're not going to be in an arms race." The U.S. military is not into "attrition warfare but into precision strikes," adds George Muellner, president of Boeing's Phantom Works research center and a retired U.S. Air Force lieutenant general. The biggest immediate change is that the U.S. is not going to allow terrorism to fester as it has in the past. But "it's not obvious that this is a problem that can be fixed by throwing money at it," Muellner says.

Nevertheless, support for much higher defense spending will likely carry the day. Even if funding for the controversial National Missile Defense System seems assured, critics such as Teal Group's Aboulafia say the Star Wars programs is about as relevant as France's Maginot Line. "But politically it could prove to be very popular," he says. "People are looking for anything to protect the heartland."

By Stanley Holmes in Seattle, with Geoffrey Smith in Boston


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