Can War Outlays Give Bump To Defense-Industry Stocks? 

J. LYNN LUNSFORD / Wall Street Journal 25mar03

1,000 Tomahawk cruise missiles were fired in the first few days of this war. Each one costs around $500,000 to $700,000, equaling $500,000,000 to date. That money spent on peace would have ended the war by now. And with no loss of life or further erosion of the standing of the US in the eyes of the world.

Amid a downturn in the U.S. stock market prompted by signs that overturning the Iraqi regime won't be easy, defense-industry stocks rallied Monday, ending a long stretch of underperformance.

Does it help that there is a constant barrage of television footage live from the Middle East, showing the use of equipment, bombs and missiles made by the big U.S. defense contractors? If so, some institutional investors remain doubtful that even a drawn-out conflict will give a durable boost to defense stocks.

They argue that any bump these companies might get from replacement orders will be offset by a diversion of government funds toward paying for battle and support operations and away from the big-ticket development programs that are the companies' bread and butter.

What's more, some of the biggest contractors, Boeing Co., General Dynamics Corp. and Raytheon Co. are seeing an intensification of woes in the commercial aviation sector.

After the fighting began last week, stock prices for contractors like Boeing, General Dynamics, Raytheon and Northrop Grumman Corp. hovered within a dollar or two of prewar levels, falling as the rest of the market marched upward. Even with Monday's defense-stock rally, most remain not far off the 52-week lows they hit as a group on March 12, about when the broader market was hitting a low for 2003.

Some Wall Street analysts argue that makes the defense shares an attractive buy on valuation terms alone. According to Thomson First Call, defense stocks as a group are trading at about 17 times their trailing 12-month earnings, compared with about 30 times for the Standard & Poor's 500-stock index. Using earnings estimates for this year, the sector's price-to-earnings ratio still lags behind the benchmark index, although the gap isn't nearly as dramatic. Yet, the five-year projected growth rate for the industry is actually higher than that of the S&P 500, according to Merrill Lynch's chief U.S. strategist, Richard Bernstein.

Given the shift in recent days by investors into cyclical stocks that would benefit from a short war, Merrill Lynch analyst Byron Callan argues that defense stocks "could rally if the war doesn't go as smoothly as anticipated." The first serious resistance faced by U.S. troops in Iraq seemed to buttress his view.

A research note posted Monday by Mr. Callan pointed out that, in the first few days of the war, the U.S. had fired about 1,000 Tomahawk cruise missiles, compared with the 390 it fired in all of the 1991 Desert Storm campaign. Noting that each Tomahawk costs around $500,000 to $700,000, Mr. Callan implied a big replacement order could provide a fillip to the earnings of its maker, Raytheon.

But Rich Turgeon, a director of research at Victory Capital Management in Cleveland, isn't sold on the idea that even a prolonged conflict will result in a big rise in defense stocks. "It's naive to say defense spending is going to continue on the same growth trajectory as it has in the last three years," he explains.

Mr. Turgeon says that even if the U.S. maintains a significant presence in the Persian Gulf region, he expects a soaring U.S. budget deficit will prompt Congress to decide that, beyond the direct costs of fighting the war and rebuilding Iraq, taxpayer money would be better spent on domestic priorities. As a result, he adds, Victory, which manages about $19 billion in investments, has been a net seller of defense and aerospace stocks "for the better part of nine months."

Indeed, executives at the major defense companies have cautioned for months that every dollar spent on a war -- or maintaining a large military force overseas for a lengthy period -- would effectively equal a dollar less for high-profile longer-term projects like the Joint Strike Fighter and missile defense. The Bush administration underscored that idea by indicating Monday that it needs $75 billion to begin paying the cost of fighting in the Middle East.

Not much of that money is expected to flow into the pockets of the defense contractors, particularly those that manufacture high-cost equipment such as tanks, airplanes and ships that take a long time to build. Any armored equipment or aircraft lost in battle are unlikely to be replaced, given substantial Pentagon inventories and the Defense Department's emphasis on present development programs to replace current weapons with more technologically up-to-date equipment in coming years. An executive at one aerospace company says: "These are the types of engagements in which you pretty much already have all the heavy equipment you need."

A robust Pentagon inventory is also expected to factor in orders for so-called expendables like missiles and Boeing's J-Dam targeting kit for heavy bombs. Executives say the armed forces stocked up prior to the start of the conflict -- Boeing for instance has had one of its plants running 24 hours a day making J-Dams -- and that the war would have to go on for several months for contractors like Raytheon and Boeing to see the kind of new orders that would have a sizable impact on earnings.

For some defense contractors, another issue weighs, too. General Dynamics and Boeing have exposure to the downturn in the commercial-airplane market. Analysts for months have put the net value of Boeing's commercial-aircraft business at zero. For now, analysts say that without a positive decision on a controversial $17 billion proposal for Boeing to lease to the Air Force 100 modified 767 aircraft to be used as tankers, Boeing stock is unlikely to rebound soon to its 52-week high of $50.05 hit last April 11. A decision on the issue has been delayed repeatedly, though it is expected to come soon. Meanwhile, General Dynamics, which makes the M-1 Abrams tank and the Bradley fighting vehicle, has been hurt by the downturn in orders for its Gulfstream private jets.

The sector's bulls also see a generally uncertain geopolitical situation benefiting the defense shares. "I think a lot of people have the inaccurate perception that Iraq is an endgame," says Erik Becker, an investment analyst at Waddell & Reed Investments in Overland Park, Kan. "There is probably more of a realization that Iraq is perhaps just a starting point with regard to what the administration hopes to do in the Middle East."