Battle Against Terrorism Boosts Defense Sector

Until Sept. 11, 2001, it had been a long time since we'd had to think about full-scale war. Now the issue has returned to the forefront, and so has the defense sector. But the sector had already seen gains thanks to the "Bush effect," and the biggest beneficiaries of the post-Sept. 11 landscape weren't necessarily the usual suspects.

When the markets reopened after the attacks and troops were mobilizing for action in Afghanistan, investors had a knee-jerk reaction: They bought defense stocks across the board, which ultimately has proved to be a winning strategy.

Even though battle scenes in Afghanistan may no longer dominate the headlines, now there are other targets. The U.S. could be at just the early stages of a protracted and costly war on terrorism that may lead to further military actions in other "axis of evil" nations. Action against Iraq looks increasingly imminent. All of this defense spending and military buildup resemble the sector's last days of glory during the Reagan years.

War and Peace

This time around, the Defense Department quickly burned through the initial $17 billion in supplemental spending it received from the 2002 budget to fight the war on terrorism, and in March requested an additional $14 billion to fund its efforts for the remainder of this fiscal year, which ends in October. Indeed, on July 12, Defense Department Comptroller Dov Zackheim told reporters that the U.S. military is guzzling down an average of $2 billion a month to fight the war on terrorism.

While modernization, in terms of technology, new aircraft and communications systems investments, remains a high priority for the Bush administration, more pressing needs on the battlefield may usurp government spending priorities in the near term.

For that reason, some investors expected makers of war consumables, like bombs and bullets, to benefit most, with little collateral benefit to other defense names. The two leaders in the category (missiles and munitions), Raytheon (RTN Quote) and Alliant Techsystems (ATK Quote), handily beat the market, rising 39% and 48%, respectively, over the past 52 weeks.

But while everybody thought missile maker Raytheon would be the sector's star, it was in fact Lockheed Martin (LMT Quote), which is broadly diversified and depends more on big weapons systems and the longer-term budget picture rather than immediate battlefield needs. Lockheed has returned close to 66% since Sept. 10.

L-3 Communications (LLL Quote), which stands to benefit from increased spending on intelligence and surveillance (the company's also a big player in civilian aviation, with flight data recorders and bomb detection devices), is up 69%.

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Return to Reagan Era?

But even before last September, defense stocks were trading higher on expectations that the new Republican administration would usher in another period of defense-budget expansion. From Bush's election in November 2000 to Sept. 10, 2001, most pure-play defense stocks had outsized returns:

• Alliant Techsystems: up 61%

• Lockheed Martin: up almost 20%

• General Dynamics (GD Quote): up nearly 10%

If the Bush administration was determined to restore growth to the defense budget before Sept. 11, it has even more resolve now. In January, Bush called for a $48 billion, or 16%, increase in the fiscal 2003 defense budget, $10 billion of which was included as a "war reserve," the biggest increase in 20 years. On top of that, he's requested a 6.4% hike in Defense Department spending over fiscal 2002-2007, the highest increase since the 1981-1985 growth rate of 7%.

The end result of this spending spree would restore defense spending in 2007 to the same level ($451 billion) as the last defense budget peak during Reagan's term in 1985, using constant dollars, according to Deutsche Banc Alex. Brown estimates. The Reagan years marked one of the strongest periods of defense-stock performance: The group beat the market by an average 13% annually from 1980 to 1984, according to UBS Warburg estimates.

A Pricey Proposition

With an aggressive defense buildup in the works, investors need to figure out who would benefit most from the spending increases. Chances are, with daily war talk in the media, emotion will continue to drive performance of defense stocks. But these stocks are not particularly good values, with most trading at absolute price-to-earnings ratios at multiyear highs.

Only by looking at relative multiples do they look reasonably priced. During the Reagan defense buildup in the 1980s, the defense group traded as high as a 75% premium P/E ratio to the S&P 500, compared to an approximate 5% premium today. The long-term average is a 20% discount, according to UBS Warburg estimates.

Better values exist in diversified defense names that are troubled by worries about their more economically sensitive businesses. For example, General Dynamics is off 31% from its 52-week high of $111, partly on concerns over a slowdown at its business-jet division, Gulfstream. But the stock now sells at a P/E multiple of about 13.8 times 2003 estimates of $5.60, well below Lockheed's P/E of 23.

Boeing (BA Quote) is also down about 28% from its high on concerns over a prolonged downturn in the commercial aerospace cycle. A recovery in that business won't likely happen until late next year at the earliest, but Boeing may still earn $2.75 to $3.00 a share in 2003 based on the strength of its defense business. The stock sells at a P/E of 13, but there could be an even better buying opportunity over the next few weeks if labor negotiations hit a snag.

But undeniably, the defense sector as a whole should continue to see robust growth ahead. In the words of Defense Secretary Donald Rumsfeld, spoken in a May commencement address at the United States Air Force Academy, "Prevention and pre-emption are the best, and indeed in most cases the only defense against terrorism. Our task is to find and destroy the enemy before they strike us. And it's a big world."