The Congressional Budget Office reported recently that the U.S. must spend $145 billion per year on new equipment to sustain the Pentagon's plans for U.S. armed forces. Yet it is only on track to spend about $78 billion per year now.
This divergence probably won't remain so wide in a second Bush administration. And it's unlikely to come into parity with a fade in demand. Instead, you just have to bet that military procurement is going to grow, and possibly by a lot.
Imagine what would happen, for instance, if the U.S.-led coalition forces in Iraq meet with greater opposition in the next few weeks and months as they expand their anti-insurgency campaign beyond Fallujah. A big setback in fighting toward the end of this year wouldn't be unexpected, and could refocus investors' attention to the plain fact that an incredible amount of guns, tanks, choppers and ammo are being used up in Iraq, and must be replaced.
This is not a huge secret, so very few of the major U.S. defense contactors are what you would consider wildly cheap. But most fall into the category that is widely known as "growth at a reasonable price," or GARP. That's because investors for some reason get themselves all worked up about the potential for great growth from exciting but marginally profitable semiconductor makers, Internet retailers and biotechs and forget about the real growth of the companies that make or service jet fighters, bombs, tanks, bullets, missiles and destroyers.
As I explained in
on Nov. 2,
Engineered Support Systems
is a great example of the disconnect of late. The mid-cap company, which has posted an absolutely nuts 53% compounded annual growth in its stock price over the past 10 years, is flat this year.
It took a big hit in early August when its longtime leader resigned abruptly. But it recovered quickly and although it is up a bunch in the post-election rally, it still seems cheap at a 2004 price/earnings multiple of 19 on fiscal 2004 earnings expected to be in the 30%-plus range.
The company provides logistical support to the Pentagon with products and services like Army field generators, Afghan border-police communications systems and tank-trailer refurbishment. Earnings and revenue growth have been steady in the 30%-plus range for years, and ennui on the part of investors this year may reflect the odds that growth is slowing to the 15% to 25% range.
By the way, the stock is one of just a handful in the equity solar system that has advanced in nine of the past 10 years. (Its only decline was a 19% setback in 1999, a year that was horrible for all small-caps outside of technology.) Return on equity is 22% and there is no long-term debt. I think the stock should get to $87 over the next 18 to 24 months, which would be a 60% move if it happens.
All of the defense big-caps fall into the GARP category, but
might offer a little bit more bang for your buck. For several years, its Gulfstream division, which makes corporate jets, has been the biggest drag on performance. But the division finally showed signs of improvement in the last quarter because the company was able to raise prices and make them stick, pushing profit margins to the mid-teens. Of course, General Dynamics is better known for the 30-plus acquisitions over the years that have made it a leader in combat vehicles, armaments and warships, as well as its battlefield information technology systems.
Paul Nisbet, an analyst at JSA Research in Rhode Island, thinks margins can get to the low 20s. If the company can simply continue to achieve 10% to 15% earnings growth over the next five years and maintain its reasonable 17x forward earnings multiple, the stock should be worth north of $128 next year and around $155 in 2006. As long as there is no regime change in Washington, he notes that earnings are visible due to the transparency of the Pentagon procurement process.
Other majors such as
are in the same boat: Good growth stories that are modestly undervalued relative to their visible earnings power, and perhaps considerably undervalued if procurement steps up. To put their valuations in perspective, consider this:
is worth more in market capitalization today than Lockheed and Northrop
Mining the Mid-Cap Market
So what about the mid-caps and small-caps? One small firm that is undergoing a big transformation is
. It was a sleepy little defense electronics firm for years until an investment group called Steel Partners bought a 12% stake and helped management understand why it should sell all its non-defense units and focus on its terrific business in building unmanned aerial vehicles for the Air Force and Army.
Paul Ehrmann, another JSA analyst, says that Steel Partners is getting United Industrial in shape to sell. Most acquisitions, he says, are done at a multiple of 10 times earnings before interest, taxes, depreciation and amortization. Since $435 million market cap United has reported EBITDA of $43 million, the analyst figures it is trading as if traders believe it will be bought -- and if that happens, it will occur at a premium.
Another idea is
, which has gone straight up lately but would be good to consider on a pullback to around $42. Its price/earnings multiple now is about 15 times earnings, which is a discount from the group's average multiple of around 18. Even at the current multiple, the tank and ammo maker should get to around $60 by the end of 2005, which would be a 40% move if it happens.
In a future column I'll offer a couple of small-cap Pentagon contractors near their lows that have recovery potential.
P.S. Don't forget -- now is a great time to get in on bargain stocks before the prices go up. Get my picks with a
to TheStreet.com Value Investor.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider United Industrial to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Markman and/or his firm was long United Industrial and Lockheed Martin.
Jon D. Markman is publisher of
StockTactics Advisor, an independent weekly investment research service, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, he had no positions in stocks mentioned. He also writes a weekly column for
CNBC on MSN Money. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
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