defense stocks

[Eubulides <paraconsistent@xxxxxxxxxxx>]

washingtonpost.com
Defense Stocks Have Seen Their Peak
By Jerry Knight
Monday, September 29, 2003; Page E01


The fighting in Iraq isn't over, but the defense stock boom is.

Three major Wall Street firms downgraded the industry, or at least most of
it, last week, adding to the selling pressure that was already driving down
the stocks of Pentagon contractors.

Shares of Lockheed Martin Corp. and General Dynamics Corp., the two biggest
locally based defense contractors, each dropped more than 10 percent over
the past couple of weeks.

Lockheed Martin stock fell for nine days in a row until Thursday, when a
Morgan Stanley analyst issued a downgrade on most of the defense industry
but maintained the equivalent of a "buy" rating on the Bethesda company's
stock.

Both General Dynamics and Lockheed Martin rebounded Friday after the Senate
unanimously approved a $368 billion defense spending bill that includes
several billion dollars for projects by the two firms.

Pentagon spending is key to the financial health of defense contractors and
it is likely to slow sooner than expected, industry-watchers for Banc of
America Securities, Smith Barney and Morgan Stanley warned in their volley
of downgrades.

Most analysts' reports look at the operations and finances of individual
companies from the bottom up and reach conclusions about the entire
industry. These industry-wide revaluations were based on a top-down
assessment of the political and economic factors that determine defense
budgets and their implications for individual companies.

The economic overview is that burgeoning budget deficits and other spending
needs will force Congress and the White House to cut defense spending or at
least reduce its growth rate.

"Federal budgetary pressures and raiding to pay for the cost of operations
in Iraq and Afghanistan are likely to cause U.S. procurement and R&D
[research and development] budget growth to slow," said Nick Fothergill, who
follows defense contractors all over the world from the Banc of America
Securities offices in London.

President Bush has favored defense spending over social programs, wrote
Heidi Wood of Morgan Stanley. "If Bush wins the next election, we wonder if
he and his advisers . . . will use the second term to soften this stance for
more balance towards butter vs. guns."

Health care and Social Security top the list of needs that could challenge
the Pentagon as the top government spending priority. Defense spending might
also have to be cut simply to keep deficits from driving up interest rates
and hurting the economy.

Citing polls showing plummeting public support for defense spending, Smith
Barney's George D. Shapiro said that "the weak economy could also be hurting
public support."

"It is also possible that the problems in Iraq are causing some of the drop,
as Iraq appears to us to potentially be similar to Vietnam," Shapiro said.

All three firms concluded that military spending is nearing its peak, and
with it prices of defense stocks. The business cycle is turning as well,
they agreed, entering a period when other industries will be as good -- or
better -- investments as defense stocks.

Defense stocks outperformed the Standard & Poor's 500-stock index for three
years running (2000, 2001 and 2002), but they are expected to do no better
than the overall market from now on.

What that means for Lockheed Martin and General Dynamics is the key question
for Washington investors, and on that the analysts do not agree.

Morgan Stanley's Wood maintained her "buy" recommendations on the two local
giants, rating them as the industry's "top picks," along with Raytheon Co.
She ranks Raytheon first, General Dynamics second and Lockheed Martin third.

In contrast, Smith Barney's Shapiro dropped Lockheed Martin to "hold/medium
risk" and pushed General Dynamics down to "sell/medium risk."

Banc of America's Fothergill cut Lockheed Martin from "buy" to "neutral" and
maintained his "neutral" assessment of General Dynamics.

In Wood's assessment Lockheed Martin and General Dynamics are among the best
investments in an industry that will do about as well as the overall market
and could be attractive buys at the right price.

Smith Barney, on the other hand, does not give a "buy" rating to a single
stock in the entire aerospace and defense industry. Nor does Banc of
America, which pins the "neutral" tag on every defense contractor.

But their reports reveal differences not only about how individual firms
will fare but also about why defense spending is likely to slow down.

Shapiro bases his industry downgrade on Smith Barney's own public opinion
polling, which found a "sharp drop in public support for increased defense
spending."

Two years ago, 80 percent of the people polled said they support spending
more on defense. Last year it was 50 percent. This year it is 31 percent.

"The collapse in public support for defense spending from 80 percent in 2001
to only 31 percent now is unprecedented," Shapiro noted. The erosion of
backing for military spending was so dramatic that the poll was done twice,
and the results confirmed, he said in the report issued a week ago.

Three days later, Morgan Stanley aerospace and defense analyst Wood put out
a "change in industry view," which was less negative and included a section
headed "Debunking the Myth of Public Opinion."

"There is a view that public opinion is a lead indicator of future defense
spending," Wood wrote. "Under the light of relevant facts -- historical and
present -- we find that not to be the case."

Since the time of the Roman Empire, she said, defense spending has been
determined by three factors: the availability of funds, the threat and "the
agenda (of those in power, not the populace)." Funding could become an
issue, she agreed, and the threat is impossible to predict. But public
opinion is not the deciding factor.

"The ambitions of the powers at the top drive military expenditures, and
historically, much as today, the populace follows," Wood said. In the 1960s
when opposition to the war in Vietnam was growing, she noted, "neither the
lack of popular support in the polls nor marches in Washington were
successful in preventing the budget increases of 1965-1968."

Smith Barney's Shapiro, however, sees a close correlation over the past 40
years between public support for defense spending, the size of the Pentagon
budget and the price of defense contractor stocks.

"The level of public opinion for increased defense spending is a key leading
indicator" of how much money Congress will budget for the Pentagon, he said.

When public support is strong and the defense budget is growing, he said,
defense stocks tend to trade at higher prices relative to their earnings --
the P/E ratio. The higher the ratio, the more investors think earnings will
grow in the future. "We expect P/E multiples to contract further, as there
has been a correlation with lower public opinion causing lower multiples,"
Shapiro said.

The phrase "lower multiples" means lower stock prices, and even Wood agrees
that defense stocks are going to sell for less than they have been.

Lockheed Martin stock, which closed Friday at $45.43 a share, had peaked in
July. Nudging against $54.50 a share for a few days, then drifting down to
about $52, the shares began to slide in earnest in early September. Driven
to $45.10 by nine consecutive days of losses -- a hint that some big
investors were getting out -- they gained 3 cents a share Thursday and
another 30 cents Friday after Congress voted on Pentagon spending

General Dynamics shares held pretty close to their $87.18 high for the year
until a couple of weeks ago when they went into a seven-day slide that was
also halted by Friday's Congressional vote. Up 99 cents Friday, the stock
closed at $77.07.

The Pentagon spending bill did not stop the retreat in shares of CACI
International Inc., which until a couple of weeks ago had been the star of
the local defense stocks. After hitting a record $48.10 on Sept. 16, CACI
fell for eight consecutive days, closing Friday at $42.35.

An eight-day decline also drove down the shares of Anteon International
Corp. from $33.80 to $30.32 but that sell-off may not have been entirely
from the defense stock retreat. Anteon insiders sold several million shares
of their stock starting Sept. 16.

Jerry Knight's e-mail address is knightj@xxxxxxxxxxxxx