STOCKS

Worries about Pentagon cuts have hit defense stocks hard, but sentiment now appears to be turning, writes MoneyShow.com senior editor Igor Greenwald.

The country’s at war, the economy’s weak, and US weapons are in demand all over the world. You’d think these would be banner days for defense stocks.

Instead, they’ve been shredded like cannon fodder. The equal-weighted NYSEArca Defense Index, which represents the major Pentagon contractors, is down 17% in six weeks.

That’s still nearly triple its value at inception—ten days after 9/11—which shows what a good decade it’s been for the arms merchants. But all offensives must come to an end, and after some 35 years of purchasing guns and butter on ever-expanding credit, a thriftier nation is considering downsizing to bayonets and margarine, as it were.

Defense stocks have been caught in the fiscal crossfire, and are arguably the new budget-chopping Congressional supercommittee’s most important hostages.

That’s because the $553 billion fiscal 2012 defense “base” budget accounts for 41% of all non-discretionary US spending—which counts all outlays for agencies and programs other than mandatory entitlements, like Social Security and Medicare.

If the supercommittee (made up of six Democrats and six Republicans, drawn from both legislative chambers) fails to agree on cuts saving $1.5 trillion over a decade that would be acceptable to their colleagues by the end of this year, $1.2 trillion in across-the-board cuts would take effect starting in 2013.

And Pentagon’s share, based on that “base” budget (which doesn’t even include another $347 billion appropriated for the wars in Afghanistan and Iraq, as well as Homeland Security and Veterans Services) would be $500 billion over ten years, on top of the $350 billion in cuts already in the books under the deal to raise the debt ceiling.

So that’s why investors are running scared.

Now for the good news: both Congressional Republicans and the Obama administration have labeled the looming half-trillion in automatic defense cuts unacceptable. You can argue with that logic, but there’s no doubting the political risk of reneging on those commitments.  

So any supercommittee budget-cutting deal is likely to be kinder to military spending that the “doomsday” alternative of automatic cuts would be, the more so since, as the Associated Press points out, many of the panel’s members have significant defense work in their states and districts.

There are other reasons to believe defense contractors won’t starve. Any rational rethink of the defense budget would target first the massive, costly footprint of US forces overseas, including such anachronisms as the 50,000 US troops guarding Germany.

Furthermore, as the US retrenches and begins to bring the troops home, its allies—notably in the Asia-Pacific region—are likely to feel that much less secure, which will lead them to increase their own spending on advanced weapons systems, many of them imported from the US.

Finally, advanced weapons systems are notoriously hard to kill in Congress, and when the orders are merely scaled back, the cost-plus model protects contractors’ revenue.

Meanwhile, Northrop Grumman (NOC) is selling for eight times trailing earnings and four times trailing cash flow, while yielding 3.7%. Lockheed Martin (LMT) is comparably cheap, and yields 4.2%. Dividend chasers who’ve recently piled into utility stocks with such alacrity appear to be dipping their toes into defense stocks over the last couple of days.

A much riskier name worth considering is AeroVironment (AVAV), a maker of military drones as well as fast-charging equipment for electric vehicles. As the US winds down its expensive wars and reduces the military footprint, it’s likely to rely more heavily than ever on the relatively inexpensive drones for intelligence work and the task of hunting enemies in hostile territory.

Furthermore, if military cuts spur industry consolidation, AeroVironment, with its market cap of $620 million, would make a tasty and inexpensive snack for one of the leviathans.

The analysts at FBR Capital Markets think the company should be able to grow by 10% to 15% annually. The stock was at $28 and change on August 2 when they upgraded it to Outperform, citing upside potential after the recent declines, despite “the overwhelmingly negative sentiment for defense stocks.”

And today, AVAV is up 4% to…$28 and change. So the upside potential remains on the table, while sentiment appears to be turning.

Tickers Mentioned: Tickers: NOC, LMT, AVAV

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