Personal Finance: Defense!

05/30/2003 12:00 am EST


Stephen Leeb

Founder and Research Chairman, Leeb Group

"Defense companies are among the surest long-term beneficiaries of the current world situation," says both senior Personal Finance editor Stephen Leeb and contributing editor Ivan Martchev. Below Stephen Leeb focuses on his favorite large cap defense firms, while Ivan Martchev selects his favorite smaller cap and more speculative defense players.

"Of the major contractors, Northrop Grumman (NOC NYSE) is our favorite. The second largest defense contractor, thanks to a number of major project wins, it’s poised to grow several percentage points faster than its peers until at least mid-decade and very likely beyond. The company has a stake in virtually all major defense activities ranging from missile development, to space research and systems, to mission-critical systems. In 2002, the company finished its acquisition of TRW , whose integration should produce synergies that add at least a few percentage points to profit margins during the next three years. Top-shelf top-line earnings growth plus expansion of margins should translate into earnings growth of at least 12% for the next five years. As with most defense contractors, Northrop generates a great deal of free cash flow. Free cash should near $4.50 a share in 2004 and grow at least as fast as earnings for the next five years. Buy up to 100."

"Raytheon (RTN NYSE), created by the merger with the defense business of Hughes Electronics, is a leading defense electronics company. Its position in that sector gives the company the strongest long-term growth prospects of the major defense contractors. But at a price. The company has been plagued by a variety of problems, including high pension costs and the costs of completing two major power plants. Also, this contractor is more leveraged than its peers. Still, the firm's undeniably powerful growth prospects make the company a strong holding. Buy Raytheon up to 32."

"General Dynamics (GD NYSE) is getting a bad rap because of its commercial jet business, which, while a drag on recent profits, is still just a relatively small part of a thriving defense business. Despite the poor showing by the commercial jet business, earnings have still grown by a better than 15% annual rate during the past five years. Investors have also marked the company down because its defense business is less focused on the glamour areas such as communications and technology than its competitors. Still, General Dynamics’ strong shipbuilding and marine systems are valuable franchises that should continue to generate double-digit profit growth. The stock, which trades at less than 12 times forward earnings and has a projected free cash flow yield of over 8%, is a compelling value. Moreover, if the economy strengthens as we expect, the commercial airline business, so long a drag, could turn out to be a leveraged positive. Buy up to 65."

"Lockheed Martin (LMT NYSE), the largest defense contractor, gets high, though perhaps not sterling, marks on virtually every score.Growth of earnings and free cash should be sure and strong at about 10% during the next five years. The company has an excellent balance sheet and generates a great deal of free cash, which translates into a current free cash flow yield of over 3%. Though not cheap, by virtue of its breadth and strong management it should be a core holding in a diversified defense portfolio. Buy Lockheed Martin below 45."

While Stpehen Leeb focuses on the big boys of the defense industry, Personal Finance contributing editor Ivan Martchev focuses on the niche defense players. Here are his top picks. "We believe that the bull market in defense spending has just started— and sooner or later that has to transform into a bull market in defense stocks. Below we highlight three small defense players with proven capabilities in the high-end defense arena."

"A long-time favorite, Israel-based Elbit Systems (ESLT NASDAQ) has done little during the past two years, having been locked in trading range. If you look at Elbit Systems alone that’s not an impressive performance, but if you consider the carnage in the world equity markets, the story gets much better. The company has outperformed the S&P 500 by 50% in the same period—it’s clear there’s something right going on at Elbit Systems. It’s involved in upgrading weapons systems to new standards and has made headway in both the U.S. and Europe by leveraging its technology to help new NATO members upgrade their military technology. Elbit is heavily involved in cockpit technologies for jet fighters and ground vehicles that squeeze more years of operation from otherwise outdated equipment. Yielding 2% and trading at 15 times earnings, Elbit is a buy below 19.50."

"Another favorite is DRS Technologies (DRS NYSE), which is also a high-end electronics defense maker. The company’s products are used in a wide range of high-profile military platforms such as submarines, the Abrams Main Battle Tank, the Bradley Fighting Vehicle, the Apache helicopter, and the F/A-18E/F Super Hornet jet fighter, as well as many other non-military applications. The high-end electronics market in defense technologies was one of the few that saw new business in the 1990s as the defense budget was cut on government initiatives to increase efficiency and reduce costs. Despite the rising defense budgets, it’s clear that the current administration is again focused on making the armed forces leaner and meaner, which is benefiting DRS. The stock trades at 18 times earnings, which are growing at 15% a year. The stock has been halved in the past year, despite nothing but good news. We recommended the stock in the high teens two years ago, and it seems that the bulk of the sell-off is over. Buy DRS Technologies below 28."

"Orbital Sciences (ORB NYSE) is our most aggressive pick in the defense group. Orbital designs and operates small space systems for US government agencies and for corporate and scientific clients. Its main product lines center on sub-orbital rockets in missile defense systems, launch vehicles, and small communications satellites. One thing worth noting about Orbital is that three of its customers comprise more than 10% of its books: Boeing, the U.S. Defense Department, and PanAmSat. While that’s not necessarily bad, its business is a lot more concentrated than Elbit Systems’ and DRS’. Orbital trades at 17 times earnings and 0.5 times sales, and it's a buy below 6 for investors who want a small aggressive defense investment."

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