New Trends in Defense

07/09/2004 12:00 am EST

Focus:

Jim Jubak

Founder and Editor, JubakPicks.com

"War is different these days, and the kind of defense stock most likely to show gains is different, too," says Jim Jubak, columnist with CNBC on MSN Money. "Here are five companies that are likely to benefit from the new patterns in defense spending."

"The weapons on the front lines in today's war are assault rifles, grenade launchers, Bradley fighting vehicles, roadside bombs, and body armor. You can’t see that shift to smaller weapons in the government’s defense budget because overall defense spending is dominated by the big-ticket stuff like fighter jets and cruise missile destroyers. But the shift is there if you look at the spending trends for repair and maintenance, armor upgrades, ammunition, vehicle replacement and logistics, and communication support.

"Dirty, grinding wars like the one in Iraq are big consumers of the mundane war supplies. The additional spending on these items isn’t enough to add much to the revenue stream of a big defense company, but it can be a huge bump in the revenues of a smaller defense contractor that specializes in this kind of work. This kind of defense spending also is much less cyclical than the boom-and-bust world of billion-dollar per weapon Pentagon contracts. Bullets and Bradleys have to be replaced every month as long as there’s fighting somewhere. And unless you think the world is about to become a peaceful place, this spending is with us for the long haul.

"Congress has added about $1 billion for armored vehicles and $195 million for personal armor plates to the fiscal 2005 defense budget.  Armor Holdings (AH NYSE), with $446 million in sales, has about a 40% share of the armor plate market, so the company’s likely share of that contract is about $100 million a year. That’s a big hunk of revenue for a company showing 12-month revenue of $446 million. Armor Holdings is picking up revenue from other armor programs as well. The company is set to deliver armor packages for 3,400 Humvees in fiscal 2004, with orders for about 7,000 more. The shares trade for 17 times projected 2004 earnings per share.

"United Defense Industries (UDI NYSE) is the US Army’s No. 2 provider of ground vehicles such as the Bradley, and the company has been busy with upgrades to these aging platforms. It's is in line for a contract to provide armor for the Stryker family of vehicles, the successor to the Bradley, but the company’s future in the vehicle business is bound up with the Future Combat System (FCS), the successor to the interim Stryker. United has a lot riding on FCS, and investors need to remember that any big, new weapons program carries the risk of cancellation or cutbacks. The stock trades at just 13 times projected 2004 earnings per share in reflection of that risk.

"L-3 Communications  (LLL NYSE) is a major force in the developing digital battlefield. The company specializes in the high tech communications gear (and training) that today’s soldiers use to figure out what’s happening on the battlefield and to communicate, display, and analyze that information. The company has a substantial non-defense business as well, utilizing many of the same technologies, in the aerospace, homeland security and high-speed/secure communications sectors. As a result of that non-defense business, L-3 tends to trade at a higher multiple than the average defense company, now at 19 times projected 2004 earnings.

"I can’t emphasize strongly enough how unusual it is to find a company in any sector, let alone the defense sector, that can consistently grow earnings per share by 20% to 30% a year. Yet Engineered Support Systems (EASI NASDAQ) has pulled off exactly that trick for the last five years, with earnings per share growing at an average of 34% a year. The company has found its logistical expertise in heavy demand in any era of rapid deployment on far distant battlefields. And I see no reason to believe that expertise is likely to become less valuable or less in demand. Earnings growth is likely to average near 20% a year for the next five years. The stock trades at 21 times projected fiscal 2004 earnings.

"General Dynamics (GD NYSE) is the most reliable ‘grower’ among the defense industry majors, which is why I’ve included it here with four smaller players. The company threw off cash flow of $1.4 billion after capital expenditures in 2003. Increasingly GD is looking to Europe for those acquisitions, with deals this year in the UK and Austria. Using its cash flow to acquire new businesses, and the recovery of its commercial jet unit, should let General Dynamics keep its growth rate well above that for the rest of the sector even as growth in defense sales slow to 5% near the end of this decade. GD trades at 17 times projected 2004 earnings per share."

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