Defense Firms Face Resistance

11/30/2009


For all the opposition to the ramp-up in defense spending during the George W. Bush administration, military expenditures as a percentage of the U.S. economy never approached the levels common during the Cold War.

Defense spending accounted for about half of total government expenditures and 9% of gross domestic product in the 1960s. During the Bush years of 2001 through 2008, despite annualized spending growth of 6.7%, defense accounted for an average of 18.2% of federal spending and just 3.8% of GDP.

Defense stocks have performed well since the end of 2000, with the S&P 1500 Aerospace & Defense Industry Index up 34% versus an 11% decline for the broader S&P 1500 Index. For the same period, the industry index’s per-share profits rose at a 10% annualized rate, while the broader index’s profits declined. Looking ahead, however, it seems contractors will have to fight a lot harder for profit growth.

In 2009, defense spending will likely account for about 4.8% of GDP, the highest level since 1992. Defense spending has been trending generally lower as a percentage of the economy for more than 50 years. And as the chart below shows, the White House Office of Management and Budget expects spending to dip in 2011 after rising next year.

Such a shift should not come as a surprise to Wall Street because of the withdrawal from Iraq. However, Afghanistan remains a wild card. President Obama has already agreed to deploy an additional 21,000 troops and at press time was considering sending at least 10,000 more. An increased commitment to Afghanistan could render the spending estimates conservative.

But no matter how things go in Afghanistan, history suggests it would be unwise to bet on defense-spending growth as rapid as that seen in the last eight years. Over the last 20 years, defense spending rose at an annualized rate of just 0.8% in inflation-adjusted dollars, or 3.8% in absolute dollars.

Spending estimates for the years ahead may frighten owners of defense stocks. But, as Gen. Norman Schwarzkopf said, “Fear will keep you alive in a war. Fear will keep you alive in business. There’s nothing wrong with being afraid.” A little healthy fear keeps you on your toes, which can be especially important on Wall Street.

For a hint about the best defense stocks in today’s difficult environment, we turn to the words of another who knew something about the art of war, French Emperor Napoleon Bonaparte: “The first virtue of a soldier is endurance of fatigue; courage is only the second virtue.”

At the start of this year, the Forecasts recommended three defense stocks. Today, only General Dynamics ($68; GD) makes the cut, in part because it has proven — both in recent quarters and in past recessions — that it has the fortitude to survive in environments of flat defense spending. Strength at the defense businesses has mostly offset a sharp downturn in demand for corporate jets. Wall Street expects General Dynamics to deliver roughly flat per-share profits this year and 5% growth next year, a target that looks conservative.

With a backlog of $66.2 billion, roughly twice annual revenue, and more than $18 billion in potential contracts in the pipeline, General Dynamics should weather the rough times. And at just 11 times trailing earnings, the stock is cheaper than most rivals. The company boasts a diversified defense portfolio that serves both the short-term and long-term needs of the U.S. armed forces, with a particularly strong position in intelligence and surveillance, likely a long-term growth area even if defense spending stagnates. And General Dynamics’ business-jet unit, while depressed at the moment, should help the company participate in the global economic recovery likely over the next several years. General Dynamics is a Buy and a Long-Term Buy.


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