Anil Daka) Trading
at low multiples, many defense stocks appear to offer a good entry
point for long-term investing. While we caution that in many instances
the multiples are justified by poor earnings growth brought on by a weak
defense budget outlook, a few defense names such as Lockheed Martin (LMT
), Raytheon (RTN
), Alliant Techsystems (ATK
), and SAIC Inc (SAI
) appear to be underpriced relative to their growth prospects and offer decent upside.
Defense Budget Outlook
After years of expansion
following 9/11, the United States defense budget is slowing down in
response to troop withdrawal from Iraq and as the government tries to
shrink the size of the federal deficit through defense cuts. The U.S.
defense budget comprises the base budget, which funds everyday
activities of the armed forces, and the supplemental budget, which
provides for special situations like the ongoing war efforts in Iraq and
Afghanistan. The long-term health of defense firms is linked to changes
in the level and mix of the base budget.
The outlook for the base budget is challenging as the government
tries to find ways to reduce the budget deficit. Current Department of
Defense projections forecast a low-single-digit nominal growth (nearly
zero real growth) over the next five years. Further, defense contracts
mostly flow from the procurement and research part of the base budget
(called investment accounts, typically about 40% of the base), which
will grow even slower than the base budget as the people-related costs
(salaries and health-care expenses) outgrow other items. In such an
environment defense revenue will demonstrate minimal growth.
Even as the federal government looks for ways to cut down defense
spending, the responsibilities of the U.S. armed forces show no signs of
slowing, and U.S. interests in the Far East, South Asia, and the Middle
East are continually challenged by rising powers like China and
nonstate factors like al-Qaeda and the Taliban. Quite unlike the "peace
dividend" years following the collapse of the Soviet Union, the U.S.
faces a litany of security challenges, and the DoD seeks to overcome
these despite a declining budget environment.