As war machine changes, so do defense investments

Andrew Leckey

February 03, 1993|By Andrew Leckey | Andrew Leckey,Tribune Media Services

This year's military confrontation with Iraq is a reminder that wars in some form or another will always be with us.

The modern war machine, however, has changed drastically. So have the defense industry investments tied to it.

After decades of planning for potential European tank wars or nuclear war, military leaders no longer consider these events quite so likely. That puts the companies that make the proper weapons for modern specialized warfare, such as Raytheon Co. with its Patriot missiles, in a good position.

At the same time, however, the end of the cold war means U.S. defense spending has been declining. More than 300,000 jobs have been lost as government expenditures on the military fell from $206 billion in 1987 to $161 billion last year.

"Despite a decline in defense spending, certain companies that make the right missiles or intelligence-gathering equipment will prosper," predicts Lior Bregman, analyst with Oppenheimer & Co.

"The situation in Iraq reminds people that, although defense spending is down and the Soviets aren't as much of a threat anymore, there still are a great number of potential threats."

Yet the shrinkage in military spending is expected to continue at least for another two years, so consolidation is occurring rapidly as companies seek to avoid overlap in a declining industry. Defense competitors must decide whether to become the best in a specific field through acquisition, to sell off operations or to shut them down altogether.

For example, Lockheed Corp. recently acquired the General Dynamics military aircraft division for $1.5 billion, while Martin Marietta late last year purchased the General Electric Co. aerospace electronics division for $3 billion. Hughes Aircraft bought the General Dynamics missile business for $450 million and Loral picked up LTV's missile business for $261 million.

More deals are expected.

"Investors have made a lot of money on defense industry mergers and acquisitions," says Michael Lauer, analyst with Kidder Peabody. "There's an activist attitude in this industry, and the buyers and sellers have done well."

Selectivity makes a difference in investing in these stocks, because not all defense firms perform the same. For example, in recent months the stock of Allied-Signal Inc. has doubled, TRW Inc. has risen 70 percent and Loral Corp. has gained 60 percent. Others haven't fared as well.

"I've emphasized defense electronics firms which also have some non-military commercial exposure and they have done well the past six to nine months," explains Byron Callan, analyst with Prudential Securities. "Part of that is based on the sentiment that the Clinton administration won't be as bad for the defense industry as initially thought."

Understanding modern warfare is a big part of making the proper investments.

"Compared to its previous all-encompassing image, war in the 1990s is the equivalent of swatting gnats, with individual situations, such as Somalia, Iraq and Bosnia, likely to be the case for some time," notes Steve Binder, analyst with Bear Stearns. "The primary threat is that nuclear warheads might wind up in the hands of a country such as Iran or Iraq."

Defense industry stocks always are controversial, but industry analysts currently see some whose prices still are values.

Raytheon, a strong company and one of the biggest defense firms, is recommended by Binder and Callan. Big in air defense, Raytheon has earnings that can grow at a double-digit rate. Also, it has the large non-military Amana appliance business.

Litton Industries, a dismally performing stock that has remained inexpensive even though the firm is doing quite well operationally, is suggested by Callan and Lauer.

Loral, which should derive good earnings momentum from its acquisitions, is recommended by Bregman. Some of his other stock selections, Lockheed Corp., Martin Marietta and E-Systems, are also capable of double-digit earnings growth, he believes. In the communications area, he likes Stanford Telecommunications.

Harris Corp., in the midst of a turnaround mostly due to its semiconductor operations, is a favorite of Callan. Lauer recommends United Technologies, which is going to get more aggressive on its bottom line.

Thiokol Corp., cash-rich maker of the space shuttle rockets, is a Binder selection.

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