Defense Contractors Are Duds

 | Sep 02, 2011 | 11:30 AM EDT
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As part of my series on booze, bets and bombs, I have been trying to find stocks that are working right now. On Monday I looked at booze, and came to the conclusion that Diageo (DEO) is benefiting from volume growth and a global shift to premium spirits. The stock looks tasty. Today, I decided to look at bombs -- or, more politely, defense contractors. These companies have supplied every army except the Salvation Army. (OK, here's your cheesy Nicholas Cage quote: "Guilty!")

More specifically, I looked at General Dynamics (GD), Raytheon (RTN) and Rockwell Collins (COL). All three are down from their 52-week highs by between 19% and 28%. What gives? Why the shellacking? Two words: budget cuts.

In 2010, worldwide defense business grew 1.3% to about $1.6 trillion, with the majority of the growth in the market coming from the U.S. From fiscal 2000 through 2010, the U.S. defense budgets for weapons and research & development grew at 9% and 7.6% compound annual rate, respectively. For 2011, the U.S. defense budget is $670.8 billion. But the proposed 2012 budget faces a 3.3% cut, which includes a 25% spending reduction in Iraq and Afghanistan. If the proposed budget is enacted, it would be the most drastic cut in defense spending in more than 10 years.  In fact, longer-term, the Defense Department is on track to slash $100 billion from the budget over the next five years. Ouch!

Investors have hit the group hard because growth is drying up. Take Raytheon as an example. 2011 revenue is expected to grow just 2%, new orders are below 2010 levels, and the total backlog has declined by 6%. Because of heavy defense spending, orders grew nonstop from 2005 to 2008. But, by 2009, orders fell and now backlog is declining. Revenue growth of 2% is expected to trend below the company's historical annualized compounded growth rate of 4% for at least the next two years.  Operating margin of 10% is projected to be flat with last year, and earnings-per-share growth ($5.02 in 2011 and $5.10 in 2012) will mostly come from share repurchases. That's hardly a reason to buy the stock.


While the group may bounce off the lows, there is little reason to recommend the defense sector at the moment. Quite simply, growth has stalled. Although some analysts hold out hope for a Mideast arms race, there is nothing left to drive revenue and EPS growth. As long as Europe and the U.S. are cutting defense spending, this group will be caught behind enemy lines with little chance of rescue.

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