WILMINGTON, OH (Sept. 29, 1999) -- As many of you who read the Drip Companies message board are aware, I believe in including a company from the defense/aerospace sector to round out a portfolio's diversification. Many people ask why. I am happy to provide a brief analysis of some of my observations that I believe make this sector worthy of consideration.

The defense/aerospace sector has been a relative underperformer for over a decade. The fall of the "evil empire" and the end of the Cold War lulled the taxpaying public into a false sense of security, which negatively impacted the public's desire to maintain a strong national defense. Over the past decade, in an effort to balance the budget, Congress has responded to public opinion and reduced defense spending. Subsequently, defense/aerospace companies have had to tighten their belts.

Many of these companies have posted successive quarters of disappointing earnings, which finally necessitated large layoffs. The senior executives of these companies have been forced to fight the battle of economic survival with one hand tied behind their backs, so to speak. The U.S. government has declared "out-of-bounds" to these companies the whole arena of mergers and acquisitions. In the failed merger between major air platform suppliers Lockheed Martin (NYSE: LMT) and Northrop-Grumman (NYSE: NOC) in 1998, the Pentagon cited fear of a defense supplier monopoly and the possible compromise of national security as the primary reasons for nixing the merger. Inquiries about a potential merger between shipbuilders General Dynamics (NYSE: GD) and Newport News Shipbuilding (NYSE: NNS) were rejected over similar concerns.

But positive changes may be in store for the defense/aerospace industry. For the first time in 13 years, there appears to be an uptick in U.S. defense spending. The Clinton five-year plan, Military Procurement Spending, which was at $45 billion in 1998, is expected to rise to $75 billion by FY 2005. The growth pattern reflects about a 4.5% to 5% annual growth in modernization outlays.

In addition, the public perception is changing. When people turn on their television sets or read their daily newspapers, they see a dramatic increase in localized military conflicts. While the threat of world war has diminished (thank goodness), the threat of small, localized conflicts has increased significantly. The public is beginning to advocate more spending for national defense in response to this threat.

In Operation Desert Storm and again in Kosovo, the American public saw firsthand how their government has the ability to commit highly sophisticated weapon systems to favorably influence the outcome of a localized conflict, instead of risking ground force casualties. Many Americans now appear willing to pay to develop modern and capable weapons systems, rather than risk the lives of their sons and daughters.

The attitude against mergers involving U.S. defense suppliers appears to be conditionally softening as well. Recently, the Pentagon stated that they would not be opposed to investigating and approving mergers/acquisitions between U.S. defense suppliers and defense suppliers from European-based companies. This may allow managers within this industry sector to apply the same economies of scale to their companies that other industries have been able to utilize freely during the 1990s. The accompanying potential for favorable stock performance seems considerable.

The 1999 budget allocated $24.654 billion to Air Force procurement, $22.117 billion to Navy procurement, and $6.814 billion to Army procurement. If one breaks down this current allocation and the projected increases in defense spending from the Clinton plan, one will discover that the aircraft development for both the Navy and Air Force absorbs much of the spending increases. This should provide a positive investment environment for this area. Electronic product development is also slated for an increase. This should provide a positive investment environment for this area as well since delivery platforms are only as lethal as the technology they carry.

Sea weapons platforms (ships) appear to rank third in spending, with land platforms (tanks and land troop transport) a distant fourth. Based on a review of the major programs, investors in this sector should be attracted first to those companies with prime emphasis on both aircraft and electronics, second to those companies with prime emphasis on either aircraft or electronics, and finally to those companies concentrating on military shipbuilding.

However, circumstances do not appear as promising for those companies with significant emphasis on the production of commercial aircraft. Product orders, which declined in 1998, are expected to decline further in 1999 and 2000. Order drops inevitably are followed by a downturn in production rates. Companies with exposure in this area can be projected to experience a drag on earnings for the next several years.

Tomorrow, we'll review the major companies in the aerospace/defense sector that Drip investors can consider. To discuss this column, please visit the Drip Companies message board linked in the top right of this page.