"Price-to-earnings valuations for defense prime contractors have risen since the U.S. stepped up engagement with the Islamic State [to as much as] 14.25x. [However,] meaningfully higher defense budgets are unlikely due to budget constraints and the limited scope of engagement."
Such are the facts, as bluntly stated by Bloomberg Intelligence in a recent analysis of trends in the defense industry. And at the risk of being similarly blunt, let's put this plainly:
This is not good news for U.S. defense contractors, or the investors who own defense stocks.
Simply put, if defense stock prices have gotten more expensive in anticipation of greater spending on defense (by government), and greater profits from defense work (for defense contractors), then a failure of the former to materialize endangers the latter as well.
And it gets worse.
When Bloomberg points to "14.25" as a relatively expensive P/E ratio for defense contractors, it's actually understating the case. You see, the "14.25" that Bloomberg cites appears to be the average valuation for these stocks on a forward P/E basis. But viewed from the perspective of trailing profits -- i.e., the profits these companies are actually earning, as opposed to the profits we hope they will earn in the future -- the "Aerospace/Defense Products & Services" industry sells for an average P/E of 18.5 -- with many of these defense stocks costing more than what Bloomberg describes:
- Lockheed Martin (LMT -2.20%): 17.9 times trailing earnings
- General Dynamics (GD -1.63%): 18.1
- Boeing (BA -1.20%): 18.2
- Textron (TXT -1.83%): 19.3
Historically, of course, most defense contractors have sold for valuations well below those that we see them selling for today. Bloomberg data show that as recently as "mid-summer," defense stock prices were 10% below current levels. My own research, focused on price-to-sales ratios, suggests defense stocks as a whole now trade about 20% above historical norms (with some exception).
So, what's behind the run-up? And is it sustainable?
Hope springs eternal
One hope, as Bloomberg points out, is that the upcoming November elections in Congress will shift the balance of power in Washington from Democrats to Republicans by giving the latter control of the Senate.
And yet, Bloomberg warns that "the realities of a large deficit and debt, and the inability to lift sequestration may keep the defense budget near existing levels" regardless of which party is in power in Washington next year. Indeed -- contrary to investor hopes that a hawkish Republican party will move to boost defense spending after taking power in the Senate, Bloomberg cautions that "a Republican majority in both houses [may have] little incentive to bargain [with Democrats in Congress, or with the President] ahead of the 2016 presidential race."
The resulting gridlock could actually work to prolong the sequester and delay any hoped-for increases in defense spending as far out as 2017.
But isn't defense spending already going up? Because of, you know, ISIS?
True, investors have bid up shares of defense contractors based on more than just hopes of the Republicans taking over Congress. Investors are also making the logical assumption that the more military hardware is used in combating ISIS in Iraq and Syria -- the more planes that are flown and must be maintained, and the more bombs that are dropped and must be replaced -- the more defense contractor revenues will swell, and the more profits these companies will earn.
And yet, to date, four straight months of an intensive air campaign over Iraq and Syria have only cost taxpayers about $1 billion. Viewed in isolation, that sounds like a lot. But to put that number in context, the war in Afghanistan is costing taxpayers close to $1.5 billion per week.
Put another way, for each day of combat operations in Afghanistan we spend about as much as we're spending to fight ISIS for a month. And viewed from that perspective, $1 billion in extra spending on ISIS really isn't a lot of money at all. Rather, it's the proverbial drop in the bucket.
The upshot for investors
Call it a drop, or call it a whole bucket, $1 billion in extra defense spending is better than a sharp stick in the eye for defense contractors and the investors who own their stocks. (Apologies for the mixed metaphors.) The potential for a "long war" against ISIS costing upward of $10 billion a year would be even better news for defense stocks.
Yet even so, Bloomberg points out that the U.S. Congress overspent its income by $650 billion in 2014. Our national debt now stands at about $13 trillion, give or take a hundred billion dollars. After spending $4 trillion to $6 trillion already on more than a decade of warring in Iraq and Afghanistan (by some estimates), there's a limit to how much the U.S. will be able to afford to spend on its latest war against ISIS.
Investors who bet on the rapid run-up in defense stock prices continuing ad infinitum, in the face of a U.S. government increasingly unable to afford such spending, could be in for a rude surprise.