Has anyone else noticed that defense stocks are at multi-year lows, and that they're trading for ridiculous price-to-earnings ratios of around 8? These companies are firmly on my radar screen, and I’ll tell you why.
You must be kidding
I’ll bet many people equate investing in a defense stock with arranging potpourri -- a mundane activity. The perception is that despite their cool products, defense firms are slow-growing and somewhat boring businesses. Indeed, defense companies are considered superstars if they can generate 10% annual revenue growth.
What’s worse (the bear argument goes) is that growth will be much harder to come by in the next decade than the last. The past 10 years were phenomenal for contractors, as the defense budget more than doubled from $292 billion in 1999 to an expected $611 billion next year. But there are now major pressures on spending, including possible withdrawal from Iraq and a financial crisis that requires large sums of government money.
Didn't you say you liked defense stocks?
As a member of the Motley Fool Inside Value team who has spent five years analyzing the defense and aerospace industries on Wall Street, I believe now is the time to get excited about defense stocks. You see, investors are so scared they have forgotten why defense is an excellent area to invest. Here are some reasons:
- There are huge barriers to entry.
- Long product lifecycles mean high visibility of earnings and cash flow.
- Defense programs are hard to cut.
- Defense is counter-cyclical to the economy.
- Unfortunately, the world is not a safe place.
Entry denied
The defense industry has tremendous barriers to entry. It's a bit like the Augusta National Golf Club, which limits the number of members to about 300. It is almost unprecedented to start a new defense company from scratch. You can build a defense company up through acquisitions, like L-3 Communications (NYSE:LLL) did, but unlike Silicon Valley, for example, you won’t see random start-ups like Microsoft (NASDAQ:MSFT) or VMware (NYSE:VMW) taking the industry by storm.
Of course, there is competition amongst defense contractors, but it's usually limited within each market. There are only two makers of submarines, two main ship makers, three aircraft makers, and only one builder of aircraft carriers. Less competition is good for the existing players.
Boring is the new brilliant
Defense products have long lives, and this leads to high visibility of earnings and cash flow. Did you know that not only are Boeing’s (NYSE:BA) B-52 bombers still flying, but they are also projected to last until 2040, for a total of 80 years? Contrast this with salesforce.com (NYSE:CRM), which may be a great company, but is constantly forced to innovate just to maintain market share. Change destroys businesses, and thankfully, the rate of change in defense is relatively slow, often measured in decades, not years.
Defense programs are difficult to cut
Right now, valuations assume deep cuts to the defense budget. While the budget will face pressure, I don't believe it will fall as much as expected. First, defense programs are notoriously hard to cut because Congress must sign off, and contractors account for significant employment in many states. With the economy reeling, it is important to keep jobs in place. Also, even if programs are cancelled, contractors are entitled to termination fees.
No bailouts needed for these counter-cyclicals
Despite the recent market surge, the economy is expected to remain weak for some time, and defense companies tend to be counter-cyclical to the overall economy, which helps to insulate them from recessions. Even some of our strongest consumer brands like PepsiCo (NYSE:PEP) and Church & Dwight (NYSE:CHD) are not nearly as immune to the current economic environment.
Defense companies have risks such as underfunded pension plans, but on the whole, business results should be steady over the next few years. Indeed, one Wall Street analyst forecasts all of the "big five" defense contractors will increase their earnings in 2010 compared to 2009. I'll take that in this environment.
Are we safe?
Even though valuations have declined enormously, it's hard to argue the world is suddenly a much safer place that it was last year. Many significant threats to our security exist, and just one incident could increase the public's willingness to fund defense programs. Defense spending as a percentage of GDP is historically low at only 4.5%, compared to peaks of 6.2% in 1986 and 10% or so in the 1960s. And while it won't set any speed records, growth has been surprisingly strong -- defense spending has grown at a 5.4% annual clip over the past 50 years.
Excited yet?
It’s time to get excited about defense. Investors appear to be overlooking the many positives of this important industry and have pushed down the sector's valuation, making this a good time to get into an industry with a stable long-term outlook. Paying only 8 times forward earnings for that privilege appears very tempting.
We've scoured the industry and found two high-performing defense companies whose shares have been beaten down well below their true value. To get their names, take a guest pass to Motley Fool Inside Value completely free of charge by clicking here.
Fool analyst Andrew Sullivan really loves last month's Motley Fool Inside Value pick and has no financial position in any of the stocks mentioned in this article. PepsiCo is a Motley Fool Income Investor pick. Microsoft is a Motley Fool Inside Value recommendation. VMware and salesforce.com are Motley Fool Rule Breakers picks. The Motley Fool has a disclosure policy.
