Defense Stocks: P/E Isn't the Only Consideration

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Includes: APSG, BA, COGT-OLD, GD, ID, LMT, MRCY, NOC, OSIS, PPA, RTN, TASR
by: Scott Sacknoff

As prior commentaries have indicated, we did not expect any major changes to the defense sector with the Democratic control of Congress. And what is playing out now, a battle between the White House and Congress over authorizing supplemental funds to keep funding the wars in Iraq and Afghanistan, was expected.

To recap, both the House and Senate have approved a $124.2 billion bill to fund the wars but included language setting an October 1 date for withdrawing troops and a full withdrawal by March 2008. President Bush has stated that any bill with a specific withdrawal dates handicaps the military leadership and he will veto them. We can expect a lot of talk and posturing over the next couple of months, but here is what you need to know:

1. The Army has stated it has enough money to keep fighting into July
2. Congress could approve a smaller amount as a stopgap to the supplement while they debate the issue of withdrawal. This would provide funding for the troops, keep the debate on withdrawals alive, and require President Bush to approach Congress and request additional funds a month or two later. It would also give the Democrats the ability to take the high ground on the debate by supporting the troops and continuing to push the agenda to bring the soldiers back home.

While the Democratic leadership in Congress could back down, it is unlikely. Likewise, the past seven years have shown that President Bush is equally not likely to change his position.

As support for the war wanes, the popularity of the White House declines, and we get closer to the 2008 elections, it is possible that some Republicans may break from their support of the president. That is what DC’s policy analysts expect.

Only time will tell how the situation will resolve itself. The only guarantee is that it will resolve itself and that there will be a lot of talk from politicians between now and then.

China’s Defense Budget Rises 17.8%

The growth in the Chinese defense budget and its recent activities continue to be a major area of interest for U.S. DoD planners and strategists. China’s recent test in which it destroyed one of its satellites in orbit from the ground raised significant concerns among U.S. military officials and it was the main topic of conversation among those of us who attended the recent National Space Symposium in Colorado Springs (home of the U.S. Space Command). China’s 2007 defense budget, which is the 2nd largest in the world, is forecast to rise to an estimated $44.94 billion (up $6.79 billion) or 17.8% although many analysts believe that this budget is about 3 times the official number. (...and that doesn’t include factoring the relative output a dollar produces in China compared with that of Western nations).

Are Defense Stocks Too Rich?

I was on Seeking Alpha the other day and in chatting with a money manager and contributor to the site, he mentioned that he thought defense stocks were becoming too rich. Now, I’ve heard this several times over the past two years and with the sector on a seven-year run, one would expect the P/E ratio to steadily increase until the market feels that it is truly overvalued. To see if the facts bear this out, we decided to do a quick check and relay our observations. What we noticed is that with the SPADEDefense Index once again hitting and passing through historical highs this month, the sector’s growth has been there to keep the P/E in check.

First, a quick review of Yahoo! Finance’s ETF Center shows that the Powershares Defense ETF (NYSEARCA:PPA) had a P/E of 17.45 on May 3rd; a decline from 18.83 on February 28 -- higher than the historical broad market average but still not outrageous.

With 57 stocks currently comprising the Index, I turned to the last page of this SPADEInvestor newsletter, which provides a summary spreadsheet of each of the company’s that comprise the index, to see if I could determine any trends. What I found was the following:

27% of the companies had P/E’s <16
13% of the companies had P/E’s
16-20 22% of the companies had P/E’s >20

Most of the P/E’s that were above 20 were companies with a market capitalization below $1.5 billion and all were $3.5 billion or less.

The ‘Big 5’ defense contractors had P/E’s of the following:

Northrop Grumman (NYSE:NOC) (13.51)
Lockheed Martin (NYSE:LMT) (14.29)
Raytheon (NYSE:RTN) (15.21)
General Dynamics (NYSE:GD) (14.73)
Boeing (NYSE:BA) (15.30)

Needless to say, based solely on the numbers, the current P/E’s of defense sector companies hardly seem to signal an overvalued sector. Next, we reviewed the spreadsheet to identify which companies in the Index are more richly valued in terms of P/E. This revealed that the high P/E companies were comprised of essentially the small companies operating in homeland and border security and biometrics.

Among these were:

L-1 Identity (NYSE:ID) (56.53)
Cogent (COGT-OLD) (29.25)
OSI Systems (NASDAQ:OSIS) (29.34)
Taser (NASDAQ:TASR) (23.32)
Applied Signal (APSG) (24.16)
Mercury Computer (NASDAQ:MRCY) (38.77)

... but each is considered by analysts that cover the companies to be “growth” firms and firms defined as growth firms have historically had higher P/E’s.

So what does this all mean?

The last few months (and years for the that matter) have shown that the defense sector is in the midst of a multi-year cycle that has rewarded investors. A review of the P/E of the companies that comprise the SPADE Defense Index indicate that even with gains that have surpassed the S&P 500 for each of the last seven years, the sector is tracking higher than the 15.04 represented by the SPY (S&P500 ETF) but at 17.45 is still not high relative to historical averages. As one money manager commented in a recent speech, P/E by itself is not necessarily the only consideration in determining whether a company or a sector is overvalued.

DoD Changing Its Plans for Future Conflicts

According to Ryan Henry, DoD’s principal deputy undersecretary of defense for policy, the Bush administration plan to add 92,000 soldiers and Marines is designed to shift the military’s force structure from one that is ‘garrisoned forward for high kinetic, major combat operations to one that has more of its mass back in the U.S., but rotates forward [when needed]’. Historical Force Structure DoD 1-4-2-1 Force Structure - Defend U.S. Soil - Fight aggression through forward deployments to places such as Europe, Northeast Asia, Middle East/ Southeast Asia, and the East Asian littoral. - First two major conventional combat operations at nearly the same time - Rapidly win in one of those convention fights

Today

The Pentagon scrapped those plans in the 2006 Quadrennial Defense Review [QDR]. A CSIS analysis of the QDR stated that the U.S. military policy is shaped for three main types of missions:

- Homeland Defense
- War on Terrorism / Irregular Warfare
- Conventional Campaigns