By: Brett Arends

The Wall Street Journal

Everyone is worrying about possible deep cuts to the defense budget starting in January—everyone, it seems, except investors in defense stocks.

The Standard & Poor’s 500 Aerospace & Defense Index of leading defense companies rallied this past week, reclaiming half the modest 5.5% it lost following the defeat of Mitt Romney, the more hawkish of the two presidential candidates. Despite the political debate raging in Washington, the index is still trading within 10% of its record 2007 high.

Investors might be too complacent. Even if Washington strikes a deal and manages to avert the immediate cuts scheduled for 2013, budget pressures and the end of two wars mean U.S. military spending is likely to come under significant pressure in future years, analysts argue.

“We’re bearish on defense over the next several years,” says William Loomis, an analyst at investment firm Stifel Nicolaus in New York, which has $138 billion under management. Over time, Mr. Loomis expects military spending to be cut, putting pressure on industry revenue and profit.

U.S. defense contractors are heavily reliant on U.S. government spending, which in many cases accounts for around three-quarters of their revenue.

Some companies are more vulnerable than others. Analysts think Lockheed Martin and General Dynamics are more dependent on big-ticket items and more at risk from cuts. Raytheon might be best positioned to weather the storm.

Some in the industry already foresee trouble. “We recognize these cuts are going to happen,” Mike Madsen, president of Honeywell International’s defense and space unit, told investors this past week. “We’re not really fighting these—they need to occur.” Boeing recently reshuffled some of its defense units, rearranging senior executives, to reflect the likely decline of its defense work.

To be sure, defense stocks today look moderately priced in relation to earnings, suggesting many investors have already factored in the likelihood of cuts, or slower growth.

Raytheon, whose products include the Patriot missile, trades at 10 times forecast earnings for the next 12 months, compared with about 13 times for the Standard & Poor’s 500-stock index. Lockheed Martin, maker of the F-35 fighter plane, also trades at 10 times forecast earnings; it boasts a hefty dividend yield, meaning dividends divided by the share price, of 5.1%, compared with 2.3% for the S&P 500.

Yet the stocks might not be as much of a bargain as they appear. Today’s profits still reflect the extraordinary U.S. military spending levels since the terrorist attacks of Sept. 11, 2001. Regardless of what happens in budget talks over the next few weeks, over the longer term those levels are likely to fall. If they do, these companies’ earnings will come under pressure, and the stocks are likely to underperform.

From 2001 to 2011, the U.S. ramped up military spending to about $700 billion from $300 billion a year. Defense companies’ sales and profits soared. According to the Aerospace Industries Association, a trade group, industry net profits nearly tripled, to $18.4 billion from $6.6 billion.

Defense budgets of the last three years have been the highest on record. In constant dollars, they are about 25% higher than the peak during President Ronald Reagan’s military buildup and 30% higher than the peak during the Vietnam War, according to U.S. government data. About a third of the budget goes to procurement and research and development.

The July 2011 budget deal between the president and Congress capped military spending growth and imposed automated cuts beginning Jan. 1, 2013, if other agreements on taxes and spending weren’t worked out. In total, military spending would be cut from just above $700 billion to just over $600 billion.

Despite the heated rhetoric they have produced, these cuts would be modest by historic standards. At $600 billion, the budget would still be about $160 billion above the average level, in constant dollars, since the World War II, government data show. Veronique de Rugy, a budget expert at George Mason University, says the Pentagon could actually spend more next year than in 2012.

The world remains a dangerous place, of course. The U.S. faces a new rival in China, whose rapidly rising defense budget is considerably larger than official reports reveal, according to the International Institute for Strategic Studies in London.

If negotiations between the president and Congress produce a budget deal that avoids automatic defense cuts in 2013, the sector overall might well continue the recent rally. Yet the longer-term picture is gloomier.

Lockheed Martin and General Dynamics could be among those more at risk, says Yair Reiner, an analyst at Oppenheimer & Co., an investment bank based in New York. Lockheed’s F35 fighter project is the Pentagon’s most expensive project for the next decade, and most vulnerable to cutbacks, he says. General Dynamics makes expensive equipment, such as tanks and nuclear submarines. It also reaps significant income from information-technology services for the Defense Department, yet such work is based on short-term contracts that could come under pressure if budgets are sequestered next year.

Raytheon’s broad range of businesses, including areas of expertise in systems electronics and missile defense, might leave it better placed. Stifel’s Mr. Loomis points out the company’s electronic systems can be used to upgrade military hardware, such as older fighter planes, more cheaply than replacing them.

Not everyone is gloomy about the stocks. “They generate a lot of cash flow,” says Michael Lewis, a defense analyst at Lazard Capital Markets. Even if defense budgets are cut, he says, they can cut costs, merge, diversify and devote more of their earnings to dividends and buying back stock. He expects surprisingly strong returns over the medium return.

Yet the last time the industry faced similar circumstances was after 1986, as the Cold War wound down and the Soviet Union collapsed. Defense budgets were cut in real terms for over a decade. Aerospace and defense stocks underperformed the broader market for six years, from 1986 through 1992, according to FactSet.

Investors need to be more alert to the risk that this could happen again.

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