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Stock in Niche Defense Firms Soars in Wartime

CATEGORY: War Profiteering

DIVISION: Investments

COMMENTARY: If there's anyone who should come out ahead in the current wars, it's the people that started them. They're the ones that took the initiative, had a vision, and sold everyone on the new venture - so of course, they should reap the rewards.

We encourage you to contact your broker and get in on the action while there's still some war left.

Armaments And Investments

By Renae Merle

Washington Post Staff Writer

Sunday, July 15, 2007; F01

Bullets, trucks and armor -- the meat and potatoes of the defense industry -- are back in fashion.

After years of holding second rank to expensive, futuristic programs -- from $300 million fighter jets to robots -- the essentials have been pushed to the forefront by the wars in Iraq and Afghanistan. And that has proved good news for the stocks of companies that replenish the weapons, trucks and helicopters that see frontline action. They are among the best performers this year, analysts say.

The Iraq war may be politically unpopular, but it has been a boon for the defense industry. Last year, the sector soared 27.7 percent, while the Standard & Poor's 500-stock index rose 13.6 percent. So far this year, the industry has gained 26.7 percent, compared with the S&P's 9.5 percent increase. Since 2001, defense stocks that make up the S&P Aerospace & Defense Select Industry Index have climbed 181.7 percent; the broader market is up 17.6 percent.

But it's the niche companies, such as the makers of armored vehicles, that are the top individual gainers this year, according to the Spade Defense Index, which tracks the sector.

"Clearly anything that is still related to the war in Iraq and Afghanistan is the hottest market right now," said Byron Callan, an independent industry analyst.

Among the hottest products is the Marine Corps' newest mine-resistant vehicle. The program for the vehicles -- which cost about $1 million each -- has ballooned over the past few months to a potential $20 billion from $8 billion, lifting prospects for the vehicles' manufacturers. The military is seeking the vehicles because it thinks they can better protect troops from roadside bombs, the biggest threat to service members in Iraq.

The makers of these vehicles, including Force Protection and Oshkosh Truck, recently emerged as winners in the House version of the 2008 defense authorization bill. The administration had requested $400 million to help fund production. The House approved $4 billion. Force Protection stock is up 31percent this year, and Oshkosh has gained 34 percent.

A highly critical report from the Pentagon inspector general didn't hurt Force Protection's stock. Last week, the inspector general's office said Force Protection was slow to deliver on contracts, but the company's stock finished up Thursday after release of the report.

The larger defense industry isn't exactly suffering from the attention given to the niche players. The big weapons makers have continued to soak up huge Pentagon spending and have expanded their international business. Military spending is on target to reach $624.6 billion in fiscal 2008, including more than $100 billion in war supplemental outlays, according to a report by the Center for Strategic and Budgetary

Assessments on June 7. At those levels, the flow of military funds would be the highest in real terms since fiscal 1946, the report said.

Among big defense contractors, Lockheed Martin stock has gained 6.7 percent this year, General Dynamics has climbed 9 percent and Raytheon is up 4 percent.

Analysts caution that the huge outlays that have propped up the big defense companies may not continue. "It just seems there is a ceiling we're going to hit here. It is not like DOD is behaving like it's blue skies forever," said Callan, the independent industry analyst.

In fact, the House authorization bill shaved more than $800 million from Boeing's Future Combat Systems. That huge Army modernization project includes new tanks and equipment that will not be ready for several years.

Investing in defense companies is different from buying into most other industries. For starters, a company's income depends largely on the Pentagon and Congress. In choosing stocks, the political and military winds often matter as much as a company's operations. A weapon in favor one year could be canceled the next, requiring investors to stay sharply attuned to the companies' lobbying efforts and political clout. A company's bottom line can also be affected by government oversight. Congress has recently stepped up its criticism of firms for late and over-budget programs.

"The defense industry has done very, very well without much oversight from Congress," said David Strauss, U.S. aerospace and defense analyst for UBS Investment Research.

He noted that in the past, companies were not forced to absorb some of the expenses when a program exceeded its cost targets. "Now you've got Congress trying to put a closer thumb on that," Strauss said.

In a May industry survey, Standard & Poor's said: "The military weapons-buying business operates in a highly regulated environment." Put another way, the report added, the budget process by which contractors get money is "arduous and unpredictable."

Investors also find themselves somewhat in the dark about what exactly they're getting for their money. Often a good chunk of larger defense companies' operations are classified, meaning investors can't get a full picture of what's generating a firm's revenue.

"Even for people on Wall Street, it's very, very hard for us to know how much individual companies are benefiting from classified areas," said Strauss.

Intelligence spending is on the rise, analysts say. One hot area is information technology for gathering intelligence and identifying enemies, said Eric Hugel, an industry analyst for Stephens Inc. "I mean, there is a lot money going into these things, we just don't know how much, but theoretically it's a lot," Hugel said.

The excitement about this sector was evident last year when Northrop Grumman bought Columbia-based Essex. Northrop sought Essex because it specializes in classified technology used by the National Security Agency and other agencies. Northrop paid about $580 million for Essex, whose technology processes signals, images and information the agencies collect. Essex's projected earnings of $250 million to $300 million this year made Northrop's purchase among the priciest for a federal information technology firm in recent memory, according to Jefferies Quarterdeck, a mergers-and-acquisition investment-banking firm that served as Essex's adviser.

Information technology companies operating in the more prosaic arena of Pentagon computer upgrading and database integration have been attracting less funding in recent years. These firms, which flourished after the Sept. 11, 2001, terrorist attacks, are now losing out to sexier IT companies involved in intelligence. Organic revenue growth in the sector has declined to about 5 percent from an average of 20 percent in 2004, said Bill Loomis, a government-technology analyst for Stifel Nicolaus. The information technology company CACI International, for example, has lowered its earnings expectations and seen its stock slump in recent months. CACI of Arlington is down 12 percent this year.

"In the 1990s, the federal IT budget was growing faster than the overall defense budget. Now that has switched," Loomis said. "You don't have to put the next generation of financial software in place in a time of war, so we tend to see a number of those engagements slow down."

In the long term, the defense companies' fate could depend on the ballot box and the war. "I am positive on defense stocks still, but there is cautionary note in background. There could be potential cuts to the budget, particularly if we get a Democratic president and Democratic Congress," said Richard Tortoriello, equity analyst for aerospace and defense at Standard and Poor's.

Republicans have held down funding for non-defense projects, which has helped the Pentagon budget grow, Strauss said. "If Democrats focus on [increasing] non-defense discretionary spending, it will be difficult for the defense budget to continue to go up," he said.

And what happens if the war ends? Some analysts think the big players such as Lockheed Martin and Boeing could benefit as the focus returns to the long-range transformation of the military. "After we get out of Iraq, there has been a lot of investment activity that has been delayed that will be put back on track," said Scott Sacknoff, manager of the Spade Defense Index.

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