Wall Street Keeps Wary Eye on Defense Biz

There are many reasons why Wall Street hearts the defense industry. As analysts see it, top defense CEOs have proven to be exceptionally smart at financial engineering and dealing with investors. Even in these times of steep military budget cuts, industry stocks have reached new heights.

As companies defy gravity by slashing expenses and returning cash to shareholders, they continue to puzzle Wall Street analysts and financiers. Nobody knows if or when investors will begin to retreat, but so far financial experts continue to be favorably surprised by the performance of Pentagon contractors.

“Returns to shareholders are much higher in defense than in other parts of the market,” said David Strauss, aerospace and defense industry analyst at UBS.

Defense investors today are widespread. They include large mutual funds, pension and hedge funds. Investors have shifted their money to Pentagon contractors gradually over the past several years, Strauss said last month at an industry conference. In 2008 and 2009, there was a lot of tentativeness about defense stocks going into a downturn. But companies have managed the military cutbacks very differently than they had done in the past.

Following the post-Cold War downturn, companies rushed to acquire and merge with other companies, but not this time.

Another factor that swayed investors is that the budget has held up better than most analysts had predicted, Strauss said.

“We expected defense budgets to go down 50 percent. Today it has dropped less than 25 percent.” Sequestration is seen as a negative, but the defense top line, even under reduced spending caps, is projected to go up modestly after 2017. “That’s better than what we were thinking before,” said Strauss.

Defense firms, while loved by near-term focused shareholders, have been spurned by private equity. One firm that built its cachet on its ownership of defense contractors, The Carlyle Group, has slowly left the sector. Carlyle, with more than $200 billion in assets, has done about 80 deals over the last 20 years in defense and aerospace, but none in the defense sector since 2008, said Managing Director Frank Finelli. “That’s because we’re finding better risk-adjusted returns in other sectors in the U.S. and globally,” he said.

Some areas of the defense sector are appealing, but private equity investors worry about the long term. When they buy companies, their intent is to own them for five to 10 years.

“We bring a different perspective,” Finelli said. The dilemma is how to ensure the value of these companies goes up. “It’s a complex situation,” he added. The most worrisome red flags out there are interest rates and the rising national debt. Interest of the U.S. debt alone is on a path to reach a trillion dollars in 10 years. “That has big implications for defense,” Finelli said. “Right now, I’m looking for commercial diversification.”

A caveat for U.S. weapon makers is that they might be overestimating their opportunities for non-U.S. business. “The risk is that management will divert attention to these foreign markets and not achieve the traction,” said Finelli. “I applaud companies for pursuing international markets. But a lot of companies are not going to gain the traction.” A stronger U.S. dollar will make American equipment more expensive overseas, and many countries already shun U.S. suppliers because of burdensome export controls.

“Defense industry management across defense has done a great job with financial performance,” he said. The sector is attractive to income-oriented investors that are buying stocks today, “but as private equity investors, we are looking at what the sum of the value of the programs is from the bottom up,” said Finelli. The issue is that the future of many programs is unclear.

Another looming headache for the industry is its access to talent. Defense firms are competing for engineers against behemoths like Apple and Google, and they are likely to lose that battle, said Denis A. Bovin, senior adviser at the investment banking firm Evercore Partners. The industry is doling out its cash to shareholders rather than investing in people and technology, which is not a recipe to attract the best and the brightest, Bovin said.

Defense firms also are falling behind the technology curve.

“When Amazon.com decided it wanted to get into drones, it wrote a $500 million check,” he noted. In the defense industry, companies work on 15-year programs under dozens of layers of oversight and tens of thousands of pages of regulations. “That’s certainly not the way Amazon or Google X work,” said Bovin. “That time scale difference is a fundamental barrier.”

It is also problematic for investors that the industry’s main customer, the Defense Department, is making it standard policy to squeeze contractor profits. “There’s a major disconnect in the Pentagon,” said Bovin. “They think profit is a bad thing. They align their policies and desires very differently from the industrial base. … If industry can’t get appropriate returns, investors will look elsewhere,” he added. “The implications are rather profound.”

Defense firms are selling “declining volumes of products to a unique and sometimes problematic customer, and it’s chasing a falling market share in a declining market,” Bovin said. “Stocks are at an all-time high because the investors are getting a better return from these companies than they can from others. When interest rates go up, and they will, that will cause a major seismic shift. We will see what happens when that occurs.”

A perfect storm indeed is brewing for the defense sector. If investors do one day flee, Bovin speculated, it might make sense for the Pentagon to take ownership of its major contractors. “It is not clear to me why an arsenal company has to be public.”

The next five to 10 years, he posited, could be the test of whether a very large defense company is better off going private, getting rid of public company costs and operating in a fundamentally different way.

Topics: Business Trends, Defense Department