MARKET BEAT / TOM PETRUNO : Quarter’s Gains Spur Interest in Defense Stocks
Surprisingly good second-quarter earnings by major defense companies are sparking new interest in the stocks, which already rank among the market’s top performers this year.
Tuesday, McDonnell Douglas stock surged $5.625 to $80.875--its highest since 1989--following the company’s report of record quarterly earnings. On Monday, Rockwell International shares jumped $1.25 to $32.25 after the firm said strong results from its aerospace unit helped boost overall quarterly earnings 20%.
McDonnell’s huge stock move--Tuesday and year-to-date--is partly a function of the high “short” position in the shares by traders who had previously sold borrowed stock, betting that the company was headed for ruin. Forced to cover their positions, the short sellers are now magnifying demand for the stock.
But the healthy gains in defense stocks in general this year suggest the industry is finally getting credit for its surprisingly good management of declining military spending.
For many of the companies, cost cutting has been a big factor, of course. McDonnell, for example, has 15% fewer employees than a year ago and has also slashed its interest expense by about half since mid-1992.
More important, however, is that the rash of consolidation in the industry is yielding better than expected profit, analysts say. Martin Marietta, which reported quarterly earnings Tuesday, saw its net income boosted 25%, thanks in part to the $3-billion purchase of General Electric’s aerospace businesses in April.
“This is going to be a smaller industry but with larger players and larger market shares,” says Lior Bregman, analyst at Oppenheimer & Co. And, he adds optimistically, “the mega-deals have only begun to happen.”
What’s encouraging to big investors isn’t just that acquisitions and divestitures are taking place in the shrinking defense business, but that the transactions are in most cases only proceeding when they clearly benefit shareholders.
Peter Anderson, manager of Federated Group’s American Leaders stock mutual fund in Pittsburgh, says many defense firm managements have wisely decided against making acquisitions solely for strategic reasons (i.e., because the business fits). There has to be a solid financial payoff as well, Anderson says.
“What you hear managements saying is, ‘If the return on equity is there, we’ll consider (a deal),’ ” he says. Partly for that reason, his fund is a big owner of Martin Marietta and Raytheon, both of which have shown finesse in large-scale deals.
Even some of the most historically obstinate defense managements have shocked Wall Street with their willingness to do what’s best for shareholders. One example: Litton Industries’ decision to split its defense and commercial businesses in two, which sent the stock rocketing this spring because it unlocked the hidden value in the firm’s commercial units.
McDonnell, too, has gained new respect among analysts for the turnaround engineered over the last year. Tuesday, Cowen & Co. analyst Cai Von Rumohr raised his rating on the stock to “buy” from “speculative buy” and boosted his 1994 earnings estimate to $11.50 a share from $10.
Despite ongoing worries about McDonnell’s troubled C-17 cargo plane project and the still-heavy burden of MD-11 commercial jet development costs, Von Rumohr argues that “McDonnell has shown they can meet their payments.” A sharp improvement in its balance sheet over the last year means that financial distress “is an issue of the past,” he says.
But with the surge in most defense stocks this year, are they still cheap? Nominally, yes: Most are priced at 10 or 11 times estimated 1994 earnings, compared to a 16 multiple for the broad market. If nothing else, that puts these stocks at much less risk if there’s a major market selloff.
The stocks’ low valuations, however, tell you that Wall Street still worries about long-term earnings growth. As well it should, analysts say. Cost cutting will only go so far; eventually, “you need (sales) growth,” Von Rumohr says.
That’s why he is most bullish on companies such as Rockwell, GM Hughes and Allied-Signal--all of which, in addition to defense, have large commercial businesses that would benefit from any pickup in world economic growth, he says.
At the other end of the spectrum is Oppenheimer’s Bregman, who argues that the market will reward growth, however it’s achieved. For that reason, he favors Martin Marietta and Lockheed, expecting both to benefit greatly by expanding their shares of a smaller defense budget.
Defense Stocks Surge Here’s a look at major defense company stocks, including their performance so far this year, their price-to-earnings ratios based on 1994 earnings estimates and their annualized dividend yields.
Stock Tues. close ’93 change ’94 est. P-E Div. yld. McDonnell-Doug. 80 7/8 +68% 9 1.7% Logicon 27 1/2 +41% 12 1.0% GM Hughes 33 5/8 +31% 14 2.1% Loral 59 +28% 11 1.7% Northrop 41 5/8 +22% 9 3.8% Lockheed 67 7/8 +20% 10 3.1% Raytheon 59 7/8 +17% 10 2.3% Martin Marietta 80 3/4 +16% 10 2.1% Allied-Signal 69 5/8 +15% 13 1.7% Rockwell 31 5/8 +9% 11 3.2% E-Systems 42 1/2 +3% 11 2.6% Gen. Dynamics 89 3/8 -14%* 16 1.8% S&P; 500 index 447 +3% 16 2.8%
All stocks trade on NYSE.
P-E’s are based on analysts’ consensus earnings estimates.
* Reflects payment of two special dividends.
Source: Zacks Investment Research
