You don't need a defense expert to tell you that domestic demand for military goods and services is likely to weaken in the years ahead. The war in Iraq is ending, the federal government is running a daily budget deficit of $4 billion, and the Obama Administration has an ambitious domestic agenda. Inside the Pentagon, defense secretary Robert Gates is "rebalancing" the defense posture to put less emphasis on conventional weapons and insourcing services work that was previously contracted out. Meanwhile, the cost of pay and benefits for military personnel continues its seemingly inexorable upward march.
Clearly, we are looking at a near-term business environment that is likely to be tougher for defense contractors than in the recent past. However, there are plenty of institutional investors who must limit their purchases to the aerospace and defense sector, and many others who feel that the "counter-cyclical" features of defense stocks make them an essential component of any balanced equity portfolio.
The question for these people is which defense companies are likely to perform best in a weak business climate. Bearing in mind that I advise many of the major players in the sector, I'd like to offer a few thoughts. I'll confine my observations to bigger companies that are headquartered in the U.S. and derive most of their revenues from defense -- which means General Dynamics, Lockheed Martin, Northrop Grumman and Raytheon.
General Dynamics is widely considered to be the most shareholder-friendly of the defense majors. For well over a decade it has delivered steadily rising returns from a diverse array of product lines run much as investors might manage a portfolio. What's interesting about GD isn't so much the products it makes as the intense focus of management on generating superior returns in good times and bad. Unlike other big defense companies, GD diversified away from defense by purchasing Gulfstream and other business-jet properties that stand to gain significantly as global recovery proceeds.
On the other hand, GD has also benefited handsomely from its role in providing ammo and armor to U.S. ground forces fighting overseas -- forces that are now beginning to come home. The naval shipbuilding and information-systems parts of the company look uncommonly well positioned for the tough business climate lying ahead, so the key questions are how fast bizjets will trend upward and how fast ground combat systems will trend downward. Past experience suggests GD management will do whatever is possible to avoid disappointing investors.
Lockheed Martin is the biggest player in the defense sector and many observers believe it is the best positioned for the long term. Its aeronautics unit will be the dominant provider of fighter aircraft worldwide for the next 30 years as long as the F-35 joint strike fighter stays on track, and its versatile C-130 cargo plane may be the most successful airframe in the history of military aviation; both planes have huge overseas sales potential in the years ahead. Lockheed's space unit has recovered its status as the leading military satellite builder in the world by winning market share at the expense of competitors. Its electronics business has extended the company's dominance in naval combat systems and has a decent chance of beating GD to win the competition for the Navy's Littoral Combat Ship (another product with major overseas sales potential). Its sprawling services business is the biggest supplier of information services to the federal government. On the downside, services will be under pressure from a host of competitors in the years ahead, there is no guarantee Lockheed will prevail in the warship competition, and the vast size of the F-35 program has led investors to hang on every detail about the program in much the same way they treat Boeing's Dreamliner. Lockheed is not as exposed to Iraq and Afghanistan as some competitors, but it is so pervasive in the defense space that if military spending goes down, the company will probably suffer setbacks.
Northrop Grumman is engaged in many of the same product areas as General Dynamics and Lockheed Martin. It competes and teams with GD in building warships. It competes and teams with Lockheed Martin in building satellites. It competes and teams with Raytheon in building missile defenses. But unlike the other big defense players, Northrop Grumman is in the midst of a corporate transformation because current management is not satisfied with the financial performance of its enterprise. In particular, the company's shipbuilding operations have lagged behind the performance of chief competitor General Dynamics, even though the larger Northrop Grumman yards appear to have significant operational advantages.
More broadly, though, Northrop has extraordinary depth and breadth in aerospace, electronics, and information networks that often is under-appreciated in the investment community due to the secrecy of programs. With the company planning to move its corporate headquarters to Washington next year, Northrop may offer the greatest upside potential of any major military contractor, simply because there is more room for improvement. The company has recently reorganized business units, changed top management, adjusted financial metrics and backed away from non-core businesses, all with an eye on enhancing performance for shareholders.
Raytheon is probably performing better today than at any other time in the last 20 years, generating strong results from existing product lines while branching out into new businesses such as cyber security and intelligence-systems integration. At a time when many Rumsfeld-era networking initiatives are being canceled or scaled back, the company recently won recognition for the successful implementation of a vital spy-agency network. But Raytheon is not like the other three defense companies described above, because most of its work is performed at the subcontractor rather than the prime-contractor level.
So while outsiders can see that it is the biggest producer of missiles in the world and generates a larger portion of its sales from foreign customers, its business is a little harder to understand than that of other defense majors. But there is a positive aspect to that quality, because the company does not appear to be heavily dependent on any one program or product line to sustain its earnings, making it less vulnerable to unpleasant surprises from its Pentagon customer.
The bottom line is that there are reasons why any one of the above companies might prove to be the best sector performer over the next several years, at least on a financial-returns basis. Although they share many of the same military customers and competencies, they are distinctly different enterprises and each has to be appreciated on its own terms. Equally important, they all know that a downturn is likely, and they have been figuring out how to deal with that eventuality for some time. So the next few years in the defense sector aren't going to be like back when the Cold War ended.
The leaders of major defense companies know they have to perform come hell or high water, because their shareholders and boards won't tolerate sub-par results.