Defense Selloff Shows Wall Street Doesn't Get Pentagon Efficiency Drive
(Source: Lexington Institute; issued September 2, 2010)

(© Lexington Institute; reproduced by permission)
In June the Pentagon launched an efficiency drive aimed at freeing up money for military modernization. Faced with the prospect of flat defense budgets in the years ahead, defense secretary Robert Gates said he wanted to eliminate waste and redundancy in military spending so plans to buy the next generation of weapons could be kept on track.

The push for greater efficiency should have been good news for defense stocks, because it signaled that military spending on technology could remain robust even as U.S. forces come out of Iraq and the federal government turns to deficit reduction. But investors don't seem to be reading the announcements the way Gates and company intended.

In the three months since the efficiency drive was launched, defense stocks have sold off. General Dynamics has drifted downward from the high [$]60s to the high 50s. Northrop Grumman has declined from about 60 to the mid-50s. Lockheed Martin has fallen from above 80 to below 70. Raytheon has declined from the mid-50s to the mid-40s. Those are four of the five biggest defense contractors -- Boeing trades mainly on commercial transport trends -- and they are all well-run companies. So why is each trending downward at a time when investors should be fleeing a weakening commercial economy for the relative safety of "counter-cyclical" defense stocks?

Defense shares weren't exactly overpriced even before the recent erosion. If you add up the market capitalization of the top five military contractors (shares outstanding times share price), it isn't much more than that of one big commercial tech stock like Cisco or Intel. That isn't so surprising, because the net earnings of Cisco and Intel as a percentage of sales are twice as high as the rates prevailing in the defense sector. But Cisco and Intel are facing the prospect of a double-dip recession in the commercial economy, and that's precisely the kind of environment in which investors are supposed to look favorably on stocks which aren't tied to the commercial business cycle -- stocks like Lockheed and Raytheon.

Perhaps the steady drumbeat of pessimism about defense-sector prospects over the last two years has undercut the traditional counter-cyclical appeal of the equities. But that should have been priced into the shares long ago, and this summer hasn't seen any really bad news for military contractors. Quite the opposite -- it's becoming apparent that many of the contractors can live off of accumulated backlog for years to come without having to worry about major profit declines.

So why the sell-off?

Well, maybe, just maybe, investors don't believe the story policymakers are propounding about where the efficiency drive is headed. Maybe they think the Pentagon is going to squeeze company profits by changing terms and conditions. When your earnings are already hovering in the 6-8 percent region, it doesn't take much to make other kinds of investments look more attractive. And that, it appears, is what Pentagon policymakers have done for their biggest suppliers. What a great customer!

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