War, what is it good for? Rising profits for defence contractors

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There was a time, not really so long ago, when there was deep pessimism about U.S. defense-contractor stocks.

A new President vowed to end the country's disastrous war in Iraq, ushering in a sort of Pax Obama. Then, a financial crisis evolved into a fiscal crisis that looked as if it might cripple Washington's discretionary spending for many years to come.

Well, never underestimate the U.S. war machine. A bipartisan consensus has evolved that it's time to drop billions more dollars on the country's military. Defense stocks have already zoomed in anticipation: Most of the major defense contractors have seen their stock prices double since Barack Obama's second term began in January, 2013.

But all the coming spending may not be reflected in those share values yet, says Jason Gursky, an analyst at Citigroup Global Markets Inc. As summer waned, most of the big defense stocks priced in anticipated cash flow growth of 0 per cent to 2 per cent per year. But Gursky argues that the average growth rate could be closer to 3 per cent.

Here's the logic: "We seem to have agreement between Congress and the President that the military of the future ought to be smaller, more agile, and more technologically advanced," says Gursky. As a result, Washington will tilt new spending in favour of equipment, rather than troops. He expects that the budgetary accounts for military personnel, operations and maintenance will fall below the 2 per cent growth trajectory, and the weapons-buying accounts will move above the 2 per cent growth trajectory.

Although it's somewhat of a "perverse way to think about it," Gursky argues that Congress and the White House are behaving like a good CEO would coming out of a recession. During a slowdown, orders for a company's products and services diminish. "You usually cut heads and invest in productivity-enhancing technology," he says. "Then, during the macroeconomic expansion, you hire the heads back and put them to work on this technology you invested in during the downturn."

Among defense contractors, that strategy favours "the guys who make things that fly and float," says Gursky.

The biggest winners will include: Lockheed Martin Corp., Raytheon Co. and Northrop Grumman Corp. for missiles and airplanes; Huntington Ingalls Industries Inc. and General Dynamics Corp. for the seas.

The Pentagon's workforce will eventually increase, too, of course. "When the next war comes around, we'll hire the heads back," he says. "Like it or not, the United States is a fairly war-mongering country. We've been at war, on average, every two years of our existence. I don't think it's a question of if, it's when."

SHOPPING LIST:

• F-35A Lightning II stealth fighter (Lockheed Martin) - $85-million per plane
• Tomahawk cruise missile (Raytheon) - $1.6-million each
• RQ-4 Global Hawk drone surveillance plane (Northrop Grumman) - $222-million each
• Gerald R. Ford-class aircraft carrier (Huntington Ingalls) - $10.4-billion
• Virginia-class attack submarine (General Dynamics) - $2.7-billion per sub

Despite recent gains, the biggest U.S. military contractors are still trading at forward price-to-earnings ratios below 20

• Lockheed Martin 18.1
• Boeing 18.0
• Raytheon 16.6
• General Dynamics 17.4
• Northrup Grumman 18.1
• United Technologies 16.0
• Huntington Ingalls 13.5