Smaller defense stocks seen as bargain amid cuts


Engineer John Gardiner, foreground, and colleagues program the computer that runs an automated ultrasonic inspection system developed by Alliant Techsystems inc.'s ATK Aerospace Structures in Clearfield, Utah, on Friday, Sept. 9, 2011. (George Frey/Bloomberg)
January 20, 2013

Defense companies such as Alliant Techsystems and SAIC have lost value compared with the largest weapons producers, which may make them better bargains as Pentagon spending declines, according to JPMorgan Chase.

Investors paid on average 21 percent more for shares of four medium-sized contractors from 2008 to 2011 compared with five of the top defense firms, according to data compiled by Bloomberg. The premium, based on price-earnings ratios, eroded last year as investors weighed the risks of automatic Pentagon cuts that may begin March 1.

The smaller military contractors trade at a 5.4 percent discount to their larger peers. The shift makes them a more attractive investment than top military suppliers such as Lockheed Martin, Raytheon and Northrop Grumman, according to JPMorgan, which did a similar analysis showing the same trend.

The mid-sized defense companies “look compelling at this stage in the defense budget cycle given our expectation for industry consolidation,’’ Joseph Nadol, a JPMorgan analyst in New York, wrote in a Jan. 8 research report. He said he expects them to “ultimately regain their premium’’ versus larger military suppliers.

Large defense contractors may increase acquisitions this year if Congress and U.S. lawmakers reach a budget deal that provides clarity on future defense budgets, Nadol said.

Smaller military suppliers called attractive

Much of the consolidation will involve the bigger companies absorbing the smaller firms, potentially at attractive prices for shareholders, he wrote.

The five large contractors were Lockheed, Northrop Grumman, Raytheon, General Dynamics and L-3 Communications Holdings. Their fiscal 2011 sales ranged from L-3’s $15.2 billion to Lockheed’s $46.5 billion. Lockheed, based in Bethesda, is the federal government’s No. 1 vendor.

The mid-sized suppliers are Alliant Techsystems, Harris Corp., CACI International and SAIC. Their fiscal 2011 sales ranged from CACI’s $3.6 billion to SAIC’s $10.9 billion.

Valuations were calculated by determining how much investors were willing to pay for each firm’s expected future earnings. For example, Lockheed’s price-earnings ratio on Dec. 31 was 11.2 based on its closing share price of $92.29 and estimated 2013 profit of $8.23 a share, according to data compiled by Bloomberg.

The average price-earnings ratio for the large contractors was 10.1 on Dec. 31, compared with 9.55 for the group of smaller peers.

Lawmakers on Dec. 31 reached a last-minute deal to delay automatic budget cuts known as sequestration, prolonging a period of uncertainty for companies that supply the federal government. Unless they’re averted, about $45 billion in defense reductions for fiscal 2013 are scheduled to take effect March 1.

— Bloomberg Government

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