Armaments And Investments

Investing in defense companies is different from buying into most other industries. For starters, a company's income depends largely on the Pentagon and Congress. In choosing stocks, the political and military winds often matter as much as a company's operations. A weapon in favor one year could be canceled the next, requiring investors to stay sharply attuned to the companies' lobbying efforts and political clout. A company's bottom line can also be affected by government oversight. Congress has recently stepped up its criticism of firms for late and over-budget programs.

"The defense industry has done very, very well without much oversight from Congress," said David Strauss, U.S. aerospace and defense analyst for UBS Investment Research.

He noted that in the past, companies were not forced to absorb some of the expenses when a program exceeded its cost targets. "Now you've got Congress trying to put a closer thumb on that," Strauss said.

In a May industry survey, Standard & Poor's said: "The military weapons-buying business operates in a highly regulated environment." Put another way, the report added, the budget process by which contractors get money is "arduous and unpredictable."

Investors also find themselves somewhat in the dark about what exactly they're getting for their money. Often a good chunk of larger defense companies' operations are classified, meaning investors can't get a full picture of what's generating a firm's revenue.

"Even for people on Wall Street, it's very, very hard for us to know how much individual companies are benefiting from classified areas," said Strauss.

Intelligence spending is on the rise, analysts say. One hot area is information technology for gathering intelligence and identifying enemies, said Eric Hugel, an industry analyst for Stephens Inc. "I mean, there is a lot money going into these things, we just don't know how much, but theoretically it's a lot," Hugel said.

The excitement about this sector was evident last year when Northrop Grumman bought Columbia-based Essex. Northrop sought Essex because it specializes in classified technology used by the National Security Agency and other agencies. Northrop paid about $580 million for Essex, whose technology processes signals, images and information the agencies collect. Essex's projected earnings of $250 million to $300 million this year made Northrop's purchase among the priciest for a federal information technology firm in recent memory, according to Jefferies Quarterdeck, a mergers-and-acquisition investment-banking firm that served as Essex's adviser.

Information technology companies operating in the more prosaic arena of Pentagon computer upgrading and database integration have been attracting less funding in recent years. These firms, which flourished after the Sept. 11, 2001, terrorist attacks, are now losing out to sexier IT companies involved in intelligence. Organic revenue growth in the sector has declined to about 5 percent from an average of 20 percent in 2004, said Bill Loomis, a government-technology analyst for Stifel Nicolaus. The information technology company CACI International, for example, has lowered its earnings expectations and seen its stock slump in recent months. CACI of Arlington is down 12 percent this year.

"In the 1990s, the federal IT budget was growing faster than the overall defense budget. Now that has switched," Loomis said. "You don't have to put the next generation of financial software in place in a time of war, so we tend to see a number of those engagements slow down."

In the long term, the defense companies' fate could depend on the ballot box and the war. "I am positive on defense stocks still, but there is cautionary note in background. There could be potential cuts to the budget, particularly if we get a Democratic president and Democratic Congress," said Richard Tortoriello, equity analyst for aerospace and defense at Standard and Poor's.

Republicans have held down funding for non-defense projects, which has helped the Pentagon budget grow, Strauss said. "If Democrats focus on [increasing] non-defense discretionary spending, it will be difficult for the defense budget to continue to go up," he said.

And what happens if the war ends? Some analysts think the big players such as Lockheed Martin and Boeing could benefit as the focus returns to the long-range transformation of the military. "After we get out of Iraq, there has been a lot of investment activity that has been delayed that will be put back on track," said Scott Sacknoff, manager of the Spade Defense Index.