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Defense stocks may jump higher with big profits
The Washington Post
By Bill Rigby
Wednesday, April 12, 2006

NEW YORK (Reuters) - Shares of U.S. defense companies, which have nearly trebled since the beginning of the occupation of Iraq, show no signs of slowing down as investors anticipate strong first-quarter profits this month.

U.S. defense spending is rising faster than expected -- confounding experts' who predicted a slowdown -- and rumors of cuts to big programs have not turned into reality. Allied with a boom in commercial aerospace, the profit outlook for defense contractors has never looked more robust.

"All the defense companies -- with very few exceptions -- have been doing extremely well with mostly double-digit earnings growth," said Paul Nisbet at JSA Research, which specializes in aerospace and defense stocks. "And it's not just the military side, it's the commercial side as well. We're in the early stages of a maybe five-year up cycle."

The feeling that makers of ships, planes and weapons are just getting into their stride has driven shares of leading Pentagon contractors Lockheed Martin Corp. <LMT.N>, Northrop Grumman Corp. <NOC.N> and General Dynamics Corp. <GD.N> to all-time highs in the past few weeks.

Boeing Co. <BA.N>, which makes military jets and weapons systems as well as commercial airliners, hit an all-time high on Wednesday, while component makers like Rockwell Collins Inc. <COL.N> and Precision Castparts Corp. <PCP.N> also hit all-time highs this week. Barring any hiccups, they look set to move even higher as they report quarterly profits over the next few weeks.

"First-quarter defense company earnings should continue to be strong, as procurement and research and development outlay will increase by an estimated 7 percent," said George Shapiro at Citigroup Investment Research.

At the end of last year, most experts were predicting a 4 percent to 5 percent year-on-year growth in defense spending, as the administration tried to get a grip on the ballooning budget deficit. But contractors are actually seeing much stronger growth as the administration is spending billions of dollars more on operations in Iraq and Afghanistan, funded by separate, supplemental budget requests.

The U.S. Army is showing the greatest growth, said Shapiro, with spending up as much as 20 percent over last year. That would benefit companies like General Dynamics, which makes Abrams tanks, DRS Technologies Inc. <DRS.N>, which makes mobile power generating equipment, and L-3 Communications Holdings Inc. <LLL.N>, the maker of a range of military electronics.

The only visible constraint on defense firms appears to be their increasingly high valuation relative to other stocks.

The Amex Defense Index <.DFII>, which has risen 26 percent since October -- and almost trebled since March 2003 -- is now trading at about 18 times forecast earnings for 2006. That is comfortably above the Standard & Poor's 500 index <.SPX>, at about 15.4 times.

That means investors could be looking for an opportunity to cash in, and may punish any unexpected slip-ups.

"They (defense stocks) are above normal prices, but that is based on above-normal expectations," said Nisbet. "If those expectations are dashed by one or two companies, they are certainly going to feel it in their stock prices."

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