Stop Sitting on Defense

DRS Technologies (DRS) delivered annual revenue growth of 27%, a 34% profit boost, a 39% rise in bookings and a record orders backlog. "Our outlook for the company in fiscal 2004 is very positive," burbled the boss. "We anticipate greater momentum as the year progresses."

And by the time traders were done rewarding Parsippany, N.J.-based DRS for its rosy prospects and punishing Cisco for lack of same, the anemic giant still carried a much higher forward price/earnings ratio (27) than the hard-charging middleweight (17). I'll trust the first tech rally that rectifies this injustice. Because the military contractor's acquisition-fueled promise of "Tomorrow's Technology Today" sounds far more attractive than Cisco's current goal of yesterday's sales tomorrow.

DRS enjoys several tangible advantages over Cisco. First, its hardware isn't in danger of becoming a commodity. Its blast-resistant laptops and finicky electronic sensors sell at prices a quantum leap above eBay's or Radio Shack's. Second, the only DRS customer that really matters happens to be one of the few around with a steadily expanding capital budget. The Pentagon will be stuffing new planes, ships and tanks with the firm's computers, surveillance equipment and targeting systems for years to come.

And DRS won't be the only beneficiary. Quite apart from the hefty tabs for combat in Afghanistan and Iraq, military planners have embarked on the biggest defense buildup since Ronald Reagan shook his big stick at the Evil Empire.

Much of the Pentagon's newfound acquisitiveness is driven by the need to replace machines that aged while everyone was celebrating the post-Cold War peace dividend. Then there are the longstanding commitments to weapons-development programs starved of cash during the 1990s but never killed.

And of course the Bush Administration has now compiled its own must-have shopping list, featuring ballistic missile defense, smarter bombs and drones, a new class of aircraft carriers and the communications gear to mesh all those systems seamlessly in the heat of battle. The Pentagon's new Holy Grail is network-centric warfare . The hope is that, one day, linked-up commanders will be able to coordinate battlefield operations with the precision and speed approaching that of 12-year-old video-game jockeys at a LAN party.

Coincidentally, rising government orders were one of the few bright spots in Cisco's most recent sales tally, though there are far more direct plays on Uncle Sam's sudden passion for IT.

How much will all of this cost? The Pentagon's development and procurement allocations add up to $137 billion in fiscal 2004, and are expected to rise to an inflation-adjusted $171 billion over the next five years — a 25% gain. And the Congressional Budget Office doesn't expect such investment spending to peak until 2013, when it could total $223 billion, in today's dollars. If I were Syria or Belgium, I'd be terrified. And, naturally, those sums omit all of the hardware required by the vastly expanded intelligence and homeland-defense budgets.

Moreover, this gravy train isn't half as controversial as the 1980s express, and thus might enjoy a longer ride. The economy grew rapidly during the 1990s while defense spending shrank. So while Ronald Reagan's America spent 6% of its gross domestic product on defense, George W. Bush's expended barely more than 4% over the past year — including the huge supplemental costs of occupying Iraq and pacifying Afghanistan. Assuming the Pentagon gets all the toys on its wish list but stays out of major new wars, defense's share of the national output could decline to a very manageable 3.3% of GDP by 2009 and perhaps less thereafter, the CBO projects.

Meanwhile, the number 9/11 ensures that much larger figures fly through Congress virtually unchallenged. The 2004 defense appropriation, for example, was approved 399-19 by the House and 95-0 by the Senate, with minimal grandstanding and only modest pork-barrel stuffing.

This belated bounty is headed for the bottom line of a defense complex restructured to weather the lean 1990s. Mergers have reduced the roster of major Pentagon contractors to five from 15. Costs have been pruned to pay down heavy debts and bolster underfunded pension plans.

And the stocks are still relatively cheap, having surrendered some of 2002's big gains. Shares of the two sector leaders, Lockheed Martin (LMT) and Northrop Grumman (NOC) are down more than 30% from the year-ago peaks. Combined, the two have more than double Cisco's sales, but less than a third of its market capitalization. Each has a forward P/E ratio of roughly 20, significantly below Cisco's.

The disparity is predicated on the thesis that, at some point, a broad economic recovery will have Cisco growing again far faster that the defense contractors constrained by tight margins and government red tape, not to mention the mounting budget deficits.

But I think the thesis is wrong. The telephone giants who remain Cisco's main customers have very little pricing power and cloudy growth prospects, as competition drives their own margins ever closer to zero. Fast-growing Chinese rival Huawei (sales rising at 30% annually) poses a long-term threat to Cisco's bloated margins but none to Lockheed Martin's, given Huawei's links to the Chinese military. Whereas Cisco is sufficiently concerned to press a patent infringement suit aimed at preventing Huawei and partner 3Com (COMS) from selling Chinese-made equipment in the United States.

For now and the foreseeable future, the tailwind seems to be with the arms makers, which keep finding ways to top expectations. One Wall Street number-cruncher described Lockheed's 22% annual sales gain in the latest quarter as "startling." Dow Jones Newswires gushed that Northrop's latest results "show why the Los Angeles company is the darling among analysts."

More risk-tolerant investors could do worse than DRS Tech. It faces a much smaller pension overhang than the Big Five, subcontracts for an exceptionally broad range of weapons platforms, and has recently aggressively expanded into Pentagon hot-button areas like unmanned drones and C4ISR. That's militarese for Command, Control, Communications, Computer, Intelligence, Surveillance and Reconnaissance. Civilians might call it a network.

The downside: mergers cost money, and in the case of DRS some of the money it has spent on recent acquisitions has been borrowed. Still, the firm's long-term debt-to-equity ratio of .33 compares favorably both to the defense industry and the S&P 500, the more so given a track record of 30% annual earnings gains.

L-3 Communications (LLL) is another fast-growing, acquisition-fueled contractor run by industry veterans. It supplies a lot of the gear used by the nation's spooks and the bomb-detection machines recently installed at its airports.

Volatility-addicted Cisco diehards could always opt for the bytes-not-bullets military IT plays like Anteon International (ANT) and Caci International (CAI), whose sales and profits have exploded alongside government demand for computer network security. The problem here is that their shares have also skyrocketed this summer on speculation that each might be an attractive takeover candidate for the industry leaders. Each now sports a valuation almost as rich as Cisco's.

But most defense-stock charts seem to be doing nothing much. Tech investors might soon find that attractive.