Wall street keeps wary eye on defense biz.

Author:Erwin, Sandra I.
Position::Defense Watch

There are many reasons why Wall Street hearts the defense industry. As analysts see it, top defense CEOs have proven to be exceptionally smart at financial engineering and dealing with investors. Even in these times of steep military budget cuts, industry stocks have reached new heights.

As companies defy gravity by slashing expenses and returning cash to shareholders, they continue to puzzle Wall Street analysts and financiers. Nobody knows if or when investors will begin to retreat, but so far financial experts continue to be favorably surprised by the performance of Pentagon contractors.

"Returns to shareholders are much higher in defense than in other parts of the market," said David Strauss, aerospace and defense industry analyst at UBS.

Defense investors today are widespread. They include large mutual funds, pension and hedge funds. Investors have shifted their money to Pentagon contractors gradually over the past several years, Strauss said last month at an industry conference. In 2008 and 2009, there was a lot of tentativeness about defense stocks going into a downturn. But companies have managed the military cutbacks very differently than they had done in the past.

Following the post-Cold War downturn, companies rushed to acquire and merge with other companies, but not this time.

Another factor that swayed investors is that the budget has held up better than most analysts had predicted, Strauss said.

"We expected defense budgets to go down 50 percent. Today it has dropped less than 25 percent." Sequestration is seen as a negative, but the defense top line, even under reduced spending caps, is projected to go up modestly after 2017. "That's better than what we were thinking before," said Strauss.

Defense firms, while loved by near-term focused shareholders, have been spurned by private equity. One firm that built its cachet on its ownership of defense contractors, The Carlyle Group, has slowly left the sector. Carlyle, with more than $200 billion in assets, has done about 80 deals over the last 20 years in defense and aerospace, but none in the defense sector since 2008, said Managing Director Frank Finelli. "That's because we're finding better risk-adjusted returns in other sectors in the U.S. and globally," he said.

Some areas of the defense sector are appealing, but private equity investors worry about the long term. When they buy companies, their intent is to own them for five to 10 years.

"We bring a different perspective,"...

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