67 WALL STREET,
New York--June 12, 2003-- In an in-depth (2,100 words) Analyst Interview,
Peter Arment, a Vice President of JSA Research, Inc., examines the
outlook for the sector and shares specific stock recommendations.
This interview excerpt is part of an in-depth interview from our 25-page
TWST Defense Conference Issue featuring in-depth interviews from an
analyst and top management from five sector firms discussing long-term
trends of defense spending, recapitalization of US military, growth
margins, market shares, current trends, stock recommendations, stocks
to avoid and outlook for the sector. This issue is available to subscribers
by telephoning 212-952-7400 x1799 or through The Wall Street Transcript
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TWST: Can you give us a quick overview of your coverage?
Mr. Arment: Most of my
coverage is oriented toward more of the mid-cap and smaller cap names
within the defense and aerospace sector, names like Alliant Techsystems
(ATK) and smaller names like DRS Technologies (DRS) and EDO Corporation
(EDO). My coverage primarily consists of companies that are generally
under $5 billion in market cap.
TWST: What has gone on
in this group over the past six or nine months?
Mr. Arment: Valuations
have been impacted from a negative standpoint since last October.
At that time we saw a lot of other investors begin to dip their toes
in the water regarding higher technology names, hoping that the economy
was going to be showing some strength and improving. Investors used
the aerospace and defense names, which they had been invested in since
September 11, as a source of funds.
TWST: Has that been kind
of a correct move, given the stock performance, or not?
Mr. Arment: It appears
to be. It looks like there's been basically some multiple compression.
Momentum investors pushed the group to some pretty high levels; now,
we would argue, they are probably in line or modestly undervalued,
given the overall market, and the economy.
TWST: Now we are in a "postwar"
type of period, where do we go from here in this group?
Mr. Arment: I think the
group's performance is going to be based more on execution. The long-term
trend of defense spending remains intact in terms of the recapitalization
of the US military. Therefore, the contracts are beginning to flow,
and it's up to the companies to be able to deliver the higher earnings.
TWST: Where is the money
going to get spent as we look forward?
Mr. Arment: Various platforms
are going to be upgraded or replaced, such as older Air Force fighter
and tanker aircraft, armored vehicles and ships. In the intelligence
community, a whole breadth of technologies are going to be continually
procured - from signal intelligence to various surveillance and reconnaissance
technologies and lots of IT security-related products, especially
from a secure communications standpoint. Regarding research and development,
a lot of money is being spent in the missile defense area, which will
continue to happen over the next decade. There are also a lot of emerging
technologies that will be probably involved more with the Homeland
Security Department - things dealing with border security and various
biometric technologies for fingerprinting and a continuation of the
baggage explosive systems for packages and cargo containers.
TWST: What kind of growth
are we likely to see in defense spending over the next couple of years?
Mr. Arment: I think, when
you look at the overall defense budget, you're looking at 5%-7% for
the next several years. Procurement and research and development accounts,
which are really what are considered the investment accounts, will
be growing more in the range of 8%-10% on an annual basis. That's
the real focus for investors.
TWST: Were there any big
positive surprises or any negative surprises in the first quarter?
Mr. Arment: No negative
surprises that stand out. Northrop (NOC) beat estimates better than
expected, and I think that was a little bit of a surprise. They also
raised their guidance for the end of the year. I don't think investors
were expecting that, so I think that was probably the biggest surprise.
TWST: What names are you
recommending to investors today?
Mr. Arment: We're still
recommending ATK, a pure play on the ammunition side of things. We're
recommending EDO, which is benefiting from a lot of the aircraft that
are entering production, the F-22, and a lot of money being spent
on the JSF and bomb rack upgrades to the F-16 fleet. They're benefiting
across the board in all those areas. We are also recommending Curtiss-Wright
(CW), which has made a few acquisitions over the last year and has
raised their defense exposure now to close to 50%.
TWST: With ATK, what's
the prime appeal to you there?
Mr. Arment: Not only is
it a war stock, where you're benefiting from the replenishment of
the weapons that were expended, but we're also seeing an improvement
in terms of our spending on precision weaponry. ATK has about 40%
of their revenues tied to precision weaponry. So over time, as we
continually spend more money in that area, they're going to be a beneficiary.
TWST: How about EDO? What's
the appeal?
Mr. Arment: EDO is similar.
They made a few acquisitions and have positioned themselves quite
well. They happen to be the world leader in terms of bomb racks, which
is what ultimately holds the missile inside a fighter aircraft. As
the weapons have gotten smarter, so have the racks and so they're
receiving contracts to upgrade a lot of our current fighter aircraft
with the smart racks. They're also seeing the benefits now of the
F-22 moving to higher rates of production.
TWST: How long are these
contracts typically? Are they one shot or one platform or do they
run more broadly for somebody like EDO?
Mr. Arment: Usually with
the Defense Department, you're looking at multi-year contracts with
options that are funded on an annual basis, so you usually get awards
that probably have two- or three-year time horizons.
TWST: Is there much competition
for what they do?
Mr. Arment: No. They're
pretty much the only game in town regarding bomb rack technology.
Now, Lockheed (LMT) and Boeing (BA) can develop it themselves internally,
but they have to do it at a much higher cost, so they choose to just
partner with EDO when it involves developing the aircraft.
TWST: The other one you
mentioned was Curtiss-Wright. That's kind of an old name.
Mr. Arment: It's an old
name, but they really have changed their focus over the last two years,
going from a company that was heavily oriented toward the commercial
aircraft cycle to being one that's now got a more even mix with as
much as 50% tied to defense spending. They're really a very highly
engineering product company with very high barriers to entry regarding
their products, such as leakless valves in submarines. Curtiss-Wright
has over $60 million of content per submarine. In 2007 the US will
start procuring two subs a year, so immediately their revenues, regarding
submarines, in that one year will go from $60 million to $120 million.
They have similar related contents on ships and aircraft carriers.
When the shipbuilding rate goes from five to 10 over the next five
years, Curtiss-Wright will experience double-digit organic growth.
This interview excerpt
is part of an in-depth interview from our 25-page TWST Defense Conference
Issue featuring in-depth interviews from an analyst and top management
from five sector firms discussing long-term trends of defense spending,
recapitalization of US military, growth margins, market shares, current
trends, stock recommendations, stocks to avoid and outlook for the
sector. This issue is available to subscribers by telephoning 212-952-7400
x1799 or through The Wall Street Transcript