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The Defense Haven Isn't Overcrowded Yet; The Covid-19 crisis highlights the attractiveness of defense contractors, but unwarranted fears about the U.S. government's borrowing capacity are still holding back valuationsThe Defense Haven Isn't Overcrowded Yet; The Covid-19 crisis highlights the attractiveness of defense contractors, but unwarranted fears about the U.S. government's borrowing capacity are still holding back valuationsSindreu, Jon.Wall Street Journal (Online); New York, N.Y. Defense companies are widely acknowledged to be a good place for investors to hide in an economic downturn. In the Covid-19 crisis , though, investors have yet to put much of their money where their mouth is. On Thursday, Raytheon Technologies, the aerospace-and-defense giant resulting from the recent merger of United Technologies and Raytheon , reported its first-ever results, beating analysts' estimates for revenue, cash flow and adjusted earnings. The company's shares still fell almost 1% when the stock market opened. Since the start of the pandemic-driven selloff in February, the new Raytheon's stock performance has been stuck somewhere between that of companies that focus on commercial aviation such as Boeing and Airbus, which are facing years of depressed travel demand, and pure defense contractors including Lockheed Martin and Northrop Grumman, which recently reported bumper first-quarter earnings. Former United Technologies shareholders such as Pershing Square's William Ackman felt that its jet-engine unit was undervalued relative to the old Raytheon's unexciting defense portfolio. As it turns out, the former had more to lose, due to the cyclicality of commercial aviation and particularly the aftermarket repair-and-maintenance business. Raytheon said Thursday that its commercial aerospace shop visits were down as much as 75% in April from a year ago. Bernstein Research estimates that about 40% of its engine aftermarket sales are tied to old plane models such as Boeing 757s and 767s, which are being retired by airlines. Elsewhere in the sector, General Electric will cut 13,000 jobs from its aviation division, and Britain's Rolls-Royce is preparing to slash 8,000. Yet Raytheon still expects to make money in the second quarter, thanks to pure defense programs. These include a contract it recently won to replace the U.S.'s existing Patriot missile radar, which will provide more than $10 billion in long-term revenue. Before Covid-19, a six-year profit boom at defense companies appeared under threat, as increases in the U.S. Department of Defense's investment spending inevitably retreated from records. Now, those same predictable income streams are suddenly much more valuable to investors. However, valuations don't appear to have fully caught up. Lockheed's stock, despite being a top performer this year, is still trading in line with the S&P 500 relative to recent earnings, rather than at a premium. Many analysts and investors seem to fear that the U.S. government will struggle to repay this year's debt splurge and will soon need to slash spending. While this scenario does have a precedent following the 2008 crisis, it was the exception rather than the rule: Historically, recessions have rarely impacted military spending, not least because Washington's ability to issue public debt in its own currency is virtually unlimited. The long-term U.S. strategy of retiring the remnants of Cold War defense technology to keep pace with China and Russia is likely to prevail, even if some money is eventually slashed from overseas contingency operations. Another potential worry for defense firms is that low oil prices could put pressure on spending coming from the Middle East. As Raytheon Chief Executive Greg Hayes said Thursday, though, "I don't think peace is breaking out anytime soon in the Middle East." Whether it is better for the world or not, there may still be gains for investors to squeeze from defense stocks. |
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