Defense investing
KAREN GIBBS: It's been a difficult year for troops stationed in Iraq, and this week President Bush insisted we will not cut and run, telling the nation he's prepared to send in more troops if necessary. The war in Iraq is proving to be very different from the one military officials planned and trained for, and that's also leading to some big changes for the defense industry back home.
Wall $treet Week with FORTUNE contributor Michael Farr has been looking into this transformation for us. Tim Quillin, an analyst at Stephens Inc., says the remarkable thing about this war has been the innovations in equipment designed to keep our troops out of harm's way.
Let me start with you, Michael -- what's the impact of a longer, more expensive war?
MICHAEL FARR: The impact I think, Karen, is severalfold.
First, we saw a dramatic increase in defense spending between the first quarter of '03 and second quarter of '03, some 46 percent. What does that mean? It means that we've seen the big jump in the increase in defense spending. So in a very cyclical business, I think a lot of what is going to occur, and a lot of the benefit for a lot of the big companies, big defense contractors, is already in those stocks. So if it continues on for a long time, there might be some added benefit.
Really, the next question here, I think, is probably political. If Bush continues to stay in office, gets reelected, then he maintains that big defense budget. If Kerry, there's a notion out there that the defense spending will decrease.
GIBBS: Tim, I know that you are a security analyst covering these areas of defense, but I also know that you served in the first Gulf War, Desert Storm/Desert Shield. Can you give us some flavor about what our troops are facing now as compared to then?
TIMOTHY QUILLIN: Well, I thank God that I served in the first Gulf War as a bomb disposal technician because the current threat scenario in Baghdad is a lot more dangerous than what I faced in Kuwait City. You know, the big difference between this war and maybe all wars is that the real danger started when the initial hostilities ended, and so force protection is really becoming a critical issue within the military.
So once we become an occupying force, how do you ensure security for our soldiers? How do you ensure that they're protected?
GIBBS: How do you ensure that they're protected?
QUILLIN: Well, there's no assurances, that's for sure. But there are certain measures that we can take, such as making sure that the soldiers have the proper body armor, making sure that the soldiers have the proper vehicle armor that is some protection from small arms fire, some protection from blasts.
FARR: Tim, you follow a lot of mid-cap and small-cap companies in that space. Is there still room for appreciation there, or are they like the big caps where the move is done?
QUILLIN: No. I mean certainly a lot of the good news has been -- if you want to call it good news -- has been factored into the stocks, and we've seen a lot of the stocks go up, but I think investors have sensed that that's the case, and the real question is that, you know, how sustained is our presence in Iraq and to what level do we want to build our protection? And certainly the picture looks bleaker, and so maybe investors are underestimating the benefits that we might see in a company like Armor Holdings which does make the body armor and vehicle armor, and is kind of squarely positioned for that force protection market. They're the sole source provider of up-armored Humvees for the Army.
GIBBS: Up-armored means?
QUILLIN: Up-armored Humvees means that there's armor placed on the Humvees right after they come off the assembly lines.
Or another company I would point out is Flir Systems, which makes infrared cameras. Infrared technology is becoming vital in a lot of different areas, and certainly used for perimeter protection and in other examples where there's a need to see at night or see through smoke or see through fog.
(Note: Stephens has an investment banking relationship with Flir Systems)
GIBBS: Tim, there were two other companies that came up on your radar, DHB Industries and Ceradyne. Can you talk about those two?
QUILLIN: Yeah, DHB and Ceradyne, again, are kind of aligned with the body armor, the need for body armor in Iraq. DHB Industries makes interceptor body armor, and Ceradyne makes ceramics, it's actually a ceramics company that makes small arms protective inserts for body armor and kind of upgrades the body armor for our troops overseas. So they are also aligned with the force protection market.
GIBBS: Michael, this nation is firmly behind our troops that are fighting this war in Iraq, but it's not turning out to be the war we expected. Play out what you're hearing in Washington right now.
FARR: A number of things. Of course June 30 is the crucial date for the turnover of control to some sort of government in Iraq. It seems to be a political necessity for George Bush because clearly public sentiment is waning against the support of an ongoing conflict. The lives that are being lost, American lives that are being lost is just devastating I think to all of us. So it's a major issue. That's going to be crucial. Again, there seems to be no easy answer to extricate the U.S., and until we come up with one, I think it's going to continue to be a most difficult issue.
Two issues for this election right now: the economy and Iraq. And June 30 is crucial.
GIBBS: Congress is under some pressure now to find money to help our troops. What does this mean for the deficit and for interest rates?
FARR: It's ironic, Karen, that too much defense spending could be a bad thing, even for the defense companies, because it will increase the deficit and therefore put pressure on Congress to cut spending in the future, which of course the first place to go would be the highest, the highest wallet, the biggest wallet out there, which is the defense budget. So increased defense spending, good; too much is not so good. And Congress is going to have to cut. We can raise taxes all we want, but this $550 billion deficit is really enormous.
GIBBS: Tim, I want you to put your military hat back on and tell me some of the problems and challenges that our troops are facing on the ground as opposed to what you saw in Gulf War I.
QUILLIN: One of the constant challenges that we faced in the first Gulf War was communications, and it seemed like we could never get our communications set up and running properly. And in the current Gulf War, there's actually contractors deployed in Iraq that serve as sort of a help desk to help ensure that those communications are operating properly.
Another problem that we faced in the first Gulf War was figuring out where exactly we were. This was before GPS. So now a lot of the troops have GPS, know exactly where they are.
GIBBS: Very interesting that now that is in our lexicon, we use that (GPS) just as an everyday thing, almost like electricity. What other types of innovations in the military do you think can filter through to the consumer here?
QUILLIN: Well, that's a good question. I think that we're going to see a proliferation in communication techniques.
Anteon International, a very well-run company as well, that services I think 85 or 90 percent of their business is with the Department of Defense, primarily the Navy. The type of things they would do would be setting up command and control systems on Navy ships, and primarily making older weapons systems better and smarter.
And to your point about a rising budget deficits and perhaps making some hard decisions about what type of defense programs to cut, certainly the bigger ticket items are the easier targets: a Joint Strike Fighter program, an F-22 aircraft program, or some of the newer ships that the Navy is looking to build. So what we're going to have to do is figure out a way to do more with our current and somewhat older weapon systems and platforms. And you do that through better communications and more modernization of those existing systems.
FARR: We do, Karen, continue to see these new technological advances that come as a result of increased government spending during these periods.
We're seeing machine vision technology. Where we used to have sensors on the Canadian border, now we have cameras that can actually distinguish between a deer or between a human being. They can put them in airports, attach it to a computer, and say that if someone puts down a bag and walks away from it, an alarm goes off. It's a new level of security that they take a Flir Systems camera with machine vision and they can put it on an unmanned attack plane that can actually target, think, and see the difference between a cow and a tank or a car or a Jeep or something like that. So these advances are also terrific, leading to new corporate development and new business formation.
GIBBS: Tim, what are the lessons from this conflict that the defense industry is learning about the future of warfare?
QUILLIN: It's a changing environment and it's certainly (changed) from 50 years ago when tanks and ships ruled the battlefield -- now it's technology and communications and information that rule the battlefield. And I think what that translates into is, there's going to be less need for new tanks, new ships, even new aircraft, and just growing demand for technology and the companies that implement that technology for the government.
GIBBS: Michael, do you agree with that?
FARR: I do. Certainly, we have no more precious resource than our young men and women in this country. So to the extent that that can happen, I think the better.
GIBBS: All right. Well, Michael Farr, Tim Quillin, thank you very much for joining us.
Steve Leuthold interview
GEOFF COLVIN: Well, his technology is unglamorous -- it includes pencils and ledger books -- but his results have been beautiful. Steve Leuthold is one of Wall Street's most respected researchers, having called the start of the great bull market in 1982, the market crash of '87, and the tech stock insanity of the late 90s. More recently, he spotted the market bottom in October 2002. It does make you want to know what he's thinking -- and what he's buying -- right now, with the market spooked by interest rate worries. Steve joins us from Minneapolis.
Steve, even now after the recent small decline in stocks, there are analysts who think the market is pretty richly valued. You say now is the time to get more heavily into stocks, and you have done so. How come?
STEVE LEUTHOLD: Well, Geoff, first I'd like to tell you, I no longer use a quill pen.
COLVIN: Well, that's encouraging. That may be progress.
LEUTHOLD: And we do have a lot of people that do use computers and so on in our shop. I think the market is overvalued as well, but it's not, it's not as overvalued as it normally has been at cyclical market peaks, so we think the market has something left in it, and maybe around 20, 21 times earnings, that's been the normal cyclical peak. It hasn't been like 2000 or some of these extremes. But, yeah, so I think we've got farther to go, but it's not cheap.
COLVIN: It's not cheap, but by your counting it is what? Maybe 18 times earnings?
LEUTHOLD: Yeah, really. I mean we're looking at maybe $63, $64 on the S&P, so that's about right, yeah.
COLVIN: Okay. Well, the market was spooked big time this past week, especially on Tuesday by worries that inflation is coming back, and if so the Fed will raise interest rates and stocks will get hammered. I gather you're not so worried.
LEUTHOLD: Well, no. Actually the market does pretty well in the first stages of an interest rate rise, because that's merely a reflection that the economy is doing better. And we've looked at, oh, since World War II, 11 periods where interest rates have been rising for an average of maybe 18 months, and the market has gone up an average 37 percent. So it isn't till you get into those third, fourth, and fifth rises in interest rates, the three-steps-and-stumble type of philosophy, that you get in trouble.
COLVIN: So for now when the market does fall down on those kind of fears, it's an opportunity, as far as you're concerned.
LEUTHOLD: Well, that's right. If you actually look at the history of the first kick up by the Fed, the market went down an average in the week about 1 percent in the week following that, but if you go out for two weeks, you had an average market that was up 1 percent. You go out a year, it's up 9 percent. So it's not anything to be really concerned about, but traders are very concerned about it because they say higher interest rates, bad for the stock market.
COLVIN: They are, and in fact the market now seems almost obsessed with when the Fed is going to raise rates next. And the conventional wisdom has been not for a long time, probably not before the election. What's your view?
LEUTHOLD: Well, that's another kind of old wives' tale about the Fed never raising interest rates in a presidential election year. We looked at the numbers, and there's been I think 14 presidential elections since World War II, and you saw the Fed raise interest rates in that year of election seven out of the 14 years. So it's happened before, and I think it's probably going to happen again.
COLVIN: REITs have been very hot in the past 12 months. We've talked about them on this program in past months. A lot of people own them now. Are they still worth buying?
LEUTHOLD: Well, we've been big fans of REITs for a number of years, up until, oh, the last four to five months. And what happened as we looked at it, we look at REITs in their relationship to the underlying value of their assets, of their real estate holdings. And we got up to a peak where they were valued at 30 percent higher than the appraised value of their real estate holdings, and that made us kind of nervous about it. We were also nervous because on a contrary basis they had become one of the most popular areas for mutual fund investors, and when you see a herd movement into a certain type of fund, I think that's a real danger sign.
So we moved out of the REITs, oh, maybe a month and a half, two months ago, and of course now they're down 12 percent in the last couple of weeks, and we've eliminated a good part of that premium, so maybe if the weakness continues, it's maybe time to start looking at them again, but we're going to wait for a while.
COLVIN: You've recently bought some stocks from a group that you call undervalued and unloved.
What do you see in a stock like General Motors, for example? They've been losing market share to Toyota.
LEUTHOLD: Well, this is a -- they really are pretty much unloved. This is a screening that Jim Floyd in our shop has been doing since 1976. We have six criteria; in order to qualify, a stock has to meet five of those. They relate to price to cash flow, P/Es and so on.
And we think that the market is shifting back toward some kind of a value focus, or at least the focus is getting closer between value and growth. And these stocks are strictly what the name is, undervalued, which we think they are, and they're unloved, and that's most institutions don't like them.
COLVIN: You've got not only General Motors. A few others are Sears, J.P. Morgan Chase, ACE Limited. Looking good to you?
LEUTHOLD: I think it's cheap merchandise and we have to be patient with it. Maybe this is a time not to buy such exciting things.
COLVIN: There's another big topic in the air, and that's the election. Judging solely from your point of view as an investor, who should investors be voting for in November, George Bush or John Kerry?
LEUTHOLD: Well, I guess the normal reaction (from an investor's point of view) would be to say George Bush, but frankly I think the best environment in Washington is where power is between both parties, rather than the Republicans dominating as they currently do. One of the reasons I think it's the best is because in that environment Washington tends to do as little as possible, and that's good.
COLVIN: So vote for whom you like, but split your vote, right?
LEUTHOLD: Yeah. I think the economy is, the American electorate, ever since World War II, no incumbent president has ever been defeated if the economy is strong. So Bush is really going to have to screw up very badly between now and the election to get defeated, because Americans vote their pocketbook.
COLVIN: Steve Leuthold, it's always a valuable perspective. Thanks for being with us.
LEUTHOLD: Geoff, thank you.
Sports branding
GIBBS: Need a diversion from all these concerns over interest rates and such? Well, spring is like nirvana for couch potatoes, with four major sports in full swing. Lots of companies want to reach out and touch these fans by plastering their names on stadiums.
But historically there's been a curse on stadium sponsorship. In 2002 the stock index of stadium sponsors dropped 33 percent, but last year the index rose 27 percent. Is this a good use of shareholder money?
Terry Lefton, editor at large for Sports Business Journal, follows the trend and he joins us from New York.
Well, Terry, we've seen some big losers in the whole stadium naming business. Enron and PSINet are just a couple that come to mind. Has there been a curse on companies that get into this business?
TERRY LEFTON: Well, I think you'd have to look at the markets these companies operate in. PSINet, you know, obviously that was the dotcom boom. Enron had its own problems. Proplayer went bankrupt more than five years ago. That's why their, and their name is still on the stadium where the NFL Dolphins play in Miami. I think if you look at the individual markets, you'll find the reasons these deals didn't work. It had nothing to do with whether it was a sound marketing decision or not.
I do believe in greater forces in playing sports. I believe in the curse of the Bambino, I believe in the Billy goat curse that kept the Cubs out of the World Series. But I would suggest to you that equating stock performance with naming rights deals is like picking stocks with an astrological chart.
GIBBS: Well, Terry, when does it make sense to spend shareholder dollars to put a corporate ID on sports venues?
LEFTON: Well, think of it just as you would any other marketing expenditure. When does it make sense to have a new ad campaign, hire a new agency, do a new outdoor campaign, hire an endorser, or any kind of marketing expenditure?
I'd suggest some of the ones I like out there now, I think the United Center has kept that brand's presence very high in their home market. I think Continental Airlines, another one here just outside of New York and New Jersey does a good job. They're a Texas company that wants to look like a New York company. That's a good one.
One I'm really curious to see how it goes is Petco Park in San Diego which just opened, a non-traditional use of naming rights for a pet product retailer. I'm interested to see how that goes. Another one I like a lot is Toyota Center where the NBA Rockets play in Houston, the biggest truck market in America. They're operating at a bit of a disadvantage because it's a very American market. They want to seem more American. They put their name on a building. Suddenly the fact that they're Japanese doesn't seem so bad anymore, or at least that's what they hope.
GIBBS: Well, you mentioned Petco, and that $60 million that they put down to name the new San Diego stadium is a lot of kitty litter. Are deals such as that good business?
LEFTON: Well, I think you'd have to look at the individual markets and the individual market dynamics. It's probably most akin to the Staples deal up in L.A. where the Lakers play. You've got an expanding retailer. They want their name to be known. They're desperately seeking a source of differentiation. What's the difference between -- there's two big pet retailers, and they're desperately seeking a way to stand out from the other one. That's one way to get their name out there a little bit more.
GIBBS: Well, let's shift gears to NASCAR. Everything is branded in NASCAR, the cars, the pit crew, even the drivers. What's in it for the sponsors?
LEFTON: NASCAR is unique because it really gives sponsors a kind of brand loyalty that's almost unheard of in sports. People spend really big money on sports like the NFL for corporate sponsorships, and they have a really hard time showing a return that's direct. NASCAR fans are very loyal. The only fans I could think of that were more loyal directly to sponsors are perhaps smaller sports like gymnastics or yachting.
GIBBS: There's no more Winston Cup (NASCAR championship). RJR is out, and Nextel is in. What happened there, and is Nextel a good fit with NASCAR?
LEFTON: I think they hope they're a good fit. I am of the opinion personally they overpaid by 30 or 40 percent, and I've been trying to rationalize that deal since it went down. My suspicion, based on nothing but an educated guess, is that it makes them a more attractive acquisition target. They're the number five brand in the market. That maybe makes them look like the number two or three brand in the market. Otherwise I would tell you they paid way too much.
The problem with NASCAR, as you point out, is clutter. The good thing about NASCAR is fan loyalty and the athletes, quote-unquote, can't do enough for you. In that regard, they're unlike any other big time sport. And of course they're second only to NFL in ratings.
GIBBS: Terry, in all of sports, which company is the best marketer?
LEFTON: I think as a default, Nike is usually a pretty good choice. They're just one of those companies that's smart top to bottom. They know when to spend money, and they know when not to spend money, and their creative is always great.
GIBBS: In stadium naming, what are some of the other good deals out there?
LEFTON: Once again, you have to look at the individual markets. Let's go to Philadelphia, for example, Citizens Bank Ballpark. They're entering the market, they need their brand to get out there. They're across the street from two other naming rights deals in Wachovia and Lincoln, so in that market I'd say, yes, it makes sense.
Look at the categories that generally pay for sponsoring naming rights. You've got a lot of financial institutions, you've got a lot of airlines. These are two categories that are fairly low interest and consumers really don't care much. They don't get the warm and fuzzies. Therefore those people feel good about renting the equity from a stadium to make their brand feel, look, feel, seem a little better in the market.
GIBBS: Terry Lefton, fun topic, fun interview. Thanks very much for joining us.
LEFTON: Thank you.
Market wrap
GIBBS: Financial stocks will need more than stadium names to feel better if interest rates continue to creep higher.
The Dow was all over the map this week trying to decide whether it was playing offense or defense, finally ending the week just shy of a 10-point gain
But the Nasdaq lost more than 57 points to close under 2,000 for the first time since the end of March.
The S&P slipped nearly five.
COLVIN: That's our program. Next week we're going to visit the friendly skies: The industry everyone loves to hate is either on the verge of some revolutionary innovations, or some widespread bankruptcies -- or both. See you next week.
GIBBS: Goodbye.
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