Yes on Defense, No on Microsoft

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The New York Sun

A couple of readers have written in with questions.

One asks: “Dan, I want to add a good defense stock to my portfolio. Any ideas?”

Another says: “Microsoft ($22.79) is trading like it’s going out of business. I own 350 shares at higher prices. Should I take my loss and say goodbye?”

As I’ve mentioned before, I don’t recommend stocks personally, but veteran investment adviser Richard Moroney, editor of the well-regarded monthly Dow Theory Forecasts newsletter in Hammond, Ind., has some thoughts on both. First to defense: If you like latching onto winners, Mr. Moroney figures L-3 Communications ($77.81) is the way to go. As for Microsoft, say adios for the next two years, he says.

L-3, which was spun off from Lockheed Martin in 1997, primarily serves the military and government agencies and provides communications systems and defense electronics for aircraft, satellites, and sea vessels. Last year’s sales were $37.2 billion.

Here’s what makes L-3 a winner:

* Over the last five years, sparked by acquisitions and internal growth – especially in its defense businesses – sales have risen at a 38% annualized rate, while earnings have grown at a 29% clip.

* The company has exceeded Wall Street’s consensus earnings estimates in each of its past four quarters.

* L-3’s stock, pegged as a 15% to 20% gainer over the next 12 months, has risen in each of the last three years and is up again this year by about 60%.

Given the turmoil in the world, Mr. Moroney figures demand for intelligence, surveillance, reconnaissance, and secure communications systems should remain strong. Wall Street seems to agree, with its consensus earnings estimates calling for 19% growth this year, followed by another 13% rise in 2007.

Further, at 17 times estimated year ahead earnings of $4.98 a share, versus $4.20 in 2005, Mr. Moroney reckons L-3 trades at a warranted premium to its five-year forward price/earnings multiple of 16.

A big plus for L-3 is thought to be the expanding defense budget, which is set to rise 7% in fiscal 2006 (ending September). Yet another 7% increase in defense spending, mainly to support ongoing combat operations, has been submitted to Congress for fiscal 2007. Importantly, while the government generates about 80% of L-3’s revenues, the company does not depend on any one military program for a large percentage of its sales, Mr. Moroney notes. Its revenue streams are diversified across a broad range of products for different military branches and civilian intelligence organizations.

Further, management believes it should be able to go on performing well even if defense budget growth slows to 2% to 3% starting in 2008. Some of the reasons:

* While the military may cut down on large weapons programs, it should still modify and upgrade existing assets, thus playing to a key market niche for L-3.

* Potential increases in maintenance spending and outsourcing of training and intelligence services should also benefit L-3.

* The company is also positioned to capitalize on homeland security opportunities in America and abroad.

* Growing concern about cargo, port, border, and mass transportation security is viewed as additional opportunity for new business.

* Recent natural disasters have increased demand for L-3’s crisis management and first-responder systems.

A word of caution: L-3 is by no means undiscovered. The stock has nearly doubled in recent years and is trading not too far off its all-time high of $88.50.

As for Microsoft, whose shares are down for the last one-, three-, and five-year periods and recently hit a 52-week low, Mr. Moroney, a bull since 2002, has just thrown in the towel, pulling his near-term buy recommendation. He did so following the software biggie’s failure to meet the March quarter’s earnings estimates despite a 13% revenue gain and a fiscal 2007 estimate from management that was well below consensus expectations.

Wall Street had been projecting that Microsoft would earn $1.53 a share in fiscal 2007 (ending June). Management, though, said it expects earnings between $1.36 and $1.41. It attributed the earnings miss and a lower profit target to higher production costs and a decision to increase spending to fuel long-term growth.

Although the stock trades at less than 18 times the bottom of the company’s fiscal 2007 guidance and near the low point of its five-year valuation range, Mr. Moroney, given the shortfalls, is saying goodbye to Microsoft for at least the next two years and says he believes the stock is likely to remain choppy over the next 12 months.

The New York Sun

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