Shares of defense contractors have taken off. And they have plenty of fuel to keep flying. By Andrew Tanzer, Senior Associate Editor February 6, 2007 Not even a Wall Street seer could predict the course or end game in Iraq. Congress and the Bush Administration are locked in a struggle over policy, money and troop levels for that country. So what's the outlook for defense stocks, those publicly traded embodiments of the U.S. military-industrial complex? Pretty rosy, it seems, for several reasons. The defense industry is cyclical, but not economically sensitive. If interest rates surge or economic growth trends down this year, it won't make much difference to these companies. What matters is the federal budget, and specifically the Defense Department's "budget authority" -- the military's authorization to spend. Typically, Defense writes the checks one to two years after receiving authorization. Defense's budget authority has been on the rise since the mid 1990s. Consequently, defense stocks have had a nice run. Charles Norton, portfolio manager of Vice Fund (symbol VICEX), thinks the defense rally still has wind beneath it. Norton, who holds 18 defense and aerospace stocks in his portfolio, foresees budget authority rising at least through 2009. Several factors, many of them long-cycle phenomena, are driving the budget. There's no shortage of global security threats -- not just Iraq and Afghanistan, which are largely funded through supplemental budgets, but Iran, North Korea, China. The global war on terrorism continues. Major, multi-year modernization programs are under way to attempt to improve integration and communications among the various branches of the U.S. armed forces. You can't cut one of these programs without impairing the others, says Norton. More money is going into better mobility for the Army, improved missile defenses, stronger space capabilities and information systems, not to mention homeland security needs. The list goes on and on. When you look at the main defense contractors, one thing that jumps out is their dramatically improving financial ratios. Most are generating abundant free cash flows (cash flow from operations minus the capital expenditures needed to maintain the business), which they are using to pay down debt, increase dividends and buy back stock. Here are three strong defense stocks. General Dynamics (GD). So large is GD's defense business now that it dwarfs the company's Gulfstream division, the biggest maker of business jets in the U.S. As the largest supplier of equipment to the Army, GD benefits from the supplemental budgets for Iraq and Afghanistan, says Norton. The contractor makes armored vehicles, such as the M1 tank, as well as submarines and destroyers for the Navy. Standard & Poor's says the contractor holds an order backlog of $44 billion. The stock closed at $79.07 on February 5, up 0.5%. It trades at 16 times estimated 2007 earnings. Lockheed Martin (LMT). The average age of the U.S. Air Force fleet is the oldest in its history. That spells opportunity for Lockheed, the world's largest military weaponry maker, with $40 billion in annual sales. Lockheed makes the aging F-16 fighter and C-130 transport and is developing the next generation of fighters, the F-22 and F-35. Space systems, including space-based communications, are also Lockheed strengths. Merrill Lynch expects the contracting giant to earn a towering 34% return on equity this year and generate $2.3 billion in free cash flow. The stock, which closed at $99.08, up 0.6% for the day, trades at 17 times 2007 earnings estimates. Raytheon (RTN). The Lexington, Mass., company has traditionally earned lower returns than some of the other defense contractors. But profit margins are improving rapidly, and that has allowed Raytheon to dramatically shrink its debt load, even while the company has been raising its dividend and aggressively repurchasing shares. Raytheon has a strong position in missile systems, a sturdy business that includes Tomahawk cruise, surface-to-air and air-to-air missile systems. Raytheon also supplies electronics systems, including sensors, to the Homeland Security apparatus. The stock closed at $54.97 on February 5, up 0.2%, and sells for 20 times estimated '07 earnings.