With two wars winding down and the Pentagon facing the prospect of a
half-trillion dollars in budget cuts over the next decade, it’s no
wonder it’s white-knuckle time for the nation’s largest defense
contractors. And since these stock market titans are tucked into a lot
of portfolios, many investors could be little squeamish, too.
But the sky is not falling, and there are still a few bright spots among top defense stocks.
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The best place to start is with the Pentagon’s biggest contractors as ranked by Deloitte in a report released in April. The top five are
Boeing (NYSE:BA),
Lockheed Martin (NYSE:LMT),
General Dynamics (NYSE:GD),
Northrop Grumman (NYSE:NOC) and
Raytheon (NYSE:RTN).
For a comprehensive breakdown of the defense/aerospace industry, check out this expert analysis by InvestorPlace’s Hilary Kramer.
As she points out, the expected defense cuts haven’t hit these stocks
too hard — a theme that played out in the companies’ quarterly earnings
reports last week.
Here’s our breakdown of last week’s earnings,
the good and the bad of these defense-sector Goliaths and our verdict on
which ones should soar and which could sink.
The Top 5 Defense Stocks to Invest in 2012 #1 Boeing
With
$68.7 billion in revenue last year, BA is the defense/aerospace
industry’s top gun. All of the key metrics rose for Boeing last year:
Revenue was up nearly 7%, operating profit grew by 17.6% and margin
growth was 10%. Share price and market cap grew by 12.4% and 13.9%,
respectively.
Earnings: Boeing was the belle of
the ball in last week’s defense/aerospace earnings parade. First-quarter
profit rose a whopping 58%, to $922 million ($1.22 a share), on the
strength of its robust commercial-airplane business. Revenue also rose
by 3% in the quarter, to nearly $19.4 billion.
Good:
Boeing is selling a lot of commercial airplanes, including the $6
billion deal announced Monday to sell 20 777 jets to China Eastern
Airlines. Boeing creatively agreed to buy five Airbus A340s from China Eastern to seal the deal.
The company delivered 137 commercial aircraft in the first quarter,
versus 104 in the same quarter last year. Another big bright spot: BA
has racked up 300 orders for the new, re-engined 737 MAX, which will
compete head-to-head with Airbus’ fuel-efficient A320neo.
Bad:
The biggest potential problem for Boeing in the short term remains the
impact of high fuel prices on airlines and the economic challenges in
Europe. Although the much-delayed 787 Dreamliner is getting back on
track, costs remain high.
In the defense sector, BA could face pretax losses of $317 million in a rocket-reimbursement dispute, according to
Space News.
Stock:
With a market cap of $58 billion, BA is trading at around $77.50, about
37% above its 52-week low last August. The stock has a
price-to-earnings-growth (PEG) ratio of 1.5, suggesting it may be
oversold. Its forward P-E of over 13 is a little higher than many
companies in this sector, and its current dividend yield of 2.3% is a
little lower.
Verdict: BA’s success was due to
strong deliveries in its commercial-airplanes unit, not to its federal
government contracting business, making it the most insulated of the Big
5 to massive defense cuts. Even though it’s a little more expensive
than I’d prefer right now, I like BA on the strength of its global
commercial-aircraft sales growth — if it can produce the 737 MAX without
repeating the delays and glitches that bedeviled the 787 and 747-8. The
company also must keep production and deliveries on track with those
models. While I rank BA a buy now, I wouldn’t pursue it too ardently —
my comfort level would end around $82.
The Top 5 Defense Stocks to Invest in 2012 #2 Lockheed Martin
As the largest defense-industry pure play,
Lockheed Martin‘s (NYSE:LMT)
$46.5 billion in revenue last year places it solidly in second place,
but its metrics are less attractive than Boeing’s. Although the share
price grew 15% and market cap rose by 4%, revenue was flat. Operating
margin fell by 1.7% in 2011.
Earnings: LMT beat
the Street last week with $688 million in profit ($2.03 a share) on
$11.3 billion in revenue. Last year’s first-quarter earnings were $530
million ($1.50), and analysts had expected earnings of $1.70 a share on
$10.6 billion in revenue.
Good: The company
already has reduced overhead costs by $1.2 billion. It removed 1.5
million square feet of facilities space from 2010 to 2011 and plans to
remove nearly 3 million more square feet of space by 2014. Margins for
LMT’s electronic systems were 15% in the first quarter, particularly in
its missiles and fire-control systems.
Bad: LMT
is the prime contractor on the delay- and cost-overrun-plagued F-35
Joint Strike Fighter. In March the Pentagon announced that it will delay
delivery of 179 of the planes for five years. Japan, which has placed
orders for 42 of the fighter jets, said earlier this year it will cancel
the deal if there are any delivery delays or price increases.
Stock:
With a market cap of $29.5 billion, LMT is trading at around $91, 37%
above its 52-week low last August. It has a PEG ratio of nearly 1.7,
indicating that it may be overvalued. It has a forward P-E of about 11
and an attractive current dividend yield of 4.4%.
Verdict:
In good times it’s a boon to investors that LMT has its fingers in a
lot of pots. But with the defense sector’s many challenges, it seems
more like those fingers are just trying to plug holes in the dike. LMT
is front and center in a lot of high-profile, potentially endangered
defense contracts, including the F-35 and the Littoral Combat Ship.
The
company has non-defense federal customers, too: the FAA, NASA, National
Security Agency and the Energy Department, but their budgets will be
cut, too. Still, Lockheed is doing a very good job of cutting costs so
far. If you’re in LMT now, I’d hold, but keep a very close eye on two
things: the sequestration debate and whether Japan cancels its F-35s.
Either of those events could mean danger for LMT.
The Top 5 Defense Stocks to Invest in 2012 #3 General Dynamics
General Dynamics (NYSE:GD)
had $32.7 billion in revenue last year, but year-over-year growth was
flat, while profit and margins declined by 3%. GD’s share price slipped
more than 6%, and its market cap fell by nearly 12%. The company’s
aerospace, combat and marine-systems businesses, in particular, were
challenged in 2011.
Earnings: GD’s first-quarter
earnings missed analysts’ estimates on the top and bottom lines. Net
income in the first quarter fell to $564 million ($1.57 a share) on
revenue of nearly $5.6 billion. Wall Street expected revenue of $7.9
billion and an EPS of $1.69. For the same quarter last year, GD reported
net income of $618 million ($1.64 a share).
Good:
General Dynamics’ best prospects are in its Gulfstream business jet
unit, which grew first quarter sales by 20% and profit by 18%. The
company has an opportunity in the Marine Systems unit with the Navy’s
potential order of 9 DDG-51 Destroyers and 9 Virginia-class nuclear
attack submarines.
Bad: Income fell 27% in the
combat-systems unit, which produces the Abrams battle tank, and 21% in
its information systems and technology unit. Europe has been fraught
with challenges for GD, causing the company to take a $67 million
non-cash charge. The Defense Department’s fiscal 2013 budget will slash
$800 million from GD’s Advanced Global Hawk drones program. GD also is a
subcontractor on LMT’s vulnerable F-35.
Stock:
With a market cap of $24.7 billion, GD is trading at around $68.50,
about 27% above its 52-week low last September. It has a PEG ratio of
1.5, an attractively low forward P-E of 9 and a current dividend yield
of 3%.
Verdict: Once again, commercial-airplane
sales could be the silver lining in the cloud of looming federal budget
cuts. While it won’t help GD soar nearly as high as Boeing, the
business-jet niche, in particular, should help offset some of the
forecast declines in other businesses.
I’m not confident that GD
will get all nine of the Virginia-class submarines it’s hoping for. At
$2 billion a pop, it’s too juicy a budget target right now, which could
mean a cut in procurement levels to five — or even four — and delayed
delivery. This is another of my “hold for now, but watch closely”
stocks. With GD, I’d keep an eye on Europe and see if second-quarter
earnings show further deterioration in margins.
The Top 5 Defense Stocks to Invest in 2012 #4 Northrop Grumman
Northrop Grumman (NYSE:NOC)
experienced a 6% drop in revenue, to $26.4 billion, in 2011, but
aggressive cost management and a high percentage of flexibly priced
long-term contracts boosted last year’s profit by nearly 16%, and
margins grew by a robust 23.5%. Share price and market cap fared badly,
however, falling by nearly 10% and 19%, respectively. Shipbuilding and
aerospace operations have been among the most pressured.
Earnings:
NOC’s first-quarter earnings nosed up about 2%, to $506 million ($1.96 a
share), as the company’s cost-cutting initiatives managed to offset
revenues that were $500 million lower than last year.
Good:
Cost-cutting is a huge priority at NOC, so it hopes to boost margins
through layoffs and other measures. The company also could benefit from a
growing commercial market for unmanned drone aircraft, particularly for
police departments.
Bad: Northrop was
particularly hard hit by budget cuts on LMT’s F-35 Joint Strike Fighter
and Boeing’s F/A-18 Hornet. The company is a major subcontractor on both
programs. Even more challenging: Sales have slipped in NOC’s aerospace,
technical and information-services units.
Stock:
With a market cap of nearly $16 billion, the stock is trading at around
$63.50, nearly 30% above its 52-week low last August. It has a PEG
ratio of about 2.5, making it appear significantly overvalued compared
with its peers. NOC also has a forward P-E of 9 and a current dividend
yield of 3.1%.
Verdict: NOC has some outstanding
and sophisticated approaches to cybersecurity at a time when Congress is
moving legislation ahead that could foster a war on cyber threats.
That’s why I’m concerned that sales are down in Northrop Grumman’s
information-services unit. The obstacles facing other divisions are even
more challenging. Cost-cutting and layoffs will help, but the company
could be forced to cut intellectual muscle that it will need once the
sector rebounds. I love this company, but I hate the stock right now — I
rank it a sell, at least in the short term.
The Top 5 Defense Stocks to Invest in 2012 #5 Raytheon
Raytheon‘s (NYSE:RTN)
revenue was flat last year at $24.8 billion, but it still managed to
grow profit by nearly 10% and margins by 11%. The missile and
integrated-defense-systems company, which also is on a quest to purge
waste from its operations, saw a 4% increase in its share price last
year, though its market cap stayed about the same.
Earnings:
RTN’s first-quarter earnings soared on missile sales and the deployment
of advanced-information technology to boost productivity. Profit grew
by 17%, to $448 million ($1.33 a share), on sales of $5.9 billion. The
company raised its full-year guidance to $5.00 to $5.15 from its earlier
estimate of $4.90 to $5.05.
Good: Raytheon’s
strong position in international markets — 25% of total first-quarter
sales were to non-U.S. customers, particularly in the Middle East and
Asia. Large radars and air- and missile-defense systems were strong.
Profit in the company’s integrated-defense-systems unit, which includes
the Patriot and Aegis weapon systems, rose more than 11% in the quarter.
Cyber security spending also is giving a boost to RTN’s intelligence
and information systems.
Bad: Network-centric
operations sales and traditional sales of Army products have slipped.
And as with all defense contractors, the possibility of “sequestration” —
across-the-board automatic defense cuts set to take effect in January
2013 — will have a huge impact on U.S. federal sales.
Stock:
With a market cap of $18.2 billion, RTN is trading at around $54.50; it
set a new 52-week high last week. It has the best PEG ratio in this
group at 1.2, indicating that the stock is fairly valued. RTN has a
forward P-E of about 10 and a current dividend yield of 3.7%.
Verdict: The
company has repurchased nearly 8 million shares and is raising its
dividend by 16%, to $2. RTN is doing a lot of the right things,
including cultivating a strong international presence and solid
positioning in the cyber-security and missile-systems area.
Fundamentals
are good compared with most of its peers. I like Raytheon’s margin
growth as well as the dividend yield. RTN could be a buy now, though I
wouldn’t jump in much higher than $58. Since it just hit a new 52-week
high, I might wait to try to buy it on a dip.
