Arm your portfolio with these three defence picks

As the U.S. and its traditional allies around the world beef up military capabilities, these defence contractors and arms manufacturers are scaling up production to meet soaring demand

Vikram Barhat 13 February, 2019 | 1:00PM

U.S. President Donald Trump recently did a U-turn on the decision to cut defence spending for 2019 and agreed to instead boost military budget from US$716 billion to as much as US$750 billion, according to Reuters. The 4.7% higher than expected spending could provide a significant boost for leading U.S. aerospace and defence companies, which hold the lion’s share of the global arms market.

Going by these numbers, and the expectation that a conspiracy of factors will continue to drive global defense sector growth in 2019 and beyond, it’s reasonable to infer that U.S. arms suppliers are well positioned to profit from the increased spending on military products and services. American defence firms are the unchallenged leaders of the US$398 billion global arms industry, according to a recent report by the Stockholm International Peace Research Institute (SIPRI). Of the top 100 military services companies, or SIPRI Top 100, 42 companies were based in the United States.

As the U.S. and its traditional allies around the world beef up their military capabilities, world’s largest defence contractors and arms manufacturers are scaling up production to meet soaring demand. With a strong tailwind for long-term growth, undeniable competitive edge, and undervalued stock prices, these companies could be attractive targets for those investing for the long haul and looking to hedge against geopolitical adventurism, according to Morningstar equity research.

Lockheed Martin Corp
Ticker: LMT
Current yield: 2.93%
Forward P/E: 15.38
Price: US$297.7
Fair value: US$329
Value: 9% Discount
Data as of Feb. 08, 2019

The world’s largest defence contractor and fighter aircraft maker, Lockheed Martin (LMT) derives 60% of sales from the U.S. Department of Defense, 20% from other U.S. government agencies, and another 20% from international militaries.

Lockheed’s sustainable competitive advantage, or wide moat, is particularly strong in its aeronautics segment which houses the crown jewel of its portfolio: the F-35, the most lethal fighter aircraft ever. “The sheer complexity of designing three different aircraft variants for the Air Force, Navy, and Marine Corps with stealth characteristics, high-end avionics, and an integrated digital logistics system cannot be underestimated,” says a Morningstar equity report.

The technical expertise Lockheed builds through development of the F-35, likely the last manned fighter jet, creates intangible assets, switching costs, and efficient scale. “By 2020, the F-35 will account for about 70% of the aeronautics segment’s revenue and roughly 30% of Lockheed’s total revenue,” says Morningstar equity analyst, Chris Higgins, who recently increased the stock’s fair value from US$327 to US$329.

“In many instances, the U.S. Department of Defense has no choice but to use Lockheed because there are no other qualified bidders,” notes Higgins, adding that U.S. defence spending has bottomed out and that “Lockheed is well-positioned going into a defence spending upcycle.”

Raytheon Co
Ticker: RTN
Current yield: 1.97%
Forward P/E: 15.8
Price: US$174.13
Fair value: US$212
Value: 17% Discount
Data as of Feb. 08, 2019

Raytheon (RTN) is a U.S. defence contractor with over US$25 billion in sales, of which 70% derived from the U.S. government. It operates through five segments: integrated defence systems, intelligence and information, missile systems, space and airborne systems, and cybersecurity.

Raytheon’s strong competitive advantage stems from its three largest operating segments -- integrated defence systems, missile systems, and space and airborne systems -- which create strong intangible assets due to its engineering and technical know-how. “The firm’s Patriot missile defence system remains the global market leader thanks to its high performance in an area where failure is costly,” says a Morningstar report.

Increased geopolitical turmoil creates a tailwind for its international sales, which account for more than 30% of revenue. However, the U.S. Department of Defense remains by far its largest single customer, says Higgins, noting that increased U.S. defence spending under the Trump administration will provide additional revenue boost.

“We expect the company to continue growing from 2018 through 2022,” says Higgins, who raised the stock’s fair value from US$209 to US$212. The company’s wide moat confers durable competitive advantages, which is expected to “translate into returns above the cost of capital for years to come,” notes Higgins, who projects 5% annual average revenue growth from 2018 through 2022.

General Dynamics
Ticker: GD
Current yield: 2.14%
Forward P/E: 14.86
Price: US$171.56
Fair value: US$209
Value: 18% Discount
Data as of Feb. 08, 2019

General Dynamics (GD) makes submarines, armoured vehicles, IT systems, and business jets. This U.S. defence contractor rang up US$36.2 billion in 2018 sales and is one of the largest IT contractors for the U.S. government.

The firm’s sustainable competitive advantage is built on intangible assets, efficient scale, and higher customer switching costs, all of which are particularly strong in its aerospace systems segment which conducts most of its business under the Gulfstream brand.

The marine systems segment, which accounts for around a quarter of revenue, “operates in a duopoly for large U.S. Navy ships and submarines and the Columbia [submarine] program should drive growth and provide near-term cash flows thanks to advances,” says Higgins, who recently lowered the stock’s fair value from US$216 to US$209, prompted by management’s reduced revenue and operating profit guidance for 2019.

He adds, however, that General Dynamics’ ground combat vehicle business is poised for significant growth thanks to international work.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
General Dynamics Corp187.55 USD-0.49
Lockheed Martin Corp385.88 USD0.75
Raytheon Co186.98 USD1.03

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.