These defense stocks have a great deal going for them

Keep your sights on these names, but wait for a meaningful price drop before pulling the trigger.

Vikram Barhat 21 March, 2018 | 5:00PM
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Geopolitical tensions, growing counterterrorism efforts and increased spending by the U.S. Department of Defense are creating a tailwind for revenue growth for leading U.S. arms producers.

Last year was a record year for aerospace and defence deals. And if industry statistics so far this year are any indication, it could be another bumper year for arms dealers in the U.S., the world's biggest exporter of military products and services.

The U.S. supplies to more than 100 countries and accounts for more than a third of all arms exports, according to the Stockholm International Peace Research Institute (SIPRI). U.S. arms exports increased 25% over the five years to 2017, far surpassing its nearest rival Russia, which saw a 7.1% decline in its arms sale, according to a recent SIPRI report.

Further, the Trump administration's tax reform and large increases in defense spending are regarded as great news for the big weapons companies. The Republican-controlled Congress recently agreed to increase the 2018 defence budget to US$700 billion, an increase of 18% on the previous year, and the 2019 budget to US$716 billion, according to the Center for American Progress, a nonpartisan policy institute. Weapons manufacturers also stand to benefit from Donald Trump's aggressive push for defence exports, including last year's historic US$300 billion arms deal with Saudi Arabia.

Leading defence contractors and arms manufacturers are gearing up to meet growing demand as traditional U.S. allies and friendly nations upsize their budgets and upgrade their defence capabilities. While fast-growing stocks of these companies appear overvalued, they have undeniable growth prospects, according to Morningstar equity research. Long-term investors may want to keep their sights on these names and wait for a meaningful pullback to trigger a buy signal.

 

Lockheed Martin Corp.
Ticker: LMT
Current yield: 2.31%
Forward P/E: 21.6
Price: US$334.47
Fair value: US$310
Value: 7.9% premium
Data as of March 19, 2018

The world's largest defence contractor and fighter aircraft maker,  Lockheed Martin (LMT) generates 60% of its sales from the U.S. Department of Defense, while the rest is evenly split between other U.S. government agencies and international militaries. The firm racked up US$50 billion in sales in 2017 -- 40% from aeronautics, with rotary and mission systems (27%), space systems (18%) and missiles and fire control (15%) accounting for the rest.

Aeronautics, its largest business segment that manufactures fighter aircraft, is projected by Morningstar to contribute just over 40% of 2018 revenue. The F-35 aircraft in particular is expected to remain as a growth and profit driver, and is forecasted to account for 70% of the segment's revenue, and roughly 30% of total revenue by 2020, says a Morningstar equity report.

Decades of experience in dealing with government, as well as a leadership position in high-tech areas such as combat aircraft, missiles and helicopters, create customer stickiness and a sustainable competitive advantage for the firm. "In many instances, the U.S. Department of Defense has no choice but to use Lockheed because there are no other qualified bidders," says Morningstar equity analyst Chris Higgins, who recently increased the stock's fair value from US$284 to US$310.

The wide-moat behemoth, he says, is well-positioned going into a defence spending upcycle. Its recent acquisition of Sikorsky has further bulked up competitive advantage for the mission systems segment, Lockheed's next-largest business. "Leveraging its franchise position on the UH-60 Black Hawk helicopter for the U.S. military, Sikorsky built itself into a global leader for military rotorcraft," says Higgins, who forecasts a 4.2% growth rate for Lockheed from 2019 to 2021.

 

General Dynamics
Ticker: GD
Current yield: 1.51%
Forward P/E: 20.0
Price: US$223.44
Fair value: US$208
Value: 7.4% premium
Data as of March 19, 2018

U.S. defence contractor  General Dynamics (GD) makes submarines, armoured vehicles, IT systems and Gulfstream business jets. The firm generated nearly US$31 billion in sales with aerospace and IT systems each accounting for a quarter of sales, while combat systems (16%) and marine (23%) and mission systems (12%) making up the rest. General Dynamics derives nearly 60% of its revenue from the U.S. government.

The wide-moat firm's strong competitive position in shipbuilding and ground combat vehicles will generate both top- and bottom-line growth. "General Dynamics' ground vehicle business is poised for significant revenue increases in 2018 and beyond thanks to international sales," says a Morningstar report. "In addition, the U.S. defense budget is returning to growth, and the U.S. Army will begin spending more on vehicle modernization."

The acquisition of the government IT services firm CSRA, due to close this year, roughly doubles the size of its existing IT services business, making GD one of the largest IT contractors for the U.S. government, prompting Higgins to hike the stock's fair value from US$200 to US$208.

The arms maker's aerospace systems segment, which contributes nearly 30% of revenue and about 40% of profits, boasts industry-leading profitability, with operating margins averaging 18.6% from 2013 to 2017, far exceeding those of its peers.

Its marine systems business operates in a duopoly for large U.S. Navy warships and submarines and should drive growth and provide a cashflow tailwind over the near term, says Higgins, who projects the firm to grow at 8% annually from 2018 to 2022.

The company, which was recently awarded a US$1 billion contract from the Romanian Army and another worth US$696 million from the DoD, saw its annual profit jump 8.1% for 2017.

 

Raytheon Co.
Ticker: RTN
Current yield: 1.52%
Forward P/E: 21.6
Price: US$210.88
Fair value: US$192
Value: 9.8% premium
Data as of March 19, 2018

Leading industry player  Raytheon (RTN) sells integrated defence systems, intelligence and information, missile systems, space and airborne systems and cybersecurity, with US$25 billion in sales. The company generates about 70% of sales from the U.S. government.

Increased geopolitical tensions underpin its international sales, which account for over 30% of revenue. The large increases for 2018 and 2019 in U.S. defence spending under the Trump administration will provide further boost to its revenue which has been accelerating consistently since 2015, says a Morningstar report. "We expect the company to continue expanding in 2018 through 2022," the report notes.

The U.S. defensc contractor's Patriot system, its duopoly in missiles with Lockheed, and the mission-critical nature of its products create high switching costs. As well, the conservative buying behavior of the U.S. Department of Defense and international militaries allow Raytheon to consistently win contracts at home and away, says Higgins, who recently increased his fair value estimate for the stock from US$173 to US$192.

"Raytheon will be one of the fastest-growing U.S. defense firms we cover in 2018 at around 5% year-over-year growth," says Higgins, who forecasts 4% annual sales growth from 2018 to 2022, driven primarily by missile systems and integrated defence systems.

A robust demand in Asia-Pacific and increasing European defence spending are projected by Morningstar to help pick up the anticipated weakening in the sales to the Middle East, which constitutes 16% of sales.

Raytheon was recently awarded a US$2.3 billion U.S. defense contract, coming close on the heels of a US$641.8 million contract with the U.S. Army.

 

L3 Technologies Inc.
Ticker: LLL
Current yield: 1.49%
Forward P/E: 21.6
Price: US$206.21
Fair value: US$186
Value: 10.9% premium
Data as of March 19, 2018

 L3 Technologies (LLL) provides high-technology products, systems and subsystems in the defence electronics business. The U.S. Department of Defense and U.S. government agencies account for nearly 70% of sales, while foreign governments and commercial customers make up the rest. L3 operates four business segments: aerospace systems (26% of 2017 estimated revenue), electronic systems (33%), military communication systems (24%) and sensor systems (17%).

The firm, which generates roughly one third of its revenue subcontracting to major U.S. defence contractors, is pushing to grow its direct contracts with the DoD, says a Morningstar equity report.

The customized and complex products developed by L3 create a high degree of asset specificity and customer stickiness. "Recreating these assets would entail significant costs for the U.S. DoD customer," says Higgins, who recently upped the stock's fair value from US$175 to US$186, prompted by a lower tax rate and faster revenue growth projections for 2019 and 2020. "In addition, the mission-criticality of defense products reinforces switching costs and [technical reliance]."

Apart from pursuing growth in domestic and international markets, the company is taking strategic steps to boost operating margins. In the wake of the defence downturn, in which L3 suffered disproportionately due to a drawdown in Iraq and Afghanistan, the company spruced up its portfolio, shedding the lower-margin businesses, notes Higgins. More recently, L3 plans to divest the low-margin Vertex business (about $1 billion in revenue) from aerospace systems in 2018. The divestment, coupled with "improved margins and a narrow moat, will enable L3 to create value in 2017 and well into the future," adds Higgins.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
General Dynamics Corp273.75 USD0.52Rating
Lockheed Martin Corp431.12 USD0.52Rating

About Author

Vikram Barhat

Vikram Barhat  A Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry, Vikram also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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