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Three stocks that can benefit from increased defence spending

As geopolitical risks and terrorism threats increase, these companies are well positioned to seize the spoils.

Vikram Barhat 7 June, 2017 | 5:00PM
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The historic US$110 billion arms deal with Saudi Arabia inked by President Donald Trump on his recent visit to the Middle East kicked up a political storm back home. The deal has raised some uncomfortable questions about humanitarian damage, but it has also unlocked tremendous growth opportunities for the U.S. defence and aerospace sector.

U.S.-based defence and aerospace companies that virtually control the global market for arms trade are the biggest beneficiaries of the rising defence spending within the United States and its global allies, owing to elevated geopolitical risks and the scourge of terrorism.

The 2017 Global Aerospace and Defense Sector Outlook report from Deloitte Global shows that worldwide spending is set to experience stronger growth. Deloitte forecasts revenue for the global aerospace and defence sector (more than US$700 billion) to grow by about 2% in 2017, whereas defence sub-sector revenues are projected to grow at a much faster 3.2% for the same period, driven by the increased allocation to U.S. military funds. The U.S. budget accounts for nearly 50% of the addressable market, as per Fitch Ratings.

The world's largest defence contractors and arms manufacturers are well positioned to benefit as countries around the world juice up their defence capabilities. With little competition and a long runway of growth ahead, these companies could be a safe bet for the long haul, according to Morningstar equity research.

Lockheed Martin Corp.
Ticker LMT
Current yield 2.52%
Forward P/E 20.2
Price US$280.84
Fair value US$269
Data as of June 5, 2017

A fighter aircraft maker and the world's largest defence contractor,  Lockheed Martin (LMT) generated a staggering US$47.2 billion in sales in 2016. Aeronautics is its largest business segment, generating 38% of total sales, while the rest comes from mission systems and training (28.5%), space systems (20%) and missiles and fire control (14%).

The company derives 60% of its revenue from the U.S. Department of Defense, with the rest split equally between other U.S. government agencies and international militaries.

"Lockheed is the big winner with deals featuring missile defense (THAAD), surface ships (LCS), helicopters (S-70) and tactical aircraft," says a Morningstar report, referring to the recent arms deal with Saudi Arabia.

Aeronautics, a business that sells fighter aircraft such as the F-22, F-35 and F-16, is projected by Morningstar to bring in 41% of its revenue in 2017. Thanks to a multi-billion-dollar deal with the Pentagon, the F-35 is viewed as a major growth and profit driver for the company. "By 2020, the F-35 will account for 70% of the aeronautics segment's revenue and roughly 30% of Lockheed's total revenue," says Morningstar equity analyst Chris Higgins, who recently increased his fair value estimate on Lockheed from US$244 to US$269.

Adding to the stock's attractiveness is Lockheed's portfolio of franchise programs that "continues to focus on returning excess cash to shareholders while simultaneously hunting for future growth," says Higgins.

Lockheed, he adds, is well-positioned going into a period of increased defence spending thanks to its flagship F-35 program. Buoyed by this outlook, Morningstar forecasts a 6.4% year-over-year revenue growth for 2017, and an average growth rate of 3.5% from 2017 to 2021.

General Dynamic Corp.
Ticker GD
Current yield 1.53%
Forward P/E 19.5
Price US$202.08
Fair value US$184
Data as of June 5, 2017

A leading U.S. defence contractor,  General Dynamics (GD) makes submarines, armoured vehicles, defence-oriented information technology systems and Gulfstream business jets. The firm, which in 2016 generated US$31.4 billion in sales, operates in aerospace (27% of 2016 sales) and information systems and technology (30%), with combat (18%) and marine (25%) making up the rest. General Dynamics derives nearly 60% of its revenue from the U.S. government.

Like its U.S. peers, the company stands to benefit from the U.S. defence budget expansion. "We believe the firm is one of the best positioned contracts going into the Trump administration," says a Morningstar report. "International sales to Saudi Arabia, the UK, Canada, Egypt and Australia will continue to offset U.S. weakness, and we think this business is poised for significant growth."

General Dynamics's robust competitive position in shipbuilding and combat vehicles, along with its industry-leading aerospace business, will continue to support healthy top- and bottom-line growth, says Higgins, who recently increased his fair value estimate for the stock from US$174 to US$184.

"The aerospace systems segment boasts industry-leading profitability, with operating margins of 19% from 2013 to 2016 compared with an average operating margin of around 7% over the same period [for peers]," he adds.

The defense behemoth, which was recently awarded a US$442 million contract in the United Kingdom and another US$41million from the U.S. Navy, reported a 16.7% jump in quarterly profit.

An order backlog of approximately US$53.3 billion with the U.S. government and the recent US$15 billion deal with Saudi Arabia support a bright outlook for the firm's future growth, which is projected to be about 3.3% from 2017 to 2021.

Raytheon Co.
Ticker RTN
Current yield 1.83%
Forward P/E 19.2
Price US$161.66
Fair value US$168
Data as of June 5, 2017

Another defence giant,  Raytheon (RTN) sells US$24 billion worth of integrated defence systems, intelligence and information, missile systems, space and airborne systems every year. It also has a cybersecurity business branded Forcepoint. The U.S. government makes up about 70% of the company's total sales.

Heightened geopolitical uncertainty has boosted its international sales, which make up more than 30% of revenue. The firm's key international markets include the United Arab Emirates, Saudi Arabia, Taiwan, Turkey, Oman and Kuwait.

"Although Raytheon derives a large amount of its sales through international customers, the U.S. Department of Defense still remains its largest single customer," says a Morningstar report, noting that the defence budget under President Trump's leadership could surpass US$650 billion by fiscal 2019.

Raytheon's organic growth is set to continue to accelerate in 2017 on the back of international orders and U.S. defence budget expansion. "We expect the company to post the second-highest 2017 growth rate among major U.S. defence contractors," says Higgins, who recently upped the stock's fair value estimate from US$157 to US$168.

Raytheon's Patriot missile system and its duopoly in missiles with Lockheed Martin allow it to win international business and protect its U.S. business. "Raytheon will be one of the fastest-growing defence firms we cover, outdone only by Lockheed Martin (thanks to the F-35 program) in 2017," says Higgins, who projects average annual sales growth of nearly 4% over the next several years, and operating cash flow above US$3 billion each year through 2021, with international sales to the Middle East and Asia-Pacific boosting revenue.

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About Author

Vikram Barhat

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

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