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A different kind of 'tactical' investing

These defence companies are at the forefront of security and combat robotics.

Vikram Barhat 3 August, 2016 | 5:00PM
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The historic use of a weaponized robot by the Dallas Police Department in a recent standoff with a suspect sniper stirred much kerfuffle within privacy and civil liberties groups. While the incident has raised some uncomfortable questions, it has also brought home the reality of the ever-growing presence of robotics in everyday life.

In addition to replacing repetitive manufacturing jobs, robots and their secondary equipment are now increasingly being used to neutralize danger in military and civilian settings. Governments have been investing like never before in sophisticated mobile and security robots for various applications in domestic law enforcement and in conflict zones around the world.

The sales value of professional service robots -- of which defence applications accounted for 45% - is projected to rise from US$3.77 billion in 2014 to US$19.6 billion by 2018, according to the International Federation of Robotics. The global security robots market is forecasted by research firm Markets and Markets to grow from US$1.34 billion in 2015 to US$2.36 billion by 2022, a growth of 8.56% each year. Another study, by Research and Markets, proclaims the market for global military robots -- unmanned ground vehicles (UGV) in military parlance -- is set to grow at the compound annual rate of 9.36% between 2016 and 2022.

The market for mobile and military robots is tightly held by a handful of firms. These companies, with diversified business interests, are at the forefront of security and combat robotics and provide cutting-edge solutions for tactical challenges. With little competition and a wide open runway of growth ahead, these companies could be a strategic addition to some investment portfolios, according to Morningstar equity research.

Lockheed Martin Corp.
Ticker LMT
Current yield 2.53%
Forward P/E 18.6
Price US$254.76
Fair value US$206
Data as of July 26, 2016

The largest defence contractor in the world,  Lockheed Martin (LMT) is a global security company whose businesses include aeronautics (37% of closed 2016 sales), mission systems and training (29%), space systems (19%) and missiles and fire control (15%).

In a move to reshape its business for future needs, the company last year acquired helicopter maker Sikorsky Aircraft for US$9 billion, sold its IT unit, and combined its Energy businesses under missiles and fire control. For the same period, it clocked record levels in backlog, orders and international sales, according to CEO Marillyn A. Hewson. At Lockheed Martin's 2016 Media Day, Hewson said the company is "positioned for growth with a future-focused portfolio," pointing to the US$839 million funding last year of independent research and development.

Lockheed Martin, which recently won contracts worth US$255.8 million from the U.S. Special Operations Command and the U.S. Army, is forecasted by Morningstar to rake in US$45.6 billion in sales in 2016. The U.S. Defense Department announced earlier this year it plans to spend US$10.1 billion in 2017 on F-35 fighter jets manufactured by Lockheed Martin.

Morningstar equity analyst Chris Higgins views the F-35 as "a growth and profit driver for Lockheed" and forecasts it should "account for more than a fourth of sales by 2020," thereby boosting Lockheed's aeronautics division from US$15.6 billion in 2015 to US$21 billion by 2020.

He put the stock's fair value at US$206, and projected annual revenue growth north of 3% from 2016 through 2020.

Northrop Grumman Corp.
Ticker NOC
Current yield 1.51%
Forward P/E 18.1
Price US$218.35
Fair value US$180
Data as of July 26, 2016

Global security firm  Northrop Grumman (NOC) operates its business in the areas of aerospace (40% of 2015 sales), mission systems (41%) and technology services (19%). Its product range includes aircraft and space systems, radars, sensors, surveillance and targeting systems, cybersecurity and information technology.

It is reported that the robot used in the Dallas standoff was supplied by Northrop Grumman, whose subsidiary, Remotec, is one of the biggest suppliers of police robots.

The security firm is well positioned to directly benefit from the U.S. government's decision to raise spending, approved as part of the Bipartisan Budget Act of 2015 agreement, as well as from the growth in the defence budget over the next several years, said Higgins, who recently upped the stock's fair value from US$176 to US$180. The firm's aggressive share repurchase activity and high dividend yield will continue to bolster its share price, he added.

Northrop recently won the contract to build the U.S. Air Force's next-generation Long Range Strike Bomber. "The win locks up an important market segment and should drive revenue and profit growth for years to come," said Higgins, noting the "program win could add around US$1 billion in cumulative operating income to Northrop's bottom line over the next six years."

Northrop's US$36 billion backlog, including the US$21 billion that is fully funded, should also translate into top-line growth for the company, said a Morningstar report that projected operating margins to be around 12%.

General Dynamic Corp.
Ticker GD
Current yield 2.01%
Forward P/E 14.6
Price US$144.51
Fair value US$145
Data as of July 26, 2016

One of the leading U.S. defence contractors,  General Dynamics (GD) manufactures submarines, armoured vehicles, defence-oriented information technology systems and Gulfstream business jets. The business racked up US$31.5 billion in sales in 2015, led by aerospace (28% of sales) and information systems and technology (28%), with combat (18%) and marine (25%) making up the rest. The firm generates just under 60% of its revenue from the U.S. government.

A leader in tactical robotics and advanced automation systems for the military, General Dynamics derives its wide moat -- or sustainable competitive advantage -- from intangible assets, efficient scale and switching costs. The firm's aerospace segment is a key source of its competitive edge and generated almost 30% of revenue in 2015. "[The segment] boasts industry-leading profitability, with average operating margins of 19% from 2014 to 2015 compared with an average operating margin of 7.2% over the same period" for peers, said Higgins, who put the stock's worth at US$145.

The U.S. Army recently awarded General Dynamics a contract that has a potential value of US$193 million, while another US$116 million contract was awarded by the U.S. Navy, the firm announced recently.

The contractor staged a strong rebound as its funded backlog rose from US$38.4 billion in 2013 to US$51.7 billion in 2015, underscoring the potential for growth acceleration. "This backlog combined with a wide moat and a solid management team focused on efficiency and returning cash to shareholders makes for a compelling long-term investment case," said a Morningstar report.

Management has returned US$8.3 billion to shareholders in the past two years. The company's dividend payout has grown to US$2.67 per share from US$0.88 in 2006, which prompted Higgins to assign management an Exemplary stewardship rating.

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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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