Lockheed Martin Downgrade Puts Entire Defense Industry at Risk

Defense stocks have been up enormously during the past year; is it time for the sun to finally set? 

Up 23% over the past 52 weeks, Lockheed Martin (LMT 1.23%) stock is one of the strongest performers in the entire defense industry. It's outperformed Boeing (BA 1.51%), General Dynamics (GD 1.35%), and even the S&P 500 itself. In fact, about the only defense companies Lockheed is not currently beating are Raytheon (RTN) and Northrop Grumman (NOC 2.84%), up 27% and 33%, respectively.

Could Lockheed Martin's strong stock performance over the past year actually be a warning sign that things are about to get worse for Lockheed Martin shareholders? Could it be a clue that the entire defense industry is in for hard times?

I think so. And I'm not alone.

Cue canary in the coal mine, singing

Earlier this week, defense stock analyst Charlotte Keyworth of German investment bank Berenberg announced that she's downgrading Lockheed Martin stock to "hold" on worries that the valuation is starting to look extreme. Berenberg still likes the company's F-35 fighter-jet franchise, its "strong cash visibility," and its chances of winning contracts for "higher-margin missile programmes in 2016."

Fundamentally, Lockheed Martin is a well-run company sporting respectable growth rates and profit margins, and paying a solid 2.8% dividend yield. Problem is, Lockheed Martin stock costs too much.

Scaling the peak

That's Berenberg's primary objection to the stock, you see. At a share price more than 21 times what it earns in a year, Lockheed Martin stock sells for "all-time peak multiples." (And when an analyst says "peak," you know what she's really worrying about is how close the trough is.)

On a scale of one to 10, then, Berenberg seems to think Lockheed Martin is valued at 11. But the banker's worries go beyond just Lockheed, per se. On the one hand, Berenberg doesn't see "sufficient catalysts in 2016 to stretch [Lockheed's] valuation multiples to further unprecedented levels." But more broadly, it notes that the entire defense sector is currently trading at valuations "not reached ... in 20 years."

So let's take a look at those valuations:

*This includes years such as 2002, when weak profits drove Lockheed's and Raytheon's P/E ratios into the triple digits, and 1998, when the same thing happened to Boeing. Current P/E and growth rates courtesy of finviz.com. Historical data courtesy of S&P Global Market Intelligence.

Caveats and provisos

Now, one can quibble with Berenberg's assessment. At Lockheed Martin, for example, I count eight separate instances where S&P Global's data show Lockheed's P/E having exceeded today's P/E ratio of 21.1, at least briefly. I count five instances when the stock averaged a higher P/E than it costs today, and held onto that higher valuation over the course of an entire year. Calling today's 21.1 P/E ratio an "all-time peak multiple," therefore, seems to be stretching the truth a bit.

Lockheed Martin's stock is trading significantly above average today, as is Northrop Grumman's stock, and General Dynamic's stock looks anything but cheap. All five of the companies profiled above sell for PEG ratios significantly above the value investor's holy grail of "1.0." And every one of them, save Boeing, sells for a price-to-sales ratio far in excess of my personal "fair-value" target for defense stocks -- the one times sales ratio.

Caveats and provisos aside, therefore, I think Berenberg's warning is largely on point: Taken as a group, defense stocks today are selling for historically high multiples to earnings. In fact, their P/E ratios have climbed so high that it's hard to see how they can be justified by the stocks' projected growth rates alone.

In short, if you were getting nervous about defense stock valuations anyway, Berenberg's warning just might give you the excuse you've been looking for to bite the bullet, and sell.